Before selecting a stock, there are a number of things that you need to consider in order to ensure that you are buying the stock of a high-quality company whose shares are poised to grow in value over time. Some of these concerns include what the company does, its competitive advantages, valuation, dividend payouts and sustainability, and earnings consistency.
Another important thing that you need to consider is the financial condition of the company in question. You want to know if the company is able to continue paying its bills, and how much debt it carries. The balance sheet is one of the most effective tools that you can use to evaluate a company's financial condition. In this article, I will discuss the balance sheet of Philip Morris International PM, in order to get some clues as to how well this company is doing.
I will go through the balance sheet, reviewing the most important items, in order to assess PMI's financial condition. The information that I am using for this article comes from the company's website here. Note that this article is not a comprehensive review as to whether Philip Morris International should be bought or sold, but rather, just an important piece of the puzzle when doing the proper due diligence.
This article might be a bit too basic for some and too long-winded for others, but I hope that some of you can derive benefit from it.
Philip Morris International produces and sells cigarettes and other tobacco products outside the United States. The company's leading international brands include Marlboro, Merit, Parliament, Virginia Slims, L&M, and Chesterfield. The company also owns many local brands that are popular in some of the many countries in which they operate. The products are sold in 180 countries. PMI is the world's second largest tobacco company, with the China National Tobacco Corporation being the world's largest. Philip Morris International has over 87,000 full-time employees.
Its revenue streams have plenty of geographic diversification; 35% of the company's sales come from the European Union, 27% of sales come from Asia, 25% of 2012 revenues came from the Eastern Europe, Middle East, and Africa segment of the business, while 13% came from Canada and Latin America.
Cash and Cash Equivalents
The first line in the Assets column of the balance sheet is for the amount of cash and cash equivalents that the company has in its possession. Generally speaking, the more cash the better, as a company with a lot of cash can invest more in acquisitions, repurchase stock, pay down debt, and pay out dividends. Some people also value stocks according to their cash positions. Some of the larger and more mature companies tend not to carry a lot of cash on their balance sheets, as they might be more inclined to buy back stock with it, or pay out dividends.
Philip Morris International is one such company. As of March 31, 2013, PMI had $3.98B in cash and cash equivalents, which can be easily converted into cash. Over the last 12 months, Philip Morris International repurchased a whopping $6.65B worth of stock, and paid out $5.47B in dividends. The dividends are well-supported by the company's free cash flow of $7.81B. The remainder of the free cash flow, along with debt, is used to finance the repurchases.
The company intends to repurchase up to $6B worth of stock in 2013. Over the last 5 years, the management of Philip Morris International has reduced the company's share count from 2.06B to 1.64B, amounting to a 20% decrease. This is great for shareholders as long as the buybacks are done at favorable prices, as it boosts earnings per share, and splits up the money allocated for dividends over fewer shares, which should result in enhanced dividend growth. The company has raised its dividend every year since it was spun off from Altria in 2008.
Receivables constitute money that is owed to a company for products or services that have already been provided. Of course, the risk with having a lot of receivables is that some of your customers might end up not paying. For this reason, you usually like to see net receivables making up a relatively small percentage of the company's sales.
Philip Morris International had a total of $3.59B in net receivables on its balance sheet, which represents 4.61% of its trailing 12-month sales of $77.9B. For 2012, 4.64% of its sales were booked as receivables, while that percentage was at 4.19% for 2011.
Given that this figure is not an outlandish amount, I'm not too concerned about it.
Another factor that I like to look at is the current ratio. This helps to provide an idea as to whether or not the company can meet its short-term financial obligations in the event of a disruption of its operations. To calculate this ratio, you need the amount of current assets and the amount of current liabilities. Current assets are the assets of a company that are either cash or assets that can be converted into cash within the fiscal year. In addition to cash and short-term investments, some of these assets include inventory, accounts receivable, and prepaid expenses. Current liabilities are expenses that the company will have to pay within the fiscal year. These might include short-term debt and long-term debt that is maturing within the year, as well as accounts payable (money owed to suppliers and others in the normal course of business). Once you have these two figures, simply divide the amount of current assets by the amount of current liabilities to get your current ratio.
If a company's operations are disrupted due to a labor strike or a natural disaster, then the current assets will need to be used to pay for the current liabilities until the company's operations can get going again. For this reason, you generally like to see a current ratio of at least 1.0, although some like to see it as high as 1.5.
The current ratio of Philip Morris International is 1.15, which is decent.
Property, Plant and Equipment
Every company, regardless of the industry in which it operates, requires a certain amount of capital expenditure. Land has to be bought, factories have to be built, machinery has to be purchased, and so on. However, less may be more when it comes to outlays for property, plant and equipment, as companies that constantly have to upgrade and change their facilities to keep up with competition may be at a bit of a disadvantage.
However, another way of looking at it is that large amounts of money invested in this area may present a large barrier-to-entry for competitors. Right now, Philip Morris International has $13.6B worth of property, plant, and equipment on its balance sheet. This figure is slightly below the $13.9B that the company reported at the end of 2012, but just a little bit more than the $12.9B that it reported at the end of 2011. Of these assets, 60% is in machinery and equipment, 28% is in buildings and equipment, and 12% is in either land or construction in progress.
Given the consistency of PMI's position here, along with the fact that the company has operations all over the world, I don't see anything to be alarmed about at this time.
Goodwill is the price paid for an acquisition that's in excess of the acquired company's book value. The problem with a lot of goodwill on the balance sheet is that if the acquisition doesn't produce the value that was originally expected, then some of that goodwill might come off of the balance sheet, which could, in turn lead to the stock going downhill. Then again, acquisitions have to be judged on a case-by-case basis, as good companies are rarely purchased at or below book value.
Philip Morris International has $9.77B worth of goodwill on its most recent balance sheet, which is inline with the $9.90B worth of goodwill that it reported 3 months prior. It is also inline with the $9.93B that was reported at the end of 2011.
The overwhelming majority of the goodwill in this case comes from acquisitions that the company made in Canada, Indonesia, Mexico, Greece, Serbia, Colombia, and Pakistan, as well as from business combinations in the Philippines. The slight decreases in the company's goodwill from one year to the next come from currency fluctuations.
Overall, goodwill accounts for about 26% of Philip Morris International's total assets of $37.4B. Usually, I don't like to see goodwill account for more than 20% of a company's total assets for the reason that I discussed at the beginning of this section. Since Philip Morris International is above this threshold, this may be an area of concern. While PMI hasn't had any significant write downs in goodwill over the last few years, if it does have any significant write downs going forward, then it can negatively impact the share price, due to the decline in the company's net worth.
Intangible assets that are listed on the balance sheet include items such as licensed technology, patents, brand names, copyrights, and trademarks that have been purchased from someone else. They are listed on the balance sheet at their fair market values. Internally developed intangible assets do not go on the balance sheet in order to keep companies from artificially inflating their net worth by slapping any old fantasy valuation onto their assets. Many intangible assets like patents have finite lives, over which their values are amortized. This amortization goes as annual subtractions from assets on the balance sheet and as charges to the income statement. If the company that you are researching has intangible assets, with finite lives, that represent a very large part of its total asset base, then you need to be aware that with time, those assets are going to go away, resulting in a reduction in net worth, which may result in a reduction in share price, unless those intangible assets are replaced with other assets.
Philip Morris International currently has $3.60B worth of intangible assets on its balance sheet. This is slightly down from the $3.62B that it had 3 months prior, below the $3.70B that the company reported at the end of 2011, and the $3.87B that was reported at the end of 2010.
Of PMI's intangible assets, 58% of them are non-amortizable, meaning that they cannot be lost from the balance sheet due to amortization. These intangibles are mostly trademarks acquired through acquisitions in Indonesia and Mexico. The other 42% of intangibles do have finite lives, and they include trademarks, distribution networks, and non-compete agreements that the company made in certain of its business combinations. The remaining lives of these assets range from 2 on up to 25 years. Management is expecting amortization charges on these assets to be no more than $97M per year for each of the next five years.
While the loss of roughly $1.5B from the balance sheet is not a good thing, considering that amount only accounts for about 4% of the company's total assets, and the fact that this amortization will go on for at least the next two decades, I don't see anything to be concerned about here, going forward.
Return on Assets
The return on assets is simply a measure of the efficiency in which management is using the company's assets. It tells you how much earnings management is generating for every dollar of assets at its disposal. For the most part, the higher, the better, although lower returns due to large asset totals can serve as effective barriers to entry for would-be competitors. The formula for calculating return on assets looks like this:
Return on Assets = (Net Income) / (Total Assets).
For Philip Morris International, the return on assets would be $8.88B in core earnings over the last 12 months, divided by $37.4B in total assets. This gives a return on assets for the trailing twelve months of 23.7%, which is excellent. I also calculated PMI's returns on assets over 2012, 2011 and 2010 for comparative purposes. This can be seen in the table below.
Table 1: Strong, Consistent Returns On Assets From Philip Morris International
The numbers shown in the above table are excellent returns on assets, and they show that management is doing a fantastic job at making good use of what it has as its disposal. It is also a sign of a company that has a sustainable competitive advantage. With PMI, I believe that it does have a competitive advantage and pricing power as the result of the strength of its brands, including Marlboro.
Short-Term Debt Versus Long-Term Debt
In general, you don't want to invest in a company that has a large amount of short-term debt when compared to the company's long-term debt. If the company in question has an exorbitant amount of debt due in the coming year, then there may be questions as to whether the company is prepared to handle it.
Philip Morris International has $4.80B worth of short-term debt, with $3.26B of that total being original long-term debt that is coming due within the fiscal year. While this is not a devastating amount of short-term debt for a company like PMI, I do expect it to refinance a lot of this, at lower interest rates. So, I am not as concerned about this in the near term.
Long-term debt is debt that is due more than a year from now. An excessive amount of it can be crippling in some cases. For this reason, the less of it, the better. Companies that have sustainable competitive advantages in their fields usually don't need much debt in order to finance their operations. Their earnings are usually enough to take care of that. A company should generally be able to pay off its long-term debt with 3-4 years' worth of earnings.
Right now, Philip Morris International carries $20.8B of long-term debt. This figure is significantly above the $17.6B that was reported just 3 months prior, as well as the $14.8B that was reported at the end of 2011. Of its $20.8B in long-term debt, less than 25% of it comes due within the next 3 years.
During the first quarter of 2013, PMI issued approximately $4.66B of long-term debt, with over 80% of that debt financed at an interest rate of either 2.75% or below. The maturities on this new debt range from 2 to 30 years. The company states that it is using its long-term debt for share repurchases, the refinancing of other debt, and the satisfaction of its working capital requirements.
While most people would agree that having this large amount of long-term debt is usually not a good thing, it's really not that bad when the company is borrowing money at 2.75% or below to buy back stock on which it is paying a current dividend yield of 3.7%. I would be interested in hearing the perspectives of some of you on this matter.
In determining how many years' worth of earnings it will take to pay off the long-term debt, I use the average of the company's core earnings over the last 3 fiscal years. The average core earnings of Philip Morris International over this period is $8.23B. When you divide the long-term debt by the average earnings of the company, here is what we find.
Years of Earnings to Pay off LT Debt = LT Debt / Average Earnings
For Philip Morris International, here is how it looks: $20.8B / $8.23B = 2.53 years
This is pretty good for PMI, in that the company can pay off its long-term debt with less than three years' worth of earnings. If it wanted to, it could also dip a little bit into its cash position to pay some of it off. To me, this shows that the company's debt position, while large, is still manageable when considering the company's earnings power.
In the equity portion of the balance sheet, you will find the treasury stock. This figure represents the shares that the company in question has repurchased over the years, but has yet to cancel, giving the company the opportunity to re-issue them later on if the need arises. Even though treasury stock appears as a negative on the balance sheet, you generally want to see a lot of treasury stock, as strong, fundamentally-sound companies will often use their huge cash flows to buy back their stock. For this reason, I will often exclude treasury stock from my calculations of return on equity and the debt-to-equity ratio in the case of historically-strong companies, as the negative effect of the treasury stock on the equity will make the company in question appear to be mediocre, or even severely distressed, when doing the debt-to-equity calculation, when in reality, it might be a very strong company. In this case, I will try to calculate the debt-to-equity ratio and the return on equity both ways to help give the reader an idea as to how much effect the treasury stock really has.
Philip Morris International, part of the old Philip Morris, which most can agree is a historically-strong company, has a whopping $27.7B in treasury stock.
The debt-to-equity ratio, as normally calculated, is simply the total liabilities divided by the amount of shareholder equity. The lower this number, the better. Companies with sustainable competitive advantages can finance most of their operations with their earnings power rather than by debt, giving many of them a lower debt-to-equity ratio. I usually like to see companies with this ratio below 1.0, although some raise the bar (or lower the bar if you're playing limbo) with a maximum of 0.8. Let's see how Philip Morris International stacks up here.
Debt-To-Equity Ratio = Total Liabilities / Shareholder Equity
Unfortunately for Philip Morris International, the debt-to-equity ratio as described above cannot be calculated. This is because the company currently has a negative equity figure of $4.31B. The same can be said for the company's equity position at the end of 2012. At the end of 2011, PMI had only $229M in equity, leading to a huge debt-to-equity ratio of 147.
From this, it would appear that Philip Morris International is a severely distressed company.
However, when you cancel out the negative effects that the treasury stock has on the equity, we see something a little bit different.
In these instances, I calculate what I like to call the adjusted debt-to-equity ratio. It is calculated as follows.
Adjusted Debt-To-Equity Ratio = Total Liabilities / (Shareholder Equity + Treasury Stock)
Using the data from the most recent balance sheet of Philip Morris International, this figure is calculated as: $40.2B / $23.4B = 1.72. The table below shows how this figure has changed over the last few years.
Table 2: Adjusted Debt-To-Equity Ratios Of Philip Morris International
As can be seen from the table above, the adjusted debt-to-equity ratio of Philip Morris International is less than ideal, as we usually like to see this figure significantly lower. However, it has been consistent, showing that there hasn't been any major deterioration in the company's financial condition over the last few years.
Return On Equity
Like the return on assets, the return on equity helps to give you an idea as to how efficient management is with the assets that it has at its disposal. It is calculated by using this formula.
Return On Equity = Net Income / Shareholder Equity
Generally speaking, the higher this figure, the better. However, it can be misleading, as management can juice this figure by taking on lots of debt, reducing the equity. This is why the return on equity should be used in conjunction with other metrics when determining whether a stock makes a good investment. Also, it should be mentioned that some companies are so profitable that they don't need to retain their earnings, so they buy back stock, reducing the equity, making the return on equity higher than it really should be. Some of these companies even have negative equity on account of buybacks.
As discussed above, Philip Morris International has a negative equity position on account of its share repurchases. Because of this, the return on equity as calculated above cannot be calculated from the most recent balance sheet, or for the end of 2012. The company's return on equity from 2011 is not a meaningful number as the equity position is miniscule.
For this reason, I like to strip out the negative effects of treasury stock, just like I did with the debt-to-equity ratio.
Adjusted Return On Equity = Net Income / (Shareholder Equity + Treasury Stock)
When I strip out the negative effects of the treasury stock, here is what I come up with when using the data from the most recent balance sheet.
Adjusted Return On Equity = $8.88B / $23.4B = 37.9%.
This appears to be a pretty solid return on equity. In the table below, you can see how the adjusted return on equity has fared over the past three years.
Table 3: Adjusted Returns On Equity At Philip Morris International
While the adjusted returns on equity here are declining just a little bit, they are still consistently very strong. The main reason for the decline is that the company's adjusted equity position is growing slightly faster than the core earnings, which isn't always a bad thing.
Retained earnings are earnings that management chooses to reinvest into the company as opposed to paying it out to shareholders through dividends or buybacks. It is simply calculated as:
Retained Earnings = Net Income - Dividend Payments - Stock Buybacks
On the balance sheet, retained earnings is an accumulated number, as it adds up the retained earnings from every year. Growth in this area means that the net worth of the company is growing. You generally want to see a strong growth rate in this area, especially if you're dealing with a growth stock that doesn't pay much in dividends or buybacks. More mature companies, however, tend to have lower growth rates in this area, as they are more likely to pay out higher dividends.
Below, you can see how the retained earnings have fared at Philip Morris International at the ends of each of the last four fiscal years.
Table 4: Retained Earnings At Philip Morris International
From the above table, you can see that PMI has an impressive retained earnings figure that is north of $25B, and that it has been steadily growing since the end of 2009, at a cumulative rate of 63%. This is happening as the company is buying back more and more stock every year and paying out higher and higher dividends, both of which are supposed to bring down the retained earnings. This is just a testament to the strong earnings power of Philip Morris International.
After reviewing the most recent balance sheet, it can be concluded that there are a lot of things to like about the financial condition of Philip Morris International. For starters, the company has a tremendous cash-generating ability, as PMI has generated anywhere from $8B to $10B of free cash flow in each of the last three years. This helps the company pay out dividends and buy back stock. The company also has enough current assets on hand in order to meet its short-term obligations in the event that its operations encounter an unlikely disruption. Philip Morris International also has superior returns on assets, as well as outstanding returns on equity when adjusting for the negative effects that treasury stock has on its equity position. Retained earnings growth has also been amazing, especially when you consider the rate at which the company has been buying back stock and paying out dividends.
However, as a long-term shareholder of PMI, there are a couple of things that I am concerned about. For one, goodwill makes up over a quarter of the company's total assets. While it hasn't been a problem yet, if some of the company's acquisitions don't produce the value that was originally expected by management, then some of that might come off of the balance sheet, reducing the company's net worth and potentially hurting the company's stock price. Also, while I do understand part of the reason why Philip Morris International is borrowing so much money (to buy back stock), I would like to see the company's adjusted debt-to-equity ratio come down some. It might be saving money on dividends in the near term by pulling some shares off the market, but if interest rates rise, then taking on new debt and refinancing old debt won't be as attractive of an option.
While this is not a comprehensive review as to whether Philip Morris International should be bought or sold, I think that the company is in pretty decent financial shape overall, with its economic moats, brand strength, and tremendous earnings power. As long as it can keep generating large amounts of free cash flow every year, I remain optimistic on its prospects.