BUSINESSWEEK ONLINE : NOVEMBER 29, 1999 ISSUE
COVER STORY

Philip Morris Stock: Will It Catch a Spark--or Go Up in Smoke?
It's p-e is low, its yield is high, and its growth prospects are good -- if it doesn't get buried in tobacco claims

Are you a contrarian investor? One of those folks who likes buying a stock when it's down, doesn't mind owning a piece of a controversial business, and who gets bored analyzing company fundamentals such as earnings growth, cash flow, and market share growth. If so, Philip Morris (MO) is a stock for you.

For the beleaguered tobacco giant, the risk of litigation is so paramount right now that conventional measures of stock market worth hardly matter. What counts is lawsuits. In the wake of a series of court decisions that have gone against the tobacco industry on several fronts, Philip Morris stock is down 50% this year. It closed on Nov. 18 at 25 15/16.

Leaving aside any ethical issues associated with the cigarette business, Philip Morris looks like a bargain based on its numbers. It has a price-earnings ratio of 8 when the S&P 500 is trading at 28, and it has a dividend yield of 7.4%, when the S&P yields only 1.2%. "Just try to find another stock that makes the kind of money this does, that sells at this p-e and this yield, and that has 50% market share," says portfolio manager Don Yactman, who owns the stock in the funds his firm manages. "The stock has never sold for a multiple of earnings this low," adds Timothy M. Ghriskey, who owns Philip Morris for the Dreyfus Large Company Value Fund he manages.

FOOD AND BEER BONUS. Analysts expect the company's profits to grow, possibly even by double digits, from next year on, as Philip Morris' cigarette market share tops 50% and demand picks up as overseas economies improve. Tobacco profits are expected to grow only slightly in 1999, reflecting weaker demand caused by price increases. Those were levied to cover costs of the industry's landmark settlement with state attorneys general over Medicare health-care claims. In addition, weak overseas economies have hurt demand. In 1998, Philip Morris earned $5.4 billion, or $2.20 a share, on sales of $74 billion.

Its Kraft Foods and Miller Beer units combined are worth more than $26 a share, some analysts say, arguing that the market has actually put a negative value on the cigarette business. Philip Morris' current market cap is $60 billion, and "the underlying value of Kraft alone is worth that," says Robert J. Sanborn, portfolio manager of Oakmark Fund, which owns about 10 million shares. "The litigation has made the market unduly pessimistic," says Martin Feldman, an analyst with Salomon Smith Barney.

However, Wall Street has consistently underestimated the legal threat to the tobacco industry over the years. "The problem is that nobody knows," says Yactman. Indeed, many investors -- even those who look for cheap stocks -- wouldn't touch Philip Morris no matter how low its price goes.

SUNSHINE STATE SCARE. "The potential liabilities are so huge that it is just not something we'd do," says veteran value investor Martin Whitman, portfolio manager of the Third Avenue Value Fund. "Sure, they've got great cash-flow businesses and great franchises," he says. He agrees that Philip Morris would be an incredibly cheap stock if not for its litigation risk. "But that's like saying I'd be a different person if I had a full head of light brown hair and was six-foot-seven," says medium-build, gray-haired Whitman. "That's not the case."

Investors are particulary worried about one class action in Florida that has the potential, although most analysts see it as slight, to force the company into bankruptcy. Following a surprise Oct. 20 court decision that opened the door for lump-sum punitive damages in the hundreds of billions, Philip Morris shares fell nearly 15%. The fear is that if the industry has to post a bond in order to appeal the jury decision, it could be so large as to force Philip Morris to seek bankruptcy protection. "It's a high-risk case because it has the potential to be a blockbuster, Armageddon case," says Sanborn.

Still, for those investors willing to wade into the nitty gritty of legal cases, there are near-term trading opportunities. "I've always looked at Philip Morris as a trading stock," says Dreyfus' Ghriskey. The Florida Supreme Court agreed on Nov. 3 to hear an appeal by Philip Morris that could overturn the Oct. 20 decision. A Nov. 17 research report from Sanford C. Bernstein (which gives Philip Morris its highest rating of outperform), estimates there's a 70% chance that the court will rule in favor of the industry, which would spark a 10% to 15% gain to the stock. But if the industry loses, the company's stock would hit new lows.

BEST-CASE SCENARIO. The Florida case is just one kind of legal fight Philip Morris is facing. The Clinton Administration also filed suit on Sept. 22, for reimbursement of Medicare costs, in addition to a bunch of pending suits from insurance companies, union trust funds, and individual plaintiffs. Analysts are generally less worried about these cases than the Florida class action.

The best-case long-term scenario for Philip Morris is that in a few years some kind of comprehensive national settlement would make the federal suits and class action go away. Individual suits, which the company has a good track record of fighting, wouldn't disappear, but they could then be understood as an ongoing cost of business.

"As long as you are pretty confident that Philip Morris is not going to go out of business, which I can't imagine would happen, you get a dividend yield above that of the 30-year Treasury bond," says Ghriskey. "For the long-term, patient investor, I think this is a great opportunity."

Yactman agrees. If the stock were simply to return to its levels of earlier this year, that would be double what it is now. But he's quick to point out that the stock could fall further if the courts continue to go against the industry. "If there's one thing to be learned out of this business," he says, it's that "any stock can go up or down."

By Amey Stone with John Byrne in New York

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