Friday, January 30, 2009

Philip Morris International - a currency play

There are only two stocks I own today. PM is one of them. Unfortunately it has become one giant currency play of dollar versus all other currencies. The stock is listed in dollars. Against that, 45% of EBIT is in Euros (Even Trichet was forced to comment at Davos that Euro won't disintegrate - remember Milton Friedman said Euro won't survive its first recession - now we shall see), 10% is in ruble (crashing), another 10% from Ukranian hryvnia and turkish lira (crashing even more), 25% in Sterling, Polish Zloty, Latam currencies, Indonesian rupiah, Aussie dollar, Saudi Riyal and Egyptian Pound (most of them are weak), and 10% in Yen (the only saving grace).

It is unlikely that PM will show any EPS growth in 2009, or even in 2010. If dollar continues its rampage, especially against the EM currencies  (and I think it will) we can even see -10% EPS in 2009.  So, should I sell? 

I would have sold this, but I am trying to test a theory of long-term investment with this stock. It is this:

a) Forget EPS growth. There are hardly any companies that will show EPS growth in the next couple of years (except Amazon of course). If one can be convinced that the EPS of a company is not going to collapse like that of a steel company,  one needs to look at some other things. I am pretty sure that PM's EPS won't get cut in half, so I am looking at these other things. 

b) The most important of these other things is - does the company have the financial capacity to do some deals that will help it solidy its moat, so that whenever the tide turns three four five six years away, it is in a dominant position.  PM has a very strong balance sheet. Can it take advantage of the situation that unfolds in 2009 to acquire competitors in Russia or Indonesia or LatAm who might face trouble? 

c) Purchasing power parity: Yes all the EM currencies are depreciating against the dollar today. But doesn't it imply that there is one year of 10%-20% type inflation out there in all these countries somewhere in the next five years, in which PM's EBIT will jump by 25% in one year in EM countries and take care of some of the lost EBIT of previous years (and no, EM currencies need not depreciate further in that high inflation year - if it is just high inflation and not hyperinflation). Besides, if there is a non-zero probability of hyperinflation in US, it definitely is non-zero everywhere else. 

Suppose Euro crashes and is replaced by another currency. There will be upheavel, revolution, war etc etc. At the end of it all, it is unlikely that we get an Ipod for $99 in US and $29-equivalent in Europe. One big reason why pound had to fall at some time last year was - everything was just so expensive in London vs Paris or New York. 

If one believes that all currencies, including dollar, are risky because of what central banks and governments are doing, then the best defense is not bonds or even gold - it is stocks. After all, companies can raise prices to offset steep depreciation of currencies. But one needs to be very careful. A lot of companies will go bust - especially companies running asset-liability currency mismatch. One needs to buy stocks of companies that will not only survive the recession, but will take advantage of their immense balance sheets to snap up competitors on the cheap. So the M&A track record of management is very important going forward. 

I think this is one big reason why Buffett wrote that open letter in Oct, where he said that he is buying stocks because of the policies he expects governments worldwide to take.  

One right question to ask is - what is true EPS of PM if all currencies were trading on PPP basis. Because remember, last year's EPS of $3.34 benefitted from dollar depreciation against the Euro and EM currencies in 1H08 - which one can argue was also excessive. So, some of dollar appreciation against EM currencies is just a return to normality. 

Timing wise, one can argue that I should sell today and buy close to that time when we are close to inflation.  But I need to test my theory with some stock, and I have chosen this one. 

The other problem with PM is - cigarettes are the easiest things to tax, and don't the governments need tax revenue. 

So lets see how this turns out. 

3 comments:

Econlogic said...

Do not agree with either the micro or the macro basis for the investment.

1. "PM has a very strong balance sheet. Can it take advantage of the situation that unfolds in 2009 to acquire competitors in Russia or Indonesia or LatAm who might face trouble? "

Great point, yet some research I have seen suggests - chances are less than even that an acquisition will go on to create value - firms overpay, integration issues etc.

2. "5% of EBIT is in Euros (Even Trichet was forced to comment at Davos that Euro won't disintegrate - remember Milton Friedman said Euro won't survive its first recession - now we shall see), 10% is in ruble (crashing), another 10% from Ukranian hryvnia and turkish lira (crashing even more), 25% in Sterling, Polish Zloty, Latam currencies, Indonesian rupiah, Aussie dollar, Saudi Riyal and Egyptian Pound (most of them are weak), and 10% in Yen (the only saving grace)."

What is the nature of their currency hedges? Short-term, the impact of FX may not be significant. Yes, overtime the hedges rollover at the new spot and the company is affected. Last year was well into an extended dollar bear cycle. It is hard to say anything about the short-term unless we know how their hedge book is positioned.

3 "Purchasing power parity: Yes all the EM currencies are depreciating against the dollar today. But doesn't it imply that there is one year of 10%-20% type inflation out there in all these countries somewhere in the next five years, in which PM's EBIT will jump by 25% in one year in EM countries and take care of some of the lost EBIT"

To the extent it works, PPP operates over long periods. Half life of a deviation from PPP is about 3-5 years (Rogoff). Then there are questions about whether it works at all when measured by CPI given the presence of non-tradeables - see Balassa-Samuelson hypothesis.

There is another interesting question you raise. Which way does the causality flow? From exchange rates to prices or from prices to exchange rates? The answer to my mind is that when inflation expectations are well anchored, the causality flows from relative price differentials to the exchange rate. But in countries with a history of hyper-inflation, currency depreciation quickly feeds into inflation expectations and price formation.

Gaurav said...

Hey, thanks for the comments on PM.

I disagree with most research that indicates that M&A destroy value. The way there research papers work is - What was the stock price before the acquisition? What is the stock price one month, one year, five years after acquisition? Is there a difference? If it is negative, M&A destroyed value.

That is not true. We don't know the alternate universe that might have existed if the said M&A didn't happen, and what the competitive position of the company would have been in that universe without that M&A. Also what is important is whether it was stock or cash acquisition.

Case in point: AOL-TWX merger. People say $100-$150 billion value was destroyed because of that M&A. Just wait a sec. This was a stock transaction. Stock price of both AOL & TWX would have anyway fallen without the M&A as the dot-com bubble crashed. For AOL long-term shareholders, it has actually been a great deal. Without it, they would have lost even more. It is TWX long-term shareholders for which this has been a deal from hell.

Another case would be HDFC Bank and CBOP. People say HDFC Bank overpayed. But it used its own expensive stock to buy another expensive one. HDFC's own stock would have fallen even without the deal as Indian markets crashed.

I can see from your blogs that you are interested in both US and Indian markets as well as economics like me. Do you have an email address?

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