1 Dumb Reason and 1 Smart Reason to Sell Philip Morris

While a recent guidance cut is no sound reason to sell Philip Morris, the company is operating in a declining industry, and that's a major risk factor to consider.

Jul 6, 2014 at 10:00AM

Pm Image

Source: Philip Morris.

Philip Morris (NYSE:PM) stock fell 2.7% last week as investors reacted with pessimism to the company's reduced earnings guidance for the current year. Lower earnings due to one-time charges and transitory factors are no sound reason to sell a stock. On the other hand, the company and competitors such as British American Tobacco (NYSEMKT:BTI) and Altria (NYSE:MO) are operating in a declining industry, so investors may want to be very careful when considering investment decisions in the sector.

A dumb reason to sell
On June 26, Philip Morris said it expects full-year earnings per share of $4.87 to $4.97 per share, versus a prior forecast in the range of $5.09 to $5.19.

This adjustment was due to a combination of factors, including asset impairments and exit costs related to ending production of cigarettes in Australia and the Netherlands. In addition, unfavorable currency fluctuations are expected to have a big negative impact of $0.61 per share during the year.

CEO Andre Calantzopoulos admitted in the earnings press release that the company is going through a challenging period: "We continue to face significant currency headwinds, an improving but weak macro-economic environment in the EU and known challenges in Asia, partly offset by a robust performance in a number of markets and the contribution of our business development initiatives."

It's never nice to see a company cut guidance. Investors can always wonder if downward adjustments to earnings are a transitory setback or a sign of continued weakness.

However, Philip Morris is maintaining its forecast for sales and earnings growth in 2015 and beyond. During 2015 and in the medium term, management expects currency-neutral revenues to increase by 4% to 6% annually, and diluted earnings per share are forecast to grow between 8% and 10% per year.

Selling a company because of the negative impact from currency fluctuations and operations restructuring is clearly a shortsighted reaction, and long-term-oriented investors have valid reasons to consider that the recent weakness in Philip Morris may represent a buying opportunity.

A declining industry
None of this means the company and its peers are solid long-term bets. On the contrary, tobacco is a declining business, and there is no reason to expect any reversal in the trend over the coming years.

Philip Morris delivered a 4.4% year-over-year decline in cigarette shipment volume during the first quarter of 2014, to 196 billion units. Revenue fell 8.8% to $6.9 billion, while revenue excluding currency fluctuations declined by 1.6%. The company reported a 7.8% year-over-year decline in earnings per share, from $1.28 in the first quarter of 2013 to $1.18.

Much the same goes for competitors British American Tobacco and Altria. Declining tobacco sales are a pervasive factor across the industry, so it's not like these companies can materially improve their situation by gaining share versus the competition. A growing share of a declining pie is better than a shrinking share of that same pie, but that does not make it a smart proposition for investors.

British American Tobacco announced a 1.2% decline in tobacco sales volume during the first quarter in 2014: 164 billion units versus 166 billion units in the first quarter of 2013. Volume in the Asia-Pacific region increased from 48 billion to 50 billion units, but the company suffered volume declines in the rest of its markets.

Sales volume in the Americas fell from 32 billion to 31 billion units, Western Europe volume declined from 26 billion to 24 billion units, and the Eastern Europe, Middle East, and Africa region delivered a decline in volume from 54 billion to 53 billion units.

Altria announced a 2.5% decline in cigarette volume during the first quarter in 2014, to 28.75 billion units. Sales of Marlboro products fell 2.4% to 24.8 billion, while other premium brands declined by 8.6% to 1.6 billion. However, discount cigarette sales increased 0.9% to 2.3 billion. Total revenue fell 0.2% versus the same period in the prior year, to $5.5 billion.

Philip Morris, British American Tobacco, and Altria are resorting to price increases to buffer the impact of declining sales volume, while cost reductions and share buybacks are helping when it comes to earnings per share. However, these strategies can only go so far; at the end of the day, these companies are still operating in a waning industry, and that's a major risk for investors.

Foolish takeaway
Selling Philip Morris because of the recently reduced earnings guidance doesn't make much sense, since it's mostly based on outside factors and one-time events. However, declining sales volume across the industry is a big reason for concern regarding the company as an investment. There you have it: one dumb and one smart reason to avoid Philip Morris.

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Andrés Cardenal has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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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