Will Philip Morris Keep Losing the Tobacco War?

Will health-conscious consumers and declining foreign currencies continue to hurt Philip Morris?

May 17, 2014 at 12:00PM

The tobacco industry is not only facing global economic headwinds, it's also suffering at the hands of health-conscious people who are gradually quitting smoking. In contrast with Lorillard Tobacco (NYSE:LO) and Reynolds American (NYSE:RAI), which have overturned things to an extent, the comeback hopes of Philip Morris International (NYSE:PM) are gradually fading away.

Quarterly earnings
In the first quarter, Philip Morris posted a profit of $1.88 billion or $1.18 per share, down from $2.13 billion or $1.28 per share in the year-ago quarter. Net revenue dropped 8.8% to $6.9 billion. Excluding the impact of currency fluctuations, revenue dipped 1.6%. Revenue also missed the Zacks Consensus Estimate of $7.1 billion by 2.8%.

Total cigarette volume fell 4.4% to 196 billion units. Net revenue in the European Union region was up 2.2% backed by favorable currency fluctuations. Sales in Eastern Europe, Middle East, & Africa declined by 1.7% while Asia was down by 21.8%. As for Latin America and Canada, sales dipped by 8.7%.

As a result of higher excise taxes, the company's gross profit declined by 10.8%. Operating margin shrunk 12.3% to $3 billion due to higher marketing, administration, and research costs.

Recent developments
As a result of government production regulations which restrict its exports, Philip Morris has finally decided to stop manufacturing cigarettes in Australia by the end of this year. The "reduced fire-risk" laws in the country only allow the company to use a specific kind of paper and construction methods. The company is now moving its plant to South Korea where there are no such laws.

Over the last few years, Philip Morris has invested heavily in its Australian factory to capitalize on increasing demand in Asia. However, in 2010, the government introduced reduced fire-risk requirements to make sure that a cigarette self-extinguishes when it is dropped on the ground. Unfortunately, this didn't match consumer preferences in Asia, which led to lower exports. Shifting the production plant to South Korea will give an impetus to the company's sales in Asia.

In February, Philip Morris announced that it will launch retail trials for its electronic cigarette brand, MarkTen, in Indiana and Arizona during the second quarter. According to the company, the national roll-out will help increase international awareness of the brand. Later on, MarkTen will be sold outside the US.

What's in store for the future?
Philip Morris hasn't proven to be a valuable buy in the last twelve months. A year-over-year return of -8% testifies to this fact. In the future too, it won't be easy for the company to mint substantial profits. With more people abandoning their smoking habits in the developed countries, Philip Morris' future in these regions looks rather bleak. It can keep raising its prices in order to offset the sales volume decline, but this isn't a long-term solution. In order to grow in the region, Philip Morris will have to find a way to boost its volume instead of just raising prices.

However, in the emerging markets the company has a better future ahead of it, thanks to people who aren't as health-conscious as are people in the developed nations. Moreover, there are no smoking bans in markets like India, much of Latin America, and Africa. Plus, unlike the governments of Europe and Canada, their governments haven't implemented high taxes on the tobacco companies. Hence, cigarette volume will keep growing in these regions. However, with the U.S. dollar going strong against most of the emerging markets' currencies, profit from these regions will shrink to some extent.

Lorillard and Reynolds American
In the first quarter, Lorillard posted adjusted earnings of $0.69 per share, up 4.5% from the same quarter last year. The increasing market share of the company's brands and a lower share count thanks to its share repurchase program led to higher earnings during the quarter. Owing to higher prices, Lorillard was able to grow its cigarette (conventional cigarette) sales by 1.4%. However, electronic cigarette sales went down 10.5% due to lower prices of rechargeable kits. Lorillard has provided a year-over-year capital return of 35%.

On the other hand, Reynolds American's first-quarter earnings grew 2.8% year-over-year. Though its overall volume dropped, its flagship brands Camel and Pall Mall continued to increase their market shares. Moreover, the company's smokeless brand Grizzly and Natural American Spirit also did pretty well. For the current year, Reynolds has maintained its earnings guidance of $3.30 to $3.45 per share. Its year-over-year capital appreciation stands at 17%.

Bottom line
While people continue to quit smoking in the developed nations, Philip Morris' growth in the near future will be driven by the emerging markets. There is no doubt that the company will generate substantial income in these markets over the years but these earnings will be trimmed down slightly due to weaker currencies in these regions. Still, Philip Morris' earnings will grow more in the developing nations than in the developed nations. For the company to do well in the developed countries, its e-cigarette brand, MarkTen, will have to do wonders. However, as of now, Philip Morris isn't going great guns, which is why it doesn't appear to be a good buy.

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