Should You Be Worried About Philip Morris' High Level of Debt?

Philip Morris International  (NYSE: PM  )  has a problem: debt. However, this is not a current issue since Philip Morris' debt is, at present, sustainable. It's the company's future that I'm worried about. Fortunately, the company's domestic peers, Altria Group  (NYSE: MO  )  and Reynolds American  (NYSE: RAI  ) , do not appear to be in the same situation.

You see, Philip Morris has been borrowing more than it can afford in recent years. This is no secret, as the company recently came out and acknowledged this fact at the Morgan Stanley consumer goods conference in November.

As a result, after the completion of the company's current $18 billion share buyback, it will reduce its buybacks to a "sustainable level." Management stated that a "sustainable level" was approximately the value of free cash flow after the deduction of dividends every year. 

Payback time 
Unfortunately, this highlights a problem. If Philip Morris is planning on spending all of its free cash flow on buybacks, when will it be able to pay off its debt?

Of course, the company could just continually roll over its existing debt, never needing to pay it back. But, as interest rates rise, so too will the amount Philip Morris will have to pay to borrow, which will put even more of a strain on the company's finances.

According to data from market research company Morningstar, the majority of Philip Morris' debt matures before 2022. This indicates that the company will have to refinance a significant amount of debt while interest rates are going up, which is widely expected to be before 2022. For the most part, Philip Morris' debt maturing within the next 10 years has a fixed rate of interest below 4%. Overall, this implies that a 1% rise in interest rates is likely to push the company's average rate of interest up to 5%, assuming all other things remain equal.

So let's do the math. At present, Philip Morris has $27 billion in debt; a 1% rise in interest repayments would cost the company an additional $270 million a year--not small change, even for the maker of Marlboro.

Still, what is of concern for investors now is figuring out how much cash will Philip Morris be able to return to investors if it is not borrowing heavily and keeping its buybacks at a "sustainable level?" Well, once again using data supplied by Morningstar, Philip Morris' trailing-12 month free cash flow was $8.3 billion and dividends for the period cost $5.6 billion; so that leaves $2.7 billion for buybacks, or debt repayments--to put that in some perspective, that's one Abercrombie & Fitch.

While Philip Morris is facing higher interest rates, close peer Altria has been locking in low rates with its recent debt tender offer.

Locking in for longer 
Altria recently put out a tender to redeem up to $2.1 billion in debt from holders. The debt in question carried interest rates of between 9.9% and 10.2%, which you can agree are extortionately high levels of interest for a company of Altria's size, especially with the Fed offering rates as low as 0.2%.

To fund this tender, Altria issued $1.4 billion of 4%, 10-year notes and $1.8 billion of 5.4% 30-year securities. In total this issue was worth $3.2 billion. However, my calculations reveal that the average interest rate for this debt will be approximately 4.8%, less than half the rate of the previous issue.

If we do the math here, we can see that 10% interest on $2.1 billion is $210 million, and 4.8% of $3.2 billion is $154 million. So, Altria is paying 25% less to borrow 50% more.

This strategy is exactly the kind of refinancing operation Philip Morris needs to undertake, and it's something Reynolds American is also going to benefit from.

Slashing rates 
Reynolds has nearly $2 billion of debt, 20% of its total debt pile, maturing between now and 2019. What's more, some of this debt has a coupon of more than 7%. This level of interest is unnecessarily high for the company, as some of its longer, recent issues offer a fixed coupon of 3.2% to 4.7%.

This implies that the company can and should refinance at lower rates. If we assume rates don't rise more than 3% during the next five or so years, the company could be able to refinance some of its debt currently offering a +7% coupon with interest rates up to half of that.

Final thoughts 
While Philip Morris' debt is not a problem as of yet, management has acknowledged that if the company continues to borrow at its current rate, debt will get out of hand.

Unfortunately, this means that shareholders are going to have to get used to lower returns. That being said, both Altria and Reynolds American are locking in short-term interest rates, which should be beneficial in the long term for investors. Although it would appear that Philip Morris is going to be squeezed when interest rates rise.

Want to learn one of Wall Street's dirty little secrets?
Few finance professionals will openly admit is the fact that dividend stocks as a group handily outperform their non-dividend paying brethren. The reasons for this are too numerous to list here, but you can rest assured that it's true. However, knowing this is only half the battle. The other half is identifying which dividend stocks in particular are the best. With this in mind, our top analysts put together a free list of nine high-yielding stocks that should be in every income investor's portfolio. To learn the identity of these stocks instantly and for free, all you have to do is click here now.

 


Read/Post Comments (2) | Recommend This Article (2)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 29, 2014, at 9:23 AM, binary512 wrote:

    How can we trust anything said here if you don't know the difference between a percent and a percentage point?

  • Report this Comment On January 29, 2014, at 10:49 AM, mauric4 wrote:

    How do you get your writing assignments?

    Are they chosen for you or do you pick them yourself?

Add your comment.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 2814121, ~/Articles/ArticleHandler.aspx, 12/19/2014 7:19:52 PM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement