Company transformations and separations are not an uncommon occurrence. The goal of so-called spin-offs is to grow by shrinking first. Such special situations can create shareholder value that is uncorrelated to broader markets. Over the past days, I started to think through possible coming spin-offs. The iconic Marlboro maker Philip Morris came to my mind, as it could slowly start to make sense for them to start a divorce to focus on their growing business unit, throwing off ballast and cashing out, soon.
Summary and key takeaways from today’s Weekly
– Philip Morris develops rapidly into a majority smoke-free business.
– There will come a time, when the current combination of legacy and future businesses will have to split, because the legacy tobacco business will start to drag too much on overall results.
– My thought experiment shows that Philip Morris is currently not cheap enough to be interesting for me. But it is a clear watch.
In April, I wrote a Weekly about German conglomerates and their progressing “becoming fit again” programs (see here). The main point of this article was that while several decades ago, towards the end of the last century, it was en vogue to create big conglomerates as a sign of strength, the last two decades rather were the opposite.
Siemens (ISIN: DE0007236101, Ticker: SIE) and Bayer (ISIN: DE000BAY0017, Ticker: BAYN), two German heavyweights, kicked-off a wave of separating from not-fitting and uncorrelated (as well as more cyclical) business units that were supposed to be better off without their respective parent.
While such divorces have the goal to free up mental and financial capacity as well as to enable own decision making and agility, the results are not always, even more often than not, as hoped.
Also, parent companies can use spin-offs just as a means to throw off ballast, being it capital intensive units or spinning out low-growth, but strong cash flow generating businesses that take a lot of debt with them – creating breathing room for the parent.
For a few days now, I have been thinking about tobacco giant Philip Morris (ISIN: US7181721090, Ticker: PM), the “international Marlboro company” with its operations outside of the USA.
The situation is clear – they have a legacy tobacco business that is slowly shrinking volume-wise, but held up so far by price hikes. On the other side, PM has been heavily investing in new growth avenues through research and development, marketing new products as well as by acquiring several companies – the most prominent and by far the largest being the takeover of Swedish Match at the end of 2022.
It is no secret and PM says it by itself: The growing cigarette-alternatives are cannibalizing the still dominant core business. With this setup, doesn’t it make sense now to separate from the old and slowly dying cigarette business?
In today’s Weekly we are going to examine.
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Growing through shrinking first
The two most common ways for a company to grow are either organically out of own force or by acquiring other businesses, i.e. buying growth externally.
Three directions can be pursued with an acquisition: Swallowing direct competitors to increase the own operations and market position (so-called horizontal integration), buying suppliers or theoretically also B2B customers to cut costs (vertical integration) or diversifications into new areas (lateral integration).
Especially with the last one, it is important to not fall victim to Peter Lynch’s “diworsifiction”, meaning destroying shareholder value with unnecessary and unfitting transactions.
If done properly and where it makes sense, separations have the potential to create or increase shareholder value, enabling new growth.
However, there are certain key success factors.
The studies linked above are saying that a spin-off is not a guaranteed success by itself, but to achieve a win-win situation, where the parent company (parent co) and the spun-off entity (spin co) both flourish, it is necessary to have a strict disconnection. This way both entities will be able to make their own decisions and be more agile with important decisions.
Another point is that clear financial targets must be defined.
When it is clear what to expect, an underlying investment case can be better understood. Transparency is a crucial point and the lack of it is often the reason for holding discounts (conglomerates commonly having low valuation multiples) – they are simply too complex to be understood and valued properly.
If you have a slimmer business, straight realistic financial goals, higher management focus on its core activities and also clearer capital structures, it is easier to value the company. The reward is a higher valuation multiple.
The linked analysis by Barclay’s writes:
[…] in its analysis, the Barclays M&A Structuring Team found that nearly 60% of the spun-off companies traded at a multiple greater than their parent company post-transaction, and about half had margins exceeding those of their parent.Barclay’s: Shrinking to grow: Creating value through spin-offs (see here)
What they also write is that in order to achieve a win-win success, both, the parent co and the spin co need to have strong businesses.
On the other side, unsuccessful spin-offs also share some common characteristics like vast differences in the size of both entities, a lack of future growth and weaker margins, making them prone to lower earnings multiples.
I found it interesting to read that the study from the Harvard Business Review concluded in their analysis of 350 public spin-offs between 2000 and 2020 that 75% of them weren’t successful when measured by their cumulative performance of the standalone entities, post separation.
On average, the created shareholder value was only 5%.
However, the range was broad, where the destroyers massively underperformed and the success stories massively outperformed.
The reason for the destruction of shareholder value, despite the good intends?
HBR writes (highlights by me):
More than anything else, it is a well-crafted separation thesis that helps them to focus and provides a roadmap to value creation. In our study, we found that the existence of a clear and robust separation thesis was the single-biggest difference between top-quartile and bottom-quartile separations.Harvard Business Review, Research: Few Corporate Spinoffs Deliver Value (see here)
So, in other words, it depends on the underlying fundamentals, whether a spin-off has the potential to be value accretive. It is not a foregone conclusion that a separation will automatically lead to higher share prices, even if it can happen in the short-term.
Below you can see the share price of Mondelez (ISIN: US6092071058, Ticker: MDLZ). It was formerly part of the “big old” Philip Morris conglomerate (including today’s Altria (ISIN: US02209S1033, Ticker: MO), Philip Morris, Mondelez and the Kraft business from KraftHeinz (ISIN: US5007541064, Ticker: KHC)).
After having been spun-off itself, in 2012 Kraft Foods then spun-off its US grocery unit into a new Kraft Foods. The remaining international foods and snacking business was renamed Mondelez.
You can see that until the separation, but also including the financial crisis of 2008–2009, the old Kraft Foods / Mondelez combo has been going sideways for years. After the spin-off, the parent (Mondelez), due to having the better business, started to grow and with it its stock.
Among the largest spin-offs so far, by the way, have been several involvements of the “old” Philip Morris that comprised what are today standalone Philip Morris, Altria, KraftHeinz and Mondelez.
The old Philip Morris was a conglomerate, containing US and international Marlboro cigarettes, but also the food operations of the other two companies.
First, in 2007 the name-changed Altria (from prior Philip Morris) spun-out the Kraft business which included the whole grocery operations. The transaction value was around 46 bn. USD – a top 10 spin-off until today.
One year later, Altria separated from its international operations, creating today’s Philip Morris. This is still the biggest spin-off ever and the only one having a transaction value of more than 100 bn. USD.
And then in 2012, Kraft Foods also broke into two entities, a non-growing US grocery business (which later merged into KraftHeinz) and an international food and snack business that is today Mondelez, which I described above.
Here you can see the Wikipedia overview.
With this, let’s have a look at Philip Morris. Should it separate? What type of different entities would a spin-off create? And what about potential valuations?
Is Philip Morris about to throw off ballast?
The rationale for me for a separation between the legacy tobacco and the non-cigarette (smoke-free) business is straightforward.
The old tobacco business is strong on cash flows, doesn’t require much investments to sustain its operations, as the products don’t change and are produced en masse. Self-explanatory, it is not growing, but facing perpetual declines in volumes.
Results are holding up well due to price increases, but as I wrote in my Weekly “A king is falling – why Altria’s butt is burnt down” (see here), prices cannot be hiked into infinity. At a time, there comes a natural end to this cycle, requiring disproportionate price increases, meaning the decline of business results can be slowed down, but it cannot be stopped with this tactic.
What I described as “non-cigarette” is a fast growing set of offerings like the self-developed heat-not-burn device IQOS, a vaping option and the recently acquired business of Swedish Match with its nicotine pouches and non-combustible tobacco products (plus a cigar business, Swedish Match wanted to spin-off itself, see here).
You see, these two segments are as contrasting as they can be:
- tobacco: not growing, declining volumes, strong cash flows, only low sustaining investments needed, strong margins
- smoke-free: fast growing and cannibalizing tobacco, growth and especially marketing investments needed, cash flows and margins not publicly broken down, but confirmed by management to have higher margins in the future
Regarding the last point, the CFO said this February on a conference the following (highlights by me):
“Now, we thought it was important to here emphasize again the fact that we’re not moving away from combustible cigarette to replace it with the business of lower quality. On the contrary, we are coming with a business that has a potential to be significantly better in term of growth of course and in term of profitability than the combustible business. […]”Philip Morris CFO Babau, CAGNY Conference, February 2023
It is out of question that at some point in time, the tobacco operations will start to drag on the overall results through declining volumes and also having less profitability.
So it would make sense to get rid of it, as long as cash flows are so strong in order to free up the smoke-free business, wouldn’t it? Smoke-free could achieve a higher multiple due to its growth profile and make use of it to raise capital if ever needed (with only minimal dilution).
On the other side, the old tobacco unit is still subsidizing the growth of its own cannibal.
Hence, the timing question is not so easy to answer.
On the chart above, you can see that total volumes are slowly shrinking from 173 bn. sticks or units on a combined basis between tobacco and smoke-free products to 171 bn. units (excluding the acquired offerings from Swedish Match).
On an annualized basis, 171 bn. units make 680 bn. sticks.
For comparison, five years ago, Philip Morris sold in total close to 800 bn. cigarette sticks (see here). Now, it’s less than 600 bn. cigarettes annualized or about 25% less. IQOS – the main smoke-free product – was first introduced in Japan and Italy in 2014.
In Q1 2023, Tobacco decreased by 3%, while smoke-free was able to increase its volume by 10%. With this overview, we see that tobacco makes 84% of volume sold (excluding modern oral).
But what about revenues?
PM’s smoke-free products are already responsible for roughly 35% of total revenues! And this with only having a share of 16% volume-wise.
This means that smoke-free generates between 2x–2.5x as much revenues per unit as the legacy tobacco business!
Combine this with a higher profitability in the future and you see my point.
As far as I know, the goal is to break-even in about two years, reaching parity between cigarettes and smoke-free products on a revenue basis. Or in other words, from 2025 onwards, what is currently known as Philip Morris, should be a majority smoke-free business.
With IQOS entering the US market during the first half of 2024, the fast growing and dominant nicotine pouches Philip Morris acquired from Swedish Match and several other new smoke-free products, this goal is achievable at prevailing growth and decline rates (the latter for tobacco).
Until then, I don’t think a separation is likely.
Another advantage of a separation would be that Philip Morris could push the majority of the current debt load to the tobacco business. To finance the acquisition of Swedish Match, Philip Morris borrowed heavily and unfortunately at not low anymore interest rates. The current net debt position on the balance sheet is more than 40 bn. USD (4x free cash flow before the dividend of ca. 8 bn. USD).
That’s a sizable chunk, even for a cash generative business like Philip Morris.
Refinancing will bring higher interest payments. A few days ago, PM already refinanced several bn. USD with bonds having interest rates of 5% (see here).
The tobacco business on a standalone basis (without subsidizing smoke-free) could handle even the whole debt load, enabling a debt-free non-combustibles business. Or smoke-free would take some of the debt with lower interest rates and longer durations, while the cigarette business could borrow a new amount to pay a special dividend to the smoke-free business to give it marketing firepower.
There are several variations to play this.
However, you see there would be a growing business and a “bad” legacy business, likely slowly decaying. This makes it rather unlikely that both entities would develop favorably and creating a win-win.
In the case of a separation, the legacy tobacco business should be a reliable dividend company for the time being, but I expect sluggish stock price performance at best. Look at Altria or British American Tobacco (ISIN: GB0002875804, Ticker: BATS).
Many hold these stocks solely for their dividends and because they look “cheap”.
However, over the last ten years, with the exception of the dividend, there was not much to earn. Altria’s stock at least climbed by 24%, but this is less than 3% p.a. BAT even is down by 26%. As said, including the dividends, the performance is okay.
But the crucial question will be, whether these dividends are safe.
I am not so sure for the rest of this decade.
What about potential valuations?
Let’s start how the whole Philip Morris business is valued, currently. Its enterprise value, including the whole debt load, is 180 bn. USD. Generating a yearly free cash flow of around 10 bn. USD, results in a multiple of 18x (EV / FCF).
This is not very expensive, but also not cheap, showing the power of both forces pulling the rope in opposite directions!
But this multiple already includes a small growth premium!
Although in the current status-quo, the company is slowly growing and not looking overly expensive with an EV / FCF of 18x, the next paragraphs will show you that there seems to be already much priced into the stock!
We know that the legacy business generates around 20 bn. USD in yearly revenues. Say, it achieves a free cash flow margin of 40% (which will be pressured by higher interest rates). This means, 8 bn. USD in free cash flow. An equity multiple of 10 would be rather an optimistic goodwill due to the perpetually declining business (no other cigarettes business has such a high multiple).
Nevertheless, using the 10x multiple plus taking the whole debt load, results in an enterprise value of up to 120 bn. USD. More carefully, we could say 100 bn. USD.
With the assumptions above, the smoke-free business (Swedish Match was also quite profitable before), the remaining nearly 2 bn. USD free cash flow stand against sales of around 12 bn. USD, for a margin of 15–16%.
This is realistic, however, with lots of upside potential, with a fully scaled business.
But of the current 180 bn. USD in enterprise value, the smoke-free business would be valued at the minimum at 60–80 bn. USD. Put against my estimates above, this results in an EV / FCF valuation of 30–40x with the currently depressed margins due to scaling up the business. This is not cheap, even debatable for a growth company (it is modestly growing, not a hyper-growing rocket).
The calculation above – if roughly true and giving the legacy tobacco unit a high valuation – implies that a double either in margins or the whole business of smoke-free is already baked into the stock price!
And then, you’ll still be having a modest growth premium.
With that said, this shows that the whole Philip Morris today is rather not attractively valued – or in other words, a growth premium is already included! What I’d like to see is first a massive debt reduction to lower the enterprise value and also a break-down by the management concerning individual margins of both businesses. At a certain size, this should be demandable.
All in all, a separation is imaginable. At some point in time, it will rather be even necessary. But I am staying on the sidelines, as the price and debt load are too high for me at the moment. I’ll continue watching.
Maybe it could be worth a look again in the low 80s area. Then also the dividend yield would be above 6%, again.
Philip Morris develops rapidly into a majority smoke-free business.
There will come a time, when the current combination of legacy and future businesses will have to split, because the legacy tobacco business will start to drag too much on overall results.
My thought experiment shows that Philip Morris is currently not cheap enough to be interesting for me. But it is a clear watch.
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