Chit Chat Stocks - Philip Morris International (Ticker: PM) Not So Deep Dive

Episode Date: April 18, 2023

Philip Morris International Inc. (PM) manufactures and sells tobacco products, with a focus on reduced-risk products, but faces regulatory challenges and declining smoking rates. At the end of the month, we will publish an Arch Capital episode that will cover the company: Nintendo. Listen closely as Brett and Ryan go through the history, financials, and future prospects of Philip Morris. Enjoy the show! ****************************** This episode is sponsored by Stratosphere.io, a web-based terminal for financial data, KPIs, and more. Try it out for FREE or use code “CCM” for 15% off any paid plan. Sign up here: https://www.stratosphere.io/ ****************************** Subscribe to our Substack to receive free show notes and charts that go along with every episode: https://chitchatmoney.substack.com/ Want updates on future shows and projects? Follow us on Twitter: https://twitter.com/chitchatmoney Contact us: [e-mail] Timestamps Company Background | (3:02) Industry | (16:14) Management & Ownership | (21:01) Earnings | (26:06) Balance Sheet | (30:39) Valuation | (33:54) Our Analysis | (35:25) Disclosure: Chit Chat Money hosts and guests are not financial advisors, and nothing they say on this show is formal advice or a recommendation. Brett Schafer and Ryan Henderson are general partners and portfolio managers at Arch Capital. Arch Capital and its partners may hold securities discussed on this show. Learn more about your ad choices. Visit megaphone.fm/adchoices

Welcome to Chit Chat Money. On this show, host Ryan Henderson and Brett Schaefer interview industry experts and riff on the world of investing. As a quick reminder, Chit Chat Money is a CCM Media Group podcast. Ryan and Brett are also general partners at Arch Capital, and Arch Capital may have positions in the securities discussed in this podcast. Anything discussed on Chit Chat Money by Ryan or Brett or any other podcast guests is not formal advice or recommendation. Now, please enjoy this episode. Welcome in. This is the Tuesday Not-So-Deep-Dive episode on Chit Chat Money. My name is Brett Schaefer, and I am joined by my co-host, Ryan Henderson. Today is our Tuesday Not-So-Deep-Dive

episode where we analyze one stock by covering its business model, ownership, financials, future growth opportunities after listening to this episode we hope you get a better perspective on the company that we cover and today we are covering philip morris international which we'll be talking about later on the show but before we get to that this episode is presented by stratosphere our invest favorite web-based research terminal for fundamental investors ryan is going to be pulling up the shared screen right now with a nice nifty chart from stratosphere on philip morris international as a as you can tell they have long dated financial statements and they're especially useful for some of the older companies like philip morris international or any company that has been

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you know, do you think you could add that anytime soon? They said, boom, right on it. It's in the queue. So since they're so, I don't know, young, agile, and they have such a great team over there, they're way better at adding tools that you want to their interface. And plus they already have so many that you want as well. They have employee data, SEC file aggregation, the works. Now, If you want to check them out, use our link in the show notes, go to stratosphere.io and use 15, or excuse me, use our code CCM to get 15% off any paid plan. All right, let's kick off the episode. Ryan, what is Philip Morris International? Because this is a bit of a, I wouldn't necessarily call it a conglomerate, but it's a little bit hard to understand because they have a few different moving parts here.

yeah that's that's probably accurate way to describe them um but the first of all i want to say when we kicked off this consumer goods or cpg uh theme i was i had mixed feelings but now i've got to say i'm really excited that we did this one because philip morris kind of is right in our wheelhouse and you know it's certainly in our circle of competence it's a business it's very durable. There's a lot of characteristics to like about it. And so I'll get into what those are. But yeah, I was excited digging into this one this week. But yeah, let's talk about the basics of the business. Philip Morris, we're probably going to call him Philip Morris PMI, PM. Basically, it's Philip Morris International. And I'll talk a little bit about the history of

the spinoff, but they're the world's largest tobacco company, excluding, I think it's called like China National Tobacco Corporation or something like that. So if you exclude the Chinese market, Philip Morris is the largest. But it's also, I think the reason I find it exciting is it's also the global leader or seen as the global leader in reduced risk products. And I'll talk about kind of what those are as well. But the business is pretty simple and it can be broken down into two segments, combustibles or smoking, and then smoke-free products. And so combustibles, this refers to their cigarettes business. It also will probably include cigars after the Swedish match deal. The Swedish match deal is closed, and we'll talk about that in a second

also. But I assume they'll just lump the cigars business into the combustibles as well. But the operations of a cigarette manufacturer are pretty straightforward. So as of the end of 2022, Philip Morris had 53 manufacturing facilities located all around the globe. They source from a variety of tobacco leaf suppliers that are also located all around the globe. And keep in mind, the sourcing for the different types of leaves often requires transporting some of those goods, which over the last year has become more expensive. And so that's why they've seen a little bit of a contraction in their gross margins.

But then once they've manufactured them, they have basically a web of distribution points. They go to a lot of retailers on their own. They go through distribution partners. It all kind of depends on the market. And they really operate literally everywhere around the globe, minus pretty much the US. But we'll talk about why that is in a second. And so, yeah, that's the basics of the business. And the gross margins on the cigarette business are high.

They're like 60%. So it doesn't cost a lot to make. They're able to sell it for a lot. And the brands within kind of Philip Morris' portfolio include, most notably, Marlboro, which accounts for 39% of all their cigarette sales. But also they own Parliament, Chesterfield, L&M, Philip Morris. And then there's a number of brands that are really popular in Indonesia and the Philippines that most people probably wouldn't know about, but they are the market leaders over there. And then in total, combustibles or smoking, the smoking segment accounted for 68% of Philip Morris' revenue in 2022. So it's still the largest contributing segment to Philip Morris' top line. But then the second segment is what they call smoke-free. And so there's pretty much two products that most people think of now, if you know Philip Morris, and that's Icos and Zin. But there's also a lot more that's within that segment. So I guess kind of traditional oral tobacco will probably be included in there now as well, because they acquired some of that within the Swedish Match acquisition. but also they have like evape products or evaper um neither one of those are big contributors the two big ones are really icos and zen and so icos for people that don't know it's basically this pen-shaped device that heats tobacco instead of burning it i'm not gonna pretend to know all the specifics of how that uh is better health-wise but according to reports according to a number

of different studies. By heating it instead of burning it, there's less toxic chemicals that are created. It's the smoke. Right. The smoke apparently provides most of the toxic chemicals. And so this is seen as a reduced risk product. And it's grown really quickly, primarily in Europe, but also in some of Philip Morris's other markets as well. And so the initial machine or the actual device costs around $80, depends on the market, but it's a big upfront expense. And then customers buy the Icos heat sticks on a recurring basis. And the Icos heat stick, it's the razor and the blades model. Those are basically, think of them as cigarettes. They're a little shorter, but you

just plug them into your Icos device and it burns it for you. So that's Icos. And then they've rolled out a couple of different models. There's higher end looking ones. They just launched Luma, which is really popular. That's the Illuma Icos device. But then the other segment that's important here is Zinn. Zinn is the premier nicotine pouch brand in the United States, which they acquired in the Swedish match deal. Zinn touts 76% market share in the US among nicotine pouches and basically 50% operating margins on a little over a billion dollars in revenue. I'll say it right now. We're Swedish match shareholders. Zinn's very popular on the West Coast of the United States where we live. This is really a solid business and seen as,

I think, one of the premier brands within the reduced risk market as a whole. Zinn continues to grow really quickly. Shipments have grown by 35% in the most recent quarter. In total, When I think of smoke-free, and Brett, maybe it differs a little bit for you, I think of basically Icos and Zin for Philip Morris. And it accounts for, once Swedish Match is fully included, they're expecting it to account for 40% of overall revenue. Right now, it accounted for 32% in the most recent year, but it should jump to about 40%. Yeah.

I guess two notes there. When we talk about risk-reduced products, I'm probably going to say RRPs. So when you hear us say RRPs, or if you read any of their documents, that means anything that's not the super harmful combustibles. It's a reduced risk product. Then second, let's just for any listeners, because we know not everyone's doing, you know, using nicotine pouches. Let's describe what those are. Like we do with Icos, they are tobacco free-ish. They might get the nicotine by extracting it from tobacco, but the actual pouch itself is sort of like a chewing tobacco package without the harmful tobacco in it and without the harmful things that can affect your gums.

So you get a little nicotine rush, which is what the consumers want that are addicted to nicotine or have the habitual usage of nicotine. And they have some flavors in it as well. And then it's just sort of a plant-based little, I think it's almost like cellulose maybe is what it's made out of. But I would look up what a nicotine pouch looks like. So it's super risk-reduced. These are ones, at least compared to some of the vaping products, might have 99% risk reduced or even be completely harmless outside of just the nicotine, not inhalation, but ingestion.

All right, Ryan. Yeah. We did a couple interviews on Swedish Match way back when, and something that was kind of touted is with traditional oral tobacco, you put these wads of what looks like essentially dirt into your mouth. This is a very clean package. It's just a little white strip, it looks like, and you just put it basically in the same, but it's much cleaner than oral tobacco and apparently much healthier as well. Talking about the history, though, I mean, this is a business that has a long history, so I'm not going to go into all of it.

But Philip Morris International's actual founding dates all the way back to 1847, when a gentleman named, surprise, surprise, Philip Morris opened a shop in London to sell tobacco and cigarettes. Not going to go through all the history today, since it's not very relevant to the investment anymore. But it is pretty fascinating if you go and just look at the Wikipedia page. and look at when some of their cigarette brands were introduced. And you look at Marlboro, you look at some of the ones that are popular in the Philippines,

you look at Parliament. These have all been around for more than 50 years, sometimes more than 100 years. So very durable, lasting brands in the cigarette space. Fast forward to 2008. Keep in mind, Philip Morris at one time was one giant national conglomerate. But in 2008, at some point, they had changed their name to Altria. And so Altria decided to spin off its international arm. This ultimately became Philip Morris International because of basically an onslaught of litigation.

I think there were some other reasons as well. But since that kind of 2009 to 2011 time period, once Philip Morris International was spun off, total unit shipments have slowly collapsed, driven by overall declines in cigarette smoking. Just for context in the cigarette market broadly, the US, and maybe there's some other markets as well that have decelerated this quickly, the US has really declined in cigarette volumes probably much, much faster than a lot of the international markets that Philip Morris operates in. And so that was basically the split was Philip Morris gets all the international business. They leave Altria the full US business. US has a lot of the best earning consumers, so the most spending power. So both were attractive, but Altria has seen quicker declines in volumes. However, Icos, which was launched in 2014, has basically volumes have started to grow

again over the last two years because of their smoke-free category, most notably Icos. And then once you lump in Swedish Match, it's likely to grow again this year. They acquired Swedish Match this year. I believe the deal was $16 billion. Give or take, yeah. And then a couple of months ago, they also acquired the rights to sell Icos in the US. Brett's going to talk about that a little bit later, but it's kind of interesting that now they're starting to overlap with Altria a little bit and it's kind of become-

Frenemy, yeah. Frenemies? Yeah, I think, well, here's a bit of a context. Altria has not done well in risk RRPs. Philip Morris has invested tons of money. I think they highlight something like $10 billion invested in RRPs, which is an ongoing research development. and we'll talk about their acquisitions that are even trying to accelerate this into even more RRPs into the future. They've succeeded well, and they're kind of thinking, all right, I guess if we're going to go for this, we might want the US market as well. So I wonder how that relationship, whether it's frayed a bit, I think it probably has, reading through the tea leaves, but it'll be definitely interesting to see how it develops over the next five, 10 years.

Yeah, just to kind of paint some context on shareholder returns, over the last 10 years, Philip Morris International's total shareholder return has only been 75%. That's well below the market and also well below Altria. So despite Altria, they've spent a lot of money trying to invest in reduced risk or the next generation products as well, but they've just done it with much less success and kind of a convoluted strategy, I'd say, taking minority stakes in a lot of businesses like they did with Juul. ultra is still drastically outperformed philip morris and uh so it's been a bit of a rough decade for philip morris shareholders but if i mean it's still still a decent return because you get a steady dividend basically yeah and we will talk they are at a bit of an inflection potentially an inflection point that i think whether we'll talk about probably in the bull or bear case whether that's going to materialize or not or if it's going to be more of the same where you invest in RRPs and then everything looks good. It's exciting. It sounds sexy.

And then Altria outperforms you by raising prices a little bit and expanding those operating margins. But we'll talk about that later. I'll hit industry and competition. The tobacco and nicotine market, as all listeners likely know, is huge. But here's a surprising fact, maybe to a lot of listeners, maybe some of the tobacco bros listening is not so surprising. The market, which also includes RRPs and nicotine together, and I think this was not oral tobacco, so it was only smokables, is projected to grow at a 2.5% clip through 2027 worldwide and hit over $1 trillion in annual spending. Statista has industry revenue growing worldwide, mainly due to price hikes on cigarettes. So even in, and I think some of it can be population growth and a lot of Fillmore, excuse me, PMI's markets, but it is crazy how even with the steady volume declines in a lot of areas, they are able to grow revenues or at least is projected to grow revenues. And then on top of that, we're getting a little bit of incremental growth from things like Icos and some of the vaping products.

Now, PMI, as Ryan mentioned, operates in every major market except China and the United States. when we're looking at China, that is a huge market. It's $294 billion of the annual tobacco market. So a huge chunk. And that's something that PMI is likely never going to go after. PMI have retained market share in the international in aggregate. So basically, ex-US, ex-China with pretty steady consistency over the years, mainly due to the zero new competition entering the cigarette space in 2020, 2021, and 2022. Their market share was in between 27.2% and 27.6% within cigarettes. And now, obviously, things are getting a little bit more dynamic with the introductions of ICOS, however you say it, and some of these vaping

products. But if it's from Philip Morris, it's kind of a wash because people... And honestly, they talk about how some of these RRPs have even better margins per user revenue at scale. So that'll be interesting to discuss as well. If we look at competition, I really don't care about the other cigarette brands because I think that industry is so stagnant and then the market share seems to just get retained and then overall industry volumes decline. And all that really matters is how aggressive you're going to be on your price hikes. But I want to talk about the competition in our and vaping rrps and then nicotine pouches so if we look at the competition in nicotine pouches we have ultra groups on product british american tobacco's velo product

and turning point brands um oh i wrote tpb there but i meant to write rogue like ryan mentioned zin dominates this space um but we'll see it's still really early what is this industry about seven to eight years old and really didn't become super popular until about five years ago. So yeah, I don't know. It's a tough one. It's super exciting because industry analysts I've seen project the market to grow like 20% a year for 10 years. So we'll see. But again, maybe we'll talk about whether the brands can be durable. And the other thing, I mentioned the market share within the US. The US is the biggest nicotine pouch market globally. So Velo, which is, I believe that belongs to British American

tobacco, they have number one market share in a couple of European markets, but even those in aggregate are much smaller than the US. Yeah, that's for sure. Right now, Europe is much, much smaller. Now, if we look at vaping and other RRP inhalation product competitors, there are the pod-based vaping products, which are something like Juul, Enjoy. Enjoy just got bought by Altree Group. And then Vuze, V-U-S-E, I believe. And I always get confused. That one is owned by BTI or British American Tobacco as well. And then within vapes, there's a big development over the last few years of these disposables, which maybe younger people have seen those ones called elf bars, but there's a ton of other quirky ones out there. A lot of them are from Asia and they're

very very cheap but they're disposable and you don't have these you know razor razor blade model but they're becoming very very popular at least among young people um and we're i i think we're going to discuss the key difference between for me uh of the vaping market at least in the united states and the nicotine pouch market is that nicotine pouch market share has been a little bit more stable and the vaping market has been a bit of a crapshoot over the last decade um okay management and ownership pretty simply i don't think we had to spend too much time here but i think the most important thing is that until may of 2021 pmi had andre it's gonna be a tough name here kalant sapulos say hi it sounds greek uh he was either the president coo or ceo since

2002. I'm not going to be able to say that one. Since 2002, so he was back even before the spinoff managing this company. He led them through the spin away from Altrio Group and then through these huge investments into RRPs that have been quite successful. Now, he didn't do the Swedish match acquisition, but I think he can be one of the key leaders that brought on to Icos, which is the dominant heated tobacco unit product, especially in Europe. Now, the new CEO is Jacek Olsak. These are European names. I guess it's good that they have some people that are within those markets.

He's the CEO, and Kalantzapoulos has been bumped up to executive chairman. The current CEO has been with the company since 1993 and is 58 years old, so pretty much a lifer. at PMI. If I looked at the proxy statement, really boilerplate stuff, no big concerns. It's good. No major red flags that I could find at the first pass through, but also disappointing that they just used the compensation consultant gobbledygook. It's not going to affect the stock as much as maybe weed. I don't know. You'd like the incentives to be better, but it's not a giant deal to me. We had base salary, annual bonuses, long-term equity awards. And then the only

strange thing I saw that I think would be interesting to watch for shareholders is that some of their performance stock units that they get for the long-term equity awards are based on sustainability targets and RRP volumes, which do you think that's good? Now, obviously the sustainability ones are a wash. No one really cares about that as an investor. But the RRP volumes, do you think that's a good incentive target? Because that might not actually be a good on it might force them to make some bad deals or maybe some bad investments into these rp products and they'll still get paid even if you know cash flow available to shareholders isn't isn't growing i think the economics on those things are so good anyways especially at this

point just like with icos and with uh zin that it's probably not going to matter it's not like they're they're not selling these at a loss um yeah you wish yeah you wish the incentives were better but it's not it's not going to matter yeah um not to mention i mean they're i think they're more incentivized to for shares in the company to do well and they know what they know what the shares are tied to which is generally earnings for these businesses since they're at such maturity or cash available to shareholders um yeah that is the one thing i like about these shareholder basis is either they're really old um and they love their dividends or they're very rational and it's not they're not propping i mean management knows what matters they're not

propping up like i guess irrelevant statistics generally so i do like that yeah i mean it's better than most and look at the ownership table very very boring we just got index fund people and The insider ownership is at 0.14%, which is not a giant deal, just given the company is at a market cap north of $100 billion. So I think the executive team still have good incentives there. With the insider ownership, I believe half of that is Kalon Sapulos, the CEO that has been there for a long time. So he has some good skin in the game. I think that's kind of nice. As an executive chairman, he wants everything to be aligned so he can build probably whatever his goals are with his wealth over the long term.

But let's not spend too much time on that. Ryan, earnings. What do you want to hit? 2022? 2022 earnings? Sure. And the other thing I was going to say was it's worth keeping in mind that when we look at ownership, a lot of the pension funds, a lot of the big endowments, a lot of funds just in general can't touch because of rules. They can't touch Philip Morris International or even some of the other tobacco businesses as well, not only because some people hate tobacco or don't want to invest in the company for those reasons, but also there's now, and this was called out in the 10K, there's a lot of pension funds that say, if you're still doing business in Russia, we're not going to invest in you either.

And Philip Morris does, and I'll talk about that in the earnings here. That's good. Hey, we like that though. We don't like them being in Russia. We like that no one can invest in them, obviously. Whatever, keep that on the side. Cheaper multiple. Yeah. If that drives flows away from them, that can be a good thing for a self-funding company. Yeah, absolutely. For earnings, in 2022, they did basically $32 billion in revenue. It was only growing 1% year over year, but if you exclude foreign exchange headwinds, they were growing at about 8%. So solid growth, especially relative to a lot of the other tobacco manufacturers.

Russia and Ukraine accounted for 8% of overall revenue. I think maybe we can address this here. I'll talk about Russia overall. A lot of business in Russia, they manufacture a lot of cigarettes in Russia. They have a lot of employees in Ukraine. They have been trying to divest this business or try to sell it since this stuff went on, since basically the war started. And they can't really, they've said that the regulatory environment has gotten too difficult to sell. So they continue to operate there, but they've really cut back on a lot of investments, a lot of marketing. They've downsized their manufacturing in Russia. Getting employees out of these regions. Yeah.

Getting employees. So it's been a big drag and it's been very costly for them. And so revenue has really, or at least I assume, units has declined steeply in Russia specifically and Ukraine. Well, maybe not. I don't know. Do you remember seeing that? I don't remember seeing that. I wouldn't say that's a certainty. They don't say it exclusively for Russia. I remember seeing Eastern Europe, I'm pretty sure volumes declined. But a lot of that is also because they've ceased the Icos and Illuma investments in that area. So a lot of the new growth is just not showing up in Russia. And then, you know, potentially you have a lot of your customers actually dying. So there's the risk.

I think margins, yeah, the biggest worry there, for sure. Yeah, I agree. But it's a risk. So 8% of their overall revenue comes from Russia and Ukraine. And I would just, I don't know. It depends. It's very uncertain. You could almost write it to zero if you're trying to be conservative in valuing the business.

But when we look at the margins of the business overall, 64% gross margins versus 68% last year, I mentioned a lot of the transportation costs. The CFO even called that out exclusively in the conference call. He literally told analysts, listen, we've been saying that transportation costs are up. It's not like they're up a little bit. They're like three times as expensive as they were. So it's been a huge headwind for them. But then on top of it, the actual Illuma device sales, so Icos Illuma is one of their new Icos devices. It's done really well. The device sales are lower margin and then they are higher margin on the actual, I don't want to call them cigarette, but the heat stick sales. So it has sort of a diluting effect on margins in the short term, but as these businesses scale, theoretically, they're more profitable overall in the long term. So that's kind of what we're seeing as far as the margin contraction over the last year. Over the last 10 years, it's usually been high 60% range, but $12.2 billion in operating income, that's 39% operating margins. They did about $10 billion in free cash flow this year.

Their CapEx, or their purchases of property and equipment, has accelerated quickly over the last three years because they're investing and expanding the facilities and investment into these newer devices, both nicotine pouch expansion as well as ICOS expansion. So you're probably going to see heavy investment over the next year or so, probably two years. And then they've halted buybacks at the moment, likely, well, partly because they acquired Swedish Match, but now they've got to pay down their debt, which I'll talk about in a second. They also pay out their dividends. So I haven't mentioned it yet, but they have a 5% dividend yield at current prices. And then they're going to have that increasing capex so that they still have a suspended share repurchase program, but over the years, they have repurchased kind of periodically. yeah, I guess, do you think I'm missing anything there as far as financials? I don't think so. No, that's the most important. And historically, yeah,

their operating margin has been a little higher just due to these headwinds this year. It's a little bit lower. I think a big question is whether they will go higher into the 40% range, 40 to 50% range in the near future. All right. Balance sheet, they do have a lot of debt, $43.1 billion in total debt. The bulk of that is fixed rate. And I mean, they had a lot of debt prior to the acquisition. But when they acquired Swedish Match, they also acquired some variable rate debt in that process. And so in 2022, their total weighted average cost of the debt or the interest rate, if you want to measure it that way, it was 2.5%. But shareholders should expect that to rise. Management has called that out in conference calls. Majority of the debt doesn't

mature until after 2029, but I expect them to probably pay down earlier, especially on some of the variable rate stuff. They have a habit of rolling debt. I would just expect interest rates to come up over time. Still looking at a lot of the fixed rate debt that they have, they've locked in pretty low rate financing. Kudos to the management team. I think that's a byproduct of having a very predictable business like they do. As for the asset side of things, they've got basically $3 billion in cash, $4.4 billion in equity investments. I would probably exclude the equity investments

in the EV calculation. It's not easy to sell them, I imagine. Well, no, no, I disagree. But that's just- Would you include it all? Yeah. Good. Yeah, I mean, it's not liquid for like debt,

but it's definitely what you're owning, right? So, okay. Yeah, I mean- It's not meaningful though, so. I'm thinking about it in terms of ability to pay down debt. Yeah, but that's not what you're doing an EV for. Maybe including the EV. I don't know if I'd include it in your net debt calculation.

That doesn't make sense, Ryan, because that is... I know, but it's not payable. If you're looking at cash... Okay, sure, sure, sure. You're looking at the ability to fund your debt. Right. So if you're looking at a net debt to EBITDA or something... Having long-term equity investments probably isn't that valuable or it's misleading.

Yeah, they might be illiquid, yeah. For the purposes of just calculating the basically debt ratio, I excluded the equity investments, but just know you are getting an additional sort of $4 billion in equity investments. um net debt to EBITDA ratio is about 2.9 times but if you you include full year of Swedish matches results it's about 2.75 times very manageable um not a whole lot of concern here my only gripe would be if they were able to acquire Swedish match with stock a they want to have as much debt they need to pay down early so less variable rate debt shareholders want to have bad had the tax burden and they could have just rolled it into Philip Morris stock. That's more of my personal gripe, but also they'd have more capital to potentially be buying back right now, as

opposed to having to pay that down higher rate debt. So that's kind of my only gripe, but I don't know if Swedish match management team would have been as excited to take the deal if it weren't cash. Yeah. Yeah. Not a huge deal over the long term, but yes, interesting that they decided to go that route. Let me hit valuation quick, super easy. Enterprise value today, I have at about $190 billion, just under that, depends on where the stock's trading. And if we look at the two numbers I'm going to use for them are the EV to EBIT, which is enterprise value divided by basically operating income, and then EV to free cashflow. On a trailing basis, we're looking at EV to EBIT of 15.5, which is a little bit under the market average, much higher than a couple of

other tobacco companies but people should remember that they and tbd if the margins do recover that they are at a bit of a potential margin trough here um in the near term and then we look at free cash flow um they're at 19 also doesn't include a full year that doesn't include a full year of swedish match results okay hopefully the audio is fine ryan sorry it froze it froze on me but I think I understand. Yes, it doesn't have the full year Swedish match results yet. So maybe that'd be lower. You want to run a pro forma, possibly get that a little bit lower. And we'll see how that fills out over 2023. And on free cash flow, we're at 19 and a half. They have consistently converted slightly less of their operating income into free cash flow over the

last five years. I'd maybe look for that to recover over time. We'll see. But right now, The actual cash generation has been a little bit less than the quoted earnings power. All right. Anecdotal evidence. Yeah, what do we think here? I don't know. It's a consumer brand, so I guess we have to have some anecdotal evidence here. Yeah, I don't smoke cigs, and I'm in the US, so even if I did, it would be an altruist business anyways.

But I think Zinn is a wonderful product. When I talk to friends, and a lot of people my age just carry a pack of Zins on them all the time. And so I've asked, have you considered any other nicotine pouches? And it's kind of like one of those annoying shareholder questions, but they were like, what are you talking about? I was like, any of the other Zin competitors? They're like, oh, I didn't know it was a category. They just think it's Zin. And that's indicative of the market share, 76, basically three quarters of all can volumes are Zin cans. And I think it's a wonderful business. I think tons of pricing power with probably tons of room to grow volumes. I don't know how it would pan out in Europe, but I know in the US, Zin is really loved by a lot of customers.

yep and in europe icos is doing phenomenal as well how do you think icos would do in the u.s i'm a little bit lukewarm i don't know yeah don't know what do you think yeah i'm lukewarm i don't think it's a cinch yeah i agree just like anything because it's still kind of cigarettes in a way and i think there's just this big aversion to cigarettes in the u.s among younger people Yeah. Or anything that looks like that. Yeah. It's more of a negative socially. Yeah. I guess my anecdotal evidence may... Do we want to talk about what we think the RRP market might look like five to 10 years from now? Do you think pouches plus whatever heated tobacco units plus vaping are really going to continue gaining share? I mean, is there a ceiling for what these are going to be out there? I would think they could easily, as a whole, and now TBD, if Phil Morris is going to retain their leadership position, could be three, four times the size as they are now, say, seven, eight years into the future. Yeah, I think so.

And this kind of eats into our future growth opportunities, but everything I've seen from ICO in Europe and globally shows that there's just like tons of momentum behind the brand. Zinn, I've seen it like in person, there's tons of momentum. It's a wonderful business. So I suspect both those will, and this gets into the math that we were going to do for the bull case as well. I would not be surprised if both of those businesses really surprised the upside volume-wise over the next decade relative to what people think. Yeah, or relative to what the price is indicating today. Yeah, I'd agree. I think I'd lean that way as well.

And I also like the – in one way, I like the international tobacco market more because in a lot of the countries that Phil Morris operates, there is less public scrutiny around cigarettes. However, I didn't read this after I wrote this down, but I would like to hit on it. In some of the markets, there has been more pricing implementation than in the United States. So there might be a little less room to grow prices, which compared to someone like Altria over the long term, but it's not a huge deal. Let's move to future growth opportunities. We're going to get to two big ones that everyone cares about, and that's Swedish Match and

iCoast. Ryan has Swedish Match. So Ryan, why don't you discuss a little bit more of the details of that business? Yeah. So I guess we've talked a lot about Zinn, but they also have traditional oral tobacco. They also have a cigars business. They have a lighters business, which is tiny. So there's other things in there.

But Philip Morris closed on their acquisition of Swedish Match for $16 billion in November of 2022. So you'll see a little bit of Swedish match results in Philip Morris' financial statements, but it's really only like 50 days, a little over a month. Philip Morris paid basically 17 times Swedish match's expected 2023 EBITDA. I've said it before. I think Zinn is one of the best businesses around, and kudos to Philip Morris for being able to pull this off. Yeah, Brett's pulling up the Zinn shipment volumes here. It's truly astounding.

since q4 of 2017 i just ran the numbers zen has tripled its volume annually now it's obviously slowing and a lot of those were kind of front end loaded but tripled it every year if you do the math backing into q4 between q4 of 2022 and q4 of 2017 they've gone from what was it four million cans a quarter to 238 million cans a quarter it's pretty staggering just to think about. And then on top of it, I already mentioned it, that they do have tremendous operating margins in that business, better economics even than Philip Morris's core cigarettes business. And the other thing here, management wants to begin deploying Zin across its international distribution channels as well, which should hopefully supercharge growth.

i have some concerns i guess i like i never you never know how a brand is going to translate in a different market i you know i would think is in would do well but they might be kind of dominant over there yeah they might they might try some new name they might use a different they might even use a different product i mean they talk about how they have i think it was a thousand or whatever it is it's a lot the biggest rnd team in nicotine working on products like this so maybe they have an improved Zen product that the more, how do I say, more, I guess, untackled European market, excluding the Nordics, for snus-based or whatever, these nicotine pouch things, it could even have a better one. And maybe that's how they try to counter position

themselves to Velo, but we'll see. I think the interesting part was in is you kind of have a call option to add on their, whatever it is, the nicotine pouch product, whatever they're going to call it onto philip morris international's distribution network across the globe and vice versa and vice versa on on zin's distribution channels in the u.s yep yep yep 100 and i would also note that the eastern part of the united states i think they basically do east of the rocky so the vast majority of the population of the united states is about two to three years behind on nicotine pouch penetration versus the West Coast. So my thinking is, unless there's a bunch of disruption,

that this growth that Zinn has been on should continue for at least a couple more years and volumes should probably double or triple within five years. The last thing I'll say is the US dollar revenue that they earn, so Swedish match earns a lot of money in the US, that should help slightly smooth out some of the foreign exchange headwinds that Philip Morris has been seeing, but still it's a relatively small percentage of Philip Morris' overall business. Yep. And who knows? Maybe it reverses.

Yeah. Maybe it reverses. They become headwinds. Who knows? But not a big deal, but yeah, nice little thing. I'll talk about, I mean, there's a lot of future growth opportunities. I don't know if this is my favorite one. I think I like to say it a little bit better, just because I think that market's a bit more predictable. But one that is going to be important this decade is entering Icos into the United States. Originally, PMI had a distribution agreement to bring the innovative Icos platform to the United States through Altria's distribution network. And remember, for any listeners that don't know this industry beforehand, Altria is the remaining group of Philip Morris USA, and Philip Morris International is the international

brands that split off in, what was it, 2009, 2010? I can't remember the exact date. whatever the economics of this deal were, it is now broken with the official closing date as April 2024. So one year from this recording, PMI is paying Altria $2.7 billion to get out of this deal. And I believe it was done because now they're going to be on the Swedish match distribution network and are going to build out their own distribution and through the US to put both icos and zen into convenience stores now let me see anything else i mean they talked about those are the two growth avenues yeah okay yeah but anything i'm just thinking anything else with icos that i had in my notes here oh yeah in the press release the executives threw a little bit

of shade at altria saying that they will they want to let icos quote live up to its full potential in the market now my question is do you think this is a smart move to break the deal i just i don't know i have no idea it might not i have concerns that icos just might not be able to gain as much success in the u.s it's not yeah it's not altria's fault yeah so maybe paying out what it was at two billion dollars dollars in total to do this it's kind of risky just because the habits are different in the u.s than they are internationally i do think there's this massive aversion to anything cigarettes based in the u.s it's not really accepted socially like it is and i think what's the most common smoking markets italy italy is

probably one of the highest France I don't know South America yeah there's a few there's multiple I mean and in Southeast Asia as well there's a lot

yeah it just I don't know it's still it's it's a much riskier I think growth to underwrite like if you're I think Zen can have more

success I'm I'm more I think it's more likely that Zen succeeds in Europe than Ico succeeds in the US I think Yeah. I think I'd go with that too, but both are a bit risky. Now, I think both can grow in those

core markets regardless, but I think both bets of getting global distribution, it's not a guarantee right now. I think that's one of the big risks for this company. But let's move to highlights and lowlights as we slowly wrap up the show. Ryan, what do you like, dislike about this business? Obviously, we got to like the pricing power of tobacco, but why don't you go through that? Yeah, I mean, that's one of the highlights for sure that the economics, the profits, the different characteristics of tobacco that are so positive for shareholders, the ability to raise prices and the fact that their customers are literally addicted, that bodes well for shareholders. There's also the competitive advantages of how difficult it is to enter this market today, given all the regulatory hurdles. And then on top of it, within the smoking segment, I like that Philip Morris operates in markets where it isn't declining as quickly. Smoking isn't.

That was kind of one of my big gripes with Altria. And Altria has had the ability to raise prices quicker. Yeah, we do have contention. we do debate the pricing power in the US. Ryan is a lot more nervous about it than I am, but this isn't an Altria Group show. Right. And so I like their combustibles business. I think it's obviously very durable since it's been around for 150 years. But the real positive for me is within the reduced risk product market, so the industry as a whole, which I think that market will see really good growth over the next decade, they seem to own

the two best businesses that I've seen. Yeah, so far. The only ones that I've had any sort of hints of durability yet. Yeah, and British American Tobacco seems to be kind of a close second in terms of growth within those segments, but still it's small relative to Icos and Zen

and Altra is totally fine with the transition. Yes, of course, of course. Here's the thing I don't like about BTI, British American compared to Philip Morris International, why I like them a little bit more is I do not like the vaping industry whatsoever. I think it's uncertain, right?

I just think, yeah, it's very unpredictable. Way more regulatory pressure. Yeah, it's very unpredictable to me. And PMI seems to have absolutely phenomenal regulatory capture. Just to be clear, ICOS is not vaping. So for anyone that might have it confused, hopefully regulators view it as a different category. heat not burn is different than e-vapor. But the last thing I'll say is Icos and Zinn,

both theoretically, at scale Zinn already does, have better margins than Philip Morris's core combustibles business. So it's not like they're having to make this transition to a lower quality business. It's potentially higher quality as well. As for my lowlights though, the Russian and Ukrainian exposure is obviously a big one. I mean, it's basically no one knows what's going to happen with that segment. There's the risk that Russian government kind of treats them unfairly because they've been investing less in the Russian market and helping their Ukrainian employees. So it's just really big uncertainty in that market. And so that's obviously one risk. The other one, this is being nitpicky, but they should have made the Swedish match acquisition with stock.

I would have preferred that. And then there is just interest rates will rise for them a little bit just because they added some variable rate debt. But still, they've done a good job managing their debt and allocating capital over the last 10 years. So it's hard to complain. Preston Pyshko Yep. And they should be able to pay that debt down to the more of their historical EBITDA to debt ratio within the next couple of years. It's not a giant burden. They didn't take it super aggressive here. But yes, I would mention on the Russian Ukraine stuff. Yes, that is a risk because geopolitically, it's kind of a hot potato and no one really knows, I think, what to do with

some of those businesses that aren't the ones that are the key sanctions that the Western world has put on these um operations in in russia i think we just saw like nintendo trying to make a decision on that you know some of these things that aren't geopolitically more of just consumer products and the interesting thing is i don't think they're gonna you know they're not gonna ban cigarettes in russia because i remember i think that was the market where or the country where they tried to ban it in the past and there was these there's almost like a coup i forget the story but Something happened where they tried to ban cigarettes. Oh, no. If you smoked them, it could be Russia. I think it was Eastern Europe or Russia, where if you smoke cigarettes, it was punishable by death, and people are still doing it under the black market. So I don't know. Maybe PMI's business goes away, but I think the demand for cigarettes, regardless if these areas are in total war-torn chaos, or at least the Ukraine is, this is the one business I would bet on surviving.

And I sound like I'm laughing here, but I'm being serious. It's the one business, even if the countries continue to go down a terrible path here, that's the one business I would bet on comes out the other side, at least in tax somehow. Now, whether PMI gets any of the equity value there or the intrinsic value there, that's another question. And if you're a Western country, you want them to keep serving there because they're potentially killing Russians. some sanctions yeah and they're they're extracting money uh you know it's extracting money out of the country so yeah yeah what are your highlights and lowlights ah so i think they are in the parts of the cigarette smoking universe like i mentioned before that should be quite durable everyone at this point knows that smoking is bad for you and yet usage has not fallen off a cliff in a lot of these countries yet. Will that change over the next few decades? Maybe, but that's plenty of time for PMI to introduce these new nicotine products. And then second highlight, this is more of an

industry-wide or looking at it from a historical perspective, nicotine usage along with caffeine, I think it may be added sugar in there as well, has seen rapid adoption since the industrial revolution. And I see no reason why humans will not want to continue consuming these mild stimulants on a habitual basis for the next hundred years as well. I think that's just a fantastic industry to be in where the demand is durable. Yes, there's some disruption about who the winning brands will be in these new age products, the RRPs, but, and this comes to my other highlight, they have the two brands, Zinn and ICOS, that we've talked about time and time again on this episode with the best track records of growth over the last 10 years.

and now they're both in the PMI portfolio. Lowlights, I worry about FX headwinds a bit as a US investor. It's a coin that can really land on both sides in certain periods, but it definitely adds uncertainty compared to a company like Altru Group. Second one, and we didn't talk about this yet, but I really want to know what their plans are exactly for these, what they're calling healthcare businesses that they just bought. I understand that they've succeeded very well in the last few years. Developing RRPs and ICOs, I guess, was pretty revolutionary. But I wonder whether they are overstepping their circle of competence and wasting some capital with these new divisions. We don't know exactly what they're producing here. We don't know exactly how

they're going to be used, but they did spend a good amount of money on some of these companies. I forget the names because it really doesn't matter yet. We'll see what actually ends up happening. They present some solid call options though, but I get a little bit concerned when they talk about the need to go quote beyond nicotine which has been a tagline for some of these things for a while and i i wonder whether they'll that's not their bread and butter yeah i agree and there's really limited disclosure and communication about those businesses in general also so that's kind of i don't know what they're don't really know what those are um yeah but who knows maybe um maybe another hit product maybe another hit product out there they're burning

200 million dollars a year and in those segments roughly yeah and that's not the end-all be-all but it does hurt it's not fun like it's not Altria is not doing this yeah and that's why Altria Altria's operating income has risen and if I look at PMIs uh let me just pull it up I'll have these charts again we'll have some of these nice charts if anyone's listening within the newsletter definitely subscribe to that to get all these charts in there if we look at operating income for PMI. Yeah. FX headwinds, whatever. Offering income in 2018 was 11.4 billion. Last year, 12.2 billion. So not really much higher. Yeah. Let's talk about bull case, bear case. For me, I don't think the math's too complicated. There's a very realistic scenario

for me where cashflow grows by more than 10% annually over the next decade. The next year or might be tough. It seems like they've got a lot of short-term kind of headwinds coming. And when there's big adoption of the new devices, it's margin dilutive. So that might be- It looks bad at first, yeah.

But I think the 10% plus cashflow growth annually is doable. And that would probably come, or it would have to come from strong volume and pricing growth at Icos and Zyn, expanding margins because of those two products growth, And then slow declines in combustibles, but they're able to offset that with price increases. If all that stuff occurs, I certainly see a path to 10% plus annual cash flow growth.

That would give them also the capacity to buy back shares. And maybe, and this is where it's maybe debatable here, there's some multiple re-rating. Not necessarily because it's no longer seen as a sin stock, because I still think reduced risk products would be considered sin stocks, but because it's considered a growth company. It's no longer a business where unit volumes are declining. It's a business where they've got mid-single digits to even high-single digits. Volume increases potentially in five to 10 years. Yeah, I could see that happening.

Maybe. I mean, that's nice. I think it's there. But I also think if margins go from 38% to 45% on a consolidated basis, is you basically see the multiple expansion benefits without actually seeing them, where people might be thinking, oh, okay, the earnings multiple,

they're kind of looking through and thinking margins will expand, and maybe it stays at the 15 to 16 times range as it is right now. But yeah, I think that we'll see. Does this deserve to trade at 20 times? I don't know. But I think I'm much more comfortable betting

that margins will get back to 45% unless foreign exchange just continues to be a headwind. I think it would trade at, if the trajectory of the smoke-free products continues the same trajectory they've had, I think in five years, it trades at what Swedish Match traded at prior to them being acquired, a premium to the rest of the tobacco providers. Yeah, yeah. And CBD, whether that's 20 or 15 or maybe 17 to 18 could be reasonable, but either way, you'll make money. Yeah. I think here's what I'm looking at for a bull case. Management believes consolidated margins are going to expand over time. You got to expect that happens. They grow the dividend. So the dividend payout grows and you add that into your total return here. And then you see modest

single-digit revenue growth over the next decade. The stock will perform well if this happens and they don't bungle it with bad acquisitions or something like that. So yeah, I think that's it. Bare case, what do you think, Ryan? I know it's very hard to have a bare case where you kind of lose money in the tobacco companies over the long term. So I think maybe what's the bare case of, well, the stock just continues to underperform.

Well, if there's not the growth in smoke-free that's expected, then you're still just buying the combustibles business, which my concern is that the next 10 years look like the last 10, where you're getting a bunch of like... Concern? That would be pretty good, Ryan. I mean, drastically underperformed the market.

Oh, you mean the stock? I thought you meant the combustibles business. I'm saying if you're just buying the combustibles business, I think you might get the same kind of stock performance you got over the last decade. Yeah. And it's not, I mean, that's not the end-all be-all. It's not the end of the world. You're probably getting a mid-single-digit tagger. um it's it's underperformance probably but who knows maybe that outperforms maybe maybe i guess yeah that's certainly possible um maybe the competitive dynamics are different in the smoke-free categories uh that would that would suck but i really do think this is a very different business than it was five years ago. To me, it's kind of the leader in RRPs and could be

seen potentially as a growth company at some point if those businesses are what we think they could be. Yeah. I love how you turned the bear case into the bull case. That's when I know you're going to pitch it as a stock we want to buy, but I'll take mine as well. Yeah, it's similar. Look, they have the two leading brands in RRPs right now in certain markets, Zyn, Icos. But this industry has been dynamic. It wouldn't shock me if the RRP market looked very different 10 years from now. Yes, PMI seems to be the leading position to capture that, even if they disrupt themselves with some of these new products that they're investing heavily in. But if that happens and they don't succeed, PMI could have a declining SIG business and then declining brands in RRPs

piece that showed not to be durable i think they're better positioned but it's not a certainty that they're i i don't think it's a certainty that their volumes are higher materially higher let's say five to ten years from now although i would bet that they are i would bet that they are but there's still a scenario where they aren't if you go what i mean like we could think that they're not, but I think there is a scenario where they're not. I agree. And I don't like when companies, you look back and it's constantly been these one-time things where it's like, oh, margins, we're depressed this year for this reason, or there was this headwind and we invested here, but it's because we see the long runway. And ultimately you look out over the last decade

and it's been underperformance. That seems to be what's happened at Philip Morris. However, They've really caught fire with the Icos brand, and Zinn is good as well. The other thing that maybe is worth bringing up is management has said that Icos has cannibalized their existing cigarette customers in some capacity. If Icos gets more competitive, that market of heat not burned, and someone else is cannibalizing Philip Morris' business, that would suck. I mean, that'd be a double whammy. Yeah, 100%, 100%. However, in this industry, it's generally slow moving. So yeah, you probably still come out clean on the other side because of dividends.

But yes, that would be pretty value destructive. All right. More or less interested, Ryan. I think I know your answer, but closing thoughts here. Yeah, more interested. I've been more interested in the two consumer goods businesses that we've studied. I think Philip Morris is a more attractive valuation. i still there's something kind of like not set sitting well with me after looking at this

business i'm not sure what it is i think it's kind of just that it's been like a constant theme of underperformance and kind of excuses yeah lagging altria despite having a way better position yeah or yes exactly exactly like when does it actually show up now i think Yeah, I agree. I'm more interested at the right price. Is this the right price? Potentially, given if you think margins can easily expand, which I think they can. This could be the right price for sure.

But yeah, I still have some hesitations as well. I think probably the same concerns plus Russia, Ukraine. Not great. Got to discount that a bit. All right. Next week, we're going to be covering Pepsi, which little known or well known among consumers, but maybe little known among shareholders as one of the best performing stocks ever and actually outperformed Coca-Cola since Buffett purchased it, I believe, or at least one of the times

he took a position. But I think that's what some research will do to confirm whether that's true or not. We'll cover them on the next episode. And then after that, we're going to be covering an Arch Capital episode on why we own Nintendo, another large consumer products company. As a reminder, before we leave, some housekeeping items. If you are a regular listener to the not so deep dive episodes, you're going to want to subscribe to the newsletter. It's called chitchat money, searching on sub stack search chitchat money newsletter on Google, or the link is in the show notes and sign up there. You can get the notes delivered directly to your inbox for free. If you like watching these episodes instead, when we kind

of share the screen, check out some of the stratosphere tools on there. You can do so on YouTube or Spotify. And if you want, if you enjoy the show, give us a good review on either Spotify or Apple podcast. All right, that's going to do it. As a disclosure, we are not financial advisors. Anything we say on the show is not formal advice or recommendation. We are general partners at Arch Capital and clients may hold securities discussed in this podcast. Thank you all for listening. We'll see you next week.