Description

This is an old boring company which certainly isn't going to resolve world's problems. Actually, it will  reinforce them given the socially destructive nature of the industry. But there is a good chance you won't lose money on this one which makes it worth considering. The downside is limited but what about  the upside? Well, you won't make a fortune on it, but it could earn you  a nice 30% return over the next 12 months. This is a rather safe, defensive play in the times when markets are richly valued.

Philip Morris CR (PMCR), a $2.3 billion market cap subsidiary of Philip Morris International (PMI) in the Czech Republic, is a growing business with  dominant market position, wide moat and strong pricing power trading at undeserving low ex-cash P/E multiple of 13(ttm).

History of Philip Morris in the Czech Republic begins in 1987 when PMI granted a license to produce Marlboro cigarettes to the Czechoslovakian tobacco industry. After the collapse of the communist regime, government decided to privatize the industry so in 1992 PMI acquired a majority stake in Tabak a.s. and after a few years renamed it to Philip Morris ÄŒR. Currently, PMI owns 77.6% of PMCR and the rest is traded on the Prague stock exchange. Volumes are not huge but it is still the 7th most traded stock on the Prague stock exchange.

The industry is, I believe, known to every VIC member so there is no need for lengthy introductions. The tobacco industry may be one of the most harmful industries to society, and yet, at the same time, one with the most loyal consumers and strong pricing power. It is an asset light business with great returns on capital.

Philip Morris CR sells well-known international brands like Marlboro, L&M, Chesterfield, Philip Morris plus local brands Petra Klasik and Sparta in more than 50 variants across different price segments. They are all produced in the Kutna Hora factory which now has the capacity of at least 40 billion units per year reached after the 2010 factory expansion increased the capacity by 10 billion units. PMCR made large investments in equipment in recent years, so the capacity might have increased. PMCR is also a distributor of smoke-free tobacco products and IQOS devices.

The company breaks down its revenue into three segments/markets: the Czech Republic, Slovakia and manufacturing services/other markets.

The Czech Republic is the largest and most important market for PMCR with CZK 6 billion in revenue in 2016, an increase of 5.7% over the previous year.  In the first half of 2017 revenue increased further, by 8.5% (with services even higher), despite a drop in volume, as a result of price increase. PM is the market leader in the Czech Republic with 46% share, followed by BAT. The CR segment accounts for more than half of the company’s operating profit.

Czech business ran into some trouble a few years ago. Revenue and shipment were on a decline and margins got squeezed due to a variety of reasons. Since PM was the first to enter the Czech market, it gained unsustainably high level of the market share but it shrank over the years mostly as a result of the elimination of the 55% import duty. Also, it was hit by a combination of an economic slowdown and excise tax-driven price increases in the last decade due to which a number of smokers decided to quit, smoke cheaper fine cut tobacco or turn to the black market. Now, the economy is on the path of recovery with rising revenue and margins. Market share has stabilized as well. In 2016, after years of decline, operating profits increased by 18% and kept increasing in the first half of 2017 with outstanding growth of 33% ( including services) The growth probably slowed down in the second half of the year due to introduction of the smoking ban in coffee shops, restaurants and cinemas. On the other hand, there were no new tax-driven increases in the 2H 2017 and following an increase on January 1, 2018 no new excise tax hikes have been planned for 2019. Besides, tax hikes of 2017 and 2018 are smaller than those introduced in previous years, which I will address later on.

In Slovakia PMCR is present through its 99% owned subsidiary Philip Morris Slovakia. Unlike in the Czech Republic, PMCR doesn’t have its own manufacturing facilities in Slovakia. Cigarettes are all imported from other PMI affiliates, most likely from the Kutna Hora factory due to its proximity to Slovakian market. Like in the Czech Republic, PMCR is the market leader in Slovakia, with 57% share and the main competitor is Imperial Brands. 2016 revenue was €102 million or CZK 2.7 billion at the time, an increase of 1% over the previous year. Revenue continued to grow in the first half of 2017 with a further increase of 6.5% in local currency terms. In the same period, profit growth was 26% yoy. The Slovakian business went much differently than CR throughout the last decade. Only in 2015 they hit a bump, but recovered fairly quickly and 2017 was probably the record year in terms of earnings and revenue.

Manufacturing services. PMCR’s fastest growing segment over the last decade was exports to other PMI affiliates. In unit terms, this segment has probably doubled since 2010 and is, by far, the largest one. PMCR used to give export numbers and revenue, but after the change of operating model in production in 2015 (which explains the fall in revenue in 2015 in the table), PMCR receives only a manufacturing service fee. In 2016 the fee was CZK 2.7 billion, an increase of 200 million over CZK 2.5 billion in 2015 and CZK 2.3 billion in 2014. Due to the change of operating model this has become a better business due to decrease in the  working capital requirements; i.e. PMCR is no longer the owner of materials for the production of cigarettes intended for other markets and is being remunerated for its service in a form of manufacturing service fee. This is still  the lowest margin and the least profitable  segment of the business because PMCR is not in charge of distribution business in its export markets, yet it got somewhat better after the change. Returns on capital increased because of it as well.

The growth in this segment comes, in part, from a declining demand in Europe, as a result of shutting down the manufacturing facilities in Western Europe. There are at least two reasons for PMI’s production transfer to the Czech Republic. In regulatory, as well as cost related terms, CR has been one of the best countries in Europe for tobacco manufacturing and a clear winner in the EU. During the 2010 expansion of the Kutna Hora plant the former Czech president who cut the ribbon expressed his reservations towards EU rules against smoking. The current one Miloš Zeman, a chain smoker, gave a unique health advice to young Czechs while visiting the factory in 2014:  “I myself only started smoking when I was 27 years old, when my body had fully developed, and tobacco could no longer harm it. So let me recommend your children to do the same: wait until the age of 27, and then smoke without any risk whatsoever”. Zeman was reelected a week ago. His views obviously are not prevalent, but they would be unthinkable for a high public official in any western European country. Even the parliament had a hard time introducing the smoking ban bill and tobacco lobby is very influential. The Czech Republic is moving in the right (meaning, more stringent) direction with regards to smoking, but it appears it will happen with some delays giving the tobacco industry more friendly legislative environment than they would find in other EU countries. This means further relocation of production to CR. In a recent interview, CEO of a company has confirmed that production from other PMI factories is being transferred to Kutna Hora and that the production in 2017 was considerably increased.

The management is of highest quality, exactly what you would expect from a company owned by PMI, which has, over the last 50 years, created tremendous value for its shareholders. Although you can argue it is the nature of the business that makes them shine. Anyhow, operationally, there is not much to criticize the management for. High margins, market leadership in both core markets, continuous price increases, declining costs....They excel at all those things. The only issue I have with the management is the fact they are incentivized to increase the value of PMI shares rather than those of PMCR since their share-based compensations relate to PMI shares. In line with their incentives, the company doesn’t use leverage, prefers dividends to buybacks, they don’t organize conference calls, give no guidance, investors have only two reports per year and presentations are in Czech, not English. I suppose management’s main objective is profitability and paying dividends to shareholders, not increasing the market value of the subsidiary, which is not too bad for minority shareholders. Probably the largest risk lies in the possibility that management may use too much cash flow for investments in equipment in order to increase manufacturing capacity for lower margin export business.

Valuation

The long thesis is based on two underpinnings: a) earnings growth b) multiple re-rating

PMCR’s shares are trading as if the market expects slow erosion of profitability in the coming years. This pessimistic view has been following PMCR for a while. Sell-side analysts have been underestimating PMCR earnings for years now. EPS reached a trough in 2013 and has recovered strongly since. I expect this momentum to continue for some time, on the back of (I) strong consumer spending in domestic markets and (II) lower tax hikes in the near future. In addition, significant investments in capacity should lead to increased exports to other affiliates. Despite being less important segment of the business, this growth will add up to earnings nicely. 

During the years of economic slowdown demand has shifted toward illicit trade and cheaper brands where there is a stronger competitive environment. This should go in reverse now. The economy is strong, both in the CR and Slovakia, unemployment is at all-time low, and consumers have more money in their wallets. They can now return to their beloved brands. Furthermore, a pack of cigarettes costs significantly less in the Czech Republic and Slovakia than in Western Europe, which is going to change over time with the rise in standard of living. Cigarettes in the CR and Slovakia are among the cheapest in the EU, both in retail and net price.

As the table above shows, the retail selling price is on the constant rise, reflecting the wide EU excise tax driven increase. The net price per pack has increased as well, not as steeply as a retail price but nevertheless an increase which reflects a strong pricing power of Philip Morris brands. 

One aspect of it is especially neglected by the market and sell-side analysts and that is the dynamics of tax-hikes. Excise taxes have been rising for years, hurting consumers already weakened by a stagnant economy. Even though the excise tax was increased in 2017 and 2018 as well, these hikes were significantly lower on a relative basis than the ones in 2015 and 2016(cheaper brands were hit harder by the tax hikes than the premium ones). These relatively lower tax rises provide an opportunity for the price rise, the greatest beneficiary of which won’t be the government but the shareholders. I believe a lower level of tax hikes combined with a stronger consumer explains the strong growth in the first half of 2017 and it could continue for some time since there was no proposal of Ministry of Finance of the CR so far to increase tobacco tax rates in 2019 or later. The fact that the CR is running a fiscal surplus (and Slovakia only a small deficit) makes new tax hikes, including those on tobacco, less likely. In Slovakia additional tax increase isn’t planned until February 2019 and it is also going to be smaller than the last one.

It’s hard to give a precise number since earnings have been very volatile and unpredictable, but CZK 1200 for 2017 won’t be too far off and I am thinking somewhere around CZK1350 for 2018. These approximations are based on assumptions that the smoking ban in the CR is having only a modest effect on consumption like it had in comparable European countries where the effects were short-lived.

Earnings growth should be the catalyst for rerating of the stock. Even without it, I believe the market is giving undeserving low multiple to PMCR. Neither its parent company nor other big tobacco companies are booming, yet they are trading at a significant premium to PMCR. The discount further widens when the net debt is included in the calculation.  I don’t think PMCR deserves the same multiple as the parent company given the increasing share of low margin/higher capex segment of the business, but the current discount is just too big.

So what happens if I am wrong and smoking ban would have a more severe impact on sales, or I am overestimating the effects of increased consumer spending and lower tax hikes? Or the Czech currency depreciate which would lead to excise tax increase because of the EU rule that overall excise tax must be at least €90 per 1000 cigarettes?  Well, not much, in my opinion. The downside is protected with a relatively low price and a strong dividend yield. The market is anticipating no growth.  Should the second half of 2017 or the first half of 2018 disappoint, ditch the stock and move on.

Catalyst

Annual report 2017

Mid-year report 2018