Shares of Philip Morris Have Few Catalysts Going Forward

Philip Morris is facing numerous pressures and they are all constricting the company's earnings. This is unlikely to change anytime soon.

Jul 10, 2014 at 12:40PM

Philip Morris (NYSE:PM) is struggling. The company's management has stated that 2014 will be a "truly atypical" year for the company as it goes through a number of changes.

Put simply, atypical means that 2014 does not represent the company's future, or past, performance. Neither is the performance comparable to that of the wider industry . Essentially, Philip Morris' management expects 2014 to be a tough one-off year for the company.

Multiple headwinds
The problem is that a number of headwinds are currently buffeting Philip Morris, and it can't avoid most of them.

Specifically, the company is suffering from a strong US dollar, in comparison with emerging market currencies, and slowing demand for the company's cigarettes. It can manage both problems, however, in the short term both have hit its earnings.

Philip Morris' management revealed at the end of June that it expects diluted per-share earnings for fiscal 2014 of roughly 2.3% lower than its $4.87-$4.97 forecast less than two months ago. The company reported EPS of $5.26 for fiscal 2013.

However, excluding the hits from currency and plant closures it forecast that earnings will expand 6%-8% this year. In other words, negative currency and restructuring charges will cost the company around $0.73 per share this year.

Unfortunately, this slower rate of growth is a big change from the 10% per annum growth reported by the company over the past five years.

Falling volumes
Alongside unfavorable currency trends, falling cigarette sales volumes are the main culprit behind Philip Morris' lower forecast.

Management expects a 1%-2% decline in total global cigarette sales next year and a drop of 5%-6% within Europe. Philip Morris expects its own volume of cigarettes sold to decline 1% next year. With volume collapsing within Europe, this is the most obvious place to cut costs -- exactly what Philip Morris is doing .

The global tobacco behemoth is closing its factory in Bergen op Zoom in the Netherlands to slash costs within the region. Additionally, Philip Morris closed its factory in Australia last year and shifted production to a cheaper South Korean factory.

The company expects these two closures and their related costs to impact its earnings per share by a few cents. Hopefully these closures should drive its costs down and boost its profits, a long-term positive.

Another factor
Another more pressing problem is holding Philip Morris back: debt.

Specifically, over the past few years Philip Morris has pushed its earnings higher by using three strategies. Price increases have added around 5% per annum to EPS growth, operating leverage and cost-control efforts have added 1%-2% of growth, and buybacks have pushed growth up to 10 %.

However, Philip Morris has recently started talking about scaling back its buybacks. In particular, the company has historically relied upon debt to fund its buybacks. Now, its leverage ratios are becoming stretched and this is worrying management.

From Philip Morris' presentation to the Consumer Analyst Group of New York Conference at the beginning of this year:

...We spent $2.3 billion on these four business development initiatives. Last year we spent $6 billion on share repurchases and our outlay on dividends was $5.7 billion. As a result, on our cash outflow was $14 billion. Our free cash flow in 2013 increased by $990 million to $8.9 billion...This translated into net financing requirement of $5.1 billion ...our total debt last year by $4.8 billion to $27.7 billion...

...We're intent on maintaining our single A credit rating and recognize that we're approaching the high-end of ratio and supporting it... to scale back our share repurchase target to $4 billion in 2014. We are committed to share buyback and our operating corridor is defined on one side by the upper limit of our credit rating and on the other side by providing 100% of our free cash flow to our shareholders through dividend and share buyback. We intend to operate within this corridor in the future ....

This implies that the company may be looking to scale back its repurchases, which will hit its EPS growth. Perhaps 2014 will not be such an atypical year after all, and investors will have to get used to a lower rate of return.

Increasing returns
Meanwhile, Philip Morris' domestic peer Altria (NYSE:MO) is looking at increasing investor returns. On the first quarter conference call, when questioned by analysts about the possibility of returning more cash to investors, Altria's management responded that:

...our normal practice has been that most of the cash returned to shareholders come through our 80% dividend payout ratio but opportunistically we'll do some share repurchase. So additional share repurchase is sure to be a discussion topic here over the next several months...So, certainly use of cash for something, we'll be looking at over the next few months  ...

This is great news for investors who are already profiting from the company's existing 4.6% dividend yield.

Foolish summary
All in all, Philip Morris is warning of a tough year ahead but whether the company's lackluster performance will be a one-off or not is another matter.

With cigarette sales slumping and debt rising, Philip Morris' investors might have to get used to a lower rate of growth, as the company adapts to a 'reduced tobacco' world.

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Rupert Hargreaves owns shares of Altria Group. 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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