Over the past few months, I've had a great discussion with investors when it comes to Philip Morris (PM). The cigarette giant is a value investor's dream, with a solid dividend and billions in share buybacks. I have been one of PM's biggest supporters on this site over the past two years, but a weakening balance sheet has been a small concern of mine. While I'm not saying Philip Morris is in any financial trouble, there are some numbers getting worse. Still though, I've been told by a number of investors that Philip Morris should take on more long-term debt to increase the buyback. Philip Morris is already buying back about $6 billion a year on their 3-year, $18 billion program. Today, I'll show why Philip Morris might not want to add additional long-term debt for buybacks, that is, on top of what they are already planning to do.
Balance sheet review:
Let's look at some numbers, and see what's going on at the moment. The first table I'll show provides some key balance sheet numbers for Philip Morris going back to the end of 2010. Dollar values in millions.
There may be some numbers that are a concern here. The first obviously would be the equity balance going from more than $5 billion to a negative $4 billion in just two years. Philip Morris for the past three quarters has had more total liabilities than assets. Now that you've gotten a high level look at the balance sheet, let's drill down a little further, specifically looking at cash and debt statistics over that time. I've highlighted this year's Q2 against the year ago period to show a year over year comparison. Again, dollar values in millions.
*Liabilities to assets ratio.
So over the past year, the cash balance has declined by about $260 million. That is despite the company taking on an additional roughly $4.7 billion in debt. With the added debt, plus cash balance decline, Philip Morris' net debt position has increased by more than $4.95 billion.
Is there a funding gap?
So what's going on here? Does something not seem right to you? Well, the fact that cash has declined with the addition of debt is something to look at in more detail. As you can most likely assume, the main culprits for this "issue" are the dividend and the buyback. On average, Philip Morris expects to buy back $6 billion a year under the 3-year plan I mentioned above (you might get a little more or a little less in some quarters). So that is $6 billion there. Then you have the dividend. Before the company's dividend raise, the dividend sat at $0.85 per quarter, or $3.40 per year. It's now been raised to $0.94 per quarter, or $3.76 per share, a very nice raise and one that was a little more than I expected. Looking at their most recent 10-Q filing, it appears that the company has about 1.62 billion shares outstanding. Let's call that 1.6 billion for now, because they are buying back stock. So at the old dividend ($3.40), 1.6 billion shares would cost them almost $5.5 billion in dividends per year. At the new rate, you're around $6 billion in dividends per year. So $6 billion in dividends and $6 billion in buybacks is about $12 billion a year to shareholders. That's really nice, and is why investors love the company.
But currently, cash flow numbers are not at the level needed to support this amount of capital returns. In 2011, the company reported free cash flow, after currency impacts, of $9.632 billion. But in 2012, they saw a huge decline in free cash flow to $8.517 billion. That's a decline of more than $1.1 billion. So far in 2013, the picture has not gotten any better. According to the company, free cash flow for the first six months of 2013 was $4 billion. In the first six months of 2012, it was $4.9 billion. So we're down almost another $1 billion in free cash flow during the first six months of the year, after being down more than a billion in 2012. To see all of the company's quarterly and yearly results, you can visit their earnings page here.
So what's my main point here? Well, the company's free cash flow is well below the current dividend and buyback rate right now. That's why you saw a decrease in the cash balance above, even though they took out a lot of debt. This is not an issue that will resolve itself in one or two quarters. The main takeaway is that the company will be adding more debt to fund the buyback and dividend in the near future. They did have almost $3.6 billion in cash on the balance sheet at the end of Q2, but you have to figure that they also want to have a "margin of safety". So I wouldn't be surprised if at some point during the remainder of 2013, more debt is coming. There was a dividend payment in July (during the current Q3), will be a dividend payment in early October, plus another one in January. The company also is expected to repurchase another $3 billion in stock during the second half of 2013. Again, my argument today is not about the current dividend or buyback. It's about adding more debt on top of this to expand the buyback. There's already a gap here.
Why long-term debt may not work here:
Interest rates are low, that's what everyone is telling me. That is true to a point, but what interest rate are you specifically talking about? I've heard a lot of people telling me that Philip Morris should issue long-term debt right now, because who cares about the company 30 years from now. They want the buyback, and they want it now. Well, issuing 30 year debt may not be the smartest move, and in this section, I'll attempt to explain why.
First, let's look at the last two issuances of both 10 and 30-year debt. The main point of my argument centers around 30-year bonds, but you have to see the whole picture. The following table shows the two issuances from August 2012 and March 2013 of both 10 and 30-year Philip Morris debt. I also threw in the benchmark (10 and 30 year US Treasury rates, respectively) trading range for that issue date, and the spread above treasuries (to the midpoint) that Philip Morris paid. Yes, I've rounded to the nearest basis point in one or two places. You can see all of their debt information here.
The first thing to look at is in regards to the 10-year issuances. While the benchmark rate edged up slightly, 3 basis points at the midpoint, Philip Morris paid 12.5 basis points more in March 2013, and that was for an issuance of 20% less debt. The spread widened, and that is not a surprise, given how I've shown above that the net debt position of this company is expanding. The more debt the company takes on, generally speaking, the more of a spread they'll have to pay. If their credit rating gets hit, the spread will go higher as well. It is very interesting to note the increase in rate despite the smaller dollar amount of debt issued.
So now onto the 30-year issues. Philip Morris paid an extra 25 basis points in March. That may not be too surprising, given the benchmark rose by approximately 12.5 basis points, plus they added another $100 million on. Again though, the spread widened a bit. Don't forget, the March issuance was before the Q1 2013 results. Philip Morris added even more debt on later in March, plus some in June. As far as I can tell, they have not issued any new debt since, but like I said above, it would not surprise me if they add more before the end of the year. It will be especially interesting to see what rates they pay with their next issue(s), but it also depends on the maturity.
So why does the math get difficult? Well, Philip Morris stock was yielding 4.46% on an annual basis last week, based on the raised dividend and the previous day's closing price. But with the stock's recent rally, the yield is down 30 basis points to 4.16%. That number is just above the last interest rate Philip Morris got on a 30-year debt issuance, 4.125%. However, since that March debt date, the 30-year US treasury rate has jumped by 70 basis points. Philip Morris has also taken on more debt since then, and balance sheet internals have gotten weaker. I detailed above how I already expect them to take on more debt either late this year or early next year to continue paying for the dividend and buyback. The more debt they take on, the more of a spread they probably will have to pay, and it will set them up for potential ratings downgrades.
So adding more 30-year debt on top of this to fund an increased buyback does not seem that great. For this deal to work for the company and shareholders, they'd have to have an after-tax rate less than the dividend rate. Is that possible on 30-year debt? Maybe, but it probably wouldn't be worth it. It would all depend on the spread and the tax rate you are using to offset the debt. Also, taking on this debt, and making the balance sheet even weaker, will make other debt issues carry even higher rates. So even if the company appears to be saving money on dividend payments from this one issue, the associated impact from higher expenses on other debt issues could easily turn this to a negative.
It's hard to speculate what interest rate would be appropriate here, but my best guess would be somewhere in the 5.00% to 5.50% range. Remember, the company has not issued more than $1 billion in US dollar debt since 2011, and at that point, paid almost a 70 basis point spread on 5-year notes. Since then, the balance sheet has gotten even more debt loaded, and long-term rates have gone up. Philip Morris' tax rate the past two years has been a little over 29% in each year. So if you use the 5.25% interest rate midpoint, and a 29.3% tax rate average, you'd get to an effective tax rate of 3.71%. With a dividend only 45 basis points north of there, the benefit is not fully there. The added debt would push up interest costs for the company, so every other debt issue they take out would see higher rates (primarily from the spread). A few basis points here, a few basis points there, and any potential money saved is gone in a flash.
For those that keep arguing Philip Morris should take on long-term debt to fund an additional buyback, please stop. The math just isn't there. Philip Morris at this point is giving their shareholders enough, expected to be about $12 billion in capital returns over the next year. The company does not have free cash flow anywhere near that level, so they will continue to take on additional debt for those reasons.
The idea that they should then come out and take out even more long-term debt to increase the buyback just doesn't fly. Rates have risen, and this company, due to their large debt pile already, pays a large spread to treasuries to begin with. Putting out debt with interest rates around or above 5% doesn't give the company a tremendous amount of cash flow savings from the dividend payment reductions. Those savings could easily be wiped out, thanks to the added interest expenses from other debt issues.
Right now, Philip Morris investors should be happy with the status quo. Take your $6 billion in annual buybacks plus $3.76 in annual dividends and appreciate them for what they are. Don't ask for more 30-year debt for buybacks, because the math just is not there. It could actually hurt the company more than it helps. If your argument is for short-term debt, that's another story, but please stop with the long-term debt for buyback calls.
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.