Philip Morris International has a problem; debt. However, this is not a current issue. No, Philip Morris' debt is, at present, sustainable. However, it's the company's future that I'm worried about. Fortunately, the company's domestic peers, Altria Group and Reynolds American , do not appear to be in the same situation.
You see, Philip Morris has been borrowing more than it can afford in recent years. This is no secret, as the company recently came out and acknowledged this fact at the Morgan Stanley consumer goods conference last month.
As a result, after the completion of the company's current $18 billion share buyback, it will reduce its buybacks to a 'sustainable level.' Management stated that a 'sustainable level' was approximately the value of free cash flow after the deduction of dividends every year.
Unfortunately, this highlights a problem. If Philip Morris is planning on spending all of its free cash flow on buybacks, when will it be able to pay off its debt?
Of course, the company could just continually roll over its existing debt, never needing to pay it back. Nevertheless, as interest rates rise, so will the amount Philip Morris will have to pay to borrow, which will put even more of a strain on the company's finances.
According to data from market research company Morningstar, the majority of Philip Morris' debt matures before 2022. This indicates that the company will have to refinance a significant amount of debt while interest rates are going up, which is widely expected to be before 2022. For the most part, Philip Morris' debt maturing within the next 10 years has a fixed rate of interest below 4%. Overall, this implies that a 1% rise in interest rates is likely to push the company's average rate of interest up to 5%, assuming all other things remain equal.
So let's do the math. At present, Philip Morris has $27 billion in debt; a 1% rise in interest repayments would cost the company an additional $270 million a year...not small change even for the Marlboro man.
Why Philip Morris is facing higher interest rates, close peer Altria has been locking in low rates with its recent debt tender offer.
Locking in for longer
Altria recently put out a tender to redeem up to $2.1 billion in debt from holders. The debt in question carried interest rates of between 9.9% and 10.2%, which you can agree are extortionately high levels of interest for a company of Altria's size; especially with the Fed offering rates as low as 0.2%.
To fund this tender, Altria issued $1.4 billion of 4%, 10-year notes and $1.8 billion of 5.4% 30-year securities. In total this issue was worth $3.2 billion. However, my calculations reveal that the average interest rate for this debt will be approximately 4.8%, less than half the rate of the previous issue.
If we do the math here we can see that 10% interest on $2.1 billion is $210 million, and 4.8% of $3.2 billion is $154 million. So, Altria is paying 25% less to borrow 50% more.
This strategy is exactly the kind of refinancing operation Philip Morris needs to undertake, and it's something Reynolds American is also going to benefit from.
Reynolds has nearly $2 billion of debt, 20% of its total debt pile, maturing between now and 2019. What's more, some of this debt has a coupon of more than 7%. This level of interest is unnecessarily high for the company, as some of its longer, recent issues offer a fixed coupon of 3.2% to 4.7%.
This implies that the company can and should refinance at lower rates. If we assume rates don't rise more than 3% during the next five or so years, the company could be able to refinance some of its debt currently offering a +7% coupon with interest rates up to half of that.
In summary then, while Philip Morris' debt is not a problem as of yet, the management has acknowledged that if the company continues to borrow at its current rate, debt will get out of hand.
Unfortunately, this means that shareholders are going to have to get used to lower returns. That being said, both Altria and Reynolds American are locking in short-term interest rates, which should be beneficial in the long term for investors. Although it would appear that Philip Morris is going to be squeezed when interest rates rise.
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The article Philip Morris International Has a Problem originally appeared on Fool.com.
Fool contributor Rupert Hargreaves owns shares of Altria Group. The Motley Fool owns shares of Philip Morris International. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.