Philip Morris' Second-Quarter Report Didn't Mention the 1 Thing That Could Sink Its Stock

Philip Morris beat earnings expectations and showed promise in Europe, but it didn't mention the one thing that could leave shareholders sitting on a big loss.

Ted Cooper
Ted Cooper
Jul 22, 2014 at 9:00AM
Consumer Goods

Shares of Philip Morris International (NYSE:PM) are trading slightly higher after strong pricing enabled the company to beat Wall Street's second-quarter earnings forecast. The company reported a 20% increase in earnings per share after adjusting for currency fluctuations and other items. Philip Morris also reaffirmed its full-year guidance after it had lowered it at an investor day conference last month. Europe is improving and emerging markets can be fixed, but one thing that Philip Morris didn't tell investors could have a huge impact on the stock in 2015 and beyond.

Photo credit: Philip Morris International

Quarter recap: Strong in Europe, weak in Asia
Overall cigarette volume declined 2.7% in the quarter compared with the same quarter last year. The drop was most pronounced in Asia, where volume declined 6.7% compared with the 2013 period due to poor sales performance in Japan and the Philippines. Volume increased 2.7% in Europe and pulled back to near-even in the region for the first two quarters of 2014. This continues the narrative of a recovering European market and a deteriorating Asian market.

The Asian segment continues to be dragged down by a major competitor in the Philippines that Philip Morris accuses of bypassing excise taxes, thus giving the competitor an unfair price advantage. The Philippines tax-paid market declined a whopping 13.4% in the quarter. After adjusting for inventories, industry tax-paid volume is down a more modest 1.2% on the year.

Philip Morris CFO Jacek Olczak believes that tax stamps and other measures taken by the Philippine government will help curb tax evasion. "I think the tax stickers implementation is an important step in the whole portfolio of the steps which we wish the government should have already taken to address that issue," said Olczak on Thursday's conference call with Wall Street analysts. Philip Morris accounts for nearly 86% of the tax-paid market, so it is crucial that the company successfully lobbies the government for tougher restrictions on locally based tax-evaders.

Japan is another sore spot for Philip Morris' Asian markets. The Japanese cigarette market has declined by 2.8% since the start of the year, with a fall of 3% to 3.5% expected for the full year. The decline was only offset by low-single-digit increases in Indonesia and Korea. However, demand could pick back up again if economic activity increases in the years ahead.

An issue investors can no longer ignore
Despite the weakness in Asia, Philip Morris still reported strong currency-adjusted results. After adjusting for one-time accounting items, currency-neutral income increased by 9.5% in the quarter -- a solid result for a company that is struggling to grow shipment volume. However, currency fluctuations have the potential to cause investors serious pain in the coming years.

It is no secret that Philip Morris' earnings have been increasingly affected by adverse currency fluctuations. Exchange rates lowered its earnings by 4% in 2012, 6% in 2013, and an estimated 11% for full-year 2014. Unfortunately, the trend could worsen in the years ahead.

If the Federal Reserve tightens monetary policy by raising interest rates, Philip Morris could experience the double shock of a stronger dollar and weaker emerging market economies. When interest rates rise in the US, the dollar is apt to appreciate against foreign currencies like the euro and Japanese yen. If this occurs, it would lead to even worse currency translations and lower dollar-denominated earnings for Philip Morris.

Moreover, rising US interest rates negatively impact other economies, particularly in Europe and emerging markets. The Bank for International Settlements estimates that dollar-denominated international credit topped $7 trillion in 2014, far more than any other currency. This means that dollars are the life-blood of economies around the world. When dollars become more expensive (i.e., appreciate relative to other currencies), the cost of executing dollar-denominated transactions increases -- which leads to fewer transactions and lower economic activity.

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The dollar's enormous impact on foreign currencies is part of the reason why the so-called BRIC nations -- Brazil, Russia, India, and China -- are taking steps to reduce their reliance on the currency. James Rickards, author of Currency Wars, told Russian news service RIA Novosti that "by shifting its policies, the Fed massively affects foreign currencies and makes it difficult for them to plan investments." Unless the dollar hegemony reaches a swift end, rising US interest rates will have an adverse impact on Philip Morris' earnings going forward.

Foolish takeaway
Philip Morris prepared investors for lower earnings during an investor conference last month, so the company's second-quarter earnings beat on lower expectations is not anything to cheer. Still, higher volume in Europe and the prospect of better performance in the Philippines remain bright spots for the company.

However, an appreciating US dollar could spoil earnings growth in 2015 and beyond. If the Federal Reserve raises interest rates this year or next, it could send a shockwave through the global economy that slows international trade and decreases the value of profits abroad in dollar terms. If this were to happen, Philip Morris might become a tax-loss candidate for investors come December.