Philip Morris International (NYSE:PM) reported lower second quarter earnings this Thursday on declining cigarette volumes, currency headwinds and unfavorable volume mix. The company’s adjusted diluted earnings per share (EPS) declined 4.4% to $1.30 for the quarter. Lower shipment volumes in EU and Philippines put considerable pressure on the company’s earnings while unfavorable volume mix and strengthening U.S. dollar worsened the situation. Philip Morris also lowered its earnings guidance for the full year as the company increased its estimated unfavorable currency impact. Pricing strength, which comes from the popular brands marketed by the company will play a key role in future earnings growth as we expect Philip Morris’ operating conditions to remain challenging during the second half of the year as well. 
Lower Cigarette Volumes
Philip Morris’ second quarter cigarette shipments declined in all the operating regions of the company primarily driven by sharp cuts in the European Union (EU) and Philippines. Increasing excise taxes, high unemployment rates due to weak macroeconomic conditions, growing illegal trade of cigarettes and shifting consumer preferences towards other tobacco products are some of the key factors dragging down tax-paid cigarette consumption in the EU. Philip Morris’ shipment volume in the region dipped by ~6% y-o-y during the second quarter and by ~8% y-o-y for the first six months on these factors. We expect the company’s full year shipment volume to EU to decline by ~8% as we do not see these trends easing in the short term.
One-third of the total volume decline reported by Philip Morris for the second quarter can be attributed to Philippines where a sharp hike in indirect taxes implemented earlier this year has disrupted an otherwise flourishing tobacco industry. 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 more than 16% decline in cigarette shipments to the market during the second quarter. The company expects its full year volume in Philippines to decline by 20-25%, which is in line with our estimates. The Philippines is one of the key markets for Philip Morris as it contributed ~22% to the company’s shipments to Asia last year.
While we expect EU and Asia to remain light on volumes during the second half of the year as well, Russia, the world’s second largest market for cigarettes might further aggravate operating conditions for Philip Morris. 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 their smoking in public areas. According to the World Health Organization (WHO), the public smoking ban is the most effective tool for reducing smoking prevalence after indirect taxes.
Pricing Remains The Key
Tobacco companies are generally able to grow earnings despite lower volumes through pricing measures, as demand for cigarettes is relatively inelastic due to their addictive nature and consumer brand loyalties. However, we saw during the quarter that Philip Morris was able to only marginally grow its revenues net of excise taxes adjusted for currency fluctuations, which was more than offset by higher costs. As a result, the company’s adjusted operating income declined by 0.3% excluding the unfavorable impact of currency. The fact that higher relative prices resulted in unfavorable volume mix for the company in Japan and Philippines is not a good sign, as pricing strength holds the key to earnings growth in the tobacco industry. Since we expect shipment volumes to remain stressed during the second half of the year as well, Philip Morris will have to rely primarily on its pricing strength to meet the earnings target for the year. The company’s adjusted diluted EPS has declined by ~0.8% to $2.58 during the first six months.
Philip Morris sells cigarettes in more than 180 countries internationally. Since the company operates primarily in local currency in these markets, strengthening U.S. dollar negatively impacts its financial results. Philip Morris’ adjusted EPS declined by more than 5% due to stronger U.S. dollar during the second quarter. The company also lowered its full year diluted EPS target range to $5.43 to $5.53 against $5.17 last year as it now expects the full year negative impact of strengthening U.S. dollar to be at $0.31. It should be noted that depreciation of a local currency against 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.
We have updated our price estimate for Philip Morris to $87, which is almost in line with the current market price.Notes: