Tobacco companies are well known for their cash-generative nature and tendency to return most this cash to investors. However, there is a problem. These distributions won't last forever, and both Reynolds American (NYSE:RAI) and Philip Morris (NYSE:PM) are already coming under pressure to rein in returns.
During 2013, the volume of cigarettes sold by Reynolds' slumped 6.8%. These declines accelerated during the fourth quarter to 8.6%. In comparison, the wider industry reported a 4.6% decline in volumes, with 6.2% during the fourth quarter.
How did this affect Reynolds? For a start, R.J. Reynolds (Reynolds' tobacco division) reported a 4% decline in revenue year on year. Reynolds' total revenue declined by around $70 million, or 1%, including the contribution from other divisions.
Due to cost cutting and price increases, however, Reynolds' operating income jumped 41%, including one-off items .
Can only cut so much
The issue is that Reynolds can only cut costs so far. The company can also only hike prices so far. Eventually, Reynolds' management will have to accept the fact that income is going to start sliding.
If current cigarette volume declines are anything to go by, Reynolds' income could sliding at an alarming rate of more than 5% per year.
Reynolds' e-cig sales could go some way to offset this slump, though the company has not yet provided any income figures for its e-cig divisions (during the full-year 2013 report, "other divisions" which could include e-cigs raked up a loss of $70 million.)
Realistically, it's going to be some time before it gets to the point where Reynolds is unable to cut costs and hike prices further. Nevertheless, with sliding income, Reynolds is going to have trouble paying down debt.
This could be a big issue. Reynolds' net debt jumped 50% year-over-year at the end of the first quarter as the company spent heavily on buybacks and dividends. Standard & Poor's has already placed Reynolds on a negative credit watch, warning of a downgrade. The company currently has a credit rating of BBB-, which is the lowest investment grade; a downgrade would see the company's credit rating drop to "junk" status, inhibiting its ability to borrow at attractive rates
It is clear that Reynolds is heading for trouble. So is the company's larger peer Philip Morris, although Philip Morris is taking decisive action.
You see, Philip Morris has returned much more cash than it has realistically been able to afford since its spin off. The company has returned in excess of $44 billion to investors since 2009, but free cash flow has been much less.
During 2013 alone, Philip Morris spent $2.3 billion on capital projects, $6 billion on share repurchases, and $5 billion on dividends. Cash outflow totaled $14 billion while cash inflow fell seriously short at only $8.9 billion, so this gap had to be filled with debt .
This was not a one-off situation, either. Philip Morris' debt has nearly doubled since 2009, and now stands at just under $28 billion.
To combat this and maintain its credit rating, Philip Morris is planning to scale back share repurchases, limiting them to free cash flow after the payment of dividends. While this is prudent decision, the problem of debt repayment arises. That is an issue for another day, however.
Still, Philip Morris' management has stated that
...We're intent on maintaining our single A credit rating and recognize that we're approaching the high-end of ratio and supporting it... to scale back our share repurchase target to $4 billion in 2014. We are committed to share buyback and our operating corridor is defined on one side by the upper limit of our credit rating and on the other side by providing 100% of our free cash flow to our shareholders through dividend and share buyback. We intend to operate within this corridor in the future....
The company wants to insure that its investors feel that their capital is safe by maintaining a stable credit rating.
All in all, Reynolds' and Philip Morris' debt issues are worrying and could have serious future implications. Philip Morris is taking action to combat the situation, but Reynolds is failing to show any sign of action. If the company does not act soon and is downgraded by the ratings agencies, Reynolds' future could be extremely uncertain.
Rupert Hargreaves 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.