Philip Morris' Problems Are Not Skin Deep

Philip Morris' (NYSE: PM  ) profit warning last month was a shock for investors. Management tried to play down the severity of the warning, stating that 2014 would be a "truly atypical" year for the company.

In layman's terms, this means that management does not expect 2014's performance to reflect that of any other year.

While on the face of it this warning appears to be a one-off, underlying trends may imply that falling revenues and contracting earnings could actually become a more permanent issue for Philip Morris.

Poor performance
Philip Morris expects to report full-year fiscal 2014 earnings per share of $4.87 to $4.97, below the previous forecast of $5.09 to $5.19.

Management blamed a strong U.S. dollar for this revision lower. Indeed, the company has been wrestling with a strong U.S. dollar for some time now. Unfavorable currency effects took $0.16 per share out of the company's first-quarter earnings, and it looks as if this trend is set to continue going forward.

In addition, Philip Morris expects to take one-off charges during the year relating to the closure of certain factories. Factories are being closed within the Netherlands and Australia. A charge for the Australian closure has already been taken.

The closure of Philip Morris' factory in the Netherlands is expected to cost the group $495 million, or $0.24 per share. This reflects approximately $356 million in employee separation costs and $139 million in asset impairment costs.

Underlying trends
Philip Morris' management can blame factory closures and unfavorable currency movements all it likes, but there is no denying that the company is facing a more serious threat.

The most serious threat that the company is facing is declining cigarette sales around the world. Over the long term, this is likely to affect the company more than unfavorable currency or restructuring charges.

Philip Morris' management expects a 1%-2% decline in total global cigarette sales this year, led by a drop of 5%-6% within Europe. Philip Morris expects its volume of cigarettes sold to decline 1% this year.

However, these figures are somewhat different to the ones reported by the company during the first quarter. During the first quarter, the volume of cigarettes shipped by Philip Morris declined by 4.4% year on year. These declines were led by Europe, where volume fell 7.2%. Asia, traditionally a shining star in Philip Morris' empire, reported a decline in volumes of 2.5%.

As I write, Philip Morris has just released second quarter results which show a 2.7% decline in cigarettes shipped from the year ago period. During the period, total shipments of Marlboro cigarettes edged up 1%, mostly due to Eastern Europe, the Middle East, Africa, and Asia.

Sliding margins
What's of even more concern is Philip Morris' contracting operating margin. Tobacco companies are well known for this ability to consistently drive margins wider, but Philip Morris has been failing to do this recently.

Based on first quarter results, Philip Morris' gross margin during the period came in at 25.5%. This was around 2% below the margin of 27.5% reported during the same period the year period.

Further, Philip Morris' operating margin declined from 18.3% to 16.6% over the period.

Why is the company's margin declining at this rate? The declines can be traced back to rising excise taxes, which actually rose as a percentage of revenues year on year for the reported period. Excise taxes as a percentage of revenue ticked up from 58.9% to 61.5% year on year during the first quarter .

There is no denying that these are some really worrying figures, implying that Philip Morris is going to have to work extra hard to drive growth going forward.

The bottom line
The bottom line is that Philip Morris is struggling. Underlying trends within the tobacco market, especially falling cigarette sales volumes, will impact the company over the longer term.

While the company's management may have been able to brush off its lower guidance for 2014, it will be interesting to see what trends develop over the next few years. Philip Morris could report further declines in both volume and income as an increasing number of smokers kick the habit.

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