Will Debt Trouble the World's Most Profitable Company?

Philip Morris has lots of debt, which could come back to haunt the company if its management does not get things under control.

Apr 4, 2014 at 2:33PM

Philip Morris International (NYSE:PM) has a problem: debt. However, this is not a current issue. No, Philip Morris' debt is, at present, sustainable. It's the company's future that I'm worried about.

You see, Philip Morris has recently been borrowing more than it can afford. As a result, after the company completes its current $18 billion share buyback allocation, it will reduce its buybacks to a "sustainable level." Management defined a 'sustainable level' as approximately the value of free cash flow after the deduction of dividends every year. Philip Morris ended 2013 with just under $26 billion in net debt, 1.8 times the company's annual earnings before interest, tax, amortization, and depreciation.

Will this become a problem for the world's most profitable company?

Cash flow king
In business, cash is king and Philip Morris tops the list of the most profitable and cash-generative companies in the world. Specifically, the company has converted approximately 29% of its net revenue into free cash flow during the past five years. As a quick comparison, according to the U.S. Commerce Department, U.S. corporations currently report an average profit margin of 9.3%. The average margin since 1952 has been 5.9%.

Why is this important?
According to Investopedia, free cash flow, or FCF, is a measure of financial performance calculated as operating cash flow minus capital expenditures. Free cash flow represents the cash that a company generates after it lays out the money required to maintain or expand its asset base. It is important because it allows a company to pursue opportunities that enhance shareholder value. Without cash, it's tough to develop new products, make acquisitions, pay dividends, and reduce debt.

Payback time
Unfortunately, this highlights a problem. If Philip Morris plans to spend 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 so it never needs to pay it back. Nevertheless, as interest rates rise so 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, as expectations widely call for this to occur 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 that all other things remain equal.

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

Still, investors need to figure out how much cash Philip Morris can return to investors if it keeps its buybacks at a "sustainable level" and does not borrow heavily. Well, once again using data supplied by Morningstar, Philip Morris' free cash flow during 2013 was $9 billion and its dividends for the period cost $5.7 billion; that leaves $3.3 billion for buybacks or debt repayments.

Not the only one
However, Philip Morris is not the only company that has borrowed heavily in recent years and faces a hefty interest bill when interest rates rise. Both DIRECTV (NASDAQ:DTV) and FirstEnergy (NYSE:FE) have also been tapping the market constantly for loans during the past few years, as they made use of ultra-low interest rates.

DirecTV has been one of the worst offenders as the company's debt has jumped an astonishing 77% since 2010. Over the same period, the company's annual interest expense rose by only 51%. Taking a look at the numbers, DirecTV had net debt of $17.3 billion at the end of 2013 on which it paid interest of $840 million, which indicates an interest rate of 4.9%. According to data supplied by Morningstar, most of DirecTV's debt has fixed interest rates. However, most of the debt issues will mature around the end of the decade, around the same time as forecasts call for interest rates to start rising. This could become an issue in the future but it's not something that DirecTV's management has to worry about in the near-term.

Meanwhile, FirstEnergy's net debt has jumped 40% since 2010 and the company's operating income has declined by 15% over the same period, which is not good news. Unfortunately, rising debt and falling income forced First to slash its dividend payout by 35% at the beginning of this year, which happened for the first time in 17 years. First did this in part to fund the upgrade of its power delivery system. First has been selling assets so it can refocus its efforts on regulated assets. The company plans to spend $4.2 billion on systems throughout 2017 as it seeks out growth, although with interest rates going up soon First's income could come under further pressure and its investment plans could come into question.

Foolish summary
Philip Morris' debt has become a burden to the company in recent years and investors should watch how the company manages its debt pile in the future. Philip Morris' management could suspend buybacks to make debt repayments.

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Rupert Hargreaves has no position in any stocks mentioned. The Motley Fool recommends DirecTV and Morningstar. 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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