The Long and Short
A surprise deal out of Philip Morris
Meredith Contente | April 28, 2023
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
Philip Morris (PM) recently announced plans to tap the primary market for a second time in roughly two and a half months. The deal comes as a surprise after the company noted on its February earnings call that it would focus on deleveraging after the close of its Swedish Match acquisition in January. Proceeds of the new deal are earmarked for general corporate purposes, which may include debt repayment, capital expenditures or to fund its cash consideration payments to Altria (MO) with respect to the termination of the IQOS agreement.
A majority of proceeds look likely to be used to refinance upcoming debt maturities as PM has $1.75 billion of debt maturing through 2023. PM could also look to chip away at its $4.1 billion commercial paper balance. PM’s solid first quarter 2023 results put the company on track for a strong fiscal year, while free cash flow generation should cover both the dividend and debt reduction. With the company executing a tap of its deal issued in February, we see any pricing concession to secondaries as attractive. Furthermore, PM represents an attractive yield relative to other single-A consumer staple credits, particularly in tenors of 5 years or longer (Exhibit 1). Spread performance should benefit from both an improving credit profile and an increased percentage of its revenue base generated from smoke-free products.
Exhibit 1. PM Curve vs. Single-A Consumer Staple Curve
1Q Results Better Than Expected – Guidance Affirmed
PM noted that 1Q23 results came in better-than-expected as growth was largely driven by pricing actions. Adjusted net revenues were up 4.6%, driven by net pricing growth of 4.0%. Organic net revenue growth was a solid 3.2%, which management noted was impressive given that the company had posted 9.0% organic growth in the year-ago period. PM noted that 1Q was expected to be the weakest quarter of the year with respect to margins, largely related to supply chain and inflation headwinds coupled with inventory phasing. That said, the gross margin contracted 470bp year-over-year to 63%, while the adjusted operating income margin fell 630bp to 37.3%. However, management noted that they anticipate progressive margin improvement weighted towards 2H23 as headwinds subside. SG&A is expected to return to a level below the rate of net revenue growth for the remainder of 2023, which will support improvement in the adjusted operating income margin.
Management noted that the solid first quarter performance supports full year visibility. That said, PM continues to expect net revenue growth in the 7.0%-8.5% range. Net revenue growth will benefit from shipment volume growth of heated tobacco units (HTUs), as they carry higher revenue per unit versus combustibles. HTU volume growth is guided to be in the 125 billion – 130 billion range for 2023. Adjusted diluted EPS growth was reaffirmed in the 7%-9% range.
Leverage Should Improve Through 2023
PM ended 1Q23 with gross leverage of 3.5x and net leverage of 3.3x. We expect leverage to slightly tick up from this issuance but see management using its strong free cash flow generation to support debt reduction in addition to the dividend. With cash from operations reaffirmed to be in the $10 billion -$11 billion range in 2023, PM is on a path to generate over $9.0 billion in free cash flow this year. This would leave at least $1.0bn for debt reduction, after funding the dividend. Coupled with EBITDA estimates of approximately $15 billion, PM should end the year with net leverage of 2.9x, which is flat to year-end 2022. Management has noted that they would not repurchase any shares in 2023, as it is prioritizing both the dividend and debt reduction. PM has roughly two years form the close of the Swedish Match acquisition to delever. Moody’s expects PM to reduce leverage to the 2.5x area by year-end 2024, while S&P expects adjusted leverage to be comfortably below the 3.0x level over the same time period.
Smoke Free Transition Underway
PM is currently embarked on its biggest shift in its history as it transitions to a smoke-free company. At quarter end, roughly 35% of net revenues came from smoke-free products and its target is to increase that figure to at least 50% by 2025. PM is also aiming for at least $1bn in annual net revenues derived from wellness and healthcare products. While this transition is not risk-free, it is a better business model to support the longevity of PM. The Swedish Match acquisition will further help to increase its smoke-free revenue base and management noted that volume at Swedish Match was up over 10% in the quarter. Management plans to further accelerate their smoke-free share with the global roll-out of IQOS Iluma. IQOS has been successfully launched in over 70 international markets and PM is on track with its U.S. launch by 2Q24.