Valuation of Philip Morris ČR a.s.

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M.Sc. in Economics and Business Administration Specialisation: Accounting, Strategy and Control

Master's thesis

Supervisor: Christian Vriborg Petersen Department of Accounting and Auditing

_____________________

Author: Martin Cingroš

Hand in: August 2, 2010

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Page count

Front page and appendices excluded

Characters including spaces 143,483

Illustrations 18 14,400

Tables 30 24,000

Total characters 181,883

Total standard pages 79.95

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Resumé

The master thesis is conducted on the theory obtained at the Accounting, Strategy and Control graduate programme at Copenhagen Business School.

This thesis presents the results from a strategical and a financial analysis and valuation of Philip Morris ČR a.s. Philip Morris ČR is the clear leader of the Czech and Slovak tobacco market. Furthermore, it produces cigarettes for export to the various countries of European Union.

The main purpose of this report is to find the theoretical value of Philip Morris ČR as at June 30, 2010. Number of various mathematical and statistical approaches has been applied in an in-depth analysis through the historical performance analysis and cost of capital estimation.

The financial analysis, forecasting and valuation is mainly based on the framework by McKinsey & Co. For the valuation itself, the Discounted Cash Flow model has been applied as the main tool. The financial statements have been reformulated to better reflect economic position of the Company and express some figures such as NOPAT or Invested Capital.

The result of DCF valuation suggests that one share is worth CZK 15,329, while it was traded at the value of CZK 8,720 as at June 30, 2010.

Because the forecasts are always to a great extent uncertain and many assumption have been made in the valuation phase, supporting models and tools have been applied to verify the estimated share price. Firstly, EVA valuation and multiples valuation has been conducted. The EVA valuation provides us with the result of CZK 15,442 and multiples valuation indicates the price per share at CZK 15,238. Secondly, sensitivity analysis has been applied for the DCF model in order to explore how changes in variables will affect the result.

The supporting models and tools confirmed result from the main valuation model.

The conclusion of this paper indicates that the Company value could be undervalued by the market. This would give a BUY recommendation.

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Illustration Index

Illustration 1: Stock historical performance...14

Illustration 2: Stock historical performance...15

Illustration 3: Market share in the Czech Republic...17

Illustration 4: Market share in Slovakia...18

Illustration 5: Top 10 cigarette brands in the Czech Republic...19

Illustration 6: Top 10 cigarette brands in Slovakia...20

Illustration 7: Composition of the price of a cigarette pack in the Czech Republic...26

Illustration 8: Cigarette taxation...27

Illustration 9: Market sizes...29

Illustration 10: Porter's five forces...32

Illustration 11: SWOT...36

Illustration 12: Sensitivity Analysis for Foreign Exchange rates...44

Illustration 13: Sensitivity Analysis for Interest rates...44

Illustration 14: ROIC tree...58

Illustration 15: Profit Margin vs. Capital Turnover...61

Illustration 16: Economic Value Added...68

Illustration 17: Sensitivity Analysis graph - Growth as a Variable...89

Illustration 18: Sensitivity Analysis graph - RONIC as a Variable...89

Index of Tables

Table 1: Total shipment...16

Table 2: Consolidated highlights...21

Table 3: Net profits (losses) from foreign exchange ...39

Table 4: Liquidity ratios...46

Table 5: Analytical Consolidated Income Statement...49

Table 6: Analytical Consolidated Balance Sheet...52

Table 7: Common size analysis - Analytical Income Statement...53

Table 8: Indexing - Trend analysis - Analytical Income Statement...53

Table 9: Common size analysis - Analytical Balance Sheet...55

Table 10: Indexing - Trend analysis - Analytical Balance Sheet...56

Table 11: ROIC...57

Table 12: Results for ROIC tree...59

Table 13: Cost of Equity...65

Table 14: Cost of Debt...66

Table 15: Weighted Average Cost of Capital...67

Table 16: Results for Economic Value Added...68

Table 17: Free Cash Flow...69

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Table 18: Spread between ROIC and WACC...72

Table 19: Sales Estimates 2010 - 2013...74

Table 20: Correlation Analysis for the Analytical Income Statement...76

Table 21: Correlation Analysis for the Invested Capital...78

Table 22: Forecast for 2010 – 2019 + CV...79

Table 23: Results for ROIC tree 2009 – 2019 + CV...80

Table 24: Estimated WACC for 2009 – 2019 + CV...82

Table 25: Valuation of FCF for 2010 - 2019...86

Table 26: DCF - Valuation Summary...87

Table 27: Sensitivity analysis...88

Table 28: Valuation of EVA for 2010 - 2019...91

Table 29: EVA - Valuation Summary...92

Table 30: Multiples Valuation - Summary...93

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1 Introduction

Philip Morris International is the leading international tobacco company, with products sold in approximately 160 countries. The company owns seven of the top 15 brands in the world and has a strong mix of international and local products.

In this master thesis only one branch of Philip Morris International will be taken into account, namely Philip Morris ČR, subsidiary located in the Czech Republic. The scope of this thesis is to compute the theoretical value for the Philip Morris ČR. Philip Morris ČR will be presented in details in the next chapter.

Company valuation is an essential of all publicly traded companies. The value is important to be known for both existing and potential investors. Philip Morris ČR is a publicly traded company on the Prague Stock Exchange (PSE), thus the valuation will be done on the basis of the officially published information.

Moreover, value is the best metric for performance, that has been known. It is best because it is the only metric that requires complete information.

Valuation is based on the forecasts of the future performance and company's cost of capital.

It is obvious that both these factors contain high degree of uncertainty. Due to the uncertainties, historical analysis will be conducted before forecasting itself. During this stage it is necessary to identify value drivers in order to determine correctly the value created by the company.

1.1 Research question

Purpose of this master thesis is to value the company Philip Morris ČR.

The research question is:

What is the fair theoretical value of Philip Morris ČR?

The research question will be answered by conducting in-depth analysis of the Company. The analysis will conclude two parts – strategic and financial analysis, which will be followed by forecasting and valuation. The result for the research question will be acknowledged by using few valuation models in order to check the integrity.

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Answer to the research question will be dated as at June 30, 2010.

1.2 Methodology and applied theory

An objective of this thesis will be to provide theoretical result to a real world problem, thus the cardinal challenge will be to apply relevant theories to practical matters. Due to the nature of the research question, many assumptions will have to be carried out. It is obvious that these assumptions will have impact on the final results. Hence, the assumptions will be backed up, where possible, by data from various and reliable sources.

In order to valuate Philip Morris ČR, number of steps has to be conducted. This section will explain each step and elaborate on the theoretical tools used.

1) The first step is introduction and presentation of the Company. Before we will start the analytical section of the thesis, it is essential to acquire a deep knowledge of the Company – to understand to its business. This will endow us with the basis for the successful valuation. These two sections will form the basic structure and outlook of the thesis.

2) The second step is the strategic analysis. In this section, there will be focus on the Company's position within the industry, level of competition and Company's strengths, weaknesses, or threats and opportunities which the Company faces. This will provide us with the basis for the forecasting section. The theoretical models applied here will be the PEST analysis and Porter's Five Forces. The overall results will be summarized in the SWOT analysis. The SWOT output will be utilized in matching and converting.

This section will, unlike the rest of the thesis, look at the Company from inside and provide some managerial recommendations.

3) The third step is the financial analysis. There will be put stress on the financial performance of the Company, assessing the overall financial health of the Company and examine the value creation. Number of various concepts will be used, e. g. Return on Invested Capital tree or liquidity ratios among others. It will also be necessary to find the appropriate Weighted Average Cost of Capital. For the purpose of calculating the WACC, number of tools, e. g. Capital Asset Pricing Model, will be undertaken.

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The task of the financial analysis is to identify historical trends and these findings will be applied in defining value drivers for the forecasting. To have more foundations for the forecasting, Economic Value Added and Free Cash Flow concepts will be introduced.

4) The fourth step consists of forecasting. It will include evaluation of the strategic position and assessing of the competitive advantage. Moreover, before the forecasting itself, there will be analysis of the future development of the tobacco industry. Further, financial statements and and estimations of the cost of capital for next ten years plus for terminal year will be prepared. At the last, contingency of the forecasts will be checked by using ROIC tree, the same way, like in the historical financial analysis.

5) The last step is the valuation itself. It will be comprised of the summarized results of the whole thesis. The theoretical value of Philip Morris ČR will be computed in this section. First, possible valuation models will be introduced, followed by the clarification which models will be used. Main tool for valuing the Company will be the discounted cash flow model. The results will be checked by using another valuation models, namely EVA and multiples and some tools, such as sensitivity analysis.

6) The really last step is the conclusion, which where will be summary of the whole master thesis.

All theories will be discussed in details, as they will appear in the paper

1.3 Data used

For the purpose of the thesis a number of various data will be used. They can be divided into two groups:

1.3.1 Firm specific data

The data used in this thesis are mainly obtained from the PM Annual Reports. Because Philip Morris is a listed company, it has to publish Annual Report every year. I will use the Annual Reports for the years 2005 – 2009.

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Moreover, I will use data published by research companies, such as Euromonitor International or Datamonitor, to obtain more information about the Company.

1.3.2 Market data

For some parts of the thesis it will be necessary to use market data. I will use data published by Prague Stock Exchange (PSE) and Yahoo Finance for comparable companies in the cigarette industry, among others.

Other sources of information about the tobacco industry in general and specific markets will be by independent research companies as mentioned in the firm specific data section.

Moreover, the data published by Czech Statistical Office or by Czech National Bank will be used.

Newspapers articles will be used too. They will be mainly used to link the analysis with the real world information. Newspapers that will be used can be considered as reliable. The validity will be secured by taking the information from more than one source.

1.3.3 Criticism of sources of data

Most of the data that will be used for the purpose of this master thesis, is published by the company itself. In general, the valuation will be made from the external point of view.

Therefore it will be solely based on publicly available information. From this point we can question the reliability. However, the Annual Reports have been confirmed by external independent auditors, thus I consider them as reliable. Other information are taken from reliable source or validated by using more sources.

1.4 Definition

By Philip Morris, Philip Morris ČR or simply the Company, I refer to the Philip Morris ČR a.s, an affiliate of Philip Morris International Inc. By Philip Morris SK, I refer to the Philip Morris Slovakia s.r.o. By the Group, I refer to the Philip Morris ČR a.s. and Philip Morris Slovakia s.r.o. together. By PMI, I refer to the Philip Morris International Inc.

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1.5 Limitation of the research subject

The relevant theories I will use in this thesis have been mainly taught in the concentration Accounting, Strategy and Control at Copenhagen Business School. It is beyond the scope to prepare full forecasted financial statements. So, simplified models will be used.

Results of the thesis are based on external point of view. Therefore, I will usually not include managerial recommendations etc. Moreover, I will rely only on the public information and data as I do not have any access to the Company's internal information.

Due to the page limitation of the thesis, main competitors will not be deeply analysed and hence their performance will not be compared to that of Philip Morris.

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2 Description of the company

Philip Morris International is the leading international tobacco company, with products sold in approximately 160 countries. In 2009, company held an estimated 15.4% share of the international cigarette market outside of the USA. In 2009, company reported net revenues of $62 billion, and operating income of $10 billion. The total cigarette shipment was 864 billion of units.

Company owns seven of the top 15 brands in the world and has a strong mix of international and local products that seek to appeal to a wide array of adult smokers. Company operates globally, with manufacturing and sales facilities throughout the world. In total they own 58 factories and lease two additional ones.

Company is the market leader in 11 of the top 30 international markets and number two in additional 11 markets. Their size and scope in both mature and emerging markets enables them to be efficient and effective in serving their customers worldwide.

Company has the industry's strongest and most diverse brand portfolio, led by Marlboro, the world’s number one selling brand. Marlboro has been the world’s number one cigarette brand since 1972 and is one of the most powerful trademarks among all consumer products. Other strong international brands are L&M, Chesterfield, Philip Morris, Parliament, and Virginia Slims. Company owns a number of important local brands, enabling to maintain strong market share in sharply differentiated markets across the world, including Petra in the Czech Republic and Slovakia. PMI portfolio includes a variety of blends and styles, across 150 distinct brands and over 1,900 variants.¹

History of the Czech branch started in 1992 when Philip Morris International acquired a majority holding in state-owned Tabák a.s.²

Philip Morris ČR is the largest manufacturer and marketer of tobacco products in the Czech Republic and Slovakia, providing adult smokers with popular international and local brands in more than fifty packaging variants across different taste and price segments.³ The Company

1 http://www.philipmorrisinternational.com/PMINTL/pages/eng/ourbus/

2 http://www.pmicareers.com/COUNTRY/cze/about.asp 3 PM Annual Report 2009, p. 6

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employs around 1,100 people across the country.

In the next table there is a price development of Philip Morris ČR stock since January 1, 1999.

The development is compared to the benchmark index, which is in this case index of Prague Stock Exchange PX.⁴ For better illustration I converted the stock prices into index with a base value 100 for the starting date.

The data is as at June 10, 2010.

Source: Prague Stock Exchange online data and penize.cz for Philip Morris stock price

Note, that the historical stock performance starts on January 1999 as this was the first date which I was able to obtain data for Philip Morris stock's historical price.

We can see that Philip Morris was unable to beat the market index. PX index rose by 200 % over the years, but Philip Morris returned to the original level currently. Only in the period from mid 2002 until mid 2006, Philip Morris was able to slightly outperform the PX index.

The average yearly return (computed as an arithmetic average return) for Philip Morris is only 0.22%, while corresponding figure for PX index is 9.39%.

However, in the historical performance analysis, I will focus on the previous 5 years, hence I prepared graph of historical performance from beginning of 2005 until end of 2009, too.

4 The PX Index (until March 2006 the PX 50)

Illustration 1: Stock historical performance

01/01/99 15/05/00 27/09/01 09/02/03 23/06/04 05/11/05 20/03/07 01/08/08 14/12/09 0

100 200 300 400 500 600

Stock historical performance 1999 - mid 2010

Philip Morris PX

Date

Price

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Source: Prague Stock Exchange online data and penize.cz for Philip Morris stock price

During these years Philip Morris stock really underperformed the market, ending at the value less than 50% of the starting value. PX index performed pretty good until 2007, but then, because of the worldwide financial crisis, sharply decreased by more than 120% and ended at the value of only 6% more than the starting value was.

During this time Philip Morris' yearly average return reached very poor result -15.44%.

The benchmark index return was 1.25%. It is not that good result neither, but still it is positive.

2.1 Ownership

Philip Morris ČR a.s. is a joint-stock company registered in the Czech Republic, and is owned by Philip Morris Holland Holdings B.V., subsidiary of Philip Morris International Inc, located in Lausanne, Switzerland.

Philip Morris Slovakia s.r.o. is a subsidiary of Philip Morris ČR a.s., that owns 99%.

Philip Morris International Inc. is the ultimate controlling party of the Group.⁵

5 PM Annual Report 2009, p. 29

01/01/05 20/07/05 05/02/06 24/08/06 12/03/07 28/09/07 15/04/08 01/11/08 20/05/09 06/12/09 0

20 40 60 80 100 120 140 160 180 200

Stock historical performance 2005 - 2009

Philip Morris PX

Date

Price

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2.2 Markets

It is possible to identify three main geographical markets where the Company is represented.

Philip Morris ČR divides its business markets into Czech Republic, Slovakia and export. The Company exports its products to the affiliates of PMI in the European Union. The shipment in each of these areas is illustrated by the following table:

Source: PM Annual Reports

Czech domestic shipments decreased 5 billion units versus the prior year from 2007 to 2008.

This was due to the fact of excise tax increase from January 1, 2008. Other reasons for decline in consumption were higher retail prices and increase in illicit trade. But in 2009 the shipment increased to almost 11 billion again.

Shipment in Slovakia in 2008 increased by 0.1 billion units versus the prior year benefiting from higher consumption during the first nine months of the year when inventories of old tax products continued to be present in the market following the January 1, 2008 excise tax increase. However, in 2009 it declined to 3.9 billion. This decline was due to the rise of excise tax, overall market decline and higher consumption of Slovak consumers in Poland and Hungary due to the currency depreciation making the retail prices more attractive.

Export shipment increased by almost 10 billion mainly due to the higher exports within Philip Morris affiliates in the European Union in 2008. But in 2009 it decreased by 0,6 billion.

I could not find the same figures for previous years. I could only find revenues according to market segments. These revenues indicated that importance of export is rising every year. Just few years ago the export revenues were around 20% of the revenues in the Czech market.⁶ But if we take a look at the figures for the last 2 years, they indicate that exports are on the similar level as cumulative sales from the Czech Republic and Slovakia. And if the actual trend will continue, the exports will be the most important market segment soon.

6 PM Annual Report 2006

2009 2008 2007

Czech republic 10.9 9.5 14.5

Slovakia 3.9 4.1 4

Exports 13.8 14.4 5

Total 28.6 28 23.5

Shipment (Bio units)

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2.2.1 Market situation

The following tables illustrate market share of the largest tobacco companies, first in the Czech Republic and then in Slovakia for the 5 anterior years. I consider only companies with a market share over one percent point at least.

Source: Tobacco: Euromonitor from trade sources/national statistics

The data that I used are obtained from Euromonitor International. The data that are contained in the PM Annual Reports differs lightly. However, there are only data for Philip Morris, not for other companies, thus I use data by Euromonitor.

We can see that Philip Morris is the main marketer of cigarettes in the Czech Republic. Its market share is more than 55% during all the years. Yet, the Company's market share had a clear downtrend and was decreasing every year significantly until 2007. Back in 2005, its market share was 70%, and current share is around 55%. However, in 2007 the market share got stabilized and is between 55% to 56% every year since then.

Its main competitors are gaining bigger market share year by year. We can see one more trend, namely, that Others are loosing market share and starting to be unimportant competitors.

In 2005 their market share was more than 15%, whilst in 2009 it went down to less than 4%.

We can state that Philip Morris has only three direct competitors in the Czech Republic.

The next graph illustrates the same data from Slovakia.

2005 2006 2007 2008 2009

0 10 20 30 40 50 60 70

Market share in the Czech republic (in %)

2005 - 2009

Philip Morris International British American Tobacco Imperial Tobacco Group Japan Tobacco Others

Year

Percentage

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We can see that the market situation in Slovakia is different. Although Philip Morris' market share started at around 53% in 2005, it declined to less than 45% in 2009. And its market share, as well as in the Czech Republic, followed the downtrend until 2007. Since then, it got stabilized and now for three following years, the market share is around 44%. More negative point is that, Imperial Tobacco group's share are following uptrend and getting closer to the Philip Morris' share. Currently, the difference is only few percentage points. Another competitors are very remote. Others count for bigger market share then competitors ranked as no. 3, 4 and 5. Yet, the market share of Others is declining as well. We can also state that Philip Morris has only few direct competitors in Slovakia. One of them is the main, having market share almost as high as Philip Morris.

2.2.2 Products

Philip Morris International does not own any tobacco farm. They buy quality tobacco from all over the world. After harvesting and curing, tobacco is transported to the manufacturing sites.

One of these in located in the Czech Republic.

Philip Morris is the biggest cigarette producer in the Czech Republic and Slovakia.

It manufactures international brands like Marlboro, Philip Morris, L&M, Red & White, Chesterfield, Next or RGD. Furthermore, company manufactures Czech and Slovak brands such as Petra, Sparta, Start or Clea. In 2008 Company successfully commercialized Chinese

2005 2006 2007 2008 2009

0 10 20 30 40 50 60

Market share in Slovakia (in %)

2005 - 2009

Philip Morris International Imperial Tobacco Group Japan Tobacco British American Tobacco Continental Tobacco Group Others

Year

Percenatge

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cigarette brand RDG as a part of long-term strategic cooperation with China National Tobacco Corporation (CNTC) in the Czech market.

The sequent graphs show the 10 most popular cigarette brands in the Czech Republic and in Slovakia. It is measured according to their portion of the total retail volume. For better substantial evidence of the market situation, I prepared the graph which takes into consideration 5 preceding years. The top 10 is ranked according to their retail volume numbers in 2009.

Seven out of ten most sold brands in the Czech Republic belong to the Philip Morris' portfolio (six brands belong there directly and one through cooperation with CNTC). Yet, the brand no. 1 and 10 belong to British American Tobacco (BAT), while brand no. 5 belongs to Imperial Tobacco Group (ITG). It only confirms the fact that Philip Morris is a dominant firm within the tobacco industry in the Czech Republic.

We can conclude one negative thing for Philip Morris from this graph. All the competitors' brand are expanding, while most of the Philip Morris' brands' retail volume is falling. The only exception is Red & White and commercialized Chinese cigarette brand RDG. The most obvious example is trio of brand – Start, Petra and Marlboro, the most popular brands during 2005. That time they counted for almost half of the whole retail volume, while now they count for less than 30%.

One more trend, which is obvious from the graph, is that 10 most popular brands are gaining

2005 2006 2007 2008 2009

0 5 10 15 20

Top 10 cigarette brands in the Czech republic (in %)

2005 - 2009

Viceroy Red & White Start Petra Moon Marlboro Sparta RGD L&M Steels

Year

Percentage of retail volume

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bigger and bigger share every year. In 2005 the portion of their total retail volume was 68%, in 2009 it already was 78%.

I included the same graph about top 10 brands in Slovakia.

The situation in the Slovak market is from some points similar to the Czech market. Philip Morris has six out of ten most popular brands in Slovakia. However, like in the Czech market, no. 1 does not belong to Philip Morris' portfolio. In addition, brands no. 5, 6 and 9 do not belong to the Philip Morris portfolio neither.

The Philip Morris' brands are loosing market share, one exception is Clea which rose significantly in 2006 and since then keeps similar share over the years. Another Philip Morris' brand that does not follow downtrend is Red & White, that keeps the same portion of market share for the last 4 years. Otherwise, the other brands are decreasing. This can be demonstrated by pair of Philip Morris' brands, that were the most popular brands in 2005 – Marlboro and Petra. In 2005 they counted for almost 30% of the total retail volume, while in 2009 they count for only 20%. Nevertheless, the retail volume of competitors' brands are decreasing, too. The only exception is the brand no. 1 – Golden Gate, whose retail volume is increasing steadily over the years.

The top 10 counts for around 76% of the total retail volume nowadays, while in 2005 it was around 71.5%.

Illustration 6: Top 10 cigarette brands in Slovakia

2005 2006 2007 2008 2009

0 5 10 15 20

Top 10 cigarette brands in Slovakia (in %) 2005-2009

Golden Gate Clea Petra Marlboro West Mars Red & White Sparta Moon L&M

Year

Percentage of retail volume

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2.3 Economy

A brief overview of Philip Morris ČR consolidated highlights:

Source: PM Annual Reports

In general we can see downtrend in all the financial highlights since 2004 to 2008. The only light exception was year 2007 when the downtrend reversed into slight uptrend. However, the figures for 2009 revealed rise to the level comparable with 2006.

Even the share price started to rise in 2009 again, as shown in the beginning of this chapter.

2.3.1 Financial year 2009

Net revenues increased 19.9% versus the year 2008. This was mainly driven by favourable volume and pricing in the Czech Republic and favourable currency. However, this was partially offset by unfavourable volume/mix in Slovakia and by lower cigarettes export volume to other PMI affiliates within the EU. Excluding the impact of currency, net revenues increased 15.9% versus the prior year.

Pre-tax income increased 46%. In addition to the points above, it was due to lower interest expense related to the financing of 2009 inventory built-up in Slovakia.

Net income increased 48%. This was caused by decrease in the corporate income tax rate in the Czech Republic from 21% in 2008 to 20% in 2009.⁷

2.3.2 Financial year 2008

Consolidated revenues went down by 4.5% due to the unfavourable volume in the Czech Republic. However, this was partially offset by significantly higher cigarette export volume to other PMI affiliates within EU. Another point was adverse currency movement. Excluding the impact of currency, net revenues were on the pretty similar level like the prior year.

Pre-tax income decreased 16.6%, mainly because of the reasons mentioned above plus higher

Table 2: Consolidated highlights

Year ended December 31 (CZK mil) 2009 2008 2007 2006 2005 Revenues, net of excise tax and VAT 11,690 9,902 10,369 10,031 11,790

Pre-tax income 3,182 2,178 2,613 2,572 3,780

Net income 2,506 1,692 1,968 1,906 2,736

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interest expense related to the financing of Philip Morris Slovakia inventory build-up.

Net consolidated income decreased 14%. The corporate income tax rate declined from 24% to 21% in the Czech Republic.⁸

2.3.3 Financial year 2007

Consolidated revenues increased 3.4% in 2007. The increase reflected higher shipments in both the Czech Republic and Slovakia, then favourable pricing in the Czech Republic, and furthermore, higher export of material. Another positive point was favourable currency translation which impacted revenues in Slovakia by 8% due to the strengthening of the Slovak crown. But the negative points were unfavourable product mix in the Czech and Slovak domestic markets and partial excise tax absorption on certain brands starting in 2006 in the Slovak Republic.

Pre-tax income increased 1.6%, primarily due to the higher revenues and operating cost savings, but this was partially offset by higher variable and fixed manufacturing costs, currency translation which negatively impacted costs in Slovakia due to the strengthening of Slovak crown. Moreover, Philip Morris participated in PMI and EU Cooperation agreement, which was followed by higher costs that were recharged to Philip Morris ČR.

Net consolidated income increased 3.3% reflecting a lower effective income tax rate.⁹

2.3.4 Financial year 2006

Consolidated revenues went down by 14.9%, despite the 1.1% increase in total shipments.

The increase mainly reflected unfavourable product mix and pricing in the Czech and Slovak domestic markets.

Pre-tax income fell drastically by 32%. Even though the revenues decreased, the variable manufacturing costs remained basically unchanged. The decline was partially offset by operating cost savings.

Due to the notes mentioned above net consolidated income decline by 30.3%. The reason why it went down less than pre-tax income is another decline in corporate tax rate from 26% to

8 PM Annual Report 2008, p. 7 9 PM Annual Report 2007, p. 9

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24% in the Czech Republic.¹⁰

2.3.5 Financial year 2005

Even though the total shipment increased by 2.2%, consolidated revenues again decline by 10.7% compared to the previous year. The rise in total shipment reflected product and geographic mix degradation.

Pre-tax income decreased by 27.8%. This of course reflected lower revenues and also the extraordinary costs that occurred because of closure of the Hodonín factory followed by factory consolidation.

Overall net consolidated income declined by 26.3% due to the reasons mentioned above. It was partially offset by the corporate income tax rate decline from 28% to 26% in the Czech Republic.

Excluding the extraordinary costs, pre-tax income would have declined by 20.6% and net consolidated income by 17.4% versus the prior year.

2.4 Conclusion

From the description and facts about the Company, we can state that Philip Morris is a dominant player in the Czech Republic and Slovakia. Although, the Company is a market leader in both countries, the most sold brand belongs to their competitors. While the Company lost market share in these 2 markets, it has increased total shipments over the years thanks to the export of cigarettes to the PMI affiliates within EU. Even though, that Company is active in innovating of its products, majority of its cigarettes' brands retail volumes are decreasing.

The basic economic highlights showed that PM followed downtrend until 2008, yet in 2009 the trend reversed and the levels of highlights went up again. Net income counts for bigger portion of pre-tax income, mainly due to the lowering of corporate tax rate.

Historical performance of Company's stock showed poor results, especially when compared to the benchmark.

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3 Strategic analysis

The first step of valuation of a company is strategic analysis. Strategic analysis is applied in order to understand which factors influence the industry and company itself. I will examine these factors on the micro and macro economic level.

I will use different analytical tools in order to examine the macro-environment of the industry and its attractiveness. In this chapter I will analyse Company's strategic position and its direction through an analysis of external and internal environment.

I will conclude all the findings in evaluating of the strategic position of Philip Morris by SWOT matrix. This will enable me to produce better forecasts for future years.

3.1 Strategy

Before I will start the strategic analysis, we can take a brief look at the Philip Morris' strategy.

Philip Morris International overall strategy is defined in the Fact Sheet.¹¹

Company wants to be innovative and develop products with the potential to reduce the risk of tobacco related diseases, while generating superior revenues and offer a balanced program of dividends and share repurchases. Moreover, PMI wants to offer tobacco products of the highest quality available in different price categories.

PMI wants to be perceived positively in the public, therefore is not concerned only about generating profits, but is also active in some activities, which are against its own business.

Namely, supporting effective tobacco regulation and clear communication of the health risks related to smoking or being a responsible corporate citizen and conducting their business with the highest degree of integrity.

Motto of Philip Morris ČR, as mentioned in the Annual Report 2009, is: ”Driving business growth by delivering on consumers expectations.”

3.2 External analysis

I will begin with external analysis. I will examine the macro-environmental factors using

11 http://www.pmi.com/eng/about_us/documents/pmi_factsheet_final.pdf

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PEST analysis, where I will analyse macro-environment of the industry and Porter's five forces framework, where I will analyse attractiveness of the industry.

Philip Morris ČR divides its markets into 3 groups: Czech Republic, Slovakia and export countries. I will analyse mainly Czech market (which is the the base and biggest integrated target market). I will also include some points about Slovak market. Czech Republic and Slovakia used to be one country¹² and their markets are still very similar with similar consumers.

Moreover, some information will be general. When necessary I will include information about all three dominant markets. Otherwise, I will, due to the page limitation of the master thesis, generalize on the Czech example.

Further, it would be impossible to analyse exporting countries particularly, because it is impossible to find out the certain countries, where Philip Morris ČR exports its goods, and next there will be for sure a number of variable countries, so the extend of analysis would be enormous.

3.2.1 PEST

PEST analysis describes a framework for analysing of key macro-environmental factors which might affect future situation of the industry. It is a useful strategic tool for understanding market growth or decline, business position, potential and direction for operations. The PEST model consists of four different factors:¹³

● Political – e.g. public services, subsidising of firms or support of business

● Economic – e.g. taxation changes, economic growth, inflation and exchange rates

● Social – e.g. demographics or lifestyle

● Technological – technological advances create new possibilities – e.g. online shopping 3.2.1.1 Political factors

Philip Morris operates in the Czech Republic and Slovakia. Both these countries are stable

12 Czechoslovakia, which divided into 2 independent countries on January 1, 1993 13 http://www.oup.com/uk/orc/bin/9780199296378/01student/additional/page_12.htm

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economies. Furthermore, Philip Morris exports its goods to some countries of EU. These countries have well developed and stable business environment, too. But there are still many political factors which can affect Philip Morris.

The next graph demonstrates composition of the price of a cigarette pack. Unfortunately, I could only find information for the Czech Republic, but I assume that this composition will be similar in other countries as well. And on the top of it, this graph is for approximate visualisation, what are the key components of the price of cigarettes and what is likely to affect it, than to demonstrate precise numbers.

Source: http://www.dokurte.cz/?stranka=Fakta_o_tabaku&typ=clanky&vypsat=1943

From the scheme, it is obvious that majority of the price is excise tax, somewhere around two thirds. When we sum up both taxes, excise and value added tax (VAT), the result is over four fifths. It is clear that the price of cigarettes is predominantly determined by a state and the tobacco producers do not have so many possibilities how to affect it in a broad way. As PM's Chief Financial Officer, Daniel Gordon, said: “Currently approximately 80% of the retail selling price of cigarettes is excise tax and VAT. In other words, the state is an 80%

stakeholder in the cigarette business. As tax policy is in their hands, further developments will be closely linked to their decisions.”¹⁴

14 http://www.patria.cz/Rozhovor/1617988/financni-reditel-philip-morris-cr-daniel-gordon-na-patriacz---prave- online.html

Excise tax 66

VAT 16

Manufacturing costs and margin 10

Wholesale margin 1

Retail margin 7

0 10 20 30 40 50 60 70 80 90 100

Composition of the price of a cigarette pack

in the Czech republic (in %)

Percentage

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Because cigarettes are considered to have a negative effect on the population's health, states usually impose huge taxes in order to reduce their consumption. Moreover, excise tax presents easily anticipated, regular and pretty high income for the state budget. In the following graph I illustrated the excise tax levels in the Czech Republic and Slovakia.

Source: PM Annual Report 2009, p. 13

According to the EU regulation the level of excise tax should be rising in the following years in the Czech Republic and Slovakia.¹⁵ The current excise tax per 1000 pieces of cigarettes is 79 EUR in the Czech Republic and 81 EUR in Slovakia. But according to the EU regulation it should rise to minimum of 90 EUR until 2014 (current EU regulation is 64 EUR).¹⁶

This can post problems to Philip Morris ČR because some EU countries, like Poland, Hungary or Romania among others, negotiated exception and the obligatory excise tax rate (90 EUR per 1000 cigarettes) will be valid from the beginning of 2018 for them.

Current financial crisis has turned attention of politicians into how to get more revenues from taxes. Indirect taxes including excise tax were increased at the first place. The evidence is that the levels of excise tax in both Czech Republic and Slovakia are highly above the obligatory level demanded by EU.

Permanent growth in prices can encourage illegal smuggling of cigarettes. The tobacco

15 http://hn.ihned.cz/c1-40588570-cigarety-zdrazi-dalsi-kuracka-dan 16 http://hn.ihned.cz/c1-40588570-cigarety-zdrazi-dalsi-kuracka-dan

2010 2014

72 74 76 78 80 82 84 86 88 90

Cigarette taxation (per 1000 pcs.)

Czech republic Slovakia

EUR

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companies are well aware about this fact. Smuggling has became easier when the Czech Republic and Slovakia joined Schengen Zone. In 2008, illicit cigarettes trade in the Czech Republic accounted for 1.3 billion sticks and tobacco-related crime is gaining ground.¹⁷ The smuggled and illegally produced cigarettes represents 21% of the total cigarettes volume sale.¹⁸ Illicit trade is becoming a serious threat for leading tobacco players in the Czech Republic and Slovakia.

In the past Czech Republic was considered only as a transit country for smuggled cigarettes but now is becoming a target country.

The Czech Republic is visited by more than 6 million tourist every year and they buy more than 3 billion cigarettes.¹⁹ On the other hand, despite the high excise tax, Czech consumers usually do not buy cigarettes abroad. According to surveys, only merely 2% of cigarettes are bought abroad.²⁰

Price of a cigarette pack is specified on the bandrol, and is the same all over the Czech Republic.

Philip Morris is obliged to follow the general rule of law for business operating in the Czech Republic and Slovakia. Philip Morris is also imposed additional regulation and guidelines for publicly traded companies. Philip Morris has to follow other accounting regulations like International Financial Reporting Standards (IFRS). Most of the production is consumed within Czech Republic and Slovakia. But considerable part of the production is exported to EU countries. This imposes more regulation on Philip Morris, but Czech Republic is a member country of EU, which eases doing of business abroad. Philip Morris ČR does not export its products outside EU.

3.2.1.2 Economic factors

Nature of the business of Philip Morris is not sensitive to the state of the economy. Cigarettes are considered as a product with stable demand, they are price inelastic. Tobacco products

17 Cigarettes – Czech Republic, Euromonitor International, Country sector briefing, January 2010 18 Cigarettes – Slovakia Euromonitor International: Country Sector Briefing, March 2009 19 Cigarettes – Czech Republic, Euromonitor International, Country sector briefing, January 2010 20 http://www.tyden.cz/rubriky/byznys/cesko/ceska-spotrebni-dan-na-cigarety-je-vyssi-nez-narizuje-

eu_62285.html

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do not have real substitutes and are addictive goods. Therefore, when the price moves, the demand will remain more or less the same. The next graph demonstrates total consumption of cigarettes in the Czech Republic and in Slovakia.

We can see that the consumption since 2005 follows the slight uptrend and, on the top of it, is quite stable regardless of economic factors such as national income, inflation or unemployment. Even the impacts of the financial crisis do not affect the total consumption.

From the nature of the cigarettes, demand for them is quite stable regardless of their price. We can say that cigarettes are price inelastic goods. So the percentage change in price will not affect consumption of cigarettes at the same level.

I did not include data for Europe because of few points. Firstly, because due to its market size, Philip Morris ČR does not play important role (the export volume counts for 1.01% of the total European consumption of cigarettes²¹) and moreover, even the trend of European market does not have to affect export of Philip Morris ČR, as it will be more likely directed by cooperation among Philip Morris' affiliates and the headquarters.

Other economic factors, that influence industry situation, are the exchange rates. Slovakia and export countries use different currency than Philip Morris' functional currency. From this point the overall economic situation of Philip Morris is affected by movements in foreign exchange rates. On contrary, Philip Morris does not do business in a wide range of different

21 The total consumption in Europe in 2009 was 1,367,135.6 mil sticks of cigarettes

2005 2006 2007 2008 2009

0 5000 10000 15000 20000 25000

Market sizes

Retail volume (in mil sticks)

Czech Republic Slov akia

Year

No. of sticks

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currencies which makes the potential hedging much easier.

Positive point is the corporate tax rate in the Czech Republic. The tax rate is decreasing steadily, starting on 28% in 2004 and falling to 20% in 2009.

3.2.1.3 Social factors

From my point of view, social factors are the ones that are the most dangerous for Philip Morris. Smoking is considered as something badly affecting health. We can demonstrate this fact by short paragraph from the Philip Morris official web page: ”Tobacco products, including cigarettes, are dangerous and addictive. There is overwhelming medical and scientific evidence that smoking causes lung cancer, heart disease, emphysema, and other serious diseases.”²²

Philip Morris is actively engaged in corporate social responsibility and thus supports comprehensive regulation of tobacco products based on the principle of harm reduction. Harm reduction is most commonly used to refer to the objective of modifying conventional tobacco products and/or developing novel tobacco products that will reduce the risk of tobacco-related diseases.²³

However, according to the National Institute of Public Health in the Czech Republic, the portion of smokers on the population remains more or less the same in the last few years.

Around 28% of the population are smokers.

But the problem of tobacco industry is that the smoking has started to be viewed as something inappropriate. Nowadays the whole Europe fights against smoking and prepares anti-smoking regulations.²⁴

3.2.1.4 Technological factors

Following of current technological trends is necessary for all industries, tobacco industry included. Philip Morris is well aware of this fact, and they started to modernize the production facilities recently.

22 http://www.pmi.com/marketpages/pages/market_en_cz.aspx

23 http://www.pmi.com/eng/tobacco_regulation/regulating_tobacco/pages/harm_reduction.aspx 24 http://www.e15.cz/byznys/prumysl-a-energetika/philip-morris-investuje-300-milionu-korun-do-sve-

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As chairman of the board of directors Alvise Giustiniani said:” The production plant in the Czech Republic is one of the most important in Europe.”²⁵ Its production capacity is intended to be used for producing goods Czech and Slovak markets and for export, too. The Company continues with investing to its factory this year as well. They plan to invest around CZK 700 mil. Capacity of production is expected to rise to 40 bio. sticks by the end of this year. Philip Morris International has strategic plans for the Czech plant.

3.2.1.5 Evaluation of PEST

The analysis of macro-environment factors shows that Philip Morris operates in a stable economic environment. Due to the nature of its business, really positive thing is that cigarettes are inelastic goods. The consumption remains on similar levels with a slight uptrend over the years.

The main problem that industry faces is tax, namely excise tax, which counts for biggest portion of cigarette price. Excise tax will rise in the future even more. This fact can be followed by price war and illicit trade. However, the positive thing about taxes, is that corporate tax rate in the Czech Republic, where the headquarters of Philip Morris ČR are located, is decreasing every year.

Another problem is that cigarette is a product which has bad effect on the health. This impose many strict regulations, that make the business harder.

But despite all these problems, the total consumption is rising, and there is still stable demand for cigarettes.

3.2.2 Porter's five forces

Next tool of the external analysis is Porter's five forces model. This framework is used in order to evaluate attractiveness of the industry. It will reveal the competitive situation in the market by analyzing five forces, namely:

● Threat of intense segment rivalry

● Threat of new entrants

25 http://www.e15.cz/byznys/prumysl-a-energetika/philip-morris-investuje-300-milionu-korun-do-sve- kutnohorske-tovarny

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● Threat of substitute products

● Threat of buyers' growing bargaining power

● Threat of suppliers' growing bargaining power

The model of Porter's five forces can be demonstrated by the following drawing.

Source: http://kelas.files.wordpress.com/2009/10/porters-five-forces-model.jpg 3.2.2.1 Threat of intense segment rivalry

The tobacco industry can be described as differentiated oligopoly. There are actually only few huge companies which offer similar but differentiated product. From all the available information I can assume that the type of oligopoly is non-collusive as we could recently see some price wars etc.²⁶

Philip Morris is obviously market leader in the Czech and Slovak market. Here applies book example of the price leadership. Other companies are in position of the followers. But all the tobacco companies are more or less interdependent, meaning that each firm is affected by its rivals' decisions. Likewise its decision will affect its rivals.²⁷

Another typical point for oligopoly is brand loyalty. However, according to Philip Morris'

26 http://ekonomika.idnes.cz/philip-morris-rozpoutal-cenovou-valku-luxusni-cigarety-kvuli-dani-nezdrazi-1wz-/

ekonomika.asp?c=A100202_134006_ekonomika_spi 27 Sloman, p. 113

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survey, price is the dominant factor for more than 80% of smokers.²⁸ Hence, if the price changes too significantly, smokers will usually try to find cheaper way how to get cigarettes, legal or illegal, but they will not stop smoking. Therefore, this point does not follow the theory assumption.

According to the theory the previous points make the market segment unattractive.

Furthermore, the industry is relatively stable and plant additions are done in large increments.

All these conditions will lead to price or advertising battles, which makes it expensive to compete.²⁹

3.2.2.2 Threat of new entrants

It would be quite difficult for a new company to enter the tobacco industry. In the tobacco industry there are quite strong barriers to entry:

1) Entering tobacco industry is financially demanding.

2) There are many regulations and laws concerning tobacco industry.

3) Furthermore, new company would have to make new brands and persuade consumers to buy them. All the world's famous brands accompanied by Czech and Slovak local brands are already present in the market.

4) On the other hand, the tobacco industry is not vertically very integrated, which would make it easier for new companies to enter the market. However, the market is quite horizontally integrated, where there are few dominant players around the globe which merged over majority of local players. From this point it will be hard to find a space for new market participant.

5) Another point about entering the market would be retailing. Entering the retailing could be quite easy. There are few large companies which distribute goods like cigarettes etc. So for new companies it could be easy to get into their portfolio and get distributed to the retail network.

Exit barriers are high as well. The company cannot just switch into different industry, because

28 Cigarettes – Slovakia Euromonitor International: Country Sector Briefing, March 2009 29 Marketing Management, Volume 1, p. 158

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the tobacco industry is quite special and the equipment and goods cannot be just used for producing of different goods.

From the points I mentioned above, it is obvious that new entrants are not very likely to enter the tobacco industry.

3.2.2.3 Threat of substitute products

Cigarette is a product which does not have a real substitute. Moreover, it is an addictive product, so the users typically cannot stop smoking whenever they would like. There are some products which try to be able to replace cigarettes like inhalator patches, gums, sprays³⁰ or electronic cigarettes, but nothing went so far that it could completely replace cigarettes.

On the other hand, different brands of cigarettes are substitutes. Smokers can easily switch between different marks. These substitutes place a limit on prices and profits. So company has to monitor price trends closely.³¹ The clear evidence is when the excise tax rose in the beginning of the previous year, Philip Morris decided to keep prices at the level from last year. And because Philip Morris is a dominant company, the other tobacco producers had to follow this strategy.³²

From the theory we know that a segment is unattractive when there are actual or potential substitutes. This makes the segment unattractive.

3.2.2.4 Threat of buyers' growing bargaining power

Because of the high intensity of the competition in the tobacco industry one could expect that the buyers hold some bargaining power. However, Philip Morris has a dominant position in the Czech and Slovak market. Most of the top sold brands are produced by Philip Morris.

Smokers are usually somewhat loyal to their favourite brand and switch to another brand usually only due to the huge price changes etc. But even in the case when price changes, it is quite likely that customers would switch to another Philip Morris brand, as it holds the biggest market share. Furthermore, all the cigarettes' producers often follow the same changes in

30 http://www.nicorette.co.uk/stop-smoking/products.aspx 31 Marketing Management, Volume 1, p. 158

32 http://ekonomika.idnes.cz/philip-morris-rozpoutal-cenovou-valku-luxusni-cigarety-kvuli-dani-nezdrazi-1wz-/

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prices. This suggests that buyers hold little bargaining power over the suppliers.

Moreover, the end-users are very fragmented and numerous, therefore cannot hold power over the suppliers. The only kind of some buyers' power is already mentioned, ability to switch to different brand. The buyers do not have enough power to force the companies but to follow their pricing strategy.

The buyers do not posses neither strong nor growing bargaining power, which makes the segment attractive.

3.2.2.5 Threat of suppliers' growing bargaining power The most important input factor is tobacco.

The suppliers are not threatened by backward vertical integration, as it is PMI's policy not to own any tobacco production plant. PMI does not own tobacco producers itself but gets the tobacco from external suppliers. This could enhance suppliers' bargaining power.

But there are not so many suppliers, which could as well enhance suppliers' bargaining power.

In the tobacco industry there are just few dominant players world wide. They have established long - term relationship with tobacco producers. On one side, cigarette producers cannot easily switch between different tobacco producers, but on the other hand, tobacco producers do not have much choice to whom sell the tobacco.

None of the parties has a strategic advantage, as these companies need each other. Both kinds of companies are in an equal relationship. As a consequence, price is set by mutual agreement in the environment, where no one has bargaining power over each other. Both suppliers and buyers do not have too big bargaining power.

Company's suppliers are not able to raise prices or reduce quantity supplied easily. This makes the segment kind of attractive. But from all the facts mentioned above, I can assume that supplier buyer relationship is well balanced and none of them hold big advantage. This makes the segment neither attractive nor unattractive.

3.2.2.6 Evaluation of Porter's five forces

When we conclude all the information from Porter's five forces, we find out that the tobacco

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market segment is more unattractive than attractive. It is quite unlikely to attract more companies to enter the tobacco industry.

3.3 SWOT analysis

SWOT analysis is a technique used for identifying strengths, weaknesses, threats and opportunities both internal and external origin as well.³³ SWOT analysis will be based on the findings from strategical analysis chapter. For now, I will only concentrate on strategical analysis, the financial analysis will be examined in the following chapter.

SWOT analysis can be schematically demonstrated by the following illustration:

Source: http://www.librarian.net/talks/nylink/nylink.key/320px-SWOT_en.svg.png

3.3.1 Strengths

● dominant position in the Czech and Slovak market

● part of the world cigarette leader – know how

● strong portfolio – mix of international and domestic brands

● product is price inelastic

● modern production facilities

33 http://en.wikipedia.org/wiki/SWOT_analysis

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● long-term and well established links with the suppliers

● cigarette brands in different segments

● zero indebtedness

● integration in a one factory and thus saving costs

3.3.2 Weaknesses

● revenues are influenced by exchange rates

● no diversification – entirely dependant on the cigarette industry

● inability to price the products independently

3.3.3 Threats

● strong competition within the tobacco industry

● decline in the market share

● cigarettes are subject of a high taxation

● illicit trade and pirate production of cigarettes

● rise of excise tax faster than in some neighbouring countries (e.g. Poland)

● cigarettes are subject to regulations, as they are addictive and badly affecting health

● trend of smoking bans around Europe

● cigarettes brands have substitute

3.3.4 Opportunities

● stable political conditions

● smokers are usually somewhat loyal to the certain brands

● tobacco industry is a differentiated oligopoly

● high barriers to enter the tobacco industry for new entrants

● cigarettes themselves do not have a real substitute

Valuation of Philip Morris ČR a.s.

Table of Contents

Illustration Index

Index of Tables

1 Introduction

1.1 Research question

1.2 Methodology and applied theory

1.3 Data used

1.4 Definition

1.5 Limitation of the research subject

2 Description of the company

2.1 Ownership

2.2 Markets

2.2.1 Market situation

2.2.2 Products

2.3 Economy

2.3.1 Financial year 2009

2.3.2 Financial year 2008

2.3.3 Financial year 2007

2.3.4 Financial year 2006

2.3.5 Financial year 2005

2.4 Conclusion

3 Strategic analysis

3.1 Strategy

3.2 External analysis

3.2.1 PEST

3.2.2 Porter's five forces

3.3 SWOT analysis

3.3.1 Strengths

3.3.2 Weaknesses

3.3.3 Threats

3.3.4 Opportunities