The Game of Getting Rich
“I used to say that always, the name of the game is not to be big but to be rich.” - Jacek Olczak, CEO of Philip Morris International
Following the announcement of an upbeat Q1 2024 result, PMI share price increased by 3.83%. In a nutshell, PMI is executing its strategy very well and getting richer as the operating metrics suggest, though stellar organic growth during the quarter was overshadowed by FX headwind. For more detailed coverage of the quarterly result, you may refer to an article on Tobacco Insider. I guess Devin Lasarre may share his thoughts on Substack soon so stay tuned.
Over the past 10 years, while PMI has been delivering high single digit adjusted EPS growth per annum on constant currency basis, its adjusted EPS CAGR in USD term was only around 1.5%, somehow in line with its share price growth during the period, which is also 1.5% coincidentally. i.e. there’s no P/E multiple expansion or contraction during this period, although net debt gearing has gone up. It implies that the market still has faith in the growth algorithm of PM, but also acknowledges the FX headwind impact on adjusted EPS.
While I understand investors’ frustration with the neverending FX headwind, even in hindsight, there’s not much PMI could have done to close the gap between the two numbers. While the result is important, one shouldn’t overlook how PMI played the cards that were dealt to it. It is always wiser to play the best hand and let the chips fall where they may. If you mess with the game, the game will mess with you.
For operations in emerging countries, currency hedging is very expensive so the best practice shall be adopting natural hedge strategy, i.e. to increase pricing at or above local inflation rate to offset currency devaluation, assuming inflation differential between such country and the U.S. more or less account for currency devaluation against USD, effectively increase local pricing when measured in USD term. However, it assumes purchasing power parity holds which in turn depends on many other factors. For certain countries with questionnable fiscal discipline or sluggish real income growth when compared to the U.S., inflation rate could be lower than currency devaluation magnitude. PMI can only increase pricing to certain extent considering affordability in each local market.
For operations in developed countries with hard currencies (e.g. GBP / EUR / JPY / CHF), normally one would expect the FX rate against USD to appreciate or depreciate in certain cycle. Thus it is not necessary to enter into full FX hedging considering the diverse geographic exposure of PMI, though it is feasible to do so. Very often the best practice is to match the revenue exposure against the currency of debt instrument, which PMI is already doing. Or perhaps limited scale of FX hedging to mitigate the transactional FX with respect to its cost base, which I believe PMI has also been doing.
When it comes to mitigation of FX headwind, I notice that going forward PMI may increase combustible pricing more strategically in markets with strong presence of IQOS. By increasing combustible pricing more aggressively and widening the price gap between IQOS and Marlboro, combustible volume may decline more rapidly but it would also accelerate recruitment of IQOS consumers, provided that availability of IQOS and consumer awareness has attained certain level. I want to emphasise that this was not a viable option previously. If PMI did it prematurely, it would end up having a smaller customer base of combustible products for conversion to IQOS. Consumers could have switched to other combustible brands even before learning anything about IQOS. If that happened, the customer acquisition cost of IQOS could be higher.
While IQOS and ZYN continued to perform well, it is worth noting that PMI’s vaping brand, VEEV, targets to become profitable in 2H 2024, though its scale is too small to move the needle. As Emmanuel Babeau, CFO of PMI mentioned in the earnings conference call,
We stick to our strategy which is we don't want to be big in vaping if it is to lose money.
Sometimes, what defines a great company not only lies within what it does, but also what it avoids doing. To get rich, it is not only about making money, but also about avoiding to lose money. This principle is not that difficult to understand, but somehow ignored by many companies. To be fair, PMI has also made some regrettable investment decisions but it was quick to realise something went wrong.
To put the post-earnings announcement share price increase into perspective considering the aforementioned, the magnitude of a single day share price movement is equivalent to more than 2 years’ worth of share price growth. In long run the market doesn’t quite misprice PMI regarding organic growth and FX headwind, but from time to time, investors may assign various degree of value to PMI’s growth. Has anything changed fundamentally following PMI’s Q1 2024 results announcement? Very little. PMI is still playing the game of getting rich.