Analysts Are Expecting Too Much

Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Being a stock analyst has to be one of the hardest jobs in the world.

When companies match your estimates, in large part the stock market yawns in response. When companies miss estimates, you get chided for being wrong. If a company beats estimates, you get in trouble for not knowing the company would do better. That being said, in the case of Philip Morris International (NYSE: PM), analysts have been calling for around 11% Earnings Per Share (EPS) growth for a while, and the company’s results suggest this guess is too high.

This is not As Big Of A Problem As You Think

I’m sure many investors in Philip Morris think that once the troubles in the European Union start to fade that their stock will explode. While it’s true that these issues are not helping matters, it probably won’t do as much for the company as some would think.

In a strange way, the domestic tobacco producers have already experienced what Philip Morris is dealing with. Domestic producers like Altria (NYSE: MO), Lorillard (NYSE: LO), and Reynolds American (NYSE: RAI), all had to face major economic headwinds domestically over the last several years. These companies saw smokers decline not only from the health related concerns, but also from economic forces.

Now that the domestic economy is doing better, these same companies are beginning to see revenue growth in spots. For instance, Lorillard saw revenue growth of 3.3% in the last three months, but Altria and Reynolds American still saw declines of 2.1% and 2.6% respectively. Just for comparison, Philip Morris saw revenue increase by 3.2%. Revenue growth would have come in higher without a 5.4% decline in the European Union territory, but at about 26% of total revenue, even positive sales growth wouldn’t be a massive difference maker.

Even if we assume 5% revenue growth for the European Union, the company’s total weighted average for revenue growth would only go from about 3.5% to 6.2%. While this sounds like a huge improvement, this also assumes that the company’s Eastern Europe, Middle East, and Africa segment continues to report better than 10% revenue growth. In addition, all of these numbers are excluding currency changes, so real revenue growth would likely be less.

I Know It Sounds Good

Some readers are thinking, if Philip Morris produces 6.2% revenue growth overall, then how can you question an 11% EPS growth rate? Given that the company turned 3.2% revenue growth into EPS growth of 8.8%, I understand the confusion. The assumption would be that with greater sales growth, Philip Morris could cut costs and increase profits.

This sounds good, but the company has two major issues working against this theory. First, the company routinely has the lowest gross margin among their peers. In the last three months, Philip Morris’ gross margin was just 27.5%. When you compare this result to the 63% margin at Reynolds American, the 45% margin at Lorillard, or the 48% margin at Altria, you can see Philip Morris doesn’t carry the same pricing power as its domestic counterparts.

The second issue is, Philip Morris is already one of the most efficient operators when it comes to selling, general, and administrative expenses. The company’s SG&A expense was just 8.76% of revenue in the last three months. By comparison, only Altria was more efficient, with SG&A using just 8.36% of revenue. When you look at Lorillard’s SG&A expense of 9.64%, or Reynolds American’s 15.99%, Philip Morris looks extremely efficient already. The simple fact is, the company can’t cut much from its spending to raise earnings growth.

The Company’s Financials Don’t Look Great Either

The other issue with the idea that Philip Morris can produce 11% EPS growth is, the company’s financials have taken a hit while the troubles in the European Union have persisted. Philip Morris retired 4.25% of their diluted shares in the last year. Their peers retired between 1.5% and 4.17%. If the company can continue this torrid pace, this would seem to argue for better returns in the future.

Unfortunately, Philip Morris and Lorillard share the distinction of having negative debt-to-equity ratios. Both companies have been buying back shares, and borrowing money to do so. If you want proof, consider that Philip Morris produced about $1.38 billion in free cash flow, and then spent about $1.39 billion on dividend payments. If the company’s dividend payout ratio is 100%, where does money for share repurchases come from?

Philip Morris’ long-term debt increased by over $3.6 billion in the last year. While their cash reserves increased by about $1 billion, this isn’t enough to offset this additional debt burden. By comparison, Philip Morris’ old parent company carries a debt-to-equity ratio of 3.33, and Reynolds American’s debt-to-equity is a more reasonable 0.98. The bottom line is, Philip Morris has been borrowing money to buy back shares.

While it sounds great to assume that when growth returns to the European Union that Philip Morris will do much better, the numbers don’t bear that conclusion out. If the company can’t cut costs, they would have to raise prices to improve their margins. If they can’t continue taking on long-term debt to buy back shares, their EPS comparisons become more difficult. If investors expect this company to produce 11% EPS growth, I’m afraid they are going to be disappointed.

Given that the stock already has the lowest yield of the group, and the highest forward Price/Earnings (P/E) ratio, any weakness in their growth rate would be a major headwind against the stock. Investors should temper their expectations, because it looks like analysts are going to be wrong again.


Chad Henage has no position in any stocks mentioned. The Motley Fool owns shares of Philip Morris International. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

blog comments powered by Disqus