Can Tobacco Companies Sustain Their Growing Debt?

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

I am not ashamed to admit it--I think tobacco stocks are some of the best investments in the market. Without a doubt they have provided the best investor returns around. Even with increasing tobacco regulation all over the world, tobacco companies continue to outperform the rest of the market in terms of shareholder returns, profit margins, and sustainability.

However, in recent years a trend has been developing amongst tobacco companies. This trend involves buying back huge quantities of shares to strengthen earnings per share, as sales volumes fall, slowing down organic revenue growth.

For the most part the majority of these buybacks are funded through free cash flow, as tobacco companies have some of the best free cash flows on the market. That said, big tobacco is increasingly relying on debt to finance these buy-backs.

Net Debt

<table> <tbody> <tr> <td> <p> </p> </td> <td> <p>2008</p> </td> <td> <p>2009</p> </td> <td> <p>2010</p> </td> <td> <p>2011</p> </td> <td> <p>2012</p> </td> </tr> <tr> <td> <p><strong>Philip Morris <span class="ticker" data-id="210565">(NYSE: <a href="">PM</a>)</span></strong></p> </td> <td> <p>$5,124</p> </td> <td> <p>$10,430</p> </td> <td> <p>$13,876</p> </td> <td> <p>$14,799</p> </td> <td> <p>$15,995</p> </td> </tr> <tr> <td> <p><strong>Reynolds American <span class="ticker" data-id="205182">(NYSE: <a href="">RAI</a>)</span></strong></p> </td> <td> <p>$2,085</p> </td> <td> <p>$1,709</p> </td> <td> <p>$1,906</p> </td> <td> <p>$1,707</p> </td> <td> <p>$2,593</p> </td> </tr> <tr> <td> <p><strong>Altria <span class="ticker" data-id="204556">(NYSE: <a href="">MO</a>)</span></strong></p> </td> <td> <p>-$442</p> </td> <td> <p>$10,089</p> </td> <td> <p>$9,880</p> </td> <td> <p>$10,419</p> </td> <td> <p>$10,900</p> </td> </tr> <tr> <td> <p><strong>Lorillard </strong><span class="ticker" data-id="210627">(NYSE: <a href="">LO</a>)</span></p> </td> <td> <p>-$1,200</p> </td> <td> <p>-$598</p> </td> <td> <p>-$320</p> </td> <td> <p>$961</p> </td> <td> <p>$1,391</p> </td> </tr> </tbody> </table>

The increasing reliance on debt to fund buybacks can be seen most in Philip Morris' and Lorillard's debt position. Philip Morris has driven net debt up 300% since 2008, whilst Lorillard has gone from a positive net cash position in 2008, to a net debt position of $1.4 billion in 2012.

Both Reynolds American and Altria have kept debt relatively stable over the past few years. However, since 2011, debt has risen 5% for Altria and 53% for Reynolds.

<img src="/media/images/user_14485/t1_large.png" />

Constructed from the table above, this chart illustrates the worsening debt profile of the three companies. Lorillard has swung from a net cash position into net debt, while PM has driven its net debt consistently higher!

<img src="/media/images/user_14485/t2_large.png" />

On an individual basis, the debt profile of Philip Morris shows the company increasing both cash and long-term debt. Long-term debt is not rising as fast as net debt, indicating that the company has been relying on an increasing amount of shorter term financing over the past 2-3 years. However, over the same period, cash & equivalents have grown, but not enough to reduce net debt.

<img src="/media/images/user_14485/t1_1_large.png" />

I have long thought that Reynolds American was the most fiscally prudent of the four US tobacco companies. The company was working hard to reduce net debt until 2012, when it suddenly changed its course.

However, the company does still have a significant cash balance in relation to long-term debt, giving it one of the best looking balance sheets in the group. 

<img src="/media/images/user_14485/t4_large.png" />

Altria's debt profile is one of the worst in the group, as I will explain further below.

The company's long term debt has decreased over the past year, but at the same time so has cash - leaving the company with a worse net debt position. Altria has a relatively strong cash position, although not as large as that of Reynolds, which to some extent offsets debt.

<img src="/media/images/user_14485/t5_large.png" />

I have only managed to gather the complete set of data for Lorillard for 2011 and 2012. 

This two year snapshot of Lorillard's balance sheet does not provide much information, but it does show the company's relatively large cash balance in relation to its net debt.

Debt Issuance/Reduction

<img src="/media/images/user_14485/d1_1_large.png" />

This chart shows the debt movements across four companies. A negative figure is a reduction, while a positive figure is an increase in debt. Without a doubt, Philip Morris has issued the most debt over the five year period, followed closely by Altria, although Altria did slightly reduce its debt during 2012.

As I have already said, Lorillard has only started issuing debt in the past two years to supports the company's dwindling cash balance. Reynolds's has been reducing its debt from 2008-2011, but issued new debt in 2012, virtually wiping out all of its debt reduction activities.

Philip Morris has always issued debt and has not repaid any since 2008.

So, how sustainable is this debt?

<img src="/media/images/user_14485/t6_large.png" />

On a net debt to EBITDA basis, all four of the companies have a ratio of less than 1.6, which indicates that they could all pay off their net debt with slightly more than one-and-a-half years of earnings.

In addition, while the previous section presented a picture of rising debt for the four companies, this chart shows that on a debt to EBITDA basis, debt has actually remained relatively constant, or in some cases actually fallen.

Philip Morris, which as accumulated the biggest debt pile of the four in dollar terms, has actually seen its net debt to EBITDA ratio fall over the past three years, signaling that earnings are rising faster than the company is issuing debt.

Altria's ratio has remained in a range of 1.4-1.6 times EDITDA, whilst Reynolds remains in the 0.3-0.5 net debt to EBITDA range, indicating that while the companies are actually increasing their debt piles, earnings are rising in-line, which makes the debt look much more sustainable.

Lastly, Lorillard has been the worst performer. Lorillard's debt has risen to 0.6 times EBITDA over the last two years alone. This is not an earth-shattering movement, but over the same period the same ratio at PM, MO and RAI only changed about 0.2, which means Lorillards debt is growing three times faster than that of its peers.

Finance Costs

<img src="/media/images/user_14485/t8_large.png" />

The financing costs faced by each company remain low. Every company but Altria has debt financing costs that are less than 10% of income before tax and interest costs. 

I believe that the interest rates on the debt of each company is sustainable, even Altira, with its relatively high financing rates.


So, in conclusion, while debt is growing at these companies, currently it does not appear to be a significant problem.

Reynolds American and Lorillard have levels of debt lower than their yearly EBITDA, indicating they could pay off debt over the course of one year alone. In addition, Philip Morris' net debt to EBITDA ratio is falling, and it will soon be under 1.

Altria, on the other hand, lags behind the rest of the group. Altria has the highest level of debt to EBITDA, highest debt financing rates, and has been forced to increase its debt over recent years.

It appears that all four of these companies are able to sustain their debt at the moment. That said, if Altria's earnings start to fall and Lorillard continues to issue debt at its current pace, then these two companies could run into trouble ahead.

Data Source: Saxo Capital Markets, Marketwatch

RupertHargreav owns shares of Altria Group and Lorillard. 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!

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