Description

Note all numbers are based on current FX rates:
EUR = $1.08
GBP = $1.23
JPY = $1 / 130

Basic Valuation:
Shares: 1.55bn * $90 = $140bn mkt cap
Net Debt = $42bn (this includes $700mm for the remaining 5% of Swedish Match not owned on 12/31/22 and $1.3bn for the remaining payment to Altria for iQos)
TEV = $182bn

2023 Guidance:

The USD currently trades slightly weaker than the 2022 daily average so I am excluding the negative fx effect from the guidance.

EBITA '23 = $14.25bn ($13.3bn is Organic; $950mm is from Swedish Match)
NOPAT = $11.25bn (16.2x)
Interest = $1.5bn ($800mm is from non-SM; $700mm is from SM
Taxes = $2.65bn
Net Income = $10.1bn (13.9x)

2023 margins will be affected by a number of negative items. The most important is inflation. Under normal inflation conditions, PM will raise prices over inflation, but due to the high global inflation, PM is raising prices slower than inflation to maintain customers and market share. The op margin will drop 1% (about $400mm). If/when inflation drops, I expect margins to return over a year or two.

As well, the War in Ukraine continues to weigh on both the top line and the bottom line for both Russia and Ukraine results.

The guidance expects total market (ex USA and China) of the combined cigs/HNB units to decline 1-2%. This reflects a cyclical pessimism. From 2019 to 2022, the ROW TAM fell 0.8% per year, and excluding Russia/Ukraine, it fell 0.5% per year. As HNB penetrates deeper and expands the population/frequency of users, I expect the TAM units to turn slightly positive.

The core thesis is as follows:
- PM trades at 14x P/E and 16x Unlevered FCF and has a 5.6% dividend yield
- Total Market physical unit combined cigs/HNB in ROW will be flat or better as HNB growth expands or holds steady the combined market of cigs/HNB
- PM will gain market share in ROW combined cigs/HNB due to its HNB dominance
- cigs/HNB will continue to take price at over inflation and margins will also expand.
- I expect HSD EBIT/UnlevFCF growth: 0% (total mkt units) + 4% (price -- assuming return to normal inflation) + 3% (mkt shr gains as cigs --> HNB) + 1% (margin expansion). Earnings would then grow at LDD although interest will be rising as low-interest debt rolls into higher interest debt so earnings growth will not significantly outperform EBIT growth.
- The analysis above also includes nic pouches (Zyn) in the U.S., but it is a smaller component and so I did not break it out. Zyn already dominates the mkt and will not grow mkt shr, but the mkt will continue to grow quickly, and I expect Zyn sales to continue to grow 20+% on a long runway.

What is a business that is in a flat unit volumes TAM + inflation+2% pricing power + accelerating mkt shr gains worth? It is worth more than 16x unlevered FCF. I believe this core business should receive at least a low consumer staple multiple in the 20-25x range. Based solely on the core thesis, I see PM as an attractive GARP opportunity. The stock is cheap regardless of what happens with the more speculative prospects described below.

Why does it trade where it does?
I believe PM's multiple is being held low by the gravitational pull of the rest of the industry (e.g., MO and BTI). But the rest of the industry does not have the RRP portfolio of PM.

MO, in particular, is a melting ice cube (in units, not revenue), as it has failed thus far in its 3 attempts (JUUL, iQos, On!) to establish a successful RRP product. It is trying again with its acquisition of NJOY, but I expect it to go the way of On!. Like On!, NJOY is low quality and has little appeal. MO has terrible management and has been unable to create a product in-house or acquire one and turn it into a success. So MO has turned into a bet on the offsetting race between lower volumes as cig smoking declines vs higher prices. And then throw in how much cash MO will burn in its attempts to establish an RRP foothold. FWIW, if Altria mgmt promised to give up and never pursue another RRP, the stock would trade up 20%. The mkt has zero confidence in Altria's mgmt.

Smoking volumes in the U.S. have declined at a faster rate than in ROW and this is without HNB alternatives. On the flipside, price increase in the U.S. have exceeded those in the ROW. As well, the federal, state, and local governments in the U.S. have become far more aggressive in regulation and taxing of cigs so we should expect the effect to be greater. Note, I am referring to the time delta of policy, not the absolute level. For example, the U.S. is seeking to implement a menthol cig ban at present. And California just implemented one late last year. Most of the ROW has had a menthol cig ban for years. MO's unlevered valuation is half that of PM, but it is an entirely different bet, and the success of PM's iQos and Zyn may mean the failure of MO.

BTI is more complex, and I can discuss at length in the thread. In short, BTI has aggressively pursued RRP products and have nic pouches, vapes, and HNB offerings. However, they are still unprofitable in total despite significant mkt share in European vapes and nic pouches. They do not break out, but I believe Euro nic pouches is slightly profitable alone.

Only two modern RRP products have achieved scale and high profitability in large markets: Swedish Match Zyn in the U.S. and PM iQos in the ROW. And now PM owns both.

The speculative thesis:
- There are 5 categories of RRPs: (1) traditional oral; (2) Nic Pouches; (3) Closed Vaping; (4) Open Vaping; and (5) HNB.
- Below is a model of the current situation for PM:

Cigs Trad Oral Nic Pouches HNB Closed Vaping
U.S. None Small Dominant Mkt Not Developed No Presence
ROW 25% Mkt Shr Small Weak Dominant Weak

- Let's be clear: the ROW is not a monolithic block and one brand or product type may be popular in Germany and another in S.Korea. As well, there are some sub-segments within these products (e.g., single-use vapes vs pod vapes). It is a grossly simplistic model, but I find it helpful.
- Open System vaping has so far proven to be niche and so none of the big players are focusing on it. I will ignore it.
- Traditional Oral has mainly existed in the Scandinavian countries and the U.S. It is a flat-to-down unit business, and it does not look positioned to expand beyond its current markets due to the lack of an oral tobacco tradition. It is one thing to believe a Parisian will put a nic pouch in their mouth. It is something else entirely to believe a Parisian will put a snus pouch in their mouth. Until its acquisition of Swedish Match, PM did not have a trad oral product. But it now has some popular, long-standing snus brands. I believe snus will expand in the U.S. and PM may be able to bring to other parts of world as nic pouches develop a tradition of oral nicotine. But this is not a large growth runway at present.

- So we have 4 big opportunities for PM: (1) Nic Pouches in ROW; (2) HNB in U.S.; (3) + (4) Vaping in U.S. and ROW.

HNB in U.S.
- After decades of industry false starts, PM successfully launched its HNB products (iQos), and it now dominates the market in the ROW. However, Altria failed to successfully launch the same products in the U.S. and now a patent dispute with BTI has frozen the product in the U.S. In 2022, Altria gave up and sold the rights to iQos and the HTUs (Heated Tobacco Units) to PM. It is unclear why HNB has not caught on in the U.S. like it did in Europe/Japan. I believe the main answer is a lack of marketing and distribution. But Altria rmessed up the launch and never committed itself. This is a huge opportunity, and there is a good chance PM will eventually be successful if the patents do not stop them cold.
- Altria (and PM) lost at the ITC in late 2021. The ITC decision does not validate the patents, but it does mean that PM cannot import the devices. The ITC decision is under appeal, but I am not optimistic it will be overturned. But there are quite a few pathways around the decision:
- PM will certainly challenge the validity of the two patents that BTI is applying. Foreign courts have already struck down these patents on grounds of obviousness versus expired patents and previous products. It is important to note that HNB products had been developed and marketed for decades before the success of iQos. As with any litigation, this is a crapshoot. I have read the two patents. One strikes me as clearly obvious. The other one is less clear.
- PM can design around the patents. In fact, the new induction (rather than blade) system of the iQos Iluma product seems to design around the weaker of the two patents.
- PM can manufacture the devices in the U.S. and obviate the ITC ruling. This still leaves the patent case, and BTI could eventually get an injunction or royalties.
- PM also has a lot of patents and has already successfully sued BTI. So there could be a big meeting where everyone threatens and insults everyone else and then they settle and go play golf together. My guess is that this is the likely outcome.
- Handicapping all this is very difficult, and I am not an expert, but PM clearly has a plan, or they would not have bought out Altria. And they sound confident that they will be bringing iQos to the U.S. soon.

Nic Pouches in ROW

- The purchase of Swedish Match has two strategic benefits in addition to owning the fast-growing and very profitable Zyn in the U.S.
(1) PM now has a distribution platform to launch nicotine products in the U.S. This is especially interesting when combined with their purchase from Altria of iQos in the U.S.
(2) As well, PM can use its distribution platform in the ROW to seek market share in nic pouches. While Zyn has been wildly successful in the U.S., it has not been successful in the ROW, including its home base, Scandanavia.
- I expect PM to relaunch nic pouches in ROW and try to build mkt shr with Swedish Match's product knowledge (and possibly, brands). The mkt is still developing outside Scandinavia, but PM is behind. I expect they can use their marketing/distribution muscle to give themselves a fighting chance to take share in ROW nic pouches and turn it into a profitable segment.
- PM discusses this directly on the latest quarterly call.
- I should note that PM does have one nic pouch brand on its own (Shiro) so it is not entirely ignorant of the market.

ROW Vaping

- PM has made clear that its focus currently is less on vaping than the other two opportunities. Part of this is developing regulation and part of this is their experience and products.
- PM entered the vaping market in ROW with VEEV. Versus other closed-system vaping options, it is a high-end experience. My experience is that it blows away (pun intended) every other closed-pod vaping system in the U.S. and in Europe. It is pricey (both device and pods), but it is a better product. The flavors are more mature and while they have semi-sweet flavors, they are not as artificially sweet as competitors. No cotton candy.
- Unfortunately, they mis-judged the market badly. Vaping sales (versus all other segments, RRP and cigs) are heavily weighted towards the young: under 25, including underage. And VEEV will not resonate with this segment. If vaping does swim upstream to an older, wealthier segment, I believe VEEV will be well positioned.
- PM has launched VEEBA, a single-use vape, to compete with the currently popular options. Like nic pouches, we will see if PM's marketing/distribution muscle will enable it to take mkt shr in this quickly growing mkt. I also think regulation may help PM here as it may be better positioned if some countries/EU crack down on the sweet-flavored single-use vapes targeted at youth.
- Finally, there is U.S. vaping. PM has no current dog in this fight and due to the chaos of U.S. vaping regulation at the moment, I do not expect it to enter the market for at least a year and probably 2 years. The good news is the market is being blown up at present and will need to re-form after order is restored. It looks increasingly like flavored (including mint) closed system vapes will not be allowed in the U.S. However, a 5th circuit decision issued yesterday calls this into question as the FDA PMTA process for vapes is being subjected to harsh criticism. This may aid PM in taking mkt shr when it does enter the mkt, but the mkt may be smaller as a result. This is the toughest mkt to figure out as the current situation is the Wild West. The FDA is not enforcing its decisions. Syn Nic has swarmed the mkt. It is a total mess. When the dust settles and there is legal clarity, I expect PM to enter (they need to file PMTAs) the fray.

Catalyst
- I do not expect an immediate re-rate of the stock on the core thesis. This thesis has been out there for a long time. The results are picking up steam as iQos grows and takes market share in the combined cig/HNB market, and this should prove a slow catalyst.
- The big catalyst is a successful launch of iQos in the U.S. in the next year.
- The next catalyst would be an aggressive re-launch into the ROW nic pouches market.

Risks
- The main risk to the core thesis is that there is a move against HNB. It is difficult to see how HNB is more dangerous than cigs, but is it really safer? And what happens if it is deemed by government or consumers as no safer?

- The War in Ukraine is another risk to the core thesis. If PM were to lose both the Ukraine and Russia businesses forever, it would reduce the value by HSD%.
- Menthol HTUs are about to be banned in the EU. I expect this to have little impact on sales, but it is a risk.

Catalyst

- I do not expect an immediate re-rate of the stock on the core thesis. This thesis has been out there for a long time. The results are picking up steam as iQos grows and takes market share in the combined cig/HNB market, and this should prove a slow catalyst.
- The big catalyst is a successful launch of iQos in the U.S. in the next year.
- The next catalyst would be an aggressive re-launch into the ROW nic pouches market.