Is Philip Morris' Only Problem the Strong US Dollar?
Rupert is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Philip Morris International's (NYSE: PM) second-quarter results were a mixed bag. The EPS came in below estimates but this was almost expected considering the company's exposure to currency fluctuations. Indeed, with almost all of Philip Morris' revenue coming from outside of the US but the company reporting in dollars, dollar strength was bound to hit earnings. Still, after excluding the currency effects, earnings per share were up $0.01 or 7%.
On the other hand, there are noticeable changes in other areas of the company's results. In particular, Philip Morris reported that cigarette sales were down 3.9% and operating income had slipped 7.3% or, 3.3% excluding unfavorable currency effects. For the first six months of the year, the total volume of cigarettes shipped fell 5.1%.
Management has guided that EPS for 2013 will come in the range of $5.43 to $5.53; re-based as negative currency effects have taken $0.31 off of the initial guidance. This indicates EPS growth of 10% to 12% from 2012. Most of this growth is expected to come from the effect of stock buybacks as net income is stagnating.
There could be something going wrong
Despite this year's expected growth, there are several points in the earnings report that raise concern. First off, excise taxes on Philip Morris' cigarettes are rising faster than the company's revenue, which is squeezing margins. Excise taxes have grown 5.4% year-on-year while revenue has only expanded 2.2%; so, gross margins have fallen from 27.2% in 2012 to 25.5% currently. Moreover, Philip Morris' key Marlboro brand is experiencing falling sales. Marlboro is historically a product that experiences almost constant demand.
Elsewhere, there appear to be issues regarding Philip Morris' cash flow. Net operating cash flow came in at $3.1 billion for the second quarter, down 9.9% year-on-year. However, the second quarter is historically a very strong period for the company. On average, net operating cash flow (for the last five quarters) comes in at around $2.4 billion, indicating that the dividend that currently costs $1.4 billion a quarter is only covered 1.5 times after the deduction of investing activities. Of course, this leaves almost no room for the company's stock buyback that costs on average another $1.5 billion per quarter; this is funded for the most part by borrowing.
Worryingly, Philip Morris' unfunded spending on stock repurchases is accelerating growth of the company's debt pile. Total debt grew 12% from the end of 2012 to June, net debt to EBITDA grew 13% and the shareholder deficit almost doubled indicating that each share has a net asset value of -$3.
All these are worrying trends that if continued, will keep eroding shareholder value. Furthermore, while Philip Morris is able to borrow at low rates now, how will it cope in the future when rates rise?
National tobacco could be a better choice
Philip Morris is often considered by investors to be the best choice in the tobacco sector as the company has international exposure; however, national tobacco companies Altria (NYSE: MO) and Lorillard (NYSE: LO) seem to be pulling ahead.
Indeed, Lorillard has continued to note increasing demand for its leading Newport cigarette brand, which has led to rising revenue and earnings. Meanwhile, Altria and Philip Morris US are still noting a sustained demand for the Marlboro product. Additionally, Altria is well diversified as while the majority of its revenue still comes from the sale of tobacco, it has interests in wine and beer through SABMiller.
Neither Altria nor Lorillard have sales outside of the US. Their income will be more stable than that of Philip Morris and not subject to currency fluctuations.
Moreover, on a forward-looking basis, both Lorillard and Altria offer shareholders a better cash return as they both offer stronger yields than that of Philip Morris. Although Altria does not offer much in the way of a stock buyback, Lorillard's buybacks are extremely well executed and have resulted in cash returns to shareholders equivalent to around 11.4% a year.
Overall, Philip Morris is traditionally a very defensive tobacco stock that offers exposure to the international tobacco market. However, it would now appear that the company is starting to loose its shine and it could be time to consider investing in a domestic producer such a Altria or Lorillard instead.
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Fool contributor Rupert Hargreaves owns shares of Altria Group. The Motley Fool has no position in any of the stocks mentioned. 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!