Philip Morris: Mixed Quarter Not Good Enough

| About: Philip Morris (PM)

On Thursday morning, cigarette giant Philip Morris (NYSE:PM) announced its fiscal third quarter results. The report was very mixed overall, with a number of both good and bad numbers. While results were not as terrible as the first half of this year, they weren't great either. Additionally, the balance sheet got worse, something that might become an increasing concern if the trend continues. Today, I'll break down the results, and discuss what it means for this stock.

Discussion of Q3 results:

Overall, the company reported net revenues of $7.927 billion, which was slightly below the $7.94 billion analysts were looking for. On the bottom line, the company reported earnings per share of $1.44, which came in a penny ahead of expectations. This will be a theme throughout the report, one item that was good and one that wasn't. The following table shows a margin analysis for Q3, compared against last year's period, which I'll use to further break down the results.

*Calculated before subtracting out earnings attributable to non-controlling interests.

For the quarter, net revenues after subtracting out excise taxes were up $7 million over the prior year period, basically flat. Cigarette shipment volumes were down by 5.7% to 223.1 billion units, and were down 4.1% if you exclude the Philippines. The company was able to use its pricing power to generate higher revenues. While it's good that they were able to get higher prices, you'd like to see some better volume numbers. Once that pricing power goes away, they will need a rebound in shipment volumes, and that may not happen.

Gross margins were down 40 basis points over the prior year period. While net revenues were up 0.09%, the cost of those revenues was up 1.32%. The company also saw a 2.74% rise in marketing, administration, and research costs, which was partially offset by a reduction in asset impairment and exit costs. Other operating expenses also came down, but operating margins declined slightly more than gross margins.

Further down the income statement, interest expenses rose by 13.27%. That is thanks to the company continuing to pile on debt, which I cover in more detail later. Philip Morris saw a much lower tax rate in the quarter, 28.38%, as opposed to 31.89% in the prior year period. The huge decrease in tax rate helped net earnings to rise by 3.36%, as opposed to pre-tax income which was down 1.70%. On an earnings per share front, Philip Morris produced $1.44, up from $1.32 in the prior year period. Earnings were helped by a lower share count and improved operations as well as tax items, offset by currency issues.

Overall, the company's quarter was mixed. It wasn't as terrible as the second quarter, but it wasn't great either. Shipment volumes were down big, and currency issues are still hurting. While the company was able to maintain pricing power, rising operating and interest expenses hurt pre-tax profits. The company benefited from tax items, which won't happen every quarter.

Guidance update:

When the company reported second quarter results, this was the 2013 forecast that was given:

  • PM revises, for prevailing exchange rates only, its 2013 full-year reported diluted earnings per share forecast to be in a range of $5.43 to $5.53, versus $5.17 in 2012.
  • Excluding an unfavorable currency impact, at prevailing exchange rates, of approximately $0.31 for the full-year 2013, reported diluted earnings per share are projected to increase by approximately 10-12% versus adjusted diluted earnings per share of $5.22 in 2012, as detailed in the attached Schedule 20.

There were some hopes by Philip Morris bulls that currency issues would start to turn during the third quarter. Well, that really didn't happen, as detailed by the current full year forecast that was handed in at Thursday's report:

  • PM revises its 2013 full-year reported diluted earnings per share forecast to be in a range of $5.35 to $5.40, versus $5.17 in 2012.
  • This forecast includes the unfavorable special tax item of $0.01 per share associated with the enactment of the American Taxpayer Relief Act of 2012 reported in the first quarter of 2013, an anticipated 2013 fourth-quarter charge, related to a previously announced organizational restructuring, of approximately $0.03 per share, and reflects a cautious outlook regarding certain markets.
  • Excluding an unfavorable currency impact, at prevailing exchange rates, of approximately $0.33 for the full-year 2013, and the aforementioned tax item and restructuring charge, reported diluted earnings per share are projected to increase by approximately 10% versus adjusted diluted earnings per share of $5.22 in 2012 as detailed in the attached Schedule 20.

So the unfavorable currency impact was hiked by another two cents, and the forecast includes a "cautious outlook regarding certain markets". Going into the third quarter report, analysts were looking for $5.43 in 2013 earnings. So even though the company beat by a penny in Q3, the forecast is a nickel or so light. That will mean more earnings estimate cuts for Philip Morris, something we've become all too accustomed to in the past two years. Remember, the company's original forecast for 2013 was for earnings per share of $5.68 to $5.78, based on a $0.06 negative currency impact. Their forecast has come down a lot since then. Additionally, the company maintained its business forecast, ex-currency, at the second quarter report, but it seems that it is being a little more cautious now.

Balance sheet update:

I've been criticized in the past for saying that Philip Morris' balance sheet is getting weaker, but you can't argue that fact. The real debate is whether or not you think this is a problem for the company. So far, it is not a big deal, but a balance sheet that gets worse by the quarter does become a bigger deal over time. The company has been very generous in its capital return plans, but it has been paying out more than it has produced in cash flow. That won't happen forever, and investors will need to realize that. The company's balance sheet got even weaker in Q3, as shown in the following table. Dollar values are in millions, and I've highlighted this year's period against the Q3 2012 period.

Click to enlarge

*Liabilities to assets ratio

The first thing you'll notice is that cash declined by a little more than $200 million in Q3, and about $1.435 billion over the past year. At the same time, total debt has risen by almost $4.4 billion. Thus, the company's net debt position has risen by $5.8 billion. That in itself is not a problem with rates being so low, although you saw how the extra interest expenses above hurt pre-tax earnings. The issue will be down the road. Interest rates are on the rise, meaning that when some of this debt comes due, the company will need to refinance at higher rates. Additionally, I've been stating that the buyback will probably slow down when the current plan ends in 2015. It's very strange that the word "debt" was not even mentioned once on the conference call.

Now, there are two charts that I want to show. The first one shows what's known in accounting circles as the debt ratio, which is also known as the liabilities to assets ratio. Philip Morris has seen its liabilities pile up while assets have come down. That means that the company has a negative equity balance, which is growing by the quarter. A debt ratio over 100% means a negative equity balance, because the company has more liabilities than assets.

At the end of Q3, Philip Morris had a debt ratio of 116.06%. That is up from 110.58% at the end of Q2 and 99.70% at the end of last year's Q3. That means that the company has $1.16 of liabilities for every dollar of assets. At the end of 2010, that ratio was around $0.85. Right now, the company is spending more on dividends and buybacks than it is producing in cash flow, meaning it is taking out extra debt to finance these programs. While that is shareholder friendly in the short term, lowering the share count and producing some cash flow savings (only if after-tax debt cost is lower than the dividend yield), it makes the long term health of this company worse.

The second chart I'll show compares both the total debt and net debt of Philip Morris to the trailing 12-month EBITDA figure. That EBITDA figure has come down by about $300 million in the past two quarters, and we know debt is rising. This has caused both ratios to soar. Also, this is not a ratio I am calculating on my own to be negative when it comes to Philip Morris. These two numbers are in every Philip Morris earnings report, so they are showing you how the balance sheet is getting worse. I'm just giving you the information they provide in a chart form.

The net debt ratio is the more important one to follow, as total debt is offset by the company's cash position. The net debt to EBITDA ratio rocketed higher to 1.62 at the end of Q3, from 1.52 at the end of Q2 and 1.22 at the end of last year's Q3. Again, this is a number provided by the company, and it is getting worse.

So what does this all mean? Well, for now, the company is paying back shareholders, and very well I might add. But they are adding debt to do it, debt above the cash flow they are producing. That might provide a benefit for now, although shares haven't exactly been on fire lately. Additionally, the added interest expenses will pressure margins and earnings, especially when you have revenues that are not rising. I am not arguing here that the company is in any sort of financial trouble, not by a long shot. I'm just showing how the balance sheet is getting weaker by the quarter. Down the road, unless the company really boosts its cash flow, it means that the buyback rate will probably be cut. Investors need to realize that, because it will have implications on other items, like earnings per share, and the fact that less shares will be bought back. Additionally, the company's credit rating could take a hit if a ratings agency believes the debt load is a problem.

Industry analysis:

It's been a couple of weeks now since I last discussed Philip Morris and where it stands in the cigarette space. As those who follow me know, I usually do an in-depth analysis of Philip Morris against Altria (NYSE:MO), Lorillard (NYSE:LO), and Reynolds American (NYSE:RAI) every few weeks. Because not all of these names have announced earnings yet, I won't do a full analysis here. I'll do a quick one, shown in the table below. The growth numbers below are expectations going into Thursday, so these numbers will obviously change as we get more earnings reports. For instance, the Philip Morris numbers have $5.43 as the analyst expectation for 2013 earnings, and we know that will come down.

The key takeaway here is that Philip Morris is currently in a slow growth period, and that certainly is backed up by the flat Q3 revenues, year over year. The company is not really growing right now, offers the lowest dividend yield, and costs you the most of these four stocks. For that reason, Philip Morris isn't that attractive against some of these other names, especially Lorillard. At this point, you could even make a solid argument for Altria, based on its highest dividend yield and the lowest valuation. Philip Morris has greatly underperformed these three names over the past year, as you can see in the chart below. Lorillard and Reynolds have led the way.

Click to enlarge

(Source: Yahoo Finance)

Final thoughts:

Philip Morris reported a very mixed quarter. Revenues missed slightly and were barely up over last year's period, while earnings beat by a penny. Stock buybacks and a lower tax rate certainly helped. The balance sheet continued to weaken, with another $1.5 billion in net debt added during the quarter. While the report was not bad, it wasn't great either. For that reason, this stock is likely to stay mostly range bound, and I don't think you'll see the yearly highs anytime soon. For Philip Morris to get back to $95 plus, this report was not good enough, and it was reflective of a stock currently trading at $87.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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.