The Megapolis Acquisition Will Drive Philip Morris Forward

Philip Morris International has had a rough time on the market since the beginning of the year. Its share price has risen by only 2.73%, significantly underperforming the S&P 500's gain of nearly 25%. Nevertheless, the company has continued to expand its footprint in the tobacco market around the world. Recently, Philip Morris teamed up with Japan Tobacco International to acquire a stake in Megapolis, the monopolistic cigarette distributor in Russia.

Four foreign players dominate the Russian tobacco market
Russia is the second-largest cigarette market in the world, only behind China, with a total size of around 370 billion units sold in 2012. Philip Morris is one of the leading players in Russia with around 26% of total market share. British American Tobacco has a smaller share of the Russian market at 19.6%. Philip Morris, British American Tobacco, Japan Tobacco International, and Imperial Tobacco  collectively control more than 90% of the Russian market. 

Cigarette distribution in Russia is controlled by Megapolis, which handles around 70% of the cigarettes sold in Russia via its distribution agreements with Japan Tobacco International, Imperial Tobacco, and Philip Morris. Philip Morris has agreed to acquire a 20% stake in Megapolis in Russia for around $750 million, which excludes an additional payment of up to $100 million based on Megapolis' operational results during the next four fiscal years. 

Tough market trend in Russia
Russia has been a tough market for tobacco companies because of an excise-driven price increase. In the first half of 2013, the Russia overall market volume was down 7% because of the higher excise tax and illicit trade growth. . However, the company still grew its market share in Russia, which was driven by Rothmans in the value-for-money business category. Thus, British American Tobacco's total volume in Russia was down only 1%. Two brands, Kent and Rothmans, also saw increased market share in the Ukraine. 

Philip Morris forecast a 9%-11% decline in cigarette volume in Russia next year due to the higher excise tax, the tepid economy, and illicit trade.  The excise tax and stricter regulation have also negatively affected Imperial Tobacco. However, Imperial Tobacco has managed to strengthen its brands in Russia, especially Davidoff, which has gained increasing momentum in the queen-size segment, and Style, which has a new king-size super-slim format. 

Which one could be a good pick?
All three of these tobacco players could be interesting to income investors because of their dividend payments. Imperial Tobacco leads the group with the highest dividend yield at 4.6%. British American Tobacco ranks second with a 4.2% dividend yield, and the dividend yield of Philip Morris is 4.10%. In terms of valuation, British American Tobacco is the cheapest with a trailing earnings valuation of 15.3. Philip Morris is a bit more expensive at 16.2 times its trailing earnings.  Imperial Tobacco has the highest valuation at 23.5 times its trailing earnings.

My Foolish take
With the growing challenges in the Russian cigarette industry, I personally think it is strategically wise for Philip Morris to tap into the cigarette distribution business. The deal could potentially enhance Philip Morris' market-leading position in Russia, enhancing the company's long-term growth and profitability. Among the three, I like Philip Morris the most because of its juicy dividend yield, its low comparative valuation, and its leading position in Russian tobacco market

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Anh HOANG has no position in any stocks mentioned. The Motley Fool owns shares of Philip Morris International. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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