Why Philip Morris International Got Crushed by Domestic Tobacco Stocks in 2013

Ever since its spinoff in early 2008, Philip Morris International (PM -0.24%) has gotten attention from U.S. investors who've grown tired of the extensive domestic regulation of cigarettes and other tobacco products. Unlike Altria (MO -0.02%), Reynolds American (RAI), and Lorillard (LO.DL), Philip Morris' international exposure promised to help investors avoid the potential downsides of regulation and legal liability that have plagued U.S. tobacco giants for decades. Yet more recently, foreign governments have started imposing their own crackdowns on tobacco, putting the entire premise for investing in Philip Morris in jeopardy. Let's take a closer look at what happened with Philip Morris International this year and whether its stock will remain under pressure in 2014.

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Why did Philip Morris International fall behind U.S. tobacco in 2013?
Philip Morris faced several negative factors that hurt its performance in 2013. The most obvious was the sharp decline in cigarette volume that the company faced. During its most recent quarter, Philip Morris saw shipment volumes plunge by 5.7%, which was much worse than any of its domestic counterparts reported. Reynolds saw a 4.3% drop in cigarette shipments, but both Altria and Lorillard shipped more cigarettes than in the year-ago period. Even the high-end Marlboro brand didn't have good sales abroad, with a 2.5% drop in sales in the third quarter.

Also weighing on results was the strength of the U.S. dollar. Philip Morris takes in revenue in foreign currencies around the world, having to translate those sales into dollars for financial reporting purposes. When the dollar is strong, revenue and profits suffer, as Philip Morris isn't able to pass currency-based price increases through to foreign markets without hurting its market share. Based on its most recent results, currency issues likely cost Philip Morris 5% to 6% of its net income, turning what would have been a reasonable year for earnings growth into a much less attractive performance.

Philip Morris Total Return Price data by YCharts.

But perhaps the worst sign of the lack of confidence in Philip Morris came from the company itself, which in November said that it would likely see falling cigarette volume fall again in 2014. The company concluded that it would therefore fall short of its double-digit earnings-growth targets, with earnings-per-share guidance 6% to 8% higher than 2013 levels.

The big question for Philip Morris is whether rising standards of living in emerging-market countries will produce growth that can offset weakness in developed markets with more extensive regulation. Even as sales in the European Union have dropped in recent years, Asia has been a huge growth center, as smoking rates are actually still rising there. The Eastern Europe-Middle East-Africa region has also had rising revenue and operating income to offset poor EU results.

Stats on Philip Morris International

Source: S&P Capital IQ.

What's next for Philip Morris International?
Regulation remains the key threat to Philip Morris. Russia's decision to implement smoking bans and the decision in October from the European Parliament to approve its Tobacco Product Directive were just the latest in a series of assaults that the tobacco giant has had to face from various countries. Moreover, as different countries come up with different answers on how to regulate new electronic cigarette products, Philip Morris might not be able to rely on their success to boost earnings. That would be most unfortunate, given the success that Lorillard in particular has had with its e-cigarette lineups, spurring Reynolds American and Altria to release their own products in response.

Philip Morris International could bounce back in 2014 if volumes bounce back, the dollar weakens, or regulatory efforts ease up in intensity. But with that combination of events seeming unlikely, the odds appear not to be in Philip Morris' favor for the coming year.

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