Saturday, March 29, 2008

the long-awaited spinoff of philip morris from altria

now that cigarette companies have gained the upper hand in their U.S. legal battles, altria, the parent of philip morris, is setting free its giant overseas tobacco division, philip morris international. the long-awaited spin off, which occurred friday, is a bullish development for investors in both companies, particularly the new altria, which has room to cut costs and raise profit margins.

pm is now the world's largest publicly traded tobacco company. the company and investors feared litigants would succeed in blocking a breakup, a concern that has ebbed with the cigarette industry's victories in court and a sharp drop in individual and class-action claims against the industry.

both new altria and philip morris international have some proving to do because they have trailed key domestic and overseas rivals in recent years in profit growth. a key concern is whether marlboro, the world's top-selling cigarette brand, has lost some of its cachet, especially in western europe -- a critical market for pm. marlboro's sales volume worldwide is down about 4% in the past six years.

many altria holders may be surprised to learn that the bulk of the company's value lies in its lesser-known overseas operations. pm has a market value of more than $100 billion, operations in more than 100 countries and a 25% market share in cigarettes outside the U.S., excluding china. new mo, in contrast, is more of a yield play, sporting a 5.3% dividend yield, versus 3.5% for its international cousin.

look for mo to do better than its own guidance of a 9% to 11% increase in 2008 eps, as it can do better through a combination of price increases, cost reductions and stock buybacks. tobacco investors like cost-cutting stories, citing the strong showing in recent years of reynolds american, the number 2 us cigarette producer with such brands as camel, winston and salem.

facing limited growth opportunities in the us, where cigarette consumption is declining at a 3% to 4% annual rate, new mo is apt to focus on returning cash to shareholders through dividends and stock buybacks. it aims to pay out 75% of its earnings in dividends.

the biggest prize market remains china, now controlled by a state-run monopoly and all but closed to western companies. but pm is on the verge of bringing marlboro to china, which has estimated annual cigarette sales of $100 billion, versus $70 billion in this country.

the teams at mo and pm have to be feeling a sense of release, as they met with investors without a lawyer being present for the first time in years. cigarette-related litigation is rare overseas, where people tend to have a more tolerant view of smoking.

mo bulls argue the domestic cigarette market, while declining, is still attractive. cigarette prices in the us, now about $4 a pack for marlboro and other premium brands, are below prices in much of europe, where a pack can cost $9 in britain or $7 in france. warning labels here are tamer than in the uk, where messages like "Smoking Kills" must occupy 30% of the surface area of a pack. new american smokers show a strong preference for marlboro, which controls 41% of the us market, ahead of the next 10 brands combined.

pm acknowledges it has been slow with innovations, including "light" and flavored cigarettes, and aims to bolster its presence in the developing world. rival bti, maker of pall mall and kent, is particularly strong in emerging economies, notably latin america.

i believe the bottom line is with strong brands, ample payouts and cost-cutting targets, altria and pm could wow investors.

most likely the street is underestimating an independent pm, which aims to generate 12% to 14% growth in earnings per share this year and 10% to 12% annual profit growth thereafter. it plans to pay out 65% of profits in dividends and buy back $13 billion of stock in the next two years.

both mo and pm will have strong balance sheets, with modest debt and huge annual cash flow. mo's stake in SABMiller, now worth $9 billion, or more than $4 per mo share, could be monetized in coming years. the company will pay a hefty $1.16 a share in annual dividends, and aims to buy back $7.5 billion of stock in the next two years. mo also has an ambitious cost-reduction program that already has yielded $300 million in annual savings and could deliver another $700 million by 2010.

altria's never been lean; for instance, it long had a global headquarters in manhattan; the building will be sold for a $400 million profit. new mo will be based in richmond, va., the home of philip morris usa. pm will have a small new york headquarters, but be run out of lausanne, switzerland.

mo has lots of room to lift its profit margins. philip morris usa's profit per pack is about 51 cents, versus 73 cents for lorillard and 40 cents for reynolds. it's hard to understand why philip morris lags, since marlboro is five times the size of newport, which ought to give the company significant economies of scale. philip morris long was burdened by a higher cost structure, including greater legal payments and regulatory obligations. now, however, legal expenses are down to about $200 million a year from a peak of $400 million.

philip morris is moving into related businesses like moist, smokeless tobacco, with a test of marlboro moist in atlanta. the growing smokeless market is led by ust, maker of skoal and copenhagen. the marlboro test has been deemed ok, not great, by the street, prompting talk mo might buy ust, now valued at $8 billion. but mo seems intent on building the business, not buying one, and there are few big potential acquisition targets beyond ust.

both mo and pm are eager to show they will thrive as independent companies. given their strong brands and cash flow, cost-cutting opportunities and determined management teams, that looks like a good bet.

disclosure: none, but looking

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