Philip Morris' Earnings Face Headwinds From Anti-Tobacco Measures, Strengthening U.S. Dollar
Philip Morris International ( PM ) is set to report its third quarter earnings on October 17. We expect the results to be negatively impacted by lower volumes from Philippines where a sharp hike in indirect taxes implemented earlier this year has disrupted an otherwise flourishing tobacco industry. We also expect Philip Morris' earnings from the European Union to continue to be under pressure from the growing illegal trade of cigarettes and increasing consumption of cheaper tobacco alternatives. The company's performance in Russia where the new anti-tobacco law came into effect this June will also be interesting to note. Furthermore, the strengthening U.S. dollar against international currencies is also expected to dent the company's financial performance.
Philip Morris International is a leading international tobacco company with its products sold in more than 180 countries worldwide. Until its spin-off in March 2008, Philip Morris International was an operating company of Altria Group ( MO ). Excluding the U.S. and China, the company holds more than 28% of the total international cigarette market, led by its flagship brand Marlboro .
Our $87 price estimate for Philip Morris International is almost in line with the current market price.
Philippines To Dampen Growth From Asia
According to our estimates, Asian operations contribute almost 40% to Philip Morris' total value. Three markets - Indonesia, Philippines and Japan - make up almost 80% of the cigarettes shipped by Philip Morris to Asia. In 2012, almost one-third of total shipments were made to Indonesia, the fastest growing market in the region. This was followed by Philippines, which contributed another 22% last year. As mentioned in a previous article, the Philippines government implemented a 'sin tax' law this January, which resulted in an abrupt increase in indirect taxes on cigarettes. Following the sharp tax hike, the company increased prices of its Marlboro and Fortune brands by around 60% and 70%, respectively. As a result, Philip Morris recorded a 30% decline in cigarette shipments to the market during the first half of this year. The company expects its full year volume in Philippines to decline by 20-25%, in-line with our estimates. We expect lower shipment volumes in Philippines to continue to have an adverse impact on Philip Morris' earnings in the third quarter as well.
Volumes In European Union To Continue To Decline
Philip Morris' EU operations have been under pressure over the past few years due to the growing presence of illegally traded cigarettes in the region amid weak macroeconomic conditions and a difficult regulatory environment for tobacco products. Illegal cigarette trading is a huge concern for the local governments as well as cigarette manufacturers in the EU. Its growing prevalence has been exaggerating the decline in tax-paid cigarette consumption in the region. The tax-paid cigarette market has declined by ~20% in volume over the past five years while overall cigarette consumption in the EU has declined by ~17%. This is primarily because the volume of illegally traded cigarettes grew by 8% to 65 billion units over the same period. We estimate the number of illegally traded cigarettes by using our estimates for market share and shipment volume data and then apply the amount of illicit trade as estimated by the European Commission.
More importantly, the trend has worsened over the recent years due to excise tax hikes and high unemployment rates that are driving consumers towards cheaper cigarettes. As a result, cigarette manufacturers have been reporting sharp declines in shipment volumes. Philip Morris' shipment volume in the EU dipped by ~8% y-o-y for the first six months of this year despite being able to maintain its market leadership in the region.
Also many consumers in the EU have been shifting to lower priced other tobacco products (OTP) of late. In most countries, excise taxes on tobacco products other than cigarettes (cigars, cigarillos, fine-cut tobacco for hand-rolling cigarettes, pipe tobacco, snus, chewing tobacco and so on) are subject to much lower excise tax levels compared to manufactured cigarettes, which makes them relatively cheaper. During the first half of this year, Philip Morris' OTP shipments in cigarette equivalent units grew by ~5%, reflecting growth in overall market as well as market share. We expect these trends to continue in the third quarter as well.
Impact Of Russian Anti-Tobacco Law In Focus
The Russian anti-tobacco bill that was signed into a law on February 25, 2013, came into effect on June 1. The law primarily aims at lowering annual smoking-related casualties in Russia by half over the next decade by restricting the marketing and sale of cigarettes and smoking in public areas. According to the World Health Organization (WHO), a ban on public smoking is the second most effective tool for reducing smoking prevalence in any region after indirect taxes. It will therefore be interesting to note the impact of this recently implemented law on Philip Morris' third quarter earnings. (See: What's The Impact of Russia's Anti-Smoking Law On Philip Morris?)
Russia, where 40% of the population smokes, is the second largest market for cigarettes in the world by consumption volume. The market has been one of the key growth engines for Philip Morris International over the past few years. In 2012, Russia contributed around 30% of total cigarettes shipped by the company in the Eastern Europe, Middle East and Africa ( EEMA ) region. However, we expect market-wide cigarette volumes in Russia to decline over the next couple of years due to the new anti-tobacco law, which could have a direct impact on Philip Morris International's EEMA operations.
Currency Headwinds From Strengthening U.S. Dollar
Philip Morris sells cigarettes in more than 180 countries internationally. Since the company operates primarily in local currency in these markets, the strengthening U.S. dollar negatively impacts its financial results. Philip Morris' adjusted EPS declined by more than 5% during the second quarter, and the company has lowered its full year diluted EPS target range to $5.43-$5.53 against $5.17 last year as it now expects the full year negative impact of a stronger U.S. dollar to be at $0.31 per share. It should be noted that depreciation of a local currency against the U.S. dollar might also lead to higher relative prices of Philip Morris' brands in the local market, thereby weakening its competitive positioning as well.