This Vice Play Gives Downside Protection

By Ryan C. Fuhrmann | January 22, 2009 AAA

March 28 will mark the one-year anniversary of Altria's (NYSE:MO) spin-off of its overseas businesses into Philip Morris International (NYSE:PM). The move has yet to pay off for investors as the PMI shares are down about 18% from the spin-off date, though this is far superior to the market's overall plunge of more than 30% over the same time frame.

The sell-off of PMI is overdone and places the stock price at under 13 times the $3.33 consensus analyst estimate for 2008, official results of which the company plans to release February 4. This is a very reasonable multiple considering that analysts expect long-term annual sales growth in the double digits as PMI builds off its international market share of 16% across the 160 countries it serves. Throw in a current dividend yield of 5.3%, and it's clear there is plenty of total return potential in PMI.

Vitaliy Katsenelson, author of "Active Value Investing: Making Money in Range-Bound Markets" (Wiley, 2007) and director of research at Investment Management Associates, offered his insight in a recent telephone interview. In addition to the solid top-line prospects, he sees minimal legal risks overseas. This is in stark contrast to the legal woes Altria has seen in the U.S., which is also experiencing a decline in the overall number of smokers, given the undeniable health risks that stem from smoking. (Learn how famed investor Warren Buffett finds winning stocks; read Stock-Picking Strategies: Value Investing.)

Sinful Stocks
Indeed, investing in a company that profits from a product such as this may be more than some can stomach. I find myself on the fence on this issue given that smoking, like other vices such as gambling or drinking, is completely elective and can be relatively harmless when done in moderation. Katsenelson mused that what can be bad for the end user can be good for investors given the inelasticity in demand. This makes these products recession-proof, provides pricing power in good times or bad and leaves firms like PMI, MGM Mirage (NYSE:MGM), Reynolds American (NYSE:RAI) and Molson Coors (NYSE:TAP) stable cash flow from their core operations. (Like beauty, whether something is sinful often depends on whom you ask. Read more in The Evolution Of Sinful Investing.)

Final Thoughts
Speaking of cash flow, PMI is projected to generate $7.7 billion in operating cash flow. Capex should run under $1 billion, and $4.5 billion is expected to go toward paying the dividend, which leaves a couple of billion to repurchase shares or pay down the $9.2 billion in long-term debt held as of the end of the third quarter. Katsenelson estimates PMI could pay down its debt within a year if credit markets grind to a halt, though he sees this as a worst-case scenario. Few other companies combine favorable long-term prospects with significant downside protection in the current global economic downturn.

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