Legal Victories, Pending Kraft Windfall Put Philip Morris on the Edge of Another Rally
Research Analyst: Will Frankenhoff
Since our last update, shares of Philip Morris Cos. have softened slightly as the recent rally in technology stocks, which lifted the Nasdaq Composite by 5% during the same period, enticed some investors to pare their holdings of defensive stocks.
Nonetheless, shares of the tobacco, food, and beverage giant continue to trade within sight of their 52-week high of $53, and we believe that the stock is merely consolidating its gains before moving into a new period of appreciation.
Why? Because a recent spate of legal victories by the tobacco industry, coupled with the likelihood that the pending Kraft initial public offering (IPO) could raise as much as $8.4 billion (compared with an estimated $5 billion just three months ago), have significant positive implications for Philip Morris.
The tobacco industry's recent court victories include a federal appeals court's dismissal of racketeering claims made by labor unions. This victory is significant in light of the fact that the pending Department of Justice lawsuit makes the same claims, and the dismissal could be viewed as setting a legal precedent for the tobacco companies in the event the Justice Department's suit ever goes to trial.
However, as we've mentioned in previous updates, it appears increasingly likely that the DOJ's case will not move forward, given the lack of funding and the continued silence on the subject from U.S. Attorney General John Ashcroft.
Other notable legal victories included the dismissal of claims by Guatemala, Nicaragua, and Ukraine for funds spent on sick smokers in their respective countries. A jury in New Jersey also rejected a wrongful death suit against Philip Morris and R.J. Reynolds Tobacco Holdings Inc., marking the tobacco industry's 16th win in 17 individual-smoker cases since March 1999.
The upcoming Kraft IPO should also prove to be a better-than-expected windfall, as it looks like the Philip Morris could raise as much as $8.4 billion from the offering compared with earlier estimates of around $5 billion.
In a recent filing with the Securities and Exchange Commission, the company announced it would offer 280 million common shares at a price between of $27 and $30, which implies proceeds of between $7.6 billion and $8.4 billion - making the Kraft deal the second-largest IPO in history, exceeded only by last year's offering of AT&T Wireless Group a tracking stock.
Most of the proceeds of the sale will be used to pay down debt taken on during the $19.2 billion purchase of Nabisco.
After the sale, Philip Morris will hold 275 million class A shares and 1.18 billion class B shares of Kraft. The 10-to-1 voting power of the class B shares will give Philip Morris 97% of the total voting power, and the dividends from these holdings will amount to approximately $760 million annually.
As a result of continued legal victories and the company's ability to unlock value from the Kraft food business, we believe Philip Morris is poised to see further multiple expansion from the prevailing 12 times the market has placed on this year's consensus estimate of $4.07 a share.
Given the fading clouds of litigation and the ability to accurately place a value of the Kraft business coupled with the company's strong cash-flow and a 4.5% yield, we believe Philip Morris remains undervalued and we reiterate our Buy recommendation.
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