While profits and losses are part of all investing and trading strategies, leverage and margin significantly increase the risk/reward of an investment over the short term and long term.
Phillip Morris International (PM) has been one of the strongest-performing dividend stocks in the market over the last several years.
I've written several bullish articles on Phillip Morris since the stock was in the mid-$80s. Still, I think the significant and recent deterioration of the EU economy will likely continue to challenge the company in the next year.
Philip Morris is in nearly every region of the world, but the company's biggest markets are Asia and Europe. It gets 40% of its revenues from Europe, and nearly 35% of its revenues from Asia. The company has revenues of around $30 billion a year, free cash flow of $9 billion, and long-term debt of $20 billion. The company's debt-to-equity ratio is over 300%, and management is using more than 100% of the company's free cash flow for dividends and buybacks.
To be sure, Phillip Morris does have strong coverage of interest rate payments at 13 times, and the company has been able to issue significant debt at very low rates. Still, there are some strong warning signs that the significant recent leverage the company has used may create problems longer term.
Phillip Morris has had tremendous recent growth in Asia. The Japanese earthquake and subsequent tsunami in 2011 prevented the company's biggest competitor in the Japanese market, Japan Tobacco (OTC:JAPAF), from being able to ship cigarettes within the country for nearly three months. Phillip Morris had cigarettes specially chartered in, and the company's strong market share gains in Japan and the Philippines enabled it to grow volume in Asia by over 20% last year.
Today the picture is much different. Japan Tobacco is a very well-run and innovative company, and as the world's third-largest tobacco company it has taken significant market share back from Phillip Morris in the last quarter. The company recently increased its market share in the Japanese market from 55% to 60% in the last six months. Japan and the Philippines are also considering significant raises on existing tobacco taxes.
Philip Morris' revenues in the EU dropped nearly 10% last quarter alone, and the company continues to see anemic growth in Latin America and North America. The company did report strong year-over-year growth in Eastern Europe, the Middle East, and Africa, but these are smaller markets for Philip Morris, and management also discussed how the year-over-year comparisons in these regions were misleading.
Europe has been weak for some time, but the significant deterioration in the EU has weighed heavily on this company. Germany's PMI also recently came in at a six-month low, and Spain's GDP was well below expectations. Philip Morris still gets nearly 30% of its revenues from the EU, and even companies such as Apple (AAPL) and McDonald's (MCD) have reported a significant recent slowdown in European consumer spending.
Philip Morris' heavy use of leverage has worked in the company's favor over the last several years. That's because the buyback added significant shareholder value as the stock rallied hard on the company's significant market share gains in Asia. The company's leverage also enabled management to consistently raise the dividend at a double-digit rate when many fixed-income investments offered minimal returns.
Still, leverage is double-edged sword. Philip Morris' buyback and dividend policy was great when the its revenues were growing at 10%-12% a year over the last several years. But if the company's growth stagnates and shares decline, the buyback will leave shareholders with significant debt and minimal returns. The company's aggressive buyback and significant debt will also limit possible dividend increases in the future if the company's growth continues to slow.
To conclude, Philip Morris has outperformed most of the broader indexes by fairly wide margins over the last several years, and the stock is up over 50% in the past year. Still, the company trades at 16 times an average estimate of next year's likely earnings, and the growth outlook in Asia and the EU has deteriorated significantly in the last quarter. The company's leverage boosted shareholder returns nicely in the last couple of years, but the company's significant long-term debt and decelerating growth may make future dividend increases very difficult when rates begin to rise.