How Philip Morris' Most Pressing Problem Is Stamping Out Its Profits

Philip Morris (NYSE: PM  ) has a problem on its hands; taxes. In particular, excise taxes, which the company has to pay on nearly every carton of cigarettes that it sells. Meanwhile, tobacco companies Altria  (NYSE: MO  ) and Reynolds American  (NYSE: RAI  ) are not reporting the same kind of tax pressures on their incomes.

Unfortunately, as most countries try and stamp out the consumption of tobacco, these taxes are rising and this is pressuring Philip Morris' bottom line. What's more, Philip Morris still has to pay income tax on its profit after the deduction of excise taxes. (If we include the dividend taxes investors have to pay that is triple taxation!)

What affect is this having?
We can quite clearly see the effect of these taxes on Philip Morris' profit and shareholder returns. For example, during the quarter ended September 30 Philip Morris had revenue of $20.6 billion with a production cost of only $2.6 billion which resulted in a gross margin of 87%. However, excise taxes for the period amounted to $12.7 billion. After including both excise taxes and the cost of goods sold, Philip Morris' gross margin was compressed to only 26%. If we include selling and admin costs the company's operating margin drops further to 18%. Furthermore, after including income taxes the company's net profit margin declines to just under 12%.

The effect of taxes on Philip Morris' profit has been catastrophic. Let's take Altria as a comparison. For the three months ending September 30, Altria reported revenue of $6.5 billion and paid excise taxes of $1.8 billion and its cost of manufacturing cigarettes was $1.9 billion. All in all, this gives a gross profit margin including excise taxes of 56% for Altria, around double that of Philip Morris.

Moreover, Altria's domestic peer, Reynolds American is also reporting higher margins thanks to lower taxes.

Now, Reynolds reports how excise taxes affect its income differently than both of its peers above. In particular, the company reports sales and earnings excluding excise taxes while placing a note at the bottom of the income statement that explains how excise taxes affected its income.

Still, on sales of $2.1 billion Reynolds paid excise taxes of $1 billion for the quarter. This gives a total of $3.1 billion in revenue on which Reynolds reported net income of $0.8 billion. This is an net margin of 26%, higher than Philip Morris once again.

Why is Philip Morris paying more in tax?
But why is Philip Morris paying more? Well, according to data from the Tobacco Atlas, the average excise tax rate on a carton of cigarettes is 39.9%, although this rate varies from state to state. However, internationally excise rates are significantly higher with the average tax rate across Europe in the region of 65%,  the tax rate in Canada 58% and the UK 74%! This easily shows us why Philip Morris is paying a lot more in tax than its domestic peers as a little more than one third of sales came from Europe in its most recent quarter.. As governments try to stamp out the smoking habit, these taxes are only likely to rise.

Rising taxes
Unfortunately, it appears that Philip Morris' tax burden is only going to get worse as time goes on. Indeed, Philip Morris reported within its fiscal third-quarter results that while revenue for the quarter expanded 5.3% year-on-year, the amount of excise tax the company paid expanded at a faster rate of 8.8%. This meant that while Philip Morris reported a rise in revenue and only a 1.3% rise in the cost of sales year on year, gross profit actually declined 0.5%.

Luckily for the shareholders of domestic tobacco companies, the opposite is happening. Altria for example reported a year-on-year rise in revenue of 5% for the fiscal third quarter but the amount of excise taxes the company paid only increased by $17 million. By my calculations this means that Altria went from paying 28% of revenue in excise taxes for 2012 to 27% for 2013.

As I have already mentioned, Reynolds reports its tax payments differently from both Philip Morris and Altria. However, because the company's year-on-year sales increased by 0.1% and excise taxes paid declined 0.2%, it would appear that as with Altria, Reynolds' tax burden is only falling.

Foolish summary
So overall, Philip Morris is being severely affected by the excise taxes the company is being forced to pay. These taxes, which are rising faster than the company's revenue, continue to pressure margins which could lead to lower shareholder returns. On the other hand, Altria and Reynolds are both paying less tax, or so it would appear, which is helping their profitability.

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