How Big Is This Problem for Philip Morris?

At the end of November, I wrote an article on a presentation that Philip Morris (PM +0.14%) gave to investors the week before. In summary, Philip Morris announced to the conference that its volume of cigarettes shipped was going to fall during 2014 before returning to growth during 2015. In addition, the company was going to slow its share repurchases, which have been running ahead of its free cash flow during the last five or so years.

Indeed, when we look at Philip Morris' cash flows it quickly becomes apparent that the company has been spending significantly more on share repurchases than it can afford.

Source: Marketwatch.com. Figures in $US billions.

On average, Philip Morris has generated $10 billion annually in cash from operations since 2010. Meanwhile, after paying out dividends the company's free cash flow has averaged $3.3 billion per year for the past five years. Unfortunately, Philip Morris has spent nearly double this free cash flow figure of $3.3 billion on buybacks every year, which means the company has needed to borrow aggressively to fill the hole.

Filling a hole
Fortunately, Philip Morris has been able to borrow the cash it needs in a low interest rate environment. Still, its debt has now risen to a worrying level and investors are right to raise concerns.

Source: Marketwatch.com. Figures in $US billions. Philip Morris reported negative shareholder equity of -$1.9 billion for full-year 2012.

Indeed, Philip Morris' own management has acknowledged the issue of rapidly rising debt. In particular, management revealed at the recent Morgan Stanley Consumer Conference, mentioned above, that after the conclusion of the current $18 billion buyback it will scale back repurchases and only return free cash flow to investors in the future. (In other words scale back borrowing and only spend what the company can afford.)

With Philip Morris' debt-to-equity level, or gearing, surpassing 1,000% during 2011 investors have every right to express concern. However, as with every company, we should compare Philip Morris' spending and debt buildup to those of its peers to establish whether the company is overspending or just following the rest of the industry.

Peers
So let's take a look at the cash flows and spending habits of Philip Morris' domestic peers, Altria Group (MO 0.15%), Lorillard (LO +0.00%), and Reynolds American (RAI +0.00%).

Source: Marketwatch.com. Figures in $US billions.

For these four tobacco giants, I have consolidated the cash flows of the past five years to give a more concise overview. As the table shows, in comparison to its peers Philip Morris has not been spending more money on buybacks as a percentage of free cash flow after dividends. This is actually quite interesting as it reveals that although concerns have been raised about Philip Morris' rising debt, the company has been spending less as a percentage of free cash flow than its peers.

So what does this tell us? Well, we know that Philip Morris has been spending more than it can afford to buy back stock. We also know that the company will slow down its repurchases. However, the company has been more conservative with its cash than its peers, which is surprising. Although the evidence points to the fact that Philip Morris' debt is getting out of hand, the company is spending less than its peers and this is a good thing.

Foolish summary
All in all, Philip Morris' rising debt is of concern. That said, the company has been able to borrow at record low rates in recent years and this has benefited the company. Additional, the company's management has realized that debt is getting out of control.

So in conclusion, while Philip Morris' debt pile is high, it seems under control.