valuation of philip morris Čr...

Valuation of Philip Morris ČR a.s.

M.Sc. in Economics and Business Administration

Specialisation: Accounting, Strategy and Control

Master's thesis

Supervisor: Christian Vriborg PetersenDepartment of Accounting and Auditing

_____________________Author: Martin Cingroš

Hand in: August 2, 2010

Copenhagen Business School, 2010

Master Thesis – M.Sc. in Accounting, Strategy and ControlValuation of Philip Morris ČR

Page count

Front page and appendices excluded

2

Characters including spaces 143,483

Illustrations 18 14,400

Tables 30 24,000

Total characters 181,883

Total standard pages 79.95


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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Table of ContentsResumé........................................................................................................................................3 1 Introduction.............................................................................................................................8

1.1 Research question............................................................................................................8 1.2 Methodology and applied theory.....................................................................................9 1.3 Data used.......................................................................................................................10

1.3.1 Firm specific data..............................................................................................10 1.3.2 Market data.......................................................................................................11 1.3.3 Criticism of sources of data..............................................................................11

1.4 Definition.......................................................................................................................11 1.5 Limitation of the research subject.................................................................................12

2 Description of the company..................................................................................................13 2.1 Ownership.....................................................................................................................15 2.2 Markets..........................................................................................................................16

2.2.1 Market situation.....................................................................................................17 2.2.2 Products.................................................................................................................18

2.3 Economy........................................................................................................................21 2.3.1 Financial year 2009................................................................................................21 2.3.2 Financial year 2008................................................................................................21 2.3.3 Financial year 2007................................................................................................22 2.3.4 Financial year 2006................................................................................................22 2.3.5 Financial year 2005................................................................................................23

2.4 Conclusion.....................................................................................................................23 3 Strategic analysis...................................................................................................................24

3.1 Strategy..........................................................................................................................24 3.2 External analysis............................................................................................................24

3.2.1 PEST......................................................................................................................25 3.2.1.1 Political factors..............................................................................................25 3.2.1.2 Economic factors...........................................................................................28 3.2.1.3 Social factors..................................................................................................30 3.2.1.4 Technological factors.....................................................................................30 3.2.1.5 Evaluation of PEST........................................................................................31

3.2.2 Porter's five forces.................................................................................................31 3.2.2.1 Threat of intense segment rivalry...................................................................32 3.2.2.2 Threat of new entrants....................................................................................33 3.2.2.3 Threat of substitute products..........................................................................34 3.2.2.4 Threat of buyers' growing bargaining power.................................................34 3.2.2.5 Threat of suppliers' growing bargaining power.............................................35 3.2.2.6 Evaluation of Porter's five forces...................................................................35

3.3 SWOT analysis..............................................................................................................36 3.3.1 Strengths................................................................................................................36 3.3.2 Weaknesses............................................................................................................37 3.3.3 Threats...................................................................................................................37 3.3.4 Opportunities.........................................................................................................37

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3.3.5 Matching................................................................................................................38 3.3.6 Converting.............................................................................................................38 3.3.7 Strategic summary.................................................................................................39

4 Financial analysis..................................................................................................................41 4.1 Review of accounting principles...................................................................................41 4.2 Quality review of the financial statements....................................................................42 4.3 Profitability analysis......................................................................................................43

4.3.1 Risk analysis..........................................................................................................43 4.3.1.1 Market risk.....................................................................................................43 4.3.1.2 Credit risk.......................................................................................................45 4.3.1.3 Short-term liquidity risk.................................................................................45 4.3.1.4 Long-term solvency risk................................................................................47 4.3.1.5 Conclusion.....................................................................................................47

4.3.2 Analytical financial statements..............................................................................47 4.3.2.1 Analytical Income Statement.........................................................................48 4.3.2.2 Analytical Balance Sheet...............................................................................49

4.3.3 Common size analysis and indexing......................................................................52 4.3.4 Calculating the value drivers.................................................................................57 4.3.5 Economic Value Added..........................................................................................63

4.3.5.1 Weighted Average Cost of Capital.................................................................63 4.3.5.1.1 Risk-free rate rf......................................................................................63 4.3.5.1.2 Computing cost of equity rE..................................................................64 4.3.5.1.3 Computing cost of debt..........................................................................65 4.3.5.1.4 WACC final computation.......................................................................66

4.3.5.2 Economic value added...................................................................................67 4.3.6 Free cash flow........................................................................................................68

4.4 Conclusion.....................................................................................................................70 5 Forecast.................................................................................................................................72

5.1 Evaluation of strategic position.....................................................................................72 5.2 Development of Tobacco Industry................................................................................73 5.3 Forecast individual line items........................................................................................74 5.4 Check overall forecast for reasonableness....................................................................80 5.5 Estimating the cost of capital........................................................................................81 5.6 Conclusion.....................................................................................................................82

6 Valuation...............................................................................................................................83 6.1 Choice of a valuation model..........................................................................................83 6.2 Discounted Cash Flow model........................................................................................84 6.3 Sensitivity analysis for DCF..........................................................................................87 6.4 EVA valuation................................................................................................................90 6.5 Multiple valuation.........................................................................................................92 6.6 Conclusion.....................................................................................................................93

7 Conclusion............................................................................................................................95List of abbreviations..................................................................................................................97 8 References.............................................................................................................................99

8.1 Literature.......................................................................................................................99 8.2 Documents.....................................................................................................................99

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8.3 Homepage....................................................................................................................100Appendices..............................................................................................................................102

Illustration IndexIllustration 1: Stock historical performance..............................................................................14Illustration 2: Stock historical performance..............................................................................15Illustration 3: Market share in the Czech Republic...................................................................17Illustration 4: Market share in Slovakia....................................................................................18Illustration 5: Top 10 cigarette brands in the Czech Republic..................................................19Illustration 6: Top 10 cigarette brands in Slovakia...................................................................20Illustration 7: Composition of the price of a cigarette pack in the Czech Republic.................26Illustration 8: Cigarette taxation................................................................................................27Illustration 9: Market sizes........................................................................................................29Illustration 10: Porter's five forces............................................................................................32Illustration 11: SWOT...............................................................................................................36Illustration 12: Sensitivity Analysis for Foreign Exchange rates..............................................44Illustration 13: Sensitivity Analysis for Interest rates...............................................................44Illustration 14: ROIC tree.........................................................................................................58Illustration 15: Profit Margin vs. Capital Turnover..................................................................61Illustration 16: Economic Value Added....................................................................................68Illustration 17: Sensitivity Analysis graph - Growth as a Variable...........................................89Illustration 18: Sensitivity Analysis graph - RONIC as a Variable...........................................89

Index of TablesTable 1: Total shipment.............................................................................................................16Table 2: Consolidated highlights...............................................................................................21Table 3: Net profits (losses) from foreign exchange ................................................................39Table 4: Liquidity ratios............................................................................................................46Table 5: Analytical Consolidated Income Statement................................................................49Table 6: Analytical Consolidated Balance Sheet......................................................................52Table 7: Common size analysis - Analytical Income Statement...............................................53Table 8: Indexing - Trend analysis - Analytical Income Statement..........................................53Table 9: Common size analysis - Analytical Balance Sheet.....................................................55Table 10: Indexing - Trend analysis - Analytical Balance Sheet..............................................56Table 11: ROIC.........................................................................................................................57Table 12: Results for ROIC tree................................................................................................59Table 13: Cost of Equity...........................................................................................................65Table 14: Cost of Debt..............................................................................................................66Table 15: Weighted Average Cost of Capital............................................................................67Table 16: Results for Economic Value Added...........................................................................68Table 17: Free Cash Flow.........................................................................................................69

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Table 18: Spread between ROIC and WACC............................................................................72Table 19: Sales Estimates 2010 - 2013.....................................................................................74Table 20: Correlation Analysis for the Analytical Income Statement.......................................76Table 21: Correlation Analysis for the Invested Capital...........................................................78Table 22: Forecast for 2010 – 2019 + CV.................................................................................79Table 23: Results for ROIC tree 2009 – 2019 + CV................................................................80Table 24: Estimated WACC for 2009 – 2019 + CV..................................................................82Table 25: Valuation of FCF for 2010 - 2019.............................................................................86Table 26: DCF - Valuation Summary........................................................................................87Table 27: Sensitivity analysis....................................................................................................88Table 28: Valuation of EVA for 2010 - 2019.............................................................................91Table 29: EVA - Valuation Summary........................................................................................92Table 30: Multiples Valuation - Summary................................................................................93

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1 IntroductionPhilip 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 companyPhilip 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.asp3 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)

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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 performance1999 - mid 2010

Phil ip MorrisPX

Date

Pric

e


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

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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 performance2005 - 2009

Phil ip MorrisPX

Date

Pric

e


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

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2009 2008 2007Czech republic 10.9 9.5 14.5Slovakia 3.9 4.1 4Exports 13.8 14.4 5Total 28.6 28 23.5

Shipment (Bio units)


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.

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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 TobaccoImperial Tobacco Group Japan TobaccoOthers

Year

Pe

rce

nta

ge



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

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2005 2006 2007 2008 2009

0

10

20

30

40

50

60

Market share in Slovakia (in %)2005 - 2009

Philip Morris InternationalImperial Tobacco GroupJapan TobaccoBritish American TobaccoContinental Tobacco GroupOthers

Year

Pe

rce

nat

ge


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

19

2005 2006 2007 2008 2009

0

5

10

15

20

Top 10 cigarette brands in the Czech republic (in %)2005 - 2009

ViceroyRed & WhiteStartPetraMoonMarlboroSpartaRGDL&MSteels

Year

Pe

rce

nta

ge

of

reta

il v

olu

me


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%.

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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 GateCleaPetraMarlboroWestMarsRed & WhiteSpartaMoonL&M

Year

Pe

rce

nta

ge o

f re

tail

vo

lum

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2.3 Economy

A brief overview of Philip Morris ČR consolidated highlights:


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


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


21

Table 2: Consolidated highlights

Year ended December 31 (CZK mil) 2009 2008 2007 2006 2005Revenues, net of excise tax and VAT 11,690 9,902 10,369 10,031 11,790Pre-tax income 3,182 2,178 2,613 2,572 3,780Net income 2,506 1,692 1,968 1,906 2,736


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


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


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. 79 PM Annual Report 2007, p. 9

22


24% in the Czech Republic.10


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.


23


3 Strategic analysisThe 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

24


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, 199313 http://www.oup.com/uk/orc/bin/9780199296378/01student/additional/page_12.htm

25


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

26

Excise tax 66VAT 16Manufacturing costs and margin 10Wholesale margin 1Retail margin 7

0

10

20

30

40

50

60

70

80

90

100

Composition of the price of a cigarette packin the Czech republic (in %)

Pe

rce

nta

ge


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-dan16 http://hn.ihned.cz/c1-40588570-cigarety-zdrazi-dalsi-kuracka-dan

27

2010 2014

72

74

76

78

80

82

84

86

88

90

Cigarette taxation (per 1000 pcs.)

Czech republicSlovakiaE

UR


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 201018 Cigarettes – Slovakia Euromonitor International: Country Sector Briefing, March 200919 Cigarettes – Czech Republic, Euromonitor International, Country sector briefing, January 201020 http://www.tyden.cz/rubriky/byznys/cesko/ceska-spotrebni-dan-na-cigarety-je-vyssi-nez-narizuje-

eu_62285.html

28


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

29

2005 2006 2007 2008 2009

0

5000

10000

15000

20000

25000

Market sizesRetail volume (in mil sticks)

Czech RepublicSlov akia

Year

No

. o

f st

icks


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.aspx23 http://www.pmi.com/eng/tobacco_regulation/regulating_tobacco/pages/harm_reduction.aspx24 http://www.e15.cz/byznys/prumysl-a-energetika/philip-morris-investuje-300-milionu-korun-do-sve-

kutnohorske-tovarny

30


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

31


● 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

32


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 200929 Marketing Management, Volume 1, p. 158

33


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.aspx31 Marketing Management, Volume 1, p. 15832 http://ekonomika.idnes.cz/philip-morris-rozpoutal-cenovou-valku-luxusni-cigarety-kvuli-dani-nezdrazi-1wz-/

ekonomika.asp?c=A100202_134006_ekonomika_spi

34


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

35


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

36


● 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

37


● company actively innovates its products

● production facilities located in the Czech Republic

● rising export shipments

3.3.5 Matching

The next step in applying SWOT analysis is matching.

The key to the successful achievement of company's goals depends on its ability to transform

key strengths into capabilities by matching them with opportunities. Capabilities can become

competitive advantages if they provide better value to the customers than competitors'

offerings.34

Philip Morris has the dominant position in the Czech and Slovak market and owns strong

portfolio of different cigarettes' brands. Smokers are usually loyal to the certain brands. Thus,

company should continue in the efforts of providing the best quality available through

different pricing segments, while still actively innovating its products in order to attract new

and retain current customers.

Due to its dominant position, the Company should try to persuade its customers, when they

want to switch between different brands because of the price, to switch to a cheaper Philip

Morris' brand.

Company uses modern production facilities. This could be used in order be perceived as an

up-to-dated and trendy company.

Company has its production facilities in the Czech Republic,so they should use it, to show to

its customers, that the cigarettes are Czech product.

3.3.6 Converting

The last step of SWOT analysis is converting. Firms can convert weaknesses into strengths,

and even capabilities, by investing in key areas and by linking key areas more effectively.

Likewise, threats can be converted into opportunities if the right resources are available. If

34 Marketing Management p. 63

38


this is not possible, then the company should at least try to minimize the bad affects of it.35

First, I will start with consideration of the weaknesses.

Significant part of the Company's revenue is in other currencies than CZK. Yet, as

demonstrated by the following graph.


PM earns money on the foreign exchange every year. Therefore, the Company uses this

weakness in order to generate bigger revenues.

Company entirely relies on a single product, however the trends show that consumption of

cigarettes is in slight uptrend in its base markets and demand for cigarettes from Philip Morris

ČR is rising.

Company cannot freely decide about prices of its products, as they are subject of high

taxation. But Company, due to its size and financial position, can absorb e.g. excise tax rise

and market the product for unchanged price for some time. It is more likely that its

competitors will not be able to compete in this way for long time.

Now, I will take a look at the threats.

There is a trend in rising of the excise tax, which will stimulate illicit trade or smokers will be

more likely to buy cigarettes in the neighbouring countries. The Company has to work on to

make its customers loyal to its brands. Good point about it is that Philip Morris produces

some typical Czech and Slovak brands, that cannot be bought anywhere else.

Cigarettes are badly affecting health. Philip Morris will have to try to innovate and produce

“healthier” versions of its products.

3.3.7 Strategic summary

From the strategic analysis we can conclude that the Company is sufficiently strong to strive

35 Marketing Management p. 65

39

Table 3: Net profits (losses) from foreign exchange

Foreign exchange (n CZK mil) 2009 2008 2007 2006 2005Gains 238 271 121 72 56 Losses (229) (255) (106) (35) (48)Difference 9 16 15 37 8


to maintain its dominant position in the Czech and Slovak market, while increasing its export

shipments at the same time. Company follows the strategy of organic business growth. Every

year PM reaches higher shipment, that is expected to rise in the future as well. Company

invests considerable amount of money into modernizing of its production plant in order to be

innovative.

Philip Morris has a broad variety of different cigarettes brands through all pricing sectors.

Moreover, Company can count on a numerous loyal smokers.

Philip Morris can rely on its business partners with whom they have long-term and well

established business relationship.

Philip Morris do not have to be afraid of new potential competitors as it is quite unlikely for

new companies to enter the tobacco industry.

The tobacco industry is stable with slight but permanent growth. The cigarettes do not have

any real substitutes and demand for them is stable over the year.

However, Company will face some problems in the future, such as rising excise tax and more

restrictive tobacco regulations. The illicit trade is becoming to be a serious threat.

We can also state that Company follows its strategy in a very good way.

40


4 Financial analysisIn this chapter, there will be presentation of historical financial statements analysis. The

chapter starts with overview of accounting principles and quality review of financial

statements. Then, there will be short overview of Company's risk management. After that, we

will move to the profitability analysis. In the beginning, I will prepare reformulated financial

statements and continue with computation of financial calculations. With the analytical

financial statements, we can move on to the common size and indexing analysis. Further,

I will calculate the value drivers. Afterwards, I will calculate Weighted Average Cost of

Capital and Economic Value Added measure, followed by Free Cash Flow as basis for the

forecasting.

The first step in valuing a business is analyzing its historical performance. Understanding

of the company's past performance provides an essential perspective for developing and

evaluating forecasts of future performance.36

Core objective of this chapter is to evaluate financial health of PM and to find out drivers

which will be used for the valuation of Philip Morris ČR.

4.1 Review of accounting principles

Importance of accounting principles that are applied by the company can be demonstrated by

the following statement.

It could be difficult for outside investors to determine whether managers have used

accounting flexibility to signal their proprietary information or merely to disguise reality,

a number of accounting conventions have eroded to mitigate the problem. Accounting

standards and rules limit management's ability to misuse accounting judgement by regulating

how particular types of transactions are recorded.37

Philip Morris uses international accounting principles, namely International Financial

Reporting Standards. All listed EU companies have been required to use IFRS since 2005.38

Czech Republic has been an EU member since May 1, 2004.

36 Copeland et al., p. 15437 Palepu et. al., p. 3-338 http://www.iasplus.com/country/czech.htm

41


IFRS require some qualitative characteristics of financial statements, which include:

● Understandability – to be useful, accounting data must be understandable to users,

meaning that appropriate, standard terminology has to be employed

● Reliability – accounting information should be neutral, in the sense they are not

manipulated to favour one party over another, they should be bias-free

● Comparability – accounting principles should be used consistently over the time so

they allow the results to be comparable

● Relevance – financial statements should be relevant enough to allow to the readers,

such as investors, to make economic decisions and evaluate historical and current

performance and future events

● True and Fair View – applied accounting policies should be the best for reflecting

economic value. When company changes accounting principles, it should be done in

order to ensure the previous point. Companies are not allowed to change the

accounting principles regularly so as to maximize accounting value

The earliest financial statements used in this thesis are for the financial year 2005. It makes

the historical analysis easier, as the financial statements contains comparable figures over the

years and follow the same regulations over the covered period.

The accounting standards and amendments change from year to year. However, as is stated in

the PM's Annual Report: “The Group does not expect the amendments to have any material

effect on its financial statements.”39 So, I did not explore these changes deeply.

4.2 Quality review of the financial statements

Because Annual Reports will be used as a basis for analysis not to say for forecasting, it is

necessary to asses their reliability and validity.

Broadly used way how to cope with the financial statements quality problems is external

auditing. It can be defined as a verification of the integrity of the reported financial statements

by someone else than the preparer. Therefore, external auditing ensures that managers use

accounting rules and conventions consistently over time, and that their accounting estimates

are reasonable. Auditing improves the quality and credibility of accounting data by limiting


42


a firm's ability to distort financial statements to suit its own purposes.40

Philip Morris ČR is a listed company, meaning that its financial statements have to verified by

independent external auditor, which is PricewaterhouseCoopers.

An audit also involves evaluating of appropriateness of the accounting policies used and the

reasonableness of accounting estimates made by management, as well as evaluating the

overall presentation of the financial statements.41

There has been detected no problems with using of the Annual Reports, hence the data will be

used with no exceptions.

4.3 Profitability analysis

In this chapter Philip Morris ČR profitability will be analysed. But before I will start the

profitability analysis, I will take a look at the risk analysis.

4.3.1 Risk analysis

Companies have to inform in the financial statements about how can certain risks influence

their business and how these risks are managed.

Philip Morris ČR is exposed to a variety of financial risks, namely market, credit and liquidity

risk. Market and liquidity risks are managed centrally by Treasury group in Lausanne, while

credit risk is managed primarily by the Company. In this subchapter I will evaluate the risk.

4.3.1.1 Market risk

Due to the doing business abroad Company is exposed to the foreign currency risk arising

from transactions performed mainly with companies in the European Union, including its

Slovak subsidiary, and Swiss subsidiaries. Company uses EUR, USD and used SKK in the

past. The foreign currency risk is measured against the functional currency CZK by applying

the Czech National Bank exchange rate.

The Company applies sensitivity analysis in order to asses how the potential depreciation or

appreciation will affect profit and loss before taxes. The sensitivity analysis takes into account

40 Palepu et. al., p.3-341 PM Annual Report, p. 55

43


only unpaid financial assets or liabilities denominated in foreign currencies. The Group

consider the exchange rate movements against CZK of +(-)20% as possible, as shown in the

next illustration:


Yet, the Group does not consider currency risk that serious since they do not currently use any

hedging tools for managing the risk.

Another part of market risk are interest rates. The Company is exposed to interest rates mainly

because of short-term loans and on-demand deposits with PMI companies. The interest rate is

set as overnight PRIMEAN less 0.25%.42 The Company applies sensitivity analysis, similarly

to the exchange rates. The Group assumes the possible movements in the range of +100/-50

basis points, as shown in the following illustration.


42 PM Annual Report 2009 p. 71

44

Illustration 13: Sensitivity Analysis for Interest rates


4.3.1.2 Credit risk

The Company sticks to strict policies concerning on sales on credit. Philip Morris ČR closely

cooperates with PMI central Treasury and uses the services of external rating agencies.

Therefore, acceptance of new credit counterparty has to go through standard approval controls

and procedures through the relevant department. The Company's involvement with

counterparties is monitored and re-evaluated on regular basis. PM uses some financial market

instruments like bank guarantees or advance payments to reduce the underlying risk.

Philip Morris ČR classifies receivables and on-demand deposits according to few criteria,

especially closely monitors those that are past due. In the year 2008, they counted for around

3,5% of the net profit, while in 2009 they count for mere 0.4% of the net profit. And majority

of these is past due not more than 3 months.

From these information I conclude that credit risk is carefully managed and should not post

any serious problem for the Company.

4.3.1.3 Short-term liquidity risk

It is almost impossible to time cash inflows with cash outflows. Some cash outflows, like

employees salaries, have to be paid on a regular basis and cannot be postponed. However, e.g.

customers can delay their payments.

The Company maintain sufficient cash funds. Liquidity is managed and controlled by the

central PMI treasury via domestic and international Cash pool arrangements.

Liquidity analysis evaluates company's ability to meet its short-term obligations. Short-term

liquidity can be analysed by using few financial ratios.

The most common liquidity ratios are current ratio (current assets/current liabilities) and the

quick ratio (current assets excluding inventories/current liabilities). They measure the firm's

ability to pay bills coming due with cash currently being collected. The ratios are considered

as good if above 1.0.43 The main problem with these kind of ratios is the requestion of how

liquid are the current assets in real.

Better ratio which measures company's ability to generate cash is revenues to cash ratio

43 Stickney et al., p. 290

45


(revenues/average cash balance). Because company collects revenues in cash and pay

operating costs and current liabilities with cash. And the amount of cash on the balance sheet

reflects the net effect of operating, investing, and financing activities in cash, as well as

management's judgements about the desired level of cash.44

Source: own computations

In the previous table we can see computations of the liquidity ratios. Current ratio is always,

except the year 2007, above 2, which is good result.

When I move on to the quick ratio, where the inventories are excluded, there is a declining

trend and the results are not so good, especially for the years 2007 and 2008. However, in the

last year the trend reversed and the result is the best so far. This is mainly due to the huge

decline in inventories, when inventories decreased by more than 50%. But we have to

consider that the inventories include excise tax. Excise tax counts for most of the value of

inventories. In the years 2008 and 2007, excise tax was around 75% of value of the

inventories and in the year 2009, the excise tax creates more than 63% of the value of

inventories. And we cannot forget that excise tax is rising year by year, which can be solid

explanation of the downtrend between years 2005 and 2008.

I also computed adjusted quick ratio, where I exclude the excise tax of inventories.

Unfortunately, I could find this information only for last three years. But anyway, we can see

that this adjusted quick ratio has a rising trend and the results are fine. In 2009 it even goes

over 2, which is really good result.

The revenues to cash ratio is in fact cash turnover. For easier interpretations we can express

the ratio in number of days of revenue hold in cash. Interpreting of this ratio is very dependant

from which side of view we want to interpret. Lenders will prefer smaller ratios, but

management will prefer bigger ratio, meaning that the cash is not tied up too much in idle

44 Stickney et al., p. 295

46

Liqudity ratios 2009 2008 2007 2006 2005Current ratio 2.36 2.13 1.51 2.16 2.08Quick ratio 1.62 0.64 0.68 1.06 1.21Quick ratio (adjusted) 2.08 1.75 1.31 n/a n/aRevenues to cash 3.16 5.43 3.37 1.87 2.65Days revenues held in cash 115.64 67.23 108.28 195.2 137.94


cash.

During the years 2004 and 2005 we can see uptrend peaking in 2006, followed by downtrend

until 2008. But in 2009 the downtrend reversed and the figure reached higher level than in

2007.

From the liquidity perspective, Company has sufficient funds of cash ready to pay for the

expenses. On the other hand, it seems like that idle cash is held for too long, especially in the

year 2006.

4.3.1.4 Long-term solvency risk

Long-term solvency risk is measured in order to examine a firm's ability to to make interest

and principal payments on long-term debt and similar obligations as they come due.

Perhaps the best indicator for assessing long-term solvency risk is to generate earnings over a

period of years. Moreover, if a company wants to survive in a long run, they have to be able to

survive in short-term. Short-term liquidity was analysed in the preceding subchapter.

I decided not to go deeply in analysing of long-term solvency risk, as the company in fact

does not have any long-term liabilities on its balance sheet.

4.3.1.5 Conclusion

After analysing various risks that the Company is facing, we can conclude that they are

managed carefully and they do not present any potential threat for the Company due to their

small relative size as compared to net profits etc.

The Company is stable over the long-term and is expected not to have problems post by

various kinds of risk in the future.

4.3.2 Analytical financial statements

As I already mentioned, the financial statements can be influenced by applied accounting

principles. The usual way how to cope with this possible distortion, is to form the statements

in a different way and prepare analytical income statement and analytical balance sheet. The

original financial statements are included in Appendix 1.

47


4.3.2.1 Analytical Income Statement

The analytical income statement requires that every accounting item is classified as either

operations or finance.45

The income statement is reformulated to better reflect economic value by dividing into two

parts on operations and financing.

Cost of goods sold, distribution expenses, administrative expenses and other operating

expenses are combined together in the operating expenses. Operating income consists of other

income and other operating income. Using these figures I calculated earning before interest

and taxes (EBIT). EBIT is what the firm would have earned if not for obligations to its

creditors and the tax authorities. EBIT is a measure of the profitability of the firm's operations

abstracting from any interest burden attributable to debt financing.46

Then, there is calculated net operating profit after tax (NOPAT). NOPAT is a company's after-

tax operating profit for all investors, including shareholders and debt holders.47

45 Petersen, p. 1446 Bodie et al., p. 56147 http://moneyterms.co.uk/nopat/

48


Source: own computation based on Philip Morris Annual Reports

Tax is computed by using effective tax rate, which is counted on the basis of the information

obtained from the Annual Reports.

For control purposes NOPAT and net financial expenses after tax were totted up in order to

obtain net earnings, which has to be exactly the same like the bottom line in income statement

in the Company's Annual Report.

4.3.2.2 Analytical Balance Sheet

In order to match the items in the income statement with the related items in balance, items

marked as operations and finance, respectively must be marked the same way in the balance

sheet.48

The analytical balance sheet is prepared according to Copeland et. al.

The balance sheet is reformulated to reflect the capital invested in Philip Morris ČR

48 Petersen, p. 14

49

Table 5: Analytical Consolidated Income Statement

2009 2008 2007 2006 2005Revenues 11,690 9,902 10,369 10,031 11,790 COGS (6,398) (5,771) (5,648) (4,917) n/a Distribution expenses (1,236) (1,202) (1,415) (1,697) n/a Administrative expenses (923) (721) (792) (884) n/a Other operating expenses (251) (288) (136) (94) n/a Sum of all expenses (8,808) (7,982) (7,991) (7,592) (8,177)Other income 60 86 102 59 n/a Other operating income 264 324 146 83 n/a Sum of all incomes 324 410 248 142 183 EBIT 3,206 2,330 2,626 2,581 3,796 Tax on operating earnings 681 520 648 668 1,048 NOPAT (A) 2,525 1,810 1,978 1,913 2,748

Financial expenses (24) (152) (13) (9) (16)Financial income - - - - - Net financial expenses before tax (24) (152) (13) (9) (16)Tax saving on interest expenses 5 34 3 2 4 Net financial expenses after tax (B) (19) (118) (10) (7) (12)

Net earnings (A+B) 2,506 1,692 1,968 1,906 2,736

Effective tax rate 21.24% 22.31% 24.68% 25.89% 27.62%

Consolidated Income Statement – analytical (in CZK million)


operations. Invested capital is the sum of operating current assets less operating current

liabilities, net off interest-bearing debt, plus property, plant and equipment (PP&E), PP&E

classified as held-for-sale and deferred tax assets.

Operating current assets include all current assets used in or necessary for the operations

of the business. For the Philip Morris ČR case, the current assets include inventories, trade

and other receivables, current income tax prepaid and cash and cash equivalents.

Inventories involve material, work-in-progress, finished goods and merchandise. The cost of

inventories, excluding excise tax and allocated overheads, is recognised as expense and is

included in cost of goods sold in the income statement. Inventories include excise taxes.49

Excess cash is normally excluded, because it represents temporary imbalances in the

company's cash flow. Excess cash is short-term cash and investment that company holds over

and above its target cash balances to support operations. By excluding interest and excess

cash, we can get a better sense of how operating working capital has changed over time.

Moreover, this is consistent with the practise of excluding interest income from the

calculation of NOPAT.50 Therefore, I include only cash at banks, which is completely assumed

to be operational. I do not divide the cash on the operational and excess cash. But mainly,

I do not include on-demand deposits with related parties, which are part of cash and cash

equivalents at the consolidated balance sheet.

Non interest-bearing current liabilities are subtracted to calculate operating working capital.

In the Philip Morris ČR case, current liabilities include trade and other liabilities,

non - financial liabilities, current income tax liabilities, other tax liabilities and provisions for

current liabilities.

Non-financial liabilities includes amounts due to employees and related expenses. Other tax

liabilities consist of VAT and mostly of excise tax, which is the most important tax in the

tobacco industry.

In 2008, management of the Company approved a plan related to the restructuring of sales

and distribution and to the transfer of certain procurement and information services activities

49 PM Annual Report 2008, p. 4150 Copeland et. al, p. 161

50


to the regional shared centres in Madrid and Krakow. The estimated restructuring expense

representing termination payments, to those made redundant, were CZK 22 million as at

December 31, 2008.51 This amount appears in the provisions for current liabilities.

The next step is to add net PP&E, intangible assets, deferred tax assets and PP&E classified as

held-for-sale to operating working capital.

Net PP&E value is the book value of the company's fixed assets less depreciation. The

amounts in the balance sheet are already depreciation adjusted.

Deferred income tax assets and liabilities are offset when there is a legally enforceable right to

offset current tax assets against current tax liabilities and when the deferred income tax relate

to the same fiscal authority. However, there is deferred tax asset which is not offset.52

Therefore I added it to the invested capital.

The last thing which is added in order to calculate total invested capital are non operating

assets. In the Philip Morris case it is only PP&E classified as held-for-sale. It has to be added

because it is not netted against equity or debt.53

For control purposes the invested capital can be calculated in one more way, this time by

using the liability side of balance sheet. The invested capital includes equity, deferred income

taxes and interest bearing debt.

Equity is comprised of registered capital, share premium and other shareholders'

contributions, reserves and retained earnings and minority interest. Net interest-bearing debt

involves interest-bearing assets deducted from interest-bearing liabilities. In this case it means

borrowings less on-demand deposits with related parties.

51 PM Annual Report 2008, p. 4752 PM Annual Report 2008, p. 4353 Copeland et. al, p. 162

51


Source: own computation based on Philip Morris Annual Reports

4.3.3 Common size analysis and indexing

Now, when I have prepared the analytical financial statements, I can continue with analyzing

of the Company's financial statements. I will conduct common size analysis and to pro up the

findings, I will use indexing – trend analysis, too. The common size analysis is a percentual

expression of the analytical financial statements, where revenues equal to 100%. I will start

with common size analysis of the analytical income statement.

52

Assets (Operations) 2009 2008 2007 2006 2005

Inventories 3447 7347 10296 5634 5498Trade and other receivables 1532 1749 6221 1423 821Current income tax prepaid 51 4 0 84 66Cash and cash equivalents 13 48 23 303 106Operating current assets 5043 9148 16540 7444 6491

Trade and other financial liabilities 798 571 983 694 913Non-financial liabilities 172 145 140Current income tax liability 12 66 163Other tax liabilities 3675 2388 7332 4392 5033Provisions for current liabilities 4 22 0 34 3Operating current liabilities 4661 3192 8618 5120 5949

Operating working capital 382 5956 7922 2324 542

Property, plant and equipment 2561 2269 2231 2539 2631Intangible assets 111 134 16 25 28Deferred tax assets 5 5 11 8 8

PP&E classified as held-for-sale 0 0 28 0 12

Invested capital 3059 8364 10208 4896 3221

Equity and liabilities (Financing)

Registered capital 2745 2745 2745 2745 2745Share premium 2361 2361 2357 2360 2336Reserves 551 555 549 551 549Retained earnings 3264 2290 3010 2685 3832Minority interest 1 1 0 0 1Deferred tax 112 30 0 164 57

Borrowings -5975 382 1547 -3609 -6299

Invested capital 3059 8364 10208 4896 3221

Consolidated Balance Sheet – analytical (in CZK million)



In the year 2005, the costs were unfortunately divided differently in the income statement and

it was impossible to allocate them to the same categories like in the following years.

Therefore, I only counted sum of all expenses and sum of all incomes for the first year.

For better and more descriptive interpretation, I have also prepared trend analysis. When

possible, year 2005 is the base (equals to 100), otherwise the base is year 2006. All the

following years are compared to the base year and expressed in percents.


The basic problem was decreasing revenue year by year. Since 2005 to 2008 it went down by

16%, while the costs went down by only less than 3%. But in 2009 the revenues reached

almost identical level to the year 2005. The negative point is that the costs increased by

almost 8%. The explanation for this can be that the rivalry in the tobacco industry is really

53

Table 8: Indexing - Trend analysis - Analytical Income Statement

Indexing – trend analysis 2009 2008 2007 2006 2005Revenues 99.15 83.99 87.95 85.08 100COGS 130.12 117.37 114.87 100 n/aDistribution expenses 72.83 70.83 83.38 100 n/aAdministrative expenses 104.41 81.56 89.59 100 n/aOther operating expenses 267.02 306.38 144.68 100 n/aSum of all expenses 107.72 97.62 97.73 92.85 100Other income 101.69 145.76 172.88 100 n/aOther operating income 318.07 390.36 175.9 100 n/aSum of all incomes 177.05 224.04 135.52 77.6 100EBIT 84.46 61.38 69.18 67.99 100Tax on operating earnings 64.96 49.59 61.83 63.75 100NOPAT 91.9 65.88 71.98 69.61 100

Table 7: Common size analysis - Analytical Income Statement

Common size analysis 2009 2008 2007 2006 2005Revenues 100.00% 100.00% 100.00% 100.00% 100.00%COGS -54.73% -58.28% -54.47% -49.02% n/aDistribution expenses -10.57% -12.14% -13.65% -16.92% n/aAdministrative expenses -7.90% -7.28% -7.64% -8.81% n/aOther operating expenses -2.15% -2.91% -1.31% -0.94% n/aSum of all expenses -75.35% -80.61% -77.07% -75.69% -69.36%Other income 0.51% 0.87% 0.98% 0.59% n/aOther operating income 2.26% 3.27% 1.41% 0.83% n/aSum of all incomes 2.77% 4.14% 2.39% 1.42% 1.55%EBIT 27.43% 23.53% 25.33% 25.73% 32.20%Tax on operating earnings 5.83% 5.25% 6.25% 6.66% 8.89%NOPAT 21.60% 18.28% 19.07% 19.07% 23.30%


tough and the companies are in so called price war. Furthermore, according to ACNielsen

survey, Philip Morris was gradually loosing few percents of the market share in its main

markets – Czech and Slovak, every year until 2007.54

We can also see quite drastic decrease in NOPAT versus revenues. Either if we consider

percentual expression to revenues, where it fell down by 5% during the years 2005 and 2008,

or in indexing, where it fell more than one third from 100 to mere 66. However, in the last

year the NOPAT compared to revenues rose by more than 3%. When compared to the base

year there is decline for only around 8%.

On the other hand, tax on operating income went down firstly to one half in 2008 and then

went a slightly up reaching around two thirds of the level of the base year in 2009, but it is

due to the falling EBIT and decreasing income corporate tax rate too.

When we will analyse the costs more in depth, we will find out, that COGS are getting

relatively bigger portion of revenues, peaking in 2008, while distribution and administrative

costs mildly lowered. Moreover, sum of all expenses versus revenues is percentually rising,

got 6% more since 2005. While the revenues in 2009 returned to the almost identical level

compared to the base year, the costs rose by almost 8%. Sum of all incomes rose as well, but

with comparison of the expenses, it is just a tiny part.

There is a rise in other operating income, but hand in hand with it goes rise in other operating

expense. Both income and expenses consist mainly of exchange rate gain, respectively loss.

So after all they more or less offset each other.

I will continue with common size analysis of the analytical balance sheet. I have prepared

only the operations' side, because the financing side contains only equity, insignificant amount

of deferred tax and short-term borrowings within the PMI Group.

Invested capital equals to 100%.

54 PM Annual Reports

54



Again, for better illustration, I have also prepared the trend analysis.

The very varying percentual portions of invested capital can be easily explained by huge

changes in invested capital over the years.

When we look at the common size analysis, we can see that the operating working capital

reached very different portion of invested capital over the years. Starting at almost 17% and

rising to more than 77% and declining to 12,5% in 2009.

We can see that inventories count for the biggest portion of invested capital. But the

problematic point was that they were in uptrend. However, it changed in the last year, when

they went down dramatically. Compared to the base year, they peaked in 2007 reaching 187%

and went down to only nearly 63% in 2009.

From the current operating liabilities, the biggest portion counts for other tax liabilities. This

is not surprising as the Company has to pay huge excise taxes and value added tax due to the

nature of its business. Another important part of the liabilities is trade and other financial

liabilities, which counts for significant part. The rest is just few percentage points.

55

Common size analysis 2009 2008 2007 2006 2005

Inventories 112.68% 87.84% 100.86% 115.07% 170.69%Trade and other receivables 50.08% 20.91% 60.94% 29.06% 25.49%Current income tax prepaid 1.67% 0.05% 0.00% 1.72% 2.05%Cash and cash equivalents 0.42% 0.57% 0.23% 6.19% 3.29%Operating current assets 164.86% 109.37% 162.03% 152.04% 201.52%

Trade and other financial liabilities 26.09% 6.83% 9.63% 14.17% 28.35%Non-financial liabilities 5.62% 1.73% 1.37% n/a n/aCurrent income tax liability 0.39% 0.79% 1.60% n/a n/aOther tax liabilities 120.14% 28.55% 71.83% 89.71% 156.26%Provisions for current liabilities 0.13% 0.26% 0.00% 0.69% 0.09%Operating current liabilities 152.37% 38.16% 84.42% 104.58% 184.69%

Operating working capital 12.49% 71.21% 77.61% 47.47% 16.83%

Property, plant and equipment 83.72% 27.13% 21.86% 51.86% 81.68%Intangible assets 3.63% 1.60% 0.16% 0.51% 0.87%Deferred tax assets 0.16% 0.06% 0.11% 0.16% 0.25%

PP&E classified as held-for-sale 0.00% 0.00% 0.27% 0.00% 0.37%

Invested capital 100.00% 100.00% 100.00% 100.00% 100.00%


Trade and other receivables increased, especially in 2007. Since 2005 they went up by more

than 86%, meaning that the Company might have some difficulties in collecting receivables.

Another good point is that the Company lowered dramatically their cash in hand. The idle

cash is not tied up unnecessarily. Compared to the base years it decline to only 12% in 2009.

On the other side trade and other financial liabilities did not change that much, they stayed at

the similar range over the years. They went down by a bit more than 12% since 2005.

Both operating current assets and operating current liabilities reached a similar level in 2009,

even though their way over the years was drastically different.

PP&E stayed as well at the similar level over the years. Intangible assets rose for around

300% since 2005, but in absolute number they count for a tiny part of invested capital.

When we look at the invested capital, we can see that firstly it increased during until year

2008, while in 2009 it decreased and returned to a very similar level with 2005.


56

Table 10: Indexing - Trend analysis - Analytical Balance Sheet

Indexing – trend analysis 2009 2008 2007 2006 2005

Inventories 62.7 133.63 187.27 102.47 100Trade and other receivables 186.6 213.03 757.73 173.33 100Current income tax prepaid 77.27 6.06 0 127.27 100Cash and cash equivalents 12.26 45.28 21.7 285.85 100Operating current assets 77.69 140.93 254.81 114.68 100

Trade and other financial liabilities 87.4 62.54 107.67 76.01 100Non-financial liabilities 122.86 103.57 100 n/a n/aCurrent income tax liability 7.36 40.49 100 n/a n/aOther tax liabilities 73.02 47.45 145.68 87.26 100Provisions for current liabilities 133.33 733.33 n/a 100 n/aOperating current liabilities 78.35 53.66 144.86 86.06 100

Operating working capital 70.48 1098.89 1461.62 428.78 100

Property, plant and equipment 97.34 86.24 84.8 96.5 100Intangible assets 396.43 478.57 57.14 89.29 100Deferred tax assets 62.5 62.5 137.5 100 100

PP&E classified as held-for-sale n/a n/a 233.33 n/a 100

Invested capital 94.97 259.67 316.92 152 100


4.3.4 Calculating the value drivers

Now, with the knowledge of NOPAT and invested capital, we can move on to the value

drivers. I will start with calculating of return on invested capital (ROIC). ROIC is used to

assess a company's efficiency at allocating the capital under its control to profitable

investments. The return on invested capital measure gives a sense of how well a company is

using its money to generate returns.55

Return on invested capital (ROIC)

ROIC=NOPAT

Invested capital∗100


ROIC is a better analytical tool for understanding the company's performance than other

return measures, such as return on equity, because it focuses on true operating performance of

the company.56

ROIC can be disaggregated further more.

Decomposition of ROIC

In order to better analyse Philip Morris ČR historical performance, I will decompose ROIC

into ROIC tree. The tree is compounded of key components, which will provide us with better

insights into the drivers of ROIC. The decomposition shows how the value drivers influence

ROIC.

Usually, some components such as invested capital is an average of the two periods or just

value of the current period. In this thesis I will use the the average value of the beginning and

end of the period.

55 http://www.investopedia.com/terms/r/returnoninvestmentcapital.asp56 Copeland et. al, p. 167

57

2009 2008 2007 2006 2005ROIC 44.21% 19.49% 26.19% 47.13% 41.95%


Source: own creation based on Copeland et. al.

I adapted the previous scheme to the Philip Morris case, because their financial statements are

slightly different than those in Copeland's textbook.

The abbreviations used, stand for: COGS is cost of goods sold. In one of the other box there is

other expenses less other incomes. OWC means operating working capital, net PPE is net

property, plant and equipment.

For control purpose, I included ROIC, computed in the backward way (as multiplying of

pretax ROIC and one less cash tax rate) as well. If the computations are correct, then the

ROIC has to be exactly the same like the one computed in the beginning of this chapter.

58

+

+

EBIT/ Revenues1-

+

Pretax ROICX

OWC/ Revenues

ROICX +

1-1/

+

COGS/ Revenues

Distribution exp./ Revenues

Administrative exp./ Revenues

Other exp.-other inc./ Revenues

Net PPE/ RevenuesCash tax rate on

EBITRevenues/

Invested capital

Other assets/ Revenues



Notice that in 2005 there are missing few different components. The reason is that the cost

structure in the Annual Report for 2005 was different and it would be impossible to obtain

comparable figures.

When we start our analysis from the bottom, we can see that the first line has a rising trend. It

can be explained by rising level of intangible assets, while the revenues had decreasing trend

until 2008.

The second line, where there are net PP&E compared to revenues, has similar levels. It is

because the net PP&E does not differ that much over the years. It changed few percentage

points according to the level of revenues over the years.

When we moved to the third figure, OWC divided by revenues, we can see huge differences,

starting as low as 14% and reaching around 70%. These results are mainly connected with

huge changes in OWC. OWC is composed of operating current assets (OCA) less operating

current liabilities (OCL). OCA are affected from the major part by the level of inventories and

trade and other receivables. Level of these two items is really different over the years. In the

recent years, there is a positive trend, when the level of both these items is decreasing.

The key part of OCL, which counts for more than three thirds of the total amount, is other tax

liabilities. But this fact is derived from the nature of Philip Morris' business that is highly

influenced by taxes.

The level of this driver differs in accordance with the points mentioned above.

59

2,009 2008 2007 2006 2005ROIC 44.21% 19.49% 26.19% 47.13% 41.95%Pretax ROIC 56.13% 25.09% 34.77% 63.59% 57.95%Cash tax rate on EBIT 21.24% 22.31% 24.68% 25.89% 27.62%EBIT/Revenues 27.43% 23.53% 25.33% 25.73% 32.20%Revenues/Invested capital 2.05 1.07 1.37 2.47 1.8COGS/Revenues 54.73% 58.28% 54.47% 49.02% n/a Distribution exp./Revenues 10.57% 12.14% 13.65% 16.92% n/a Administrative exp./Revenues 7.90% 7.28% 7.64% 8.81% n/a Other exp.-other inc./Revenues -0.62% -1.23% -1.08% -0.48% n/a OWC/Revenues 27.11% 70.08% 49.41% 14.29% 33.05%Net PPE/Revenues 20.66% 22.72% 23.00% 25.77% 22.12%Other assets/Revenues 1.09% 0.98% 0.42% 0.40% 0.38%


Now we will move to the next group of drivers. The first driver is other expenses less other

incomes divided by revenues. I will not analyse this driver as its amount is negligible. The

next driver is Administrative expenses. The level remains more or less the same, somewhere

around 8%, over the years. Then, the next driver is Distribution expenses. Level of this driver

is decreasing every year. It means that the Distribution expenses that are necessary in order to

generate revenues are reduced from year to year.

Unfortunately, we cannot state the same about COGS driver. Its level in the beginning rose

and only in the last year it went down.

Now we will continue with the next level drivers. Firstly, with the capital turnover, which

measures how effectively Philip Morris employs its invested capital. It reveals the revenue per

one money unit, in our case one CZK, of invested capital. It measures the ability of invested

capital to generate revenues. The higher the result, the better. In 2005 the figure was 1.8 then

it went up for one year, then it went to the value close to 1. Nevertheless, in 2009 the figure

rose up to 2.05. To put this in another way, it means that 0.49 CZK57 of invested capital was

used in order to generate one CZK of revenues.

Operating margin reveals the profitability of each one CZK of revenues. It indicates the

ability of the company to generate earning for a particular level of revenues. The results for

Philip Morris show downtrend. The figure started at 32% in 2005, then there was downtrend

until 2008 with the result 23.5%, when there was reversion and the result was more then 27%

in 2009. it reached around 47%. But the difference in operating margin over the years are

quite high. Unlike the capital turnover, the trend does not reverse over the year.

Relationship between operating margin and capital turnover can be demonstrated by the next

graph (likely position of Philip Morris in the graph is denoted by the circle with letters PM

inside):

57 The value was computed as: 1/2,05=0,49

60


Source: own creation based on Holečková, p. 72

Philip Morris is in a capital intensive field of business, with tough competition and entry

barriers. These companies have to reach high operating margin in order to attract sufficient

funds. They operate under the capacity constraint, meaning that high capital intensity creates

constraint for certain level of capital turnover.

The last but one figure is cash tax rate on EBIT. This driver follows clear downtrend. The

reason is the decreasing corporate tax rate in the Czech Republic.

The main figure is ROIC. In the Philip Morris case we can see huge differences over the

years. In the beginning ROIC is almost 42%, then rising to 47% and falling down to around

26% and 19% and in the last year rising to more then 44%. The results are good. The

differences over the years count mainly for changes in the capital turnover.

ROIC and its components differs across industries, depending on their economic

characteristics, and across firms within an industry depending on the design and

implementation of their strategies.58

I will try to explore more deeply the differences in ROIC over the years. According to

Stickney (p.207) there are three elements that account for differences in ROIC over the time:

1) Operating leverage. Shortly can be defined as process of operating with high

58 Stickney et.al, p. 205

61


proportion of fixed costs. The problem with this point is that companies do not publish

the portion of fixed costs versus variable costs. But we can assume that Philip Morris

has higher portion of fixed costs as it is a manufacturing company and from the

composition of a cigarettes' price we can conclude that the production itself is quite

cheap (when we disregard from the taxes).

Companies with higher operating leverage experience higher variability in ROIC,

because they incur more risk and therefore should earn higher returns.

2) Cyclicality of sales. This does not apply to the tobacco industry in general. As

described in the previous chapters, the demand for cigarettes is stable regardless of the

state of economy. Nevertheless, some distortions may happen, for example, before

anticipated rise in excise taxes, retailers are likely to stock up their inventories.

3) Product life cycle. Products move through different phases. Cigarettes are no

exception. Philip Morris is well aware of this fact. As Daniel Gordon said: ”Philip

Morris closely monitors customer behaviors and preferences and thus provide adult

smokers with more than fifty cigarette variants across different taste and price

segments. As an example, we recently upgraded Marlboro Gold, introduced L&M

Link and R&W Super Slims. So we indeed follow consumers’ expectations and adjust

our strategy accordingly.”59

When we conclude the previous elements, we can state that all of them affect changes in

ROIC over the time. However, the most significant point is connected with operational

leverage. Company has big portion of fixed costs and when they cannot use them

appropriately the diseconomy of scale applies. The second and third point contribute to the

changes as well, but only from the minor points.

More comprehensive analysis should include benchmarking with similar companies from the

industry. But, as the scope of the thesis is limited, I will not include this. Moreover, it would

be really problematic to find similar company in the Czech and Slovak market. Especially due

to the fact that Philip Morris' market share is more than 50% and because other tobacco

companies do not publish their financial statements.

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

62


The reason why I disregard from traditional figures like return on assets or return on equity is

that they do not distinguish between operating and non-operating activities. Return on equity

mixes operating performance with financial structure, making peer group analysis or trend

analysis less focused. The return on total assets is inadequate because it includes a number

of inconsistencies between the numerator and the denominator.60

In a valuation perspective distinction of operating and non-operating activities is essential in

order to calculate the right value of a company.

4.3.5 Economic Value Added

Another part of the profitability analysis will consist of Economic Value Added measure.

Economic Value Added (EVA) is very spread and useful measure of how well a company

performs. Before it is possible to calculate EVA, we need to find appropriate Weighted

Average Cost of Capital.

4.3.5.1 Weighted Average Cost of Capital

In this chapter I will deeply research about the most accurate cost of capital for Philip Morris

ČR. This is not necessary only for computing of EVA but for valuation too.

The weighted average cost of capital (WACC) is a weighted average of the firm's cost of

equity rE and its cost of debt rD, with the weights created by the market values of the firm's

equity (E) and debt (D):

WACC=E

EDr E

EED

r D∗1−TC

The WACC is based on the firm's current characteristics, but it is used to discount future cash

flows. That is fine as long as the firm's business risk and debt ratio are expect to remain

constant. Discounting cash flows by the WACC is only approximately correct.61

4.3.5.1.1 Risk-free rate rf

Before, I will compute cost of equity, I have to find appropriate risk-free rate rf.

60 Copeland et. al, p. 16361 Brealey et al., p. 504

63


In reality there is no such thing as a risk free interest rate, but for the purposes of this thesis,

I will use the the rates of 10 years state's bonds. I consider the state's bond as risk free

financial instrument. I will use the rates that are accessible on the official web page of the

Czech National Bank.62

4.3.5.1.2 Computing cost of equity rE

I will use Capital Asset Pricing Model (CAPM) to determine the cost of equity. The CAPM

derives the firm's cost of capital from its covariance with the market return. The CAPM is

defined as:

r E=r f [E r M −r f ]

where rf is the market risk-free rate of interest, E(rM) is the expected return on the market

portfolio, and β is a firm-specific risk. β is defined as:

=Cov r stocks , r M

Var r M

I will use data obtained from the official web page of PSE for the PX index and the web page

penize.cz for historical prices of Philip Morris stock.

Now, when β is computed, I can continue with CAPM. The next step will be Security Market

Line (SML). Firstly, I will calculate the classic CAPM, as defined above.

But the classic CAPM uses an SML, which has the basic problem and it is ignoring of taxes,

which creates distortion. Therefore, I will use the tax-adjusted SML:

Cost of equity=r f 1−T C [E r M −r f 1−T C ]

The results for for cost of equity of both the tax-adjusted and classic SML are in the following

table:

62 http://www.cnb.cz/miranda2/export/sites/www.cnb.cz/cs/financni_trhy/trh_statnich_dluhopisu/sd/download/AUKCE_SD_HISTORIE.XLS

64



To explain meaning of beta, let us have a look at the previous year. Philip Morris ČR

β2009=0.45. It means that a 1 percent increase or decrease in the monthly returns of the PX

index was accompanied by a 0.45 percent increase or decrease in Philip Morris' returns.

Moreover, I counted Company's α, which shows that irrespective of changes in the PX index,

the monthly return on Philip Morris in 2009 was α=-1.97%. On an annual basis, this is

12*(-1.97)=-23.64%. This indicates that Philip Morris had negative performance over the

period.

The R2 for 2009 of the regression shows that 12.39% of the variation in the Philip Morris'

returns is accounted for by variability in the PX index. It means that around 12% of variation

in Philip Morris returns is explicable by the variation in PX index. This number is pretty low,

the average R2 for stocks is approximately 30-40%.63

Now, when the cost of equity is known, I can move on to cost of debt.

4.3.5.1.3 Computing cost of debt

In principle, rD is the marginal cost to the firm (before corporate taxes) of borrowing an

additional money unit.

We have to consider some points before calculating of cost of debt. The Company has only

some short-term borrowings and only with related parties. They are divided into two groups:

● Interest bearing on-demand borrowings

63 Benninga p. 55

65

Table 13: Cost of Equity

2009 2008 2007 2006 2005Effective tax rate 21.24% 22.31% 24.68% 25.89% 27.62%Alpha -0.0197 -0.0231 -0.0185 0.0063 0.0069Beta

Using SLOPE 0.4464 0.8432 1.1120 0.6822 0.5119Using COV/VAR 0.4464 0.8432 1.1120 0.6822 0.5119

R-squared 0.1239 0.2159 0.2929 0.2041 0.1682rf 5.00% 4.00% 4.00% 3.80% 3.80%rm monthly 0.62% 2.40% 2.32% 2.03% 1.12%rm annual 7.38% 28.82% 27.84% 24.36% 13.40%cost of equity (tax adjusted) 5.47% 24.79% 30.63% 17.51% 8.20%cost of equity 6.06% 24.93% 30.51% 17.83% 8.72%


● Short-term borrowings

The next part of borrowings is bank overdraft, but this counts for a really small fraction of the

total sum of borrowings. Moreover, in the year 2006, the Company has no borrowings and in

2009 the borrowings were only CZK 11 million.

Before computing the cost of debt, I have to make few assumptions:

● I will consider liquid assets, such as cash and cash equivalents as a negative debt,

therefore I will deduct them from the firm's debt.

● The Company has usually large amount of cash. Therefore in some years, the net debt

is negative. I will conclude that during these years the Company has negative leverage.

● I will count cost of debt as interest expense divided by average amount of debt for

current and previous year.64


With the knowledge of rE and rD, I can calculate WACC now.

4.3.5.1.4 WACC final computation

I will count WACC twice, firstly based on classic CAPM and, secondly, based on tax-adjusted

CAPM. In both computations I will use interest rate derived from the financial statements.

64 Benninga p. 80

66

2009 2008 2007 2006 2005Cash and cash equivalents 5999 1408 2240 3912 6817Borrowings 11 1742 3764 0 412Interest expense 24 152 13 25 16Interest cost 2.74% 5.52% 0.69% 12.14% 7.77%Debt net of cash -5988 334 1524 -3912 -6405



Estimated WACC is an average of WACC based on classic CAPM and tax-adjusted CAPM.

Now, when I computed the WACC, I can continue with the Economic Value Added.

4.3.5.2 Economic value added

In this subchapter, I will focus on calculation of value created to shareholders, by applying

one of the excess return models, namely Economic Value Added (EVA). EVA measures

surplus value created by an investment. It is computed as the product of the excess return

made on an investment and the capital invested in that investment.65 If we want to use EVA

measure, we have to make one basic assumption – the main objective of any firm is to

maximize shareholder value.

The big advantage of EVA is that it is definitely good measure of performance, as it takes into

the consideration the cost of capital employed. The EVA conveniently sums up into one single

number the value created above and beyond all financial obligations.

The problem with EVA is that it is a historical performance measure, e.g. during the cycles

when there is a reversed trend, EVA will not capture this.

65 Damodoran, p. 215

67

2009 2008 2007 2006 2005

6.06% 24.93% 30.51% 17.83% 8.72%

5.47% 24.79% 30.63% 17.51% 8.20%

2.74% 5.52% 0.69% 12.14% 7.77%

21.24% 22.31% 24.68% 25.89% 27.62%Shares outstanding 2,745,000 2,745,000 2,745,000 2,745,000 2,745,000Share price, end year (CZK) 8,849 6,425 7,591 11,528 18,103 Net debt (CZK) -5,988,000,000 334,000,000 1,524,000,000 -3,912,000,000 -6,405,000,000Equity value (CZK) 24,290,505,000 17,636,625,000 20,837,295,000 31,644,360,000 49,692,735,000

WACC 2009 2008 2007 2006 2005 based on classic CAPM 7.34% 24.55% 28.47% 19.07% 9.17%

WACC 2009 2008 2007 2006 2005 based on tax-adjusted CAPM 6.56% 24.41% 28.57% 18.72% 8.59%

Estimated WACC 6.95% 24.48% 28.52% 18.89% 8.88%

Cost of equity, rE

Cost of tax-adjusted equity, rE

Cost of debt, rD

Tax rate, TC


The EVA can be illustrated by the following graphic:

Source: http://i.investopedia.com/inv/articles/site/EVAChap5Fig1.gif

Mathematically, EVA is defined as:

EVA=ROIC−WACC ∗Capital Invested=NOPAT−WACC∗Capital Invested

The EVA results for each year are in the following table:


Note that EVA is based on the average level of invested capital, to be in accordance with the

ROIC measure.

There are big differences from year to year and we can see that the Company did not always

created surplus value. During the years 2008 and especially in 2007 the EVA was negative.

This was due to the fact that WACC rose by around 20% from 2005 until 2007 and only

slightly declined in 2008, while it went down to only 7% in 2009.

4.3.6 Free cash flow

Before I will move on to forecasting, I will calculate historical free cash flow as another basis

for forecasting.

Free cash flow (FCF) can be defined as a company's true operating cash flow. FCF can be

viewed as the cash that a company is able to generate after taxes. FCF is available to all

68

Illustration 16: Economic Value Added

2009 2008 2007 2006 2005EVA 2,128 (463) (176) 1,146 2,166


providers of the company's capital. Free cash flow is important because it allows a company

to pursue opportunities that enhance shareholder value. Without cash, it is tough to develop

new products, make acquisitions, pay dividends or reduce debt.66

Free cash flow equals to NOPAT less net investment. Net investment is the change in invested

capital.67


The FCF principle is often used as the earnings can be manipulated, but it is tougher to fake

cash flow. For this reason, some investors believe that FCF gives a much clearer view of the

ability to generate cash and thus profits.

It is important to note that negative free cash flow is not bad in itself. If free cash flow is

negative, it could be a sign that a company is making large investments. If these investments

earn a high return, the strategy has the potential to pay off in the long run.68

If we take a look at the free cash flows over the years, we can see that the FCF was negative

only for one year in 2007. It was derived by negative change in invested capital. When we

take a closer look at the financial statements for 2007, we will find out that in this year the

inventory rose almost twice versus prior year. It was caused by rise in finished goods and

merchandise. Moreover, trade receivables increased almost six times. It was a bit offset by

rose in VAT and excise tax. Yet, the rise in current assets was much higher than rise in current

liabilities. On the basis of the previous points, it is quite obvious that the invested capital was

much bigger versus previous year. This caused the negative FCF. However, when we explore

the financial statements in the following years, we can see that the level of inventories as well

as level of trade receivables went down, which means that the negative FCF was not a big

deal in 2007.

66 http://www.investopedia.com/terms/f/freecashflow.asp67 Copeland et. al., p. 16768 http://www.investopedia.com/terms/f/freecashflow.asp

69

Free cash flow 2,009 2008 2007 2006 2005NOPAT 2,525 1,810 1,978 1,913 2,748 Change in invested capital 5,305 1,844 (5,312) (1,675) 6,658 Free cash flow 7,830 3,654 (3,334) 238 9,406


The Company's FCF results are outstanding, especially in the years 2005 and 2008-2009. In

2006-2007 the results were not surprising, especially in 2007, as mentioned before.

We can conclude, that FCF demonstrates good financial health of the Company in the long

run.

4.4 Conclusion

In the previous part of this paper there was an analysis of the financial performance of the

Company over the years 2005 – 2009. The accounting results in the year 2005 were very

good, nevertheless, since then most of the figures and ratios followed downtrend. But in 2009

the downtrend reversed into uptrend and Company reached really good results again.

The described path was followed by the revenues and thus NOPAT. We can find few positive

and negative things. The negative points are that the relative size of costs increased over the

years. Moreover, the trade and other receivables went up. Positive things are that the

inventories were decreased over the years significantly. Another positive point is reducing of

cash in hand.

In the other part, I calculated the value drivers as the basis for forecasting. ROIC reached very

good results over the years. But it showed different results during the years. ROIC consists of

Capital Turnover and Operating Margin. Capital Turnover showed clear downtrend from

2006, yet, reversed in 2009. Operating Margin showed as well clear downtrend with the

reversion in 2009. Capital Turnover accounted for bigger part of the differences in ROIC.

The differences in ROIC in the covered period account mainly for the operating leverage.

Then lightly for the cycles of sales, even though the cigarettes are not linked with the overall

state of economy but with the changes in excise taxes, when before the anticipate rise in the

excise taxes, the retailers build up the inventories. The product life cycle is not that relevant,

as the Company closely monitor customers' behaviour and innovate their products.

Then, I focused on absolute measures of performance. At the first place, the WACC has been

computed and with that knowledge, I could calculate EVA. To prop up the results, I calculated

FCF.

The WACC differs a lot over the years. The reason is pretty simple, the value of shares

70


declined dramatically over the years, while to benchmark index followed uptrend in general.

This was most visible during the years 2007 and 2008, when WACC was 28.5% and 24.5%

respectively. WACC in the Philip Morris case is mainly derived by the cost of equity.

Company has in fact zero indebtedness. Company is usually in the role of creditor.

The EVA measure was negative only in 2007 and 2008 due to the reasons mentioned above.

But overall the EVA measure is positive. FCF was negative only once in 2007 and compared

to the other years, the result is not that bad.

After analysing of EVA and FCF, we can state that the Company creates value and generates

sufficient cash for its stakeholders.

All in all, we can conclude that the Company is in good financial shape.

71


5 ForecastWith the knowledge of the Company's historical performance and its strategic position, we

can continue with forecasting its future performance. The key to projecting performance is to

develop a point of view on how the company can or will perform on the key value driver,

which is growth.

Because growth is not constant over the time, the time itself has to be considered.

But, before I will start with forecasting, I would like to mention that forecasting is not an

exact science. Nevertheless, forecasting is widely used in economics in general. Forecasts are

produced in order to valuate a company. Company's valuation is mainly associated with stock

analysis, whether to buy, sell or hold company's stocks or with acquisitions of a company.

I will follow Copeland's forecasting framework.69

Forecast will be divided into two periods, an explicit forecast period (in this case 10 years)

and the remaining life of the Company (year 11 on). The second part will be covered by the

continuing value. A detailed forecast will be prepared for the first period, while for the second

period the continuing value formula will be used, as described later on. The reason for the ten

years horizon is that I suppose the Company will reach a steady state after that.

Before I will start to forecast individual lines of balance sheet and income statement, I will

recap important points from the previous chapters and make assumptions.

5.1 Evaluation of strategic position

Within the tobacco industry there is a tough competition. If a company wants to earn ROIC

excessing the opportunity cost of capital, then it has to develop and exploit a competitive

advantage. We can observe Company's ROIC, WACC and spread.


We can see that in 3 years out of 5, Company performed very well and the spread was

69 Copeland et. al., p. 201

72

2009 2008 2007 2006 2005ROIC 44.21% 19.49% 26.19% 47.13% 41.95%Estimated WACC 6.95% 24.48% 28.52% 18.89% 8.88%Spread 37.26% -4.98% -2.33% 28.23% 33.07%


positive. Actually the results for 2009, 2006 and 2005 are pretty outstanding. Only during the

years 2008 and 2007, the results were negative, meaning that the Company's ROIC was lower

than its WACC. It was mainly due to the low stock performance in those times.

From this point, we can conclude that Philip Morris has a competitive advantage. When we

take in account all the facts, we can try to explore for the competitive advantage of Philip

Morris. According to Copeland, competitive advantages can be divided into 3 groups. For the

Philip Morris case, the first option seems to be reasonable: providing superior value to the

customers through a combination of price and product attributes that cannot be replicated by

competitors. For the first, Philip Morris has more than 50% market share in the Czech and

Slovak markets together, which makes them market leader. For the second, majority of the

most popular brands of cigarettes in the Czech Republic and Slovakia are produced by Philip

Morris. They have many brands across all the pricing segments. The Company is financially

strong, meaning that it does not have to project for example all the increase of VAT or excise

tax in its products immediately. It can absorb it for some time and hence win over its

competitors.

The second point according to Copeland is: achieving lower costs than competitors. This can

be valid for Philip Morris too. Due to its size and market share, it can be easier, than for its

competitors, to reach the economy of scale.

The third Copeland's point is: utilizing capital more productively than competitor. This point

cannot be answered with the publicly accessible information.

5.2 Development of Tobacco Industry

Before forecasting itself, we should take a look at the positive and negative influences on the

tobacco market for the future.

73


Positive

● popularity of international brands

● new products development

● resistant to the slowdown in economy

● no danger of being superseded by a

technologically superior products

Negative

● tax driven price rises

● public smoking bans

● health fears

● advertising restrictions

● illicit trade

Source: Euromonitor International: Global Tobacco: Market Outlook, May 2009

Moreover, we will take a look at the expected growth in shipments and volume prices in the

upcoming years.

Source: Cigarettes Czech Republic and Slovakia: Country Sector Briefing, Euromonitor

International, January 2010 and Tobacco in Europe: Industry Profile, Datamonitor, July 2009

The numbers present anticipated growth (decline) per year. Compound Annual Growth Rate

(CAGR) stands for the year-over-year growth rate over a specified period of time.70

We can see that all the estimates show rise over the estimated years. The shipment rise is not

that considerable, nevertheless, the price volume rise, especially in the Czech Republic, is

expected to be significant.

5.3 Forecast individual line items

When we start with forecasting individual line items, we have to prepare the structure of the

forecast. It means the order in which the variables are forecasted and how they relate to each

other. The forecast should start with an integrated income statement and balance sheet.

70 http://www.investopedia.com/terms/c/cagr.asp

74

Sales estimates 2010 2011 2012 2013 CAGR total growthCZ mil sticks -0.39% 1.04% 1.27% 0.64% 0.65% 2.59%SK mil sticks 0.96% 1.06% 1.26% 0.36% 0.92% 3.68%CZ CZK mil 4.38% 6.23% 5.99% 5.87% 6.11% 24.43%SK EUR mil 2.14% 2.58% 3.20% 2.72% 2.77% 11.07%

EU 2.15% 1.94% 1.91% 2.26% 2.31% 11.56%EUR bio


The most common approach to forecasting of the income statement and balance sheet for

non - financial companies is a demand-driven forecast, which starts with sales. Most of the

other variables are driven off the sales forecast.

I will use a top-down forecast, where the revenues are estimated by sizing the total market,

determining market share, and forecasting prices. The bottom-up approach, where the

company's forecasts are used, is impossible, as it is Company's policy not to publish any

forecasts.

I consider the tobacco industry as a mature one, where the aggregate market grows slowly

and is closely tied to long-term trends (e.g. changing consumer preferences). Therefore, I rely

on professional forecasts of the aggregate market (by Euromonitor International and

Datamonitor) and I will mainly focus on Company's market share.

When forecasting revenues for next years, I made few assumptions:

● market share for the Czech and Slovak market will remain more or less stable,

I assume that Company is able to capture the current market share, Company will

follow the strategy of close monitoring of customers' tastes, Company will still

continue like market leader

● Company (due to the opening of new producing facilities) will produce more

cigarettes and therefore increase its export to the EU countries

● the revenues growth until 2013 is computed from data by Euromonitor International

and Datamonitor, like an weighted arithmetic mean, where there are different weights

for all three geographical segments

● since 2014, I projected expected rise in excise tax (following the example that already

happened to Philip Morris in 2008), which is likely to increase the illicit trade and

make the customers to start buying cigarettes in the neighbouring countries with lower

excise tax, nevertheless, by 2018, the excise tax rate set by the EU, will apply to those

countries as well

● the total growth will be mainly derived by rises in price, while the total shipment in

the Czech and Slovak market will probably decline due to the strict regulations and

75


consumers life style which is becoming to be healthier

● however cigarettes will not have a substitute and many people will still be so-called

“core smokers” (consumers, who are impervious to price, bans, health warnings and

anything else)71, so even though that number of smokers is slowly decreasing, it will

never get close to zero

● Company will go on with innovation and development of new products in order to

attract new or retain old customers

When the revenues forecasts are known for the upcoming years, we can move on to

forecasting of individual lines. First step is to find out what economically drives each line. We

can suppose that most of the lines in the income statement are derived from revenues. To

check this hypothesis, I will apply correlation analysis.


I consider the driver as relevant only if the correlation coefficient is at least 0.8. The

correlation analysis confirmed that the revenues are key forecast driver – COGS,

administrative expenses and other income is derived by revenues. However, a bit surprising

fact was that distribution expenses are derived by COGS more than by revenues. Other

operating expenses are mainly driven by distribution expenses and other operating income is

dependant on the other operating expenses. Tax on operating profit is dependant on EBIT

more than on the revenues.

I will use ROIC tree to check consistency of the forecast. With the historical levels calculated,

there are few points which help to gain insight into the future level of each valuation variable.

We have to judge whether the industry and company capabilities are expected to maintain

71 Global Tobacco, Euromonitor International, p. 30

76

Driver

COGS 0.92 revenuesDistribution expenses 0.88 COGSAdministrative expenses 1 revenuesOther operating expenses 0.94 distribution exp.Other income 0.8 revenuesOther operating income 1 other operating exp.Tax on operating earnings 0.87 EBIT

Correlation coefficient


historical patterns in the future. And what factors can cause significant shift in the historical

level of the company's value drivers.

The effective tax rate, will be predicted as well. The problem of the effective tax rate is that to

calculate and predict it correctly, one needs internal information. Especially, because the

Company is active in three different business segment. The tax will be predicted mainly on

the basis of possible development of a Czech corporate tax rate.

COGS moved over the covered period from 49% to 54%. The current trend shows that it

could stay somewhere around 55% over the years. This level will be used in the forecasts.

The distribution expenses decreased over the years from almost 35% to less than 20% of

COGS. But as Company will produce bigger shipment for export, the assumption is that the

level of distribution expenses will rise slightly to around 20%, which will be used in the

forecast.

The administrative expenses stayed around 8% over all the years. So that level will be used in

the forecasting.

Other operating expenses converges to around 20% of distribution expenses. Other operating

income closely correlates with other operating expense. Its level is around 92%. These levels

will be used.

Tax on operating income follows EBIT, and will be set on the level of 21%, mainly in

accordance with the Czech corporate tax rate.

When we are done with forecasting of the analytical income statement, we can go to the

forecasting of the invested capital.

I will start the same way like with the income statement, I will apply correlation analysis in

order to find what economically drives the selected lines. I will not forecast the whole

analytical balance sheet in details, but I will forecast operating working capital (OWC) and

long-term assets.

77



Level of OWC changes significantly every year. But when we explore its level more deeply,

we will find out that it correlates really closely with the sum of all expenses. Its level will be

set as 60% of the sum of all expenses.

Net PP&E correlates with the revenues. Its level has been similar for few years, a bit above

22%. However, Company invested considerable funds into new production facilities. From

this year, when the new production facilities will start to work, so the net PP&E is supposed

to rise. Therefore the level of PP&E will be set at 26% of the revenues.

Concerning intangible assets we do not have any information from the Annual Reports.

Therefore, the level for the forecasted period will be the same like in 2009. Deferred tax

assets has had the same level for two preceding years and in addition, it counts for a really

tiny part of the invested capital. So I will leave the level the same like in 2009, too. PP&E

classified as held-for-sale has been for the majority of years 0. So it will be in the anticipated

period. More detailed forecasts can be found in the Appendices 3 and 4.

All the forecasts were prepared without anticipation of inflation. The reason is that the

inflation was not taken in account in the historical analysis, meaning that all the historical

analysis and forecasts are in nominal, not in real currency units. And moreover, inflation is not

a big deal in the Czech Republic. E.g. inflation in 2009 reached only 1%. And in the previous

years the inflation usually was around 2%.72

The forecast for next ten years plus for CV is in the following graph:

72 http://www.czso.cz/csu/redakce.nsf/i/mira_inflace

78

Driver

Operating working capital 0.99 sum of all expensesProperty, plant and equipment 0.94 revenuesIntangible assets -Deferred tax assets -PP&E classified as held-for-sale -

Correlation coefficient


Source: own estimates

79

Table 22: Forecast for 2010 – 2019 + CV

CV 2019e 2018e 2017e 2016e 2015eRevenues 12,611 12,486 12,362 12,301 12,425 12,678 COGS (6,936) (6,867) (6,799) (6,765) (6,834) (6,973)Distribution expenses (1,387) (1,373) (1,360) (1,353) (1,367) (1,395)Administrative expenses (1,009) (999) (989) (984) (994) (1,014)Other operating expenses (277) (275) (272) (271) (273) (279)Sum of all expenses (9,609) (9,514) (9,420) (9,373) (9,468) (9,661)Other income 60 60 60 60 60 60 Other operating income 255 253 250 249 251 257 Sum of all incomes 315 313 310 309 311 317 EBIT 3,317 3,284 3,252 3,237 3,269 3,334 Tax on operating earnings 696 690 683 680 686 700 NOPAT 2,620 2,595 2,569 2,557 2,582 2,634 Effective tax rate 21.00% 21.00% 21.00% 21.00% 21.00% 21.00%

2014e 2013e 2012e 2011e 2010e 2009Revenues 13,207 13,975 13,339 12,714 12,115 11,690 COGS (7,264) (7,686) (7,337) (6,992) (6,663) (6,398)Distribution expenses (1,453) (1,537) (1,467) (1,398) (1,333) (1,236)Administrative expenses (1,057) (1,118) (1,067) (1,017) (969) (923)Other operating expenses (291) (307) (293) (280) (267) (251)Sum of all expenses (10,064) (10,649) (10,164) (9,688) (9,231) (8,808)Other income 60 60 60 60 60 60 Other operating income 267 283 270 257 245 264 Sum of all incomes 327 343 330 317 305 324 EBIT 3,471 3,669 3,505 3,343 3,189 3,206 Tax on operating earnings 729 770 736 702 670 681 NOPAT 2,742 2,899 2,769 2,641 2,519 2,525 Effective tax rate 21.00% 21.00% 21.00% 21.00% 21.00% 21.24%

CV 2019e 2018e 2017e 2016e 2015eOperating working capital 5766 5709 5652 5624 5681 5797Property, plant and equipment 3279 3246 3214 3198 3230 3296Intangible assets 111 111 111 111 111 111Deferred tax assets 5 5 5 5 5 5PP&E classified as held-for-sale 0 0 0 0 0 0Invested capital 9160 9071 8982 8938 9027 9209

2014e 2013e 2012e 2011e 2010e 2009Operating working capital 6038 6390 6099 5813 5539 382Property, plant and equipment 3434 3634 3468 3306 3150 2561Intangible assets 111 111 111 111 111 111Deferred tax assets 5 5 5 5 5 5PP&E classified as held-for-sale 0 0 0 0 0 0Invested capital 9588 10139 9683 9234 8805 3059


5.4 Check overall forecast for reasonableness

The last step in forecasting is to construct the ROIC tree and to evaluate the forecast. The

forecast will be evaluated the same way the company's historical performance was analyzed.

I calculated ROIC tree the same way like in the financial analysis chapter for checking of the

reasonableness. The levels of drivers are in accordance with the assumptions I made while

forecasting. Furthermore, the value of drivers for the year 2019 and CV yields the same

results.


We can see that capital turnover in 2010 will start at the similar level to 2009, while later on

will fell down to the level around 1.4. Profit margin will stay at the comparable levels from

2006 until 2009 (2008 excluded). The reason of levels of these two figures were explored in

the previous chapters. But anyway these results are in compliance with the general

characteristics of the tobacco industry. The main figure, which is ROIC, followed the first rise

80

CV 2019e 2018e 2017e 2016e 2015eROIC 28.74% 28.74% 28.68% 28.46% 28.32% 28.03%Pretax ROIC 36.38% 36.38% 36.30% 36.03% 35.85% 35.47%Cash tax rate on EBIT 21.00% 21.00% 21.00% 21.00% 21.00% 21.00%EBIT/Revenues 26.30% 26.30% 26.31% 26.31% 26.31% 26.30%Revenues/Invested capital 1.38 1.38 1.38 1.37 1.36 1.35COGS/Revenues 55.00% 55.00% 55.00% 55.00% 55.00% 55.00%Distribution exp./Revenues 11.00% 11.00% 11.00% 11.00% 11.00% 11.00%Administrative exp./Revenues 8.00% 8.00% 8.00% 8.00% 8.00% 8.00%Other exp.-other inc./Revenues -0.30% -0.30% -0.31% -0.31% -0.31% -0.30%OWC/Revenues 45.49% 45.49% 45.61% 45.95% 46.19% 46.67%Net PPE/Revenues 25.87% 25.87% 25.94% 26.13% 26.27% 26.54%Other assets/Revenues 0.93% 0.93% 0.94% 0.94% 0.93% 0.91%

2014e 2013e 2012e 2011e 2010e 2009ROIC 27.80% 29.25% 29.27% 29.28% 42.46% 44.21%Pretax ROIC 35.19% 37.02% 37.05% 37.07% 53.75% 56.13%Cash tax rate on EBIT 21.00% 21.00% 21.00% 21.00% 21.00% 21.24%EBIT/Revenues 26.28% 26.25% 26.27% 26.30% 26.32% 27.43%Revenues/Invested capital 1.34 1.41 1.41 1.41 2.04 2.05COGS/Revenues 55.00% 55.00% 55.00% 55.00% 55.00% 54.73%Distribution exp./Revenues 11.00% 11.00% 11.00% 11.00% 11.00% 10.57%Administrative exp./Revenues 8.00% 8.00% 8.00% 8.00% 8.00% 7.90%Other exp.-other inc./Revenues -0.28% -0.25% -0.27% -0.30% -0.32% -0.62%OWC/Revenues 47.05% 44.68% 44.65% 44.64% 24.44% 27.11%Net PPE/Revenues 26.76% 25.41% 25.39% 25.39% 23.57% 20.66%Other assets/Revenues 0.88% 0.83% 0.87% 0.91% 0.96% 1.09%


in capital turnover, while then went down to the level around 28-29%. This results seems to

be reasonable.

5.5 Estimating the cost of capital

The next step in forecasting is to estimate the cost of capital for the forecasted period. The

WACC is actually the discount rate, or time value of money, used to convert expected cash

flow into present value.73

The WACC estimate for 2010 was calculated from the historical figures the same way like

five preceding years. The only estimate was effective tax rate. Since 2011 the WACC was

calculated by using estimates as described below.

Effective tax rate has been used the same like in the forecasts of the analytical income

statement, it means 21%. The β has been calculated for the years 1999 to mid of 2010 and its

value has been used for the future period, its value is β=0.4. Moreover, this is in accordance

with the β for Tobacco industry as denoted in the textbook (Stickney et. al., p. 819), where

β=0.47. For the risk free rate there is an assumption that it will decrease in the future. It will

start at the current level and steadily decrease by 1% down. The reason for this is that the

Czech Republic is viewed as a quality investment by the rating agencies, and especially after

the general elections in 2010 its risk has gone down.74 So I suppose that the risk free rate will

return to around 4% in the future. Expected return on the market portfolio has been calculated

in the same way as the β. It is average market return for the period from 1999 to mid 2010. Its

value is 9.4%.

It is hard to forecast, without internal information, total amount of debt, but I assumed that it

will be zero in the future. Company does not need to loan money for its operations. It is more

likely to be a creditor to other PMI affiliate than debtor. Company had quite significant

on - demand deposits with related parties in 2009, but as they are short-term, I expect them to

be collected soon.

The terminal value for shares of Philip Morris has been estimated with the view that the

73 Copeland et al., p. 23974 http://ekonomika.idnes.cz/trhy-jsou-po-volbach-optimisticke-zlevnuje-euro-i-dolar-p2r-/ekonomika.asp?

c=A100531_103050_ekonomika_fih

81


overall economy will recover and the stock prices will go up. This was a bit more like

guessing, however, even quite big changes in stock prices, did not affect the value of WACC

more than few decimal percentage points.

The WACC from the previously mentioned numbers has been calculated the same way like in

the historical performance analysis. The complete calculation can be found in an Appendix 2.

The estimated WACC until 2019 + Continuing Value is in the following table.


Now we are ready to start the valuation itself.

5.6 Conclusion

Task of this chapter was to forecasts financial statements for the valuation. In the beginning

I recap the strategic position of PM and I elaborated on its results, clarifying of the Philip

Morris's competitive advantage.

Moreover, I took a look at the main factors driving development of tobacco industry in

general and with use of external data I prepared the revenues forecasts for the Company. With

the forecasted revenues, I applied correlation analysis to find out what drive single lines in

income statement and invested capital calculation.

When the forecasts were done, I conducted ROIC tree to check the reasonableness of the

forecasts.

The chapter ended with estimation of WACC for the future years.

82

Table 24: Estimated WACC for 2009 – 2019 + CV

CV 2019e 2018e 2017e 2016e 2015eEstimated WACC 5.91% 5.91% 5.91% 6.02% 6.02% 6.18%

2014e 2013e 2012e 2011e 2010e 2009Estimated WACC 6.18% 6.18% 6.45% 6.45% 3.80% 6.95%


6 ValuationThis is the main chapter of the thesis. It will provide us with the answer to the research

question which is to find the theoretical value of Philip Morris ČR as at June 30, 2010.

Valuation is the process of converting a forecast into an estimate of the value of the firm.

There are two kinds of valuation – within the firm and outside the firm. The thesis since the

beginning focuses on the second kind of valuation. This kind of valuation is mainly used by

security analysts in order to support buy or sell decisions, and potential acquires to estimate

the value of target firm.75

With the forecast from the previous chapter, we are now equipped to perform valuation of

Philip Morris. It would be better to produce scenario analysis, however, due to the scope of

the thesis, it was impossible.

6.1 Choice of a valuation model

First and foremost, I have to choose a valuation model. In practise there is a wide variety of

valuation approach. There are four possible ways of valuation:

1) Asset Based Valuation

2) Discounted Cash Flow Models

3) Relative Valuation

4) Contingent Claim Models76

The Asset Based Valuation can be either liquidation value or replacement cost. But this

approach is more suitable for a single asset not for the whole company. It would be difficult to

implement it in order to answer the research question. That is why it will not be applied.

Relative valuation consists in using either equity or firm value as a measure and relating it to a

number of a firm-specific variables such as earnings. The multiples can be estimated by using

comparable firms. The problem is not that the companies should run business in the same

field, but mainly that they should have a similar size and even the capital structure. This posts

75 Palepu p. 7.176 Damodaran, p. 650

83


problems, if we would like to find really suitable comparable companies for Philip Morris

ČR. However, I intend to use the multiple valuation as a checking model.

The Contingent Claim Models are in fact valuations by real options. They lie in replicating of

a portfolio of cash flows that equals to the cash flows from the different operations in a firm.

The main problem with this technique is that it is difficult to implement due to the lack

of internal information.

DCF valuation is where the value of a company is the present value of the expected cash

flows for the company, discounted back at the discount rate. The DCF approach embodies in

that the value of an assets is not what someone perceives it to be worth, but rather it is

a function of the expected cash flows for the company. DCF approach is based on the

proposition that every asset or company has an intrinsic value, which we will try to estimate.77

For the purpose of this master thesis, I will mainly use the second choice, Discounted Cash

Flow model.

6.2 Discounted Cash Flow model

DCF is generally defined as:

Value=∑t=1

t= n CF t

1r t

where n is number of years, CFt is cash flow in period t and r is the discount rate.

There are two possible ways in DCF valuations:

1) valuation of the equity stake in the business;

2) valuation of the entire company.

In this master thesis, I will value the whole firm, using the second option. The value of

a company is obtained by discounting expected cash flows to the company, i.e. residual cash

flows after meeting all operating expenses and taxes but prior to debt payments, at the WACC.

So, the general DCF formula can be now defined as:

77 Damodaran, p. 10

84


Value=∑t=1

t=∞ CF firmt

1WACC t

where CF firmt is cash flow to the firm in period t. The cash flow to the firm is in fact free

cash flow. The main advantage of DCF is that company is treated like a cash generator. The

cash flows are based on detailed forecasts for each period. Moreover, DCF uses FCF, which

represents the cash that a company is able to generate after laying out the money required to

maintain or expand its asset base. FCF is important because it allows a company to pursue

opportunities that enhance shareholder value.78

One major problem that is connected with DCF model is that it is only good as the inputs are.

However, when we valuate a company by DCF, we have to consider how the company will

perform after the explicit forecasted period. For this purpose we can use the concept of

Continuing Value (CV).CV is a useful concept that simplifies company valuations. When we

estimate a company's value, first we separate a company's expected cash flow into two

periods and define the company's value as follows:

Value= Present Value of Cash Flowduring Explicit Forecast Period

Present Value of Cash Flowafter Explicit Forecast Period

The second part of the equation is the continuing value – the value of the company's expected

cash flow beyond the explicit forecast period. Making simplifying assumption about the

company's performance during this period (such as constant rate of growth), we can estimate

continuing value by using formulas instead of explicitly forecasting and discounting cash

flows over an extended period. The formula for estimating continuing value is:

CV t=NOPAT t1∗1−

gRONIC

WACC−g

where, NOPATt+1 is normalized level of NOPAT in the first year after the explicit forecast

period, g is expected growth rate in NOPAT in perpetuity and RONIC is expected rate of

return on new invested capital.

I assume that after 2019 the Company will reach a steady state, with constant growth,

78 http://www.investopedia.com/terms/f/freecashflow.asp

85


margins, capital turnover and WACC. Therefore, I will be able to use this perpetuity-based

formula which relies on parameters that never change.

The concrete procedure of DCF valuation has been already described so now we are ready to

start. The valuation is as June 30, 2010. In the sequent table, there is a calculation of FCF

from 2010 until 2019. Then, I calculated the present value (PV) of each year FCF by using

discount factor, that has been obtained from estimated WACC. The last line, the present value,

is sum of all PV of FCF for all the years.


The present value is almost CZK 13,900 mil. The forecast has been made for ten years, so it is

obvious that CV will be significant part of the value of Philip Morris ČR.

CV has been defined theoretically in the previous subchapter. The growth will be set at 1%.

The reason is that the growth in long-term in tobacco industry is expected to be derived only

by price, while the shipment is expected to decrease. Therefore, the increase is not correlated

with the general growth of economy, how it is normal at the long-term forecast. RONIC can

be basically seen as the ROIC. The projected ROIC is around 29%. So this figure will be used

in the CV formula.

86

Table 25: Valuation of FCF for 2010 - 2019

2019e 2018e 2017e 2016e 2015eNOPAT 2,595 2,569 2,557 2,582 2,634 Change in invested capital (89) (44) 89 182 379 Free cash flow 2,506 2,525 2,646 2,764 3,013

Discount Factor 56.35% 59.68% 63.20% 67.01% 71.04%

Present Value of FCF 1,412 1,507 1,672 1,852 2,140

2014e 2013e 2012e 2011e 2010eNOPAT 2,742 2,899 2,769 2,641 2,519 Change in invested capital 551 (456) (449) (430) (5,746)Free cash flow 3,293 2,442 2,320 2,212 (3,227)

Discount Factor 75.42% 80.08% 85.03% 90.51% 96.34%

Present Value of FCF 2,484 1,956 1,973 2,002 (3,109)

Present Value 13,889


So now, we can calculate the CV. The result is CV=51,527 mil CZK, where the present value

is PV=27,415 CZK. Now, when we got the data in present value, we have to sum them up and

divide it by the total number of shares. The results will be illustrated by the next table:


The value of Philip Morris ČR share is CZK 15,329. The price at the PSE was CZK 8,720 as

at June 30, 2010. In the next chapter I will check the result.

6.3 Sensitivity analysis for DCF

Forecasts of cash flows in the future of any firm, contain a high degree of uncertainty. The

forecasting and valuation process has an inherently high degree of uncertainty and estimation

error. In the previous subchapter we saw that major part of the Company's value accounts for

the CV. The CV formula relies on only four variables – NOPAT, RONIC, WACC and growth.

In order to check the integrity of valuation result, I will apply the sensitivity analysis, where I

will consider different values of WACC, RONIC and growth. I will test the effects of these

changes on the share value estimate.

The sensitivity analysis is based on WACC in the range from 3% to 10%. The base for

RONIC is 29% and is varied by +(-)4% and +(-)8%, while growth starting value is 1% and is

87

Table 26: DCF - Valuation Summary

mil CZKPresent Value of FCF 13,889

Present Value of CV 27,415

SUM 41,304

Subtract market value of debt (11)

SUM 41,293

Adjust for Midyear Discounting 1.019

Total Present Value 42,077

Number of shares 2,745,000

Share price (CZK) 15,329


further varied by +(-)1% and +(-)2%.


Note that the value of share, when WACC=3%, RONIC=37% and growth=3%, is not

computed. The reason is that when WACC equals to growth, the formula does not work as it

is divided by zero. The values per share differs enormously Starting as low as CZK 10,110

and reaching more than CZK 53,900. However, the growth is not supposed to be that

significant in the future, the WACC is expected to stay a bit conservative, meaning around 6%

and the RONIC will probably not rise much in the future, due to the tough competition in the

tobacco industry.

The value of WACC for CV, which is less than 6% is viewed as a reasonable, as the Company

is supposed to have zero debts in the future and risk free rate is expected to drop down as

well. I consider the WACC as the best estimate available, so the RONIC and growth are the

most uncertain variables.

In the next graph, there is illustrated, how different growth rates will affect the value per

share. Growth is a variable, starting at -3% and terminating at 5% by one percent point, while

88

Table 27: Sensitivity analysis

WACC RONIC g WACC RONIC g3% 21% -1% 18760.34 7% 21% -1% 11963.653% 25% 0% 22467.63 7% 25% 0% 12581.533% 29% 1% 30223.1 7% 29% 1% 13519.013% 33% 2% 53923.38 7% 33% 2% 14918.253% 37% 3% #DIV/0! 7% 37% 3% 17090.394% 21% -1% 16041.67 8% 21% -1% 11208.474% 25% 0% 18142.46 8% 25% 0% 11654.714% 29% 1% 21871.05 8% 29% 1% 12325.864% 33% 2% 29545.17 8% 33% 2% 13293.034% 37% 3% 52860.68 8% 37% 3% 14705.715% 21% -1% 14229.22 9% 21% -1% 10604.325% 25% 0% 15547.36 9% 25% 0% 10933.855% 29% 1% 17695.03 9% 29% 1% 114315% 33% 2% 21419.1 9% 33% 2% 12132.175% 37% 3% 29013.82 9% 37% 3% 13115.926% 21% -1% 12934.61 10% 21% -1% 10110.016% 25% 0% 13817.3 10% 25% 0% 10357.166% 29% 1% 15189.42 10% 29% 1% 10734.996% 33% 2% 17356.07 10% 33% 2% 11261.526% 37% 3% 21064.87 10% 37% 3% 11980.35

Value per Share

Value per Share


WACC and RONIC are constants as used in the CV.


From the graph it is obvious that the growth has a significant influence over the value per

share. The growth is ranging from -3% to 5%, but the value per share derived by this growth

is ranging from more than CZK 11,500 to a bit over CZK 48,100.

The following graph concerns the sensitivity analysis as well. The difference is that RONIC is

the variable this time.


The level of RONIC does not have that significant influence over the value per share. While

89

Illustration 17: Sensitivity Analysis graph - Growth as a Variable

Illustration 18: Sensitivity Analysis graph - RONIC as a Variable

-4% -3% -2% -1% 0% 1% 2% 3% 4% 5% 6%

10000

15000

20000

25000

30000

35000

40000

45000

50000

55000

Sensitivity AnalysisGrowth as a Variable

Value per Share

Expected Growth

Va

lue

pe

r S

ha

re

10% 15% 20% 25% 30% 35% 40% 45% 50%

14700

14800

14900

15000

15100

15200

15300

15400

Sensitivity AnalysisRONIC as a Variable

Value per Share

RONIC

Val

ue p

er S

hare


the RONIC is ranging from 13% to 45%, the value per share is ranging from a bit more than

CZK 14,700 to CZK 15,300.

6.4 EVA valuation

To check the results for DCF valuation, I have prepared EVA valuation. The principle is the

same like with DCF model. It embodies in counting of EVA for the forecasted years plus for

terminal value and discount it to the present value. The EVA valuation for the explicitly

forecasted years can be defined by the formula:

Value=∑t=1

t=n EVAt

1r t

where EVAt is the Economic Value Added in year t, n is number of years and r is the discount

factor.

First, I calculated EVA for each year. EVA is based on the average level of invested capital.

Then I discounted them in order to get the present value. I used the estimated WACC from the

previous chapter. And finally, I summed all PV of EVA. The results are in the following table.

90



The present value is more than PV=15,800 CZK mil. However, we have to consider how the

company will perform after the explicit forecasted period. The firm value can be defined as:

Value=Invested Capital Asset i n place∑t=1

t= n EVAt

1WACC t

EVACV

WACC CV∗1WACC t

The Company value, using this formula, was calculated in the next table.

91

Table 28: Valuation of EVA for 2010 - 2019

CV 2019e 2018e 2017e 2016e 2015eNOPAT 2,620 2,595 2,569 2,557 2,582 2,634 Invested capital 9,160 9,071 8,982 8,938 9,027 9,209 Estimated WACC 5.91% 5.91% 5.91% 6.02% 6.02% 6.18%Average Invested capital 9,116 9,026 8,960 8,983 9,118 9,398

EVA 2,082 2,061 2,040 2,017 2,034 2,053

Discount factor 56.35% 59.68% 63.20% 67.01% 71.04%

PV EVA 1,162 1,217 1,275 1,363 1,459

2014e 2013e 2012e 2011e 2010e 2009NOPAT 2,742 2,899 2,769 2,641 2,519 Invested capital 9,588 10,139 9,683 9,234 8,805 3,059 Estimated WACC 6.18% 6.18% 6.45% 6.45% 3.80%Average Invested capital 9,864 9,911 9,459 9,019 5,932

EVA 2,132 2,286 2,159 2,060 2,294

Discount factor 75.42% 80.08% 85.03% 90.51% 96.34%

PV EVA 1,608 1,831 1,836 1,864 2,210

SUM PV EVA 15,824



The share price is CZK 15,442 as at June 30, 2010 The result is slightly different than in DCF

valuation. But the difference accounts for around 0.74%, so it is not that significant. Yet, the

share price also suggests that the Philip Morris share is currently underpriced by the market.

6.5 Multiple valuation

Comparables can be used in valuation as well. Multiple valuation will be used to validate the

result from DCF valuation. Valuation based on price multiples is widely used, mainly due to

the simplicity, as they do not require forecasting.

Before we will start with multiple valuation, we have to make one basic assumption, where

we will rely on the market and its pricing of the comparable companies. This approach is

quite straightforward, however, the biggest problem is connected with finding appropriate

comparable companies.

There are no comparable companies on the PSE. Thus, I will look for comparables at

international stock exchanges. There are, of course, connected some costs with finding

comparables at the different stock exchanges. Different regulations or applied rules can be a

good example. I will use Yahoo Finance Industry Center – Cigarettes to find comparable

companies.79 There are only few companies. I decided to use four of them – British American

Tobacco Indus (BTI), Altria Group, Inc. (MO), Reynolds American Inc Common St (RAI)

79 http://finance.yahoo.com/q/pr?s=bti

92

Table 29: EVA - Valuation Summary

mil CZKSUM PV EVA 15,824

PV Perpetuity EVA 19,853 Invested Capital 5,932 SUM PV 41,610 Subtract market value of debt (11)Adjusted SUM PV 41,599 Adjust for Midyear Discounting 1.019

Total Present Value 42,388

Number of shares 2,745,000

Share price (CZK) 15,442


and Lorillard, Inc Common Stock (LO)80. They are all traded in the USA. They are not

comparable by size but they do the business in the same industry, which is kind of specific.

The closest comparable company would be probably LO as they are only twice bigger than

PM. Nevertheless, I consider all the companies, for the purpose of the checking tool, as

appropriate comparables.

I will use three ratios, namely price-to-sales (P/S), price-to-book value of equity (P/B) and

price-to-earnings (P/E). These figures can be easily found at the key statistics of each

company at Yahoo. The following table shows the results for valuation by multiples.

Source: Yahoo Finance and own computations

The final result suggests price of Philip Morris share CZK 15,238. This result is surprisingly

close to the results from valuation by DCF and EVA valuation. It also suggests that the Philip

Morris stock is currently underpriced. More detailed multiples valuation is in appendix 5.

I can state that the value computed by the multiple valuation confirmed the results from DCF

valuation.

6.6 Conclusion

Task of this last chapter of the thesis, was to valuate the Company, to provide us with the

theoretical value as at June 30, 2010. The Company has been valued by using three different

models. The first model was DCF. DCF was counted from the forecast horizon of ten years

and CV. It yields the price per share CZK 15,329.

Second model was EVA valuation. This model's result is CZK 15,442 per share. To confirm

the results, one more model has been applied, namely multiples valuation. Four another

80 Philip Morris International Inc, as PM ČR is its affiliate

93

P/S P/B P/E BAT 3.21 5.99 16.56RAI 2.12 2.62 16.90MO 2.74 10.13 13.30LO 3.08 N/A 12.56

Average 2.79 6.25 14.83

Value per share (CZK) 11,871 20,303 13,539 Average share price (CZK) 15,238


cigarettes producers has been chosen and used as comparables. The result is CZK 15,238 per

share.

All three models provide us with very similar value per share, which puts more reliability into

the valuation.

The estimated values per share suggest that the Philip Morris ČR stock could be currently

undervalued by the market and therefore could be a good investing opportunity.

94


7 ConclusionPurpose of this master thesis was to valuate Philip Morris ČR. Firstly, there was applied

strategic analysis, followed by financial analysis to prepare basis for the forecasting and

valuation.

By applying strategic analysis, we found out, that PM is a dominant firm within the Czech

Republic and Slovakia. It follows strategy of organic growth. It expands its production

capacity in order to produce more cigarettes for export. Company is well aware of the changes

in consumers' tastes and hence is active in innovation. Further, we found out that Company

conducts its business in an industry, which is unattractive for new entrants and therefore

Philip Morris does not have to be afraid of new competitors. In addition, the industry has

a stable demand as cigarettes do not have real substitute and are addictive. However, PM

faces, due to the nature of cigarettes, many restrictions and regulations. Price of the cigarettes

is tax driven, where more than 80% counts for taxes. This will encourage illicit trade, which is

viewed as one of the biggest threats for the future.

Before starting the financial analysis itself, I explored the risks that PM is facing. They are

facing few risks, such as market or credit, but all the risks are managed carefully and do not

threat the Company. I conducted the liquidity analysis, where PM shows very good result, has

sufficient funds in order to pay the expenses. The second part consisted of profitability

analysis, that was applied on the historical financial statements. Company's profitability was

examined by using various tools and approaches. PM shows very good results over the

years .Some years were not so good like others. Especially, the results for 2009 revealed sharp

rise after few years of decline. Very positive thing is that in fact Company does not have any

debts. I carried out the EVA measure, among others, and it shows that Company is successful

in creating value to its shareholders. All in all, majority of the measures demonstrate that

Company is in a good financial shape.

A danger, that is connected with the future forecasting, is that it is based on the historical data

and information, meaning extrapolating the past into the future. This can of course affect

company's valuation either overestimating after a period of high growth or underestimating

after a period of low growth.

95


To cope with this problem, the historical analysis has been prepared for 5 years. Moreover, the

tobacco industry is a mature one, where there are not expected rapid changes, and is not

an industry with considerable economic cycles. The length of the forecast has been set on ten

years, taken into account major influences over the tobacco industry in the near future. Low

growth rate has been applied in the forecasting, due to the fact that tobacco industry is

supposed to be driven mainly by price rise, while the shipment is expected to decrease. The

anticipation of the future performance of Philip Morris ČR is still connected with high level of

uncertainties. However, the estimated value is thought to be the best current estimate.

The Discounted Cash Flow model, which was used for the valuation, yields the value per

share CZK 15,329. This is higher than the value at which the share s traded at Prague Stock

Exchange. Therefore, I used another models to check the results. I conducted EVA valuation,

which yields result CZK 15,442 and multiples valuation, which suggest the value per share

CZK 15,238.

All the results provide us with very similar results, that indicate that the Philip Morris stock

could by undervalued by the market.

96


List of abbreviations

BAT – British American Tobacco Plc

CAGR – Compound Annual Growth Rate

CAPM – Capital Asset Pricing Model

CNTC – China National Tobacco Corp

COGS – Cost of goods sold

CV – Continuing value

CZK – Czech koruna

D&A – Distribution and Administrative expenses

DCF – Discounted cash flow

EBIT – earning before interest and taxes

EU – European Union

EUR – Euro

EVA – economic value added

FCF – Free cash flow

IFRS – International Financial Reporting Standards

ITG - Imperial Tobacco Group Plc

NOPAT – net operating profit after tax

OCA – operating current assets

OCL – operating current liabilities

OWC – operating working capital

PMI – Philip Morris International

PP&E – property, plant and equipment

PSE – Prague Stock Exchange

97


PV – Present Value

ROIC – return on invested capital

SKK – Slovak koruna

SML – Security Market Line

USD – United States dollar

VAT – Value added tax

WACC – Weighted Average Cost of Capital

98


8 References

8.1 Literature

1996, Marketing Management, 3rd Edition, Pearson Custom Publication

Benninga, S 2008, Financial Modeling, 3rd Edition, The MIT Press

Bodie, Z, Kane, A, Marcus, A, 1996, Investments, 3rd Edition, Irwin

Brealey, R, Myers, S, Allen, F, 2006, Corporate Finance, 8th Edition, McGraw-Hill

Copeland, T, Koller, T, Murrin, J 1994, Valuation: Measuring and Managing Value of

Companies, 2nd Edition, John Wiley & Sons, Inc.

Damodaran, A 2006, Damodaran on Valuation, 2nd Edition, Wiley-India

Damodaran, A 1996, Investment Valuation, 2nd Edition, John Wiley & Sons, Inc.

Holečková, J 2008, Finanční Analýza Firmy, 1st Edition, ASPI

Koller, T, Goedhart, M, Wessels, D, 2005, Valuation: Measuring and Managing Value of

Companies, 4th Edition, John Wiley & Sons, Inc.

Palepu, K, Healy, P, Bernard, V, 2004, Business Analysis and Valuation, 3rd Edition, Thomson

South-Western

Penman, S 2007, Financial Statement Analysis and Security Valuation , 3rd Edition, McGraw-

Hill

Petersen, C 2007, Financial Ratios

Sloman, J 2005, The Economic Environment of Business, Prentice Hall

Stickney, C, Brown, P, Wahlen, J 2007, Financial Reporting, Financial Statement Analysis,

and Valuation, 6th Edition, Thomson South-Western

8.2 Documents

Philip Morris ČR Annual Reports 2005 – 2009

Global Tobacco: Market Outlook, May 2009, Euromonitor International

99


Tobacco in the Czech Republic, Industry profile, July 2009, Datamonitor

Tobacco in Europe, Industry profile, July 2009, Datamonitor

Global Tobacco, Industry profile, July 2009, Datamonitor

Philip Morris International Inc, July 2009, Euromonitor International

Cigarettes – Czech Republic, Country Sector Briefing, January 2010 Euromonitor

International

Cigarettes – Slovakia, Country Sector Briefing, January 2010 Euromonitor International

8.3 Homepage

http://www.ct24.cz/ekonomika/

http://www.czso.cz/

http://www.iasplus.com/

http://www.idnes.cz/

http://ihned.cz/

http://www.investopedia.com/

http://www.investicniweb.cz/

http://en.wikipedia.org/wiki/Wiki

http://www.novinky.cz/

http://www.oup.com/

http://www.patria.cz/zpravodajstvi/home.html

http://www.penize.cz/

http://www.portal.euromonitor.com/

http://www.pmi.com/eng/pages/homepage.aspx

http://www.pse.cz/

http://web.ebscohost.com/ehost/

100

http://www.ct24.cz/ekonomika/

http://web.ebscohost.com/ehost/

http://www.pse.cz/

http://www.pmi.com/eng/pages/homepage.aspx

http://www.portal.euromonitor.com/

http://www.penize.cz/

http://www.patria.cz/zpravodajstvi/home.html

http://www.oup.com/

http://www.novinky.cz/

http://en.wikipedia.org/wiki/Wiki

http://www.investicniweb.cz/

http://www.investopedia.com/t

http://ihned.cz/

http://www.idnes.cz/

http://www.iasplus.com/

http://www.czso.cz/


http://finance.yahoo.com/

101

http://finance.yahoo.com/q/ks?s=BTI


Appendices

Table of ContentsAppendices..............................................................................................................................102

Appendix 1 – Historical Balance Sheet and Income Statement (in mil CZK).........103Appendix 2 – Estimating the WACC........................................................................104Appendix 3 – Detailed Forecast of Analytical Income Statement............................105Appendix 4 – Detailed Forecast of Invested Capital................................................106Appendix 5 – Multiples Valuation............................................................................107

102


Appendix 1 – Historical Balance Sheet and Income Statement (in mil CZK)

103

Assets 31.12. 2009 2008 2007 2006 2005 2004PP&E 2,561 2,269 2,231 2,539 2,631 2,586 Intangible assets 111 134 16 25 28 34 Deferred tax assets 5 5 11 8 8 8 Non-current assets 2,677 2,408 2,258 2,572 2,667 2,628 Inventories 3,447 7,347 10,296 5,634 5,498 4,283 Trade and other financial receivables 1,532 1,749 6,221 1,423 821 6,849 Current income tax prepaid 51 4 - 84 66 49 Cash and cash equivalent 5,999 1,408 2,240 3,912 6,817 2,094 Current assets 11,029 10,508 18,757 11,053 13,202 13,275 PP&E classified as held-for-sale 28 12 Total assets 13,706 12,916 21,043 13,625 15,881 15,903

Equity and liabilities 31.12. 2009 2008 2007 2006 2005 2004Registered capital 2,745 2,745 2,745 2,745 2,745 2,745 Share premium 2,361 2,361 2,357 2,360 2,336 2,336 Retained earnings 3,264 2,290 3,010 551 549 549 Other reserves 551 555 549 2,685 3,832 5,505 Capital and reserves 8,921 7,951 8,661 8,341 9,462 11,135 Non-controlling interest 1 1 1 1 Equity 8,922 7,952 8,661 8,341 9,463 11,136 Deferred tax liability 112 30 164 57 179 Non-current liabilities 112 30 - 164 57 179 Trade and other financial liabilities 798 571 981 564 913 788 Non-financial liabilities 172 145 142 130 Current income tax liability 12 66 163 Other tax liabilities 3,675 2,388 7,332 4,392 5,033 3,800 Provisions for current liabilities 4 22 34 3 Borrowings 11 1,742 3,764 412 Current liabilities 4,672 4,934 12,382 5,120 6,361 4,588 Total liabilities 4,784 4,964 12,382 5,284 6,418 4,767 Total equity and liabilities 13,706 12,916 21,043 13,625 15,881 15,903

Income statement 2009 2008 2007 2006 2005 2004Revenues 11,690 9,749 10,369 10,031 11,790 13,197 COGS (6,398) (5,658) (5,648) (4,917) (6,125) (6,123)Gross profit 5,292 4,091 4,721 5,114 5,665 7,074 Distribution expenses (1,236) (1,162) (1,415) (1,697) (1,282) (1,090)Administrative expenses (923) (721) (792) (884)Other income 60 86 102 59 105 181 Other operating income 264 324 146 83 75 132 Other operating expense (251) (287) (136) (94) (767) (1,050)Profit from operations 3,206 2,331 2,626 2,581 3,796 5,247 Financial expenses (24) (152) (13) (9) (16) (15)Profit before income tax 3,182 2,179 2,613 2,572 3,780 5,232 Income tax expense (676) (486) (645) (666) (1,044) (1,516)Net profit for the year 2,506 1,693 1,968 1,906 2,736 3,716 Earnings per share 913 616 717 694 996 1,353


Appendix 2 – Estimating the WACC

104

CV 2019e 2018e 2017e

6.16% 6.16% 6.16% 6.28%

5.66% 5.66% 5.66% 5.75%

5.00% 4.62% 4.24% 4.76%

21.00% 21.00% 21.00% 21.00%Shares outstanding 2,745,000 2,745,000 2,745,000 2,745,000 Share price, end year 14,000 14,000 15,000 14,000 Net debt - - - - Equity value 38,430,000,000 38,430,000,000 41,175,000,000 38,430,000,000

2016e 2015e 2014e 2013e

6.28% 6.46% 6.46% 6.46%

5.75% 5.89% 5.89% 5.89%

4.53% 4.26% 4.10% 4.26%

21.00% 21.00% 21.00% 21.00%Shares outstanding 2,745,000 2,745,000 2,745,000 2,745,000 Share price, end year 12,500 12,000 13,000 12,000 Net debt - - - - Equity value 34,312,500,000 32,940,000,000 35,685,000,000 32,940,000,000

2012e 2011e 2010e

6.76% 6.76% 4.17%

6.13% 6.13% 3.42%

3.26% 3.03% 1.54%

21.00% 21.00% 21.00%Shares outstanding 2,745,000 2,745,000 2,745,000 Share price, end year 10,500 10,000 9,500 Net debt - - - Equity value 28,822,500,000 27,450,000,000 26,077,500,000

Cost of equity, rE


Cost of debt, rD

Tax rate, TC

Cost of equity, rE


Cost of debt, rD

Tax rate, TC

Cost of equity, rE


Cost of debt, rD

Tax rate, TC


Appendix 3 – Detailed Forecast of Analytical Income Statement

105

CV 2019e 2018e 2017e 2016e 2015e 2014eRevenues 12,611 12,486 12,362 12,301 12,425 12,678 13,207 expected growth/(decline) 1.00% 1.00% 0.50% -1.00% -2.00% -4.00% -5.50%COGS (6,936) (6,867) (6,799) (6,765) (6,834) (6,973) (7,264)

55.00% 55.00% 55.00% 55.00% 55.00% 55.00% 55.00%Distribution expenses (1,387) (1,373) (1,360) (1,353) (1,367) (1,395) (1,453)

20.00% 20.00% 20.00% 20.00% 20.00% 20.00% 20.00%Administrative expenses (1,009) (999) (989) (984) (994) (1,014) (1,057)

8.00% 8.00% 8.00% 8.00% 8.00% 8.00% 8.00%Other operating expenses (277) (275) (272) (271) (273) (279) (291)

20.00% 20.00% 20.00% 20.00% 20.00% 20.00% 20.00%Sum of all expenses (9,609) (9,514) (9,420) (9,373) (9,468) (9,661) (10,064)

1.00% 1.00% 0.50% -1.00% -2.00% -4.00% -5.50%Other income 60 60 60 60 60 60 60

Other operating income 255 253 250 249 251 257 267 92.00% 92.00% 92.00% 92.00% 92.00% 92.00% 92.00%

Sum of all incomes 315 313 310 309 311 317 327

EBIT 3,317 3,284 3,252 3,237 3,269 3,334 3,471 Tax on operating earnings 696 690 683 680 686 700 729 NOPAT 2,620 2,595 2,569 2,557 2,582 2,634 2,742 Effective tax rate 21.00% 21.00% 21.00% 21.00% 21.00% 21.00% 21.00%

2013e 2012e 2011e 2010e 2009 driverRevenues 13,975 13,339 12,714 12,115 11,690 expected growth/(decline) 4.77% 4.92% 4.94% 3.63%COGS (7,686) (7,337) (6,992) (6,663) (6,398) revenues

55.00% 55.00% 55.00% 55.00% 54.73%Distribution expenses (1,537) (1,467) (1,398) (1,333) (1,236) COGS

20.00% 20.00% 20.00% 20.00% 19.32%Administrative expenses (1,118) (1,067) (1,017) (969) (923) revenues

8.00% 8.00% 8.00% 8.00% 7.90%Other operating expenses (307) (293) (280) (267) (251) dist.exp.

20.00% 20.00% 20.00% 20.00% 20.31%Sum of all expenses (10,649) (10,164) (9,688) (9,231) (8,808)

4.77% 4.92% 4.94% 4.81%Other income 60 60 60 60 60

Other operating income 283 270 257 245 264 other op.exp.92.00% 92.00% 92.00% 92.00% 105.18%

Sum of all incomes 343 330 317 305 324

EBIT 3,669 3,505 3,343 3,189 3,206 Tax on operating earnings 770 736 702 670 681 NOPAT 2,899 2,769 2,641 2,519 2,525 Effective tax rate 21.00% 21.00% 21.00% 21.00% 21.24%


Appendix 4 – Detailed Forecast of Invested Capital

Appendix 5 – Multiples Valuation

106

CV 2019e 2018e 2017e 2016e 2015e 2014e

Operating working capital 5766 5709 5652 5624 5681 5797 603860.00% 60.00% 60.00% 60.00% 60.00% 60.00% 60.00%

Property, plant and equipment 3279 3246 3214 3198 3230 3296 343426.00% 26.00% 26.00% 26.00% 26.00% 26.00% 26.00%

Intangible assets 111 111 111 111 111 111 111Deferred tax assets 5 5 5 5 5 5 5

PP&E classified as held-for-sale 0 0 0 0 0 0 0

Invested capital 9160 9071 8982 8938 9027 9209 9588

2013e 2012e 2011e 2010e driver

Operating working capital 6390 6099 5813 5539 sum of all expenses60.00% 60.00% 60.00% 60.00%

Property, plant and equipment 3634 3468 3306 3150 revenues26.00% 26.00% 26.00% 26.00%

Intangible assets 111 111 111 111Deferred tax assets 5 5 5 5

PP&E classified as held-for-sale 0 0 0 0

Invested capital 10139 9683 9234 8805


107

P/S P/B P/E BAT 3.21 5.99 16.56RAI 2.12 2.62 16.90MO 2.74 10.13 13.30LO 3.08 N/A 12.56

Average 2.79 6.25 14.83Average * PM data 32,585,875,000 55,732,760,000 37,163,980,000

Average 41,827,538,333 Value per share 15,238

Philip Morris ČR Sales 11,690,000,000 Earnings 2,506,000,000 Market value 23,936,400,000 Book value 8,922,000,000 Price 8,720