Over the last few months, I've discussed a weakening balance sheet for Philip Morris (PM). I've brought this issue up in some of my articles, using a variety of financial ratios to explain my concern. It's come to my attention, through a number of comments from my readers and followers, that some people don't quite understand the point I am trying to make. This became really evident in my latest Philip Morris article, where I examined the company's expected upcoming dividend raise. Today, I would like to take the time to examine the debt issue a little further. I feel as if readers believe I am stating that the company is in some sort of financial trouble, and I don't believe that at all. It appears that readers believe I am using the debt issue as some large negative stance against the company. That couldn't be further from the truth. My goal today is to explain my position on the issue. In terms of Philip Morris, I am still very positive on the name, and it is still one of my top value picks. I'm just a little less positive in the long term because of this debt issue. So instead of maybe ranking this stock as a 9 out of 10, right now I'm at 8 out of 10. To start, here's the table I've shown in the past that everyone seems to be concerned with.
Looking at overall debt:
You cannot argue that Philip Morris' debt pile is not growing. Over the last two years (ending Q1 of 2013), Philip Morris' total debt is up by nearly $8.75 billion, or 51.90%, to $25.6 billion. The amount of net debt, which is total debt minus cash and equivalents, has not risen as fast. Net debt has risen by about $6.1 billion, more than 39%, to $21.6 billion. A 40% rise in two years may not be large to some, but I'll show why it may be an issue if it continues.
Debt is also becoming a larger part of the liabilities section of the balance sheet. Two years ago, total debt represented about 56% of total liabilities. Now, we are at nearly 64%. Why does this matter? Well, there are certain liabilities that may not contain interest rates. Debt carries interest rates, so having more interest-bearing liabilities means that the company will probably be paying more in interest.
In terms of when this debt is due, most of it is very long-term. To see the in-depth breakdown of their debt transactions, click here. Most of this debt isn't due until 2020 or later, which means the company does not have to pay this debt back anytime soon. So investors looking at the next three months don't have to worry about the notes due in 2038, except for the fact that the company is paying interest on them, which reduces profits in a sense.
An interesting item that I've been asked about is interest expenses. In 2011, Philip Morris paid $800 million in interest expenses. Now, some of this is essentially "recovered", because the extra expense lowers pre-tax profits, which reduces taxes. However, in 2012 the company paid $859 million in interest expenses. That's a rise of 7.38%, which is a lot faster than the rise in revenues, gross profit, and operating profit. It does hurt a little on the bottom line.
Philip Morris' interest expenses are likely to rise again fairly quickly in 2013. Interest expenses in Q1 of 2013 were $236 million, up 10.8% from the $213 million recorded in Q1 of 2012. To look back at any of Philip Morris' past quarterly or yearly results, click here. Now one item brought up by some readers, and it could be a fair point, is the high interest rate debt coming due in 2014-2016. A few of these notes carry interest rates between 5.75% and 6.875%. Philip Morris could see some interest expense relief if they are able to refinance those notes, but we can't project that right now. We don't know what interest rates will be in 8 months to 2.5 years when they come due, and if Philip Morris goes with longer-term debt (assuming an interest rate rise), they could actually pay more in interest. Plus, on the flip side, when the lower rate notes come due, those ones they are paying very low interest on could become a lot more expensive.
The debt ratio:
The most common ratio I've discussed is the debt ratio, which is also known as the liabilities to assets ratio. This ratio basically measures how much of your assets are funded by liabilities (and thus how much by equity). So if you have a dollar of assets and 40 cents of liabilities, your debt ratio is 40%, because 40% of your assets are funded with liabilities, and 60% are funded by equity. Generally speaking, a company with a debt ratio of 10% would be better than a similar one with a debt ratio of say 50%. This is because the lower ratio would give that company more room to add debt and expand the balance sheet, and the one with the lower ratio is probably paying less overall in interest costs.
I bring up this ratio the most because it has been getting worse each quarter, especially over the past two years. Philip Morris has paid out a lot of capital to shareholders through dividends and share repurchases, but a fair amount of that has come from debt. The chart below shows the company's debt ratio since the end of 2010.
I don't bring up this ratio just because it is getting worse. I also bring it up because it passed a critical point. At the end of last year, Philip Morris had more liabilities than assets, meaning the balance sheet showed a negative equity value. In fact, at the end of Q1 this year, it got worse. Philip Morris had $1.07 in liabilities for each dollar of assets. Two years ago, they only had about $0.85 in liabilities for each dollar of assets. Now you may ask how this stacks up against some other names. I'll use the same three companies I always do, and those are Lorillard (LO), Altria (MO), and Reynolds American (RAI). To give you an extra bit of analysis, I went back three years here so you are not just looking at the changes over two years.
Over the past three years, only Lorillard's ratio shows a worse trend, but Lorillard has improved their ratio slightly in the past year. Philip Morris is the only name where the ratio got worse in each year, and they had the worst change from last year's value.
Other ratios / numbers to consider:
Now some of my commenters said they didn't see much value in the debt ratio, and would like to see something that more compares to results (income, cash flow, etc). So for this argument, I'm looking at the total debt to EBITDA and net debt to EBITDA ratios. I did not go out and calculate these ratios on my own. Philip Morris provides them in their quarterly reports, so I am giving you a ratio that they feel is important to include. The chart below shows these ratios going back to the end of 2010.
These ratios aren't just getting worse because Philip Morris is increasing its debt. They also are rising because EBITDA is not rising as fast as debt. Trailing twelve month EBITDA was $14.723 billion at the end of this year's Q1. Last year's figure was $14.709 billion. Since then, the company has added more than $4.75 billion of total debt, roughly $4.35 billion of net debt.
Investors may not realize this, but Philip Morris actually reported a first quarter decline in net income. Debt and interest rates are growing faster than revenues and profits. If you want to look at cash flow, I'll mention net cash provided by operating activities, page 8 of the most recent 10-Q filing. In Q1 this year, it was $1.363 billion. In last year's period, it was $1.898 billion. Cash from operating activities was down in 2012 as well. This company is not producing the cash flow it was in prior periods, which may be a surprise to some.
In the table I started with, there were a couple of numbers in yellow. In five of the past nine quarters, Philip Morris has ended the quarter with a current ratio below 1.00, which means negative working capital. Last quarter, the current ratio could have been below 1, but the company issued a large amount of long-term debt, which pushed the cash balance up by $1 billion, and working capital up by $2.58 billion (total debt increased by $2.76 billion). As the company uses that money, especially for the $1.5 billion per quarter buyback we are expecting, you would figure that working capital will go negative again, and then they will issue more debt.
Why these ratios are important:
These ratios are important for a couple of reasons. First, when you look at the overall health of a company's balance sheet, you would like it to be strong. As I've shown above, some of the cigarette names don't always have the prettiest balance sheets, as they return a large amount of capital to shareholders. If you are looking for their balance sheets to be like Apple (AAPL), or for them to have no debt, you are in the wrong industry.
One of the most important aspects of these ratios is their implementation, and by that, I'm talking about credit ratings. A higher credit rating means lower risk. A lower credit rating means higher risk, and thus higher interest rates. I'm sure many people realize this, but here's a chart from a recent Bloomberg/Raymond James bond guide. The chart shows corporate bond spreads (above treasuries) for a few select industries. The chart compares names with higher "A" credit ratings with those of lower "BBB" ratings.
I discussed certain financial ratios because I'm not the only one looking at them. Rating agencies are as well. If some of these ratios continue to get worse, a ratings downgrade could follow. That could mean that instead of Philip Morris paying say 75 basis points more than a 10-year US Treasury, they may need to pay an extra 100 basis points, hypothetically. That may not seem like much, but when you are issuing $5 billion of new debt a year, you could be talking about extra interest payments in the tens of millions of dollars, depending on the maturities of your debt. Extra interest costs means less profits, less cash flow, and less for dividends and buybacks.
Rates are going higher:
Unfortunately for borrowers, of which Philip Morris is one, interest rates are going back up again. The Federal Reserve could start to taper some of its QE program in the next year, and people are starting to sell their US Treasuries. The chart below shows how the 30-Year US Bond yield has risen in the past year, and especially in recent weeks.
(Source: Yahoo! Finance)
Philip Morris will start to see higher interest rates for some of its debt, and it has to a small extent already. I gave a link above to the company's fixed income page, which I can use for reference. Last August, the company issued $750 million of 30-year bonds in the US. The coupon was 3.875%. On March 4th of this year, they issued $850 million of 30-year bonds in the US. The coupon was 4.125%, a difference of 25 basis points. Part of that probably is due to the extra $100 million that was raised. However, let's also look at some 10-year bond issues. Last August, a $750 million issue had a coupon of 2.500%. This March, a $600 million issue had a coupon of 2.625%. So they took out less money this time and still had to pay an extra 1/8th of a percentage point. Philip Morris did issue some Euro debt about 5 weeks ago, but there isn't a comparable debt issue for that one. It will be interesting to see the next set of rates when they issue some more 10 and 30-year debt. One thing is certain, rates are going up, and if there happens to be a ratings downgrade, it could be even worse.
Debt is good? Less shares, better EPS, but net income?
Adding some level of debt can be good. Investors obviously like share buybacks, because they help prop up the share price and boost earnings per share. Also, as many would argue, low interest rates make buybacks even better. If Philip Morris can borrow at 2% (ignore the tax benefit for a minute, but that could help even more), they can retire shares that pay roughly 4% a year in dividends. That can improve cash flow in a sense, as you don't have as much in dividend payments. It also helps the dividend over time, as the lower share count means you can pay out more to those shareholders.
But this buyback also can hide some issues. The chart below shows how the company's buyback has helped earnings per share in the past four Q1 quarters. The numbers below may not appear correct for net earnings (or net income). Philip Morris uses a separate net income value for its earnings per share figure. I won't go into all of the details, so if you want to see them, please check out Schedule 4. The net income and share columns are in millions, with EPS being actual.
From 2010 to 2013, Q1 net income rose by 24.72%, while the share count declined by 12.17%. This led to a 42% rise in earnings per share. However, you must remember my discussion regarding net income and cash flow. Earnings per share in Q1 2013 were up three cents from the 2012 period, but net income and operating cash flow declined. Buybacks are good for earnings per share, but they sometimes hide other issues. Investors should remember that just because earnings per share are rising, that does not mean net income and operating cash flow will be as well.
Looking down the road / final thoughts:
Again, I am not concerned with Philip Morris' financial health at the moment. A few people seemed to believe that was the case, which is why I wrote this article today. However, you cannot argue that some of the company's ratios are getting worse. The debt ratio and both EBITDA ratios are going the wrong way, and I hope that they can start to improve at some point.
My concern for Philip Morris relates to the market's concern for the Fed's QE program. With the printing presses at full blast, the market loves easy money. When it seemed as though the Fed could start to taper the QE program, the markets started to panic. Even if they go from $85 billion a month to $75 billion, the markets could pull back. The same is true of Philip Morris in my opinion. When they announced their new buyback plan last year, it began a new three year process for the company. $18 billion over three years meant $1.5 billion in buybacks per quarter, on average. My worry is that a weakening balance sheet, a high debt load, and perhaps higher rates, could affect this stock when that plan ends a few years down the road. How will investors react if the buyback decreases to say $1 billion per quarter? That's a drop of one third. Philip Morris has been a great investment because of the buyback, and in past articles I've shown how the stock has traded at a premium. Part of that premium is due to the lovely buyback, but a lower buyback in theory should mean a lower premium.
I also mentioned in my last article that I expected the dividend to be raised by 5 to 8 cents this year. Due to an excel error, my math was off originally, but a 5 to 8 cent raise this year represents a 5.88% to 9.41% raise in the dividend. Last year's raise was 10.39%, and the year before was 20.31%. The five year straight average, not using compounded or weighted averages, was 13.17%. I don't expect to see a dividend raise that high this year. Part of it has to do with the balance sheet. If Philip Morris slows down the growth of its dividend, investors won't like the stock as much. Remember, this name already has a much lower dividend yield than Altria, Reynolds, and Lorillard do.
So please, don't think that I am arguing Philip Morris is in financial trouble, or that I'm talking about the balance sheet as a huge negative. I'm really not, it's just a small concern I have at the moment. Philip Morris remains a solid buy in my opinion, but like I said in my intro, I'm just slightly less optimistic than I used to be when it comes to my longer-term outlook of this stock.
Additional disclosure: Investors are always reminded that before making any investment, you should do your own proper due diligence on any name directly or indirectly mentioned in this article. Investors should also consider seeking advice from a broker or financial adviser before making any investment decisions. Any material in this article should be considered general information, and not relied on as a formal investment recommendation.