The disparity between reported results at Philip Morris International and the underlying economic reality of this tobacco business is on my mind again.
Aside from the usual moral reasons, it has become unfashionable due to its slow earnings growth during the past three years that has been met with low dividend growth as well. Profits of $4.76 per share back in 2014 are actually down a bit to $4.55 right now. The quarterly dividend payout has only grown from $1 to $1.02 to $1.04 over the same time frame. On a P/E basis, it looks like Philip Morris International is trading at almost 20x earnings while profits aren’t even growing.
My personal view is that investors should be hesitant to extrapolate from that set of data points. Philip Morris is bound by the fact that it reports its earnings in U.S. dollars and is domiciled in the United States while earning 100% of its profits outside the United States. This means that every time there is an earnings report, Philip Morris has to translate all of its profits back into U.S. dollars at whatever the exchange rate is across its currencies.
Comparing the U.S. dollar to the basket of currencies in which Philip Morris generates its profits, the U.S. dollar is 23% stronger today than it was on January 1, 2014. That $4.55 in current profits? It would be $5.59 per share in profits if the U.S. dollar maintained the status quo for the past three years. That would be 5.5% annual earnings growth rather than 1.5% annual declines that have been reported to shareholders of late.
Of course, it is fair to debate whether the current foreign exchange rates are more characteristic of a long-term status quo than the rates that existed in 2014.
But if you are shareholder of Philip Morris (if you own the S&P 500 in any form, this includes you!) then it is important to understand the distortions and constraints that can be created when profits are generated abroad yet reported in a different currency.
First, it is important to remember that the stated earnings reflect the actual cash in the bank which gets used to pay dividends. Even if the stated results of the past three years do not adequately reflect the change in Philip Morris’s earnings power, it does reflect the actual cash in the bank. That is why the dividend has only grown at 2%. It is only working with $4.55 per share right now.
But this insight can be calibrated to recognize that Philip Morris’s business and valuation is a bit better than what you’d think from looking at the stated results. On a constant currency basis, the valuation is 16x earnings rather than 20x earnings. The reported declines of 1.5% each year is really moderate earnings growth of 5.5% when you look at how Marlboro is performing in, say, Britain and the Philippines.
I have offered my opinion before that low interest rates have caused investors to ignore the importance of balance sheets such that cash-rich corporations haven’t traded as high as they should and debt-heavy enterprises haven’t been impaired by their debt load as much as you’d expect. I’ll offer a complementary opinion that companies that earn all their profits in the U.S. have seen their valuations enlarge in recent years while businesses with heavy international operations have been trading at a bit of a discount due to the strength of the U.S. dollar.
Specifically, Altria and Reynolds have climbed in recent years while Philip Morris International has lagged. I expect that trend to reverse between now and the next decade. Philip Morris International performs much better when it comes to annual cigarette volume declines, as the taxation and regulation in Southeast Asian and Eastern European countries is dramatically less than the United States. Philip Morris International get a 4.5% dividend and what I would expect to be 5-9% long-term earnings growth. At a price of $90 or lower, Philip Morris International shareholders have a better chance than not of experiencing 10% annual compounding from here.