Philip Morris ČR manufactures tobacco products in the Czech Republic. They also own a subsidiary in Slovakia that sells and distributes products there. The company is listed on the Prague Stock Exchange (ticker TABAK.PR).
Besides manufacturing tobacco products, Philip Morris ČR also distributes smoke-free tobacco products called HEETS (known as HeatSticks in some places). These units can be inserted into a IQOS device that will then heat the tobacco unit, generating an aerosol that can be inhaled by the user. The fumes produced by these electronic devices are said to contain much lower quantities of harmful substances than are found in tobacco smoke. The theory is that this makes these smoke-free alternatives less harmful to a user’s health.
The company looks pretty cheap at first glance:
Share price: 14,840 Czech Koruna (CZK)
Outstanding shares: 2,745,386
Market cap: 40.7bn CZK (~$1.86bn USD)
Net income 2019: 4.0bn
Cash – June 30, 2020: 8.9bn
This all looks quite attractive, especially when you compare some of the numbers of this company to those of other large tobacco companies in the US. If you look at the historical numbers for Philip Morris ČR, the company looks like a cash-cow. The company throws off lots of excess cash and a decent chunk of this is paid out as a dividend each year. In April 2020 the company announced a 1,560 CZK dividend per share, or a 10.5% yield on the current share price. For 2019 the dividend was 1,600 CZK per share. The dividends of the last two years were exceptionally high though, in 2018 the dividend was 1,080 per share, which was a more typical level for the last decade.
A P/E multiple of only ten, a high dividend yield, apparently stable, or even growing revenues and a bunch of excess cash, what’s not to like here? That’s what I thought initially. Of course there’s the moral side of things. Owning a tobacco company probably isn’t something you’re going to feel especially good about. But leaving that aside for now, why is this company so cheap?
I think the reasons have to do with the ownership structure. Philip Morris ČR is 77.6% owned by Philip Morris Holland Holdings BV. Philip Morris International Inc. (PMI) is the ultimate controlling party.
Traditional tobacco products are not a growing industry in most developed countries. Almost everyone is well aware of the health problems tobacco products cause and most governments try to discourage people from smoking. They do things like impose age limits for buying the products, restrict the way in which they can be marketed to consumers and they steadily make them more expensive to buy by heavily taxing them.
The smoke-free alternatives that have been developed in recent years perhaps provide something to cushion the financial effects from this negative spiral. The smoke-free products can be presented as less harmful alternatives and your users can switch. This could extend the lifetime of your consumers and perhaps the smoke-free products will be taken up by a younger group of users as well.
A Limited Risk Distributor for Reduced-Risk Products
Unfortunately for Philip Morris ČR shareholders, they won’t get the full benefit from the people who make the switch to smoke free products. The company doesn’t own the intellectual property rights for reduced-risk products, those reside with the parent:
Our profitability, and consequently, the amount of our dividend payout reflects our dual role of being a full risk entrepreneur of combustible portfolio products and a limited risk distributor for reduced-risk products. Our remuneration for commercialization of reduced- risk products is based on a set margin on revenues from sales. As a limited risk distributor, we do not own intellectual property rights for reduced-risk products and therefore do not absorb all the costs or bear the risks associated with such ownership. As our return is proportionate to our risk for commercializing reduced-risk products, the impact of the sales volume variances of such products on our profitability is limited. Consequently, if the current consumer preference trend towards reduced-risk products will continue and volume declines of combustible portfolio products accelerate, we do not expect that over time the additional profit generated from increased sales of reduced-risk products will offset the decreasing profits generated from the sales of combustible portfolio products.
Source: Annual Report 2019, page 28. Bold text mine.
This is probably the most important paragraph in the annual report. Philip Morris ČR acts only as a distributor for reduced-risk products and gets a set margin for providing this role. So it looks like the company will see a steadily decreasing portion of revenue from traditional tobacco products, where the full economic benefits are gained, but a faster growing portion of revenues from reduced-risk products where margins are much less attractive. I haven’t been able to find further details about what the company receives exactly as a distributor. So far, the profits have held up well, but from the quote above it sounds like the company itself does not expect this to last.
Excess cash
The company does have a bunch of cash on the balance sheet though. The company had 8.9bn of cash, no debt and just 12.7bn in total liabilities. They could return most of that cash to shareholders if they wanted.
Again, the parent company has its own interests and they don’t fully align with those of minority owners. Note 10 of the H1 report for 2020 shows that 4.8bn of the 8.9bn in cash are “On-demand deposits with related parties”. Note 15d has more details:
At June 30, 2020, the Group provided related parties interest- bearing on-demand deposits (cash pool) of CZK 4 847 million with Philip Morris Finance S.A. (at December 31, 2019: CZK 5 155 million). All short-term loans and deposits are classified as cash and cash equivalents in the Group’s consolidated statement of financial position as at June 30, 2020 and December 31, 2019.
So it looks like the company acts as a piggy bank to the rest of the Philip Morris companies.
That said, the company is definitely not a terrible cash-hoarder like those you can often find in Japan. The company does pay out a large part of their earnings to shareholders every year. I think it is also true though that the capital structure is not optimal and that minority shareholders would benefit if the company paid out all the excess cash and took on some debt. That’s not in the interest of the parent company though, so I don’t see that happening.
Conclusion
The ultimate parent company of Philip Morris ČR has captured most of the upside of the reduced-risk products, leaving the Czech company with just a distributor role. PM’s majority ownership also allows them to make use of the company’s cash in a way that is not optimal for minority shareholders. For these reasons, I don’t think Philip Morris ČR is the bargain it looks to be at first glance. The company looks reasonably priced to me.
The best case scenario is probably if PM decides to buy out the remaining minority shareholders. I’m not sure how likely that is to happen. Does PM benefit by taking the company private? They can save some costs by terminating the public listing. Perhaps it’s also not great from a public relations point of view to have a bunch of individual shareholders that might become unhappy and more vocal if their dividend payments go down in the future. It could make sense to offer a relatively small premium and try to buy them out. Tobacco products will also continue to be controversial. Why keep one extra company around publishing all the details of this industry in separate reports, generating extra media attention when you can keep everything contained in one PM report? But this is really searching for reasons. I don’t see a particular reason why PM would be in any hurry to take the company private.
Disclosure: no position in Philip Morris ČR
I think the transition to iqos will be quite slow. PM ČR is also selling lot of cigarettes to Poland and Germany. I think the dividend is safe for many years, bigger risk is continous increasing taxation. They are in Czech stock market many years, I doubt they would take the company private.
Yes, good point about taxation. That’s certainly a headwind for them as well.
Do you know how the ownership structure of the company came to be the way it is currently? Was the government a shareholder at one point and did they sell off their stake to the public? I noticed the company has been listed since the early 1990’s. I thought perhaps PM was required at that time to take on a minority partner to be allowed to operate in the country.
Not sure about the history, but as you say, they are traded from 1993. It was originally Czechoslovakia plant called Tabak and it was sold to Philip Morris. During communist times all companies were owned by government and this was the way how to sell them private equity (eg. same like when Skoda auto was sold to Volkswagen).
I dont think there is any obligation to have equity publicly traded. I believe they just did it to get some many back from the purchase price and just left it like that.