Philip Morris' Q2 Earnings Will Set the Tone for the Rest of the Year

Philip Morris' second-quarter earnings release will be a sign of things to come in 2014.

Jul 15, 2014 at 6:28PM

Philip Morris International (NYSE:PM) reports second-quarter earnings on Thursday in what will be a key barometer for the rest of the year. Last month, the company disappointed investors by lowering full-year earnings guidance, citing currency headwinds, slow economies, and regulation in Australia as the key culprits. Despite these issues, management expects currency-neutral adjusted earnings per share to grow at a high-single-digit pace.

In addition, the company announced an acquisition that could boost earnings even more. Investors should pay attention to each of these issues in the upcoming earnings release.

Asian markets volume
Although European economies have yet to fully recover from the global credit crisis, Philip Morris' most pressing problems stem from Asia. Philip Morris derives about one-third of its revenue and operating income from Asia, more than any other single region.

Unfortunately, significant regulatory events have plagued Philip Morris' Asia results for the last year and a half. Cigarette shipments to Asia declined 7.7% in 2013 but would have declined just 2.7% if not for the enactment of a disruptive excise tax in the Philippines. This year, Australian plain-packaging laws are weighing on Asian volumes. The company says deep discounting at the low end of the Australian market is causing its premium brands to lose market share. Although plain-packaging laws have been in effect since December 2012, management had not described the laws as having a material adverse effect on Philip Morris' results until last month's earnings guidance update.

As a result of downward pressure on volumes from Australia, continued economic weakness in Indonesia, and a higher consumption tax in Japan, investors should expect a mid- to high-single-digit decline in Asia cigarette shipments.

Currency headwinds
Aside from shipment declines, currency exchange rates are the other factor looming large over Philip Morris. A strengthening dollar puts Philip Morris, which derives all of its revenue in non-dollar-denominated markets, at a disadvantage. At prevailing exchange rates, management expects currency headwinds to have a $0.61 negative impact on earnings per share -- that's a 10.6% hit to earnings.

Normally, investors can ignore currency fluctuations because they are unpredictable and may balance out over time. However, unfavorable exchange rates have persisted for some time and may get worse in the future. Exchange rates lowered 2012 earnings by 4% and 2013 earnings by 6%. This year's estimated 10.6% hit to earnings continues the trend of higher negative currency impacts.

The dollar may continue to strengthen as the Federal Reserve rolls back its quantitative easing program and raises interest rates. The central bank's government bond purchases are expected to end later this year, and it may begin to raise interest rates in 2015 if the U.S. economy continues to improve. If U.S. interest rates rise while European and Asian central banks continue to hold interest rates lower, Philip Morris will likely experience an even greater negative currency hit next year. That's something that even long-term investors should not ignore.

One bright spot
Although falling cigarette volumes and currency headwinds will continue to plague Philip Morris for some time, e-cigarettes offer a rare opportunity for growth. Last month, Philip Morris announced that it had acquired Nicocigs, a U.K.-based e-vapor company, for an undisclosed sum. The company has a 27% share of the $350 million U.K. e-cigarette market, according to Nielsen. Although tiny compared to Philip Morris' $80 billion in revenue, the e-cigarette market has the potential to grow into a material contributor to the company's bottom line. Investors should listen for management's e-cigarette strategy on the upcoming earnings conference call.

Foolish takeaway
Management lowered expectations for 2014 earnings last month, likely due to poor second-quarter results. Investors should expect to find a mid- to high-single digit decline in Asia cigarette shipments and continued negative impacts from currency headwinds. The company has few available options to control these factors; investors can only gauge the impact and make sure the trend does not worsen.

However, investors may be encouraged by management's plans for its recent e-cigarette acquisition, though the benefits from the transaction will not be felt for many more years. Keep an eye on management's comments about long-term growth in emerging markets and actions to hedge currency risk to determine whether or not Philip Morris is still a good stock to own.

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Ted Cooper 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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