Philip Morris International's (NYSE:PM) stock price shot down nearly 2% after the company reported revenue that was lower than analysts had expected. In addition to a 9% decline in revenue, earnings plunged nearly 8%. The company faced numerous problems in the quarter which led to the poor showing, but lower cigarette volumes and unfavorable currency exchange rates were the chief culprits.
Cigarette shipments disappoint
Philip Morris shipped 196 billion units of cigarettes in the first quarter, down 4.4% from the same period a year ago. Shipments of Philip Morris' flagship brand, Marlboro, also declined 4.1% to 65.9 billion units. However, Marlboro actually increased its international market share to 9.2%, with most of the gains coming from the European Union.
Cigarette volume fell most in Eastern Europe, the Middle East, and Africa, or EEMA, down 7.2% in the quarter. The sharp decline was due to weakness in Russia and Ukraine in addition to the timing of inventory movements. Russian volume declined 6.7% as higher taxes and a robust black market soured the operating environment. Ukraine's poor economy is to blame for its 6.5% decrease in cigarette volume. Despite the struggles in Russia and Ukraine, EEMA volume declined only 3% after adjusting for the timing of inventory movements.
The biggest long-term concern stems from Asia, where revenue was down 8.7% and operating income fell 15.8%, both excluding the negative impact of currency translation. Asia is Philip Morris' most important market; the company derives almost one-third of its revenue from the continent -- more than any other region. Unfortunately, it is also the only region in which revenue declined from 2012 to 2013.
Philip Morris' troubles in Asia stem from regulatory changes and uneven enforcement of laws. For instance, the Philippines hiked excise taxes in January 2013, causing the price of Philip Morris' cigarettes to increase significantly. However, Philip Morris accuses its primary competitor in the region -- Mighty Corporation -- of not paying the tax on up to half of its production volume. As a result, Mighty is able to earn the same margin as Philip Morris at a lower price -- an unfair pricing advantage. After tax stamps are introduced in June, Philip Morris believes the Philippines headwinds will subside.
Management expects cigarette industry volume to accelerate its decline through the year; it forecasts 6% to 7% lower volume in 2014 than in 2013. As a result, investors should expect similar results from Philip Morris in future quarters.
Despite a somewhat disappointing quarter, management maintained its constant-currency adjusted diluted earnings-per-share growth target of 6% to 8% for the year. The problem is investors cannot simply write off the currency adjustments; it is a real cost that is significantly hampering Philip Morris' results.
In 2013, currency headwinds lowered earnings per share by 6%. The adverse currency translation caused earnings per share to grow just 1.7% instead of 8.3%. Currency headwinds also played a significant role in Philip Morris' results in the first quarter of 2014. Earnings per share were 12% lower as a result of unfavorable currency translation. Instead of growing by 4.7%, earnings per share declined 7.8% as a result of the currency fluctuations.
It is difficult to predict what effect exchange rates will have on Philip Morris' earnings in any given year; currencies are finicky, and rarely is a long-term trend evident against a worldwide basket of currencies. However, the fact that investors cannot predict it and the company cannot control it does not mean that investors should ignore it -- or give Philip Morris a free pass.
Dividend at risk?
Investors will take unfavorable exchange rates seriously when dividends are affected. Tobacco analyst Bonnie Herzog asked CFO Jacek Olczak if the currency headwind will have any impact on the dividend, noting that the quarterly dividend now exceeds the company's 65% payout ratio target. Olczak remained uncommitted to any course of action on the dividend, saying it would be decided by the board of directors in September.
Philip Morris pays a $0.94 quarterly dividend, a 79% payout ratio on the quarter's $1.98 in adjusted earnings per share. Full-year earnings per share would have to be at least $5.78 to come in right at a 65% payout ratio. However, management forecasts just $5.19 in earnings per share at the high end, including $0.61 of unfavorable currency translation at current rates. If the dollar continues to strengthen against the euro and the yen, Philip Morris' loyal dividend investors may not get the hike they expect.
Philip Morris' quarter was disappointing but not altogether surprising. It operates in a difficult environment, with rising taxes and high unemployment affecting most of its major markets. Continued reductions in revenue and cigarette shipments should concern long-term investors, but so should currency headwinds.
If the dollar continues to strengthen, 'currency-adjusted earnings' may become more of a distraction than a useful measure of Philip Morris' earning power. The currency headwind will become very real if it affects the stock's dividend. Investors should keep all of these factors in mind as they consider which dividend stock represents the best long-term bet for their portfolio.