Philip Morris Bull's Pen
by Dale Wettlaufer ([email protected])

Let's just save some time here. I believe people have the right to smoke and I believe companies have the right to sell tobacco products. Addiction is a mental, as well as physical, phenomenon. Current excise taxes and private insurance take care of healthcare costs for sick smokers, as well as many externalities, and people have known for more than a century that smoking can kill you. OK, now let's look at the company and its situation.

Why would I be bullish on Philip Morris? Well, let's just skip by the tobacco company for a second and take a look at what else we have at Philip Morris. We're looking at one of the most powerful line-ups of consumer brands in the country. Not only is Philip Morris a cigarette company, but it is also the largest packaged foods company on this continent. Here's a rundown of some of its food brands and products:

KRAFT
KRAFT Macaroni & Cheese dinners
PHILADELPHIA BRAND cream cheese
OSCAR MAYER
MAXWELL HOUSE
JELL-O
MIRACLE WHIP
KOOL-AID
COUNTRY TIME
TOMBSTONE and JACK'S frozen pizzas
DI GIORNO pastas, sauces, cheeses and frozen pizzas
COOL WHIP
STOVE TOP stuffing and SHAKE 'N BAKE coatings
MINUTE rice
LIGHT N' LIVELY and BREYERS dairy products

And these are just some of the company's North America brands. If you look at Flip Mo's annual report, you will see that it is a brand juggernaut around the world. Its prospects for international expansion are excellent. With very high free cash flows and what looks like good asset management (looking through the supplemental financial disclosures that Philip Morris provides in the annual report), Philip Morris' food business should carry a blue-chip valuation.

Let's take a stab at valuing the non-tobacco businesses at Philip Morris. In the interests of keeping this within the space that my handlers have given me, this will have to be brief.

With 1997 after-tax operating earnings of $2.66 billion (my estimate, adding back goodwill expense attributable to the food business and using a tax rate of 33% to account for extensive international operations), the food business alone should be priced between 28 and 32 times earnings. That's $74.36 billion to $84.9 billion.

Philip Morris' beer business (Miller) generated operating earnings of $456 million last year. At a 36% tax rate, after-tax operating earnings would be $291.8 million. I would pay between 18-20 times earnings for this business, putting my valuation on Miller at $5.25 billion to $5.84 billion.

Finally, Philip Morris has some finance operations hanging around. With a 1997 return on assets (ROA) of 2.1% (I've backed out a gain of $103 million the company took), the company generated $121.6 million in earnings before extraordinary items. With a value of 16 times earnings or 35% of assets, the valuation on the finance unit falls right around $2.06 billion.

Adding up all non-tobacco businesses, we get a range of $81.67 billion to $92.8 billion. Taking away from the net debt that I would think is reasonably attributable to these businesses (25% of the consolidated company's net debt), we get equity value of $78.95 billion to $90.08 billion. On 2.4246 billion shares, that's $32.56 to $37.15 per share.

At the recent quote of $39 1/4 for the overall company, the tobacco company is being valued at $2.10 to $6.69 per share. Adding net debt attributable to the tobacco business to those figures, the enterprise value of the tobacco business is somewhere in the range of $13.26 billion to $24.39 billion.

Let's see. We've got the tobacco company earning after-tax operating income (plus goodwill amortization) of $5.392 billion. That business is incredibly rich in free cash flow and generates incredibly high returns on invested capital (ROIC), perhaps in the 50% range. As we know, ROIC should play as large a part in valuation as earnings growth does, because a high-ROIC business has the luxury of returning lots of capital to owners at the same time that it's able to finance internally its growth needs. So, to value this segment of Philip Morris, we need to first consider what its value is if the threat of increased government regulation did not exist. Then we'll discount the regulatory threat.

To be honest, I think the tobacco operations are worth more, but to be conservative, I'll go to 30-35 times after-tax operating profit as a reasonable valuation for the tobacco business. That gets us total value of $161.8 billion to $188.7 billion for the tobacco operations. Less net debt, that's $63.36 to $74.46 per share that we add to the above. So, before all the hassles that the company and industry currently face, Philip Morris is worth $95.92 to $111.61 per share. The implied valuation on the tobacco company is 0.55 to 2.65 enterprise value to after-tax operating profit.

Hmm, do you think this thing is discounted enough when the valuation is anywhere from less than 3 times all the way down to 55% of one year's after-tax operating earnings? Can I stop the Duel here? This baby's cheap, and the risk that any tobacco settlement will almost wipe out all earnings is pretty effectively priced into Philip Morris. But look at it this way -- tobacco legislation will fall almost entirely on the shoulders of the smoker. Fewer people will smoke, probably, which will drop the market share of Americans who smoke, but there are many who will smoke even if cigarettes go to $4.00 per pack. The cost of the annual payment that Philip Morris will have to send to the government will come largely out of the pockets of its customers.

This is the cheapest high-quality large business out there. It's hugely free cash flow positive, requires little capital (relatively speaking) to operate, and has fantastic competitive advantages due to its stable of brand-name thoroughbreds. Yeah, yeah, the government's there and tobacco legislation is coming down the pike. In fact, if tobacco earnings are cut in half, the company would still be worth $45.89 to $50.48 per share. Still, that's a worst-case scenario. It's hardly something to be bearish about, though. In fact, I'm bullish and would love to see an even larger discount open up here. Over the longer term, this stock will be more satisfying than a nice fat Marlboro after a good meal. For you non-smokers, that means I think it will outperform, even with tobacco legislation.

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