Let's See if Philip Morris' Growth Is for Real

Before you go, we thought you'd like these...
Before you go close icon

Philip Morris International (NYS: PM) carries $14.7 billion of goodwill and other intangibles on its balance sheet. Sometimes goodwill, especially when it's excessive, can foreshadow problems down the road. Could this be the case with Philip Morris?

Before we answer that, let's look at what could go wrong.

AOL blows up
In early 2002, AOL Time Warner was trading for $66.27 per share. It had $209 billion of assets on its balance sheet, and $128 billion of that was in the form of goodwill and other intangible assets. Goodwill is simply the difference between the price paid for a company during an acquisition and the net assets of the acquired company. The $128 billion of goodwill in this case was created when AOL and Time Warner merged in 2000.

The problem with inflating your net assets with goodwill is that it can -- being intangible, after all -- go away if the acquisition or merger doesn't create the amount of value that was expected. That's what happened in AOL Time Warner's case. It had to write off most of the goodwill over the next few months, and one year later that line item had shrunk to $37 billion. Investors punished the stock along the way, sending it down to $27.04 -- or nearly a 60% loss.

In his fine book It's Earnings That Count, Hewitt Heiserman explains the AOL situation and how two simple metrics can help minimize your risk of owning a company that may blow up like this. Let's see how Philip Morris holds up using his two metrics.

Intangible assets ratio
This ratio shows us the percentage of total assets made up by goodwill and other intangibles. Heiserman says he views anything over 20% as worrisome, "because management might be overpaying for the acquisition or acquisitions that gave rise to the goodwill."

Philip Morris has an intangible assets ratio of 40%.

This is well above Heiserman's threshold, and you should keep a close eye on just how the company is fueling its growth. It's also useful to compare it to tangible book value, which I explain below.

Tangible book value
Tangible book value is simply what remains after subtracting goodwill and other intangibles from shareholders' equity (also known as book value). If this is not a positive value, Heiserman advises you to run away because such companies may "lack the balance sheet muscle to protect themselves in a recession or from better-financed competitors."

Philip Morris' tangible book value is -$11 billion, giving us another yellow flag.

I asked Heiserman about the tendency for some large-cap blue chips -- names like Procter & Gamble, IBM, Philip Morris, and Altria -- to have a high intangible assets ratio and negative tangible book value. He says this can be OK, provided the company has (1) modest or no net debt, (2) persistent and rising levels of free cash flow, and (3) stock buybacks at a discount to intrinsic value.

Philip Morris fares well in all but its debt load. It's much the same through the cigarette industry, as the table below will show you. Given the outstanding history of these companies -- especially Altria, one of the greatest performers ever -- I give them the benefit of the doubt.

Foolish bottom line
To recap, here are Philip Morris' numbers, as well as a bonus look at a few other companies in its industry:

Company

Intangible Assets Ratio

Tangible Book Value (millions)

Philip Morris International40%($11,003)
Altria Group (NYS: MO) 47%($12,648)
Reynolds American (NYS: RAI) 67%($4,026)
Lorillard (NYS: LO) 0%($831)

Data provided by Capital IQ, a division of Standard & Poor's.

If you own Philip Morris International, or any other company that fails one of these checks, make sure you understand the business model and management's objectives. I'll help you keep a close eye on these ratios over the next few quarters by updating them soon after each earnings report.

At the time this article was published Fool analystRex Mooreowns shares of Procter & Gamble, but no other companies mentioned in this article. The Motley Fool owns shares of Altria Group, IBM and Philip Morris International.Motley Fool newsletter serviceshave recommended buying shares of Procter & Gamble and Philip Morris International.Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

Copyright © 1995 - 2011 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

Read Full Story

Want more news like this?

Sign up for Finance Report by AOL and get everything from business news to personal finance tips delivered directly to your inbox daily!

Subscribe to our other newsletters

Emails may offer personalized content or ads. Learn more. You may unsubscribe any time.

From Our Partners