These 3 Headwinds Are Currently Buffeting Philip Morris

These three headwinds are currently holding back Philip Morris' growth.

Mar 31, 2014 at 11:41AM

As the world's largest tobacco company, Philip Morris International (NYSE:PM) is sought out by investors for the defensive nature of its business and sizable dividend payout. However, at present there are three strong headwinds facing Philip Morris, holding back growth; although peers Altria Group (NYSE:MO), Reynolds American (NYSE:RAI), and Lorillard (NYSE:LO) do not seem to have similar problems.

Currency impacts will hit growth 
Philip Morris' biggest concern over the next year will be the impact of unfavorable currency effects on its earnings. Philip Morris must convert all of its earnings back to US dollars, so the company has always reported some kind of currency impact to earnings. But 2014 is likely to be tougher than usual.

Thanks in part to the declining value of currencies in several of the company's key growth markets, such as Russia and Turkey, Philip Morris' management is guiding for a $0.71 per share negative currency impact for 2014. Most of this weakness is expected to stem from emerging markets, which will account for $0.45 per share of weakness; the weak yen will impact earnings by $0.20 per share, and other currencies will impact earnings by $0.06. These figures were compiled before the recent Russian crisis, so the final currency impact on full-year 2014 results is likely to be worse than the figures above.

Just to put these figures into some perspective, Philip Morris reported earnings per share of $5.76 for 2014, before the impact of currency. In comparison, Philip Morris peers Altria, Reynolds, and Lorillard have no currency exposure, so investors do not need to worry about instability within developing nations denting their dividend income.

A longer-term headwind that Philip Morris is facing is the management of its debt. You see, Philip Morris has borrowed more than it can afford in recent years. This is no secret, as the company 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, Philip Morris' management has stated that the company will reduce its buybacks to a "sustainable level" in an attempt to reduce debt. Management stated that a "sustainable level" was approximately the value of free cash flow after the deduction of dividends every year.

Still, what is of concern for shareholders now is figuring out how much cash Philip Morris can return to investors if it is not borrowing heavily and keeping its buybacks at a "sustainable level." Well, using data supplied by Morningstar, Philip Morris' free cash flow during 2013 was $9 billion, and dividends for the period cost $5.7 billion; so that leaves $3.3 billion for buybacks...or debt repayments.

Once again, all of Philip Morris' domestic peers appear to be in a more secure financial position than the tobacco behemoth. Indeed, according to Morningstar, at year-end 2013 Philip Morris had a debt-to-EBITDA, or earnings before interest, taxes, depreciation, and amortization, ratio of 1.8 times. Altria, Reynolds, and Lorillard had net debt-to-EBITDA ratios of 1.4, 1, and 1 times, respectively.

Illegal tobacco
Philip Morris has been fighting the rise of the illegal cigarette trade for some time. However, the recent drive by developed nations to introduce laws that prohibit the sale of cigarettes in branded packaging has made it much easier for the illegal market to operate. The full extent of this has recently been revealed within Australia, the first country to introduce these laws. A study by accounting firm KPMG found that in the one year that these regulations have been in place, illicit tobacco sales have increased by 1.5% to 13.3% of total shipments, while consumption of tobacco has not changed.

Along with plain packaging, the Australian government hiked excise taxes on cigarettes to the point that taxes now comprise around 63% of the price for a pack of cigarettes. In Australia, a single pack of 20 Philip Morris Marlboro cigarettes sells for around US $14, versus $1 in Vietnam and $2.30 in China; as you can imagine, this is not helping the battle against the illicit tobacco trade.

According to a recent report entitled "Asia-11: Illicit Tobacco Indicator 2012," an international study compiled by the International Tax and Investment Center and Oxford Economics, the volume of illicit cigarettes being smoked within developing countries is on the rise. For example, it is estimated that within many Asian markets, key regions of growth for tobacco majors, up to one-third of cigarettes are illicit.

While the issue of illegal tobacco is not limited to Philip Morris, the company's US peers are less exposed. Indeed, although it is suspected that 56.9% of all the cigarettes smoked within New York are illegally smuggled, they are usually smuggled from other states, keeping the profits in Altria's Lorillard's and Reynolds' pockets.

Foolish summary
All in all, these three headwinds are likely to impact Philip Morris' growth and investor returns over the next few years. Although as of yet, it is not possible to estimate how much the company will be affected. Still, for investors who are seeking a safer alternative, Philip Morris' US peers Altria, Reynolds, and Lorillard would make great alternatives.

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Rupert Hargreaves owns shares of Altria Group. 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.

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