Philip Morris’ Q3 Earnings Along Expected Lines

Philip Morris reported its Q3 earnings on October 16, more or less meeting general expectations. Earnings per share stood at $1.38 per quarter, 2 cents more than the analyst’s consensus estimate at Bloomberg Businessweek.  We had earlier reported on the likelihood of such a result, and the causes that may lead to it (See Philip Morris Q3 Earnings Preview). In this article we review the management’s commentary on the earnings and try to understand what it means for Philip Morris for the rest of the year. ^[1]

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Causes Of Earnings Decline

In our pre-earnings article we had identified unfavorable currency impacts and three other sources of costs that could bring the revenues down. The first of these are the investments that were to be made towards the commercialization of reduced risk products. The second of these costs related to the roll-out of Marlboro Red 2.0. The final source of increased costs were the expenses to be incurred in completing the shutdown of its factory in the Netherlands as part of optimizing its manufacturing infrastructure.

Going by the management’s presentation, unfavorable currency fluctuations took a chunk out the earnings and reduced it by 72 cents per share. This was due to the steady strengthening of the U.S. dollar versus other currencies, especially those of Europe. The dollar index, which measures the strength of the dollar against other major international currencies, saw the dollar strengthen by ~7.5% this quarter as its value went from 80 in July to over 86 in September. Since Philip Morris earns significant income in these international currencies, its earnings suffer when these currencies decline against the dollar.

The restructuring of its manufacturing network including closure of facilities in the Netherlands and Australia have also impacted earnings in a bad way. This is likely to be on account of the expensing of several associated costs. Asset impairment costs reflect the write-down of property, plant and equipment happening on account of the closure of factories and similar production facilities. The plant closed in the Netherlands was Philip Morris’ largest such facility in the world.

There are costs associated with shifting production from the Netherlands to the rest of Europe, and from Australia to South Korea. A decline in demand in these countries has precipitated this move. Then there are the costs associated with lay-off of employees and the benefits that have to be provided to them. Together, these costs described by the management as costs of optimizing their manufacturing footprint have taken 27 cents per share from the earnings.

Market dynamics in certain geographies also affected the earnings. For instance, Japan saw a reduction in both the market size for cigarettes as well as market share for Philip Morris. The market size reduction for cigarettes in Australia was made worse for Philip Morris by the consumer’s tendency to down-trade to more affordable varieties of cigarettes, especially those of its competitors. This was in response to an excise tax increase by the Australian Government. ^[2]

Outlook For Q4 2014

Philip Morris’ management expects a more challenging quarter ahead. Some of the costs we identified as potential sources of earnings decline in Q3, seem to have been partly postponed to Q4. The first among these is the cost involved in commercialization of reduced risk products. While a pilot plant for market study purposes has been built, the construction of a large scale facility for commercialization of these products is still ongoing. Together these facilities located near Bologna in Italy are expected to cost around €500 million.

This quarter will also see more of the costs associated with commercialization of the Marlboro Red 2.0 brand architecture. As part of the revamp of the brand identity, several product level changes had been introduced to this brand. Such changes include redesigned packs and filter. The commercial roll-out of these products and the associated marketing spends are expected to weigh on Q4 2014 earnings for Philip Morris. The manufacturing network restructuring costs that reduced earnings in Q3 are also expected to have a similar impact in Q4.

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1. PMI Third Quarter Earnings Result – PDF [↩]
2. PMI Third Quarter Earnings Result Presentation- PDF [↩]