ValuePlays

This is a piggyback to a post two weeks ago about Phillip Morris International (PM) and their guidance for 2009.

In the post I was looking at the possible effect of the US Dollar on their results. Yesterday CFO Hermann Waldemer was in NYC and gave the following talk on the subject (slide presentation is at the end):

We expect our underlying business performance to add 33 to 48 cents to our EPS in 2009, representing a growth rate of 10 to 14%. This strong performance will regretfully be overshadowed by a significant currency hit. Our EPS guidance for 2009 is based on exchange rates prevailing in early February.

Making predictions about currencies is particularly difficult at present due to the huge volatility, which is illustrated by the fact that the adverse currency impact would have been 40 cents, or only half, at the exchange rates prevailing just a few weeks ago in mid December 2008.

The chart shows the evolution in the exchange rate of the Dollar against the Euro for the period 2007 through early 2009.

PMI benefited from a favorable currency situation during the first nine months of 2008. In September, the US Dollar started to strengthen significantly as it was perceived as a “safe haven” in turbulent financial times. As a result, there was an adverse currency impact from the Euro on our fourth quarter results.

After significant volatility in December, the US Dollar has once more strengthened in the wake of election optimism in the USA and weak economic data in the EU and stood at 1.28 in early February, when we established our EPS guidance.

Since the beginning of September, we have also witnessed a strong depreciation of many emerging market currencies against the US Dollar, the most notable being the 47% decline in the value of the Russian Ruble and the 74% decline in the value of the Ukrainian Hryvnia.

Many in the investment community have expressed surprise at the magnitude of the currency unfavorability that we have disclosed. Let me try to explain this impact in greater detail first by addressing our exposure by underlying currency. As we mentioned during our earnings call, the currencies in the key emerging markets of Mexico, Russia, Turkey and Ukraine account for 58 cents of the total foreseen adverse variance of 80 cents, while other emerging market currencies are 11 cents negative.
The decline in the Euro is expected to have an adverse impact of 13 cents and other developed market currencies another 16 cents. This is expected to be partially offset by a 15 cent positive impact from the Japanese Yen and a 3 cent positive impact generated by the conversion of our Swiss Franc costs into US Dollars at more favorable rates.

I would like to stress that the breakdown of the variance is based on underlying currencies and that this does not necessarily equate to the impact on individual market profitability. Let me elaborate further.

Currency, whether positive or adverse, has a straight line impact on net revenues. From our discussions, it appears that some models used outside PMI, which cannot replicate the underlying details of our business model, have sought to simplify the complex effect of currency movements by applying a similar rule to profitability. However, the relationship between currency and OCI is neither linear nor simple nor consistent across our wide range of markets. What happens is that the impact of favorable and unfavorable currency movements on OCI is also influenced by the extent to which there are elements in the cost structure that are not in local currency.
Let me use a theoretical example to illustrate this. Market X has net revenues of $2.0 billion, but faces a currency depreciation of 25%. The impact on net revenues will be a decline of $500 million or 25% to $1.5 billion. If all the costs were in local currency, they would also go down by 25% and OCI of $1.2 billion in this example would decline to $900 million.

However, if half the costs in this market were in US Dollars, be they leaf costs, direct materials or marketing expenses, then total costs in this market would decline not to $600 million but to $700 million. As a result, OCI would decline to $800 million, or by 33%, and the OCI margin would decrease from 60% to 53%.

The same effect would of course work in reverse in the event that the local currency appreciated.

To what extent can we directly protect ourselves against currency swings through hedging?

Let me reiterate that it is our policy never to carry out income hedges – or what we call “translation hedges”. Such hedges are purely speculative and would have a significant unpredictable impact on the company’s profitability. We at PMI run a solid and prudent business and therefore will not speculate on currencies.
However, we do seek to protect our business, where appropriate and feasible, through so-called “transaction hedges”. The two main examples are the hedging of the Japanese Yen on the sale of cigarettes to our affiliate in Japan and the hedging of the US Dollar on the purchase of tobacco leaf.

Opportunities for additional transaction hedges are however quite limited. They are generally not available at acceptable costs due to the large interest differentials and the applied volatility charges or simply non-existent in large quantities in our key emerging market currencies.

He then looked at how currencies can effect costs:

Let’s look at PMI’s cost structure.
In 2008, our total costs above the OCI line were $16.2 billon, of which $9.3 billion represented Costs of Goods Sold and $6.9 billion marketing, overheads and other expenses.

Tobacco leaf is the single largest component in our cost structure with $3.6 billion in 2008. In terms of currency denomination in our P&L, 26% of these costs are in US Dollars, 48% in Euros and 26% in other currencies.

PMI purchases tobacco leaf from a number of countries. The most important sources of leaf are Argentina, Brazil, Greece, Malawi, Turkey and the USA.

Tobacco leaf is fundamentally a US Dollar denominated agricultural crop. However, PMI converts a large part of its leaf purchases into Euros for inventory and balance sheet valuation purposes and this currency is subsequently used in transactions with local affiliates.

Direct materials account for $2.4 billion in costs. In terms of currency, 60% are in Euros, 26% in Dollars and 14% in other currencies.

Other elements of our Cost of Goods Sold total $3.3 billion with the majority of these costs being denominated in local currencies, which here would include part of the Euro total due to our large production volume in the EU.

Likewise our $6.9 billion in sales allowances, marketing expenditures, overheads and other expenses above the OCI level are predominantly accounted for in local currency, though with 12% the Swiss Franc is relatively important, reflecting the location of our operations center in Lausanne, Switzerland.

While this gives you the overall picture, it should be stressed that there are significant regional variations in the currency split of PMI’s costs, as illustrated here with the examples of Indonesia and Russia.

In Indonesia, 88% of our costs are in Rupiah, while in Russia only 39% of our costs are denominated in Rubles. This reflects the greater Dollar and Euro sourcing of leaf tobacco and direct materials in Russia. In Indonesia, we are able to include local tobacco in our cigarette production and cloves are sourced locally. In both countries, marketing and support function costs are predominantly accounted for in their respective local currency.

The Russian example also highlights the importance to PMI not only of movements of the Ruble against the Dollar but also the Ruble against the Euro.

Let me close this section on currency by highlighting the fact that the Japanese Yen is the only major currency which has appreciated in value since the beginning of 2008. All our other main currencies have moved in the same unfavorable direction, some with large declines, thus amplifying the adverse impact. History has generally shown that large currency swings tend to be at least partially reversed over time so we are optimistic that these strong currency headwinds will be temporary.

Here is the slide presentation:
Phillip Morris International 2/17/2009 Presentation

Disclosure (“none” means no position):Long PM

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