I have been looking at Philip Morris (PM) from quite some time. It looks like a fabulous investment. Strong brands, addictive (moat) and has a very good management. The FCF during 2003-2010 has gone from $4 billion to $10.3 billion. With a market cap of $134 billion (share price $76), it does not look terribly expensive on a DCF valuation either.
But the problem had always been the debt-to-equity ratio which now stands at slightly more than 6 (with $12.87 billion LT debt and $2.44 billion equity). I had looked at the morningstar data before and never dug deeper because this ratio was too high for me. In this article, I will try to explain why this was terribly stupid of me to not dig deeper in this particular case.
I have been reading a barrage of recommendations for Philip Morris (PM). So, I decided to look a bit deeper. I found something very interesting. Here is the figures from the cash flow statement of PM.
|Item (cash flow)||2010||2009||2008|
|Short term borrowings||(9)||246||(449)|
|LT debt (net)||947||2,886||6,156|
|Repurchase common stock (net)||(4,801)||(5,448)||(5,138)|
Here is the equity part of PM’s balance sheet.
|Common stock, no par value (2,109,316,331 shares issued in 2010 and 2009)||0||0|
|Additional paid-in capital||1,225||1,403|
|Earnings reinvested in the business||18,133||15,358|
|Accumulated other comprehensive losses||(1,140)||(817)|
|Less: cost of repurchased stock (307,532,841 and 222,151,828 shares in 2010 and 2009, respectively)||14,712||10,228|
|Total PMI stockholders’ equity||3,506||5,716|
|Total stockholders’ equity||3,933||6,145|
And here we see the culprit for the high debt-to-equity ratio of PM, the share buybacks.
This was a light-bulb-on-the-head kind of discovery for me. I will explain it here.
We know the basic equation for the balance sheet.
book value=(equity-non-controlling interest)/(no. of shares outstanding)
Now, let us see what happens when a company buys back shares. Let us suppose that the company bought back $100 million worth of shares. This money goes out of the assets of the company. How do we account for this on the right side of the equation ? Well, this money goes out of the equity. And we get lower equity and lower book value. Not surprisingly if we look at the book value per share of PM we have the following data
|Book value per share||2.18||3.26||3.94|
So, here are the lessons to learn
- Share buyback reduces the book value per share and reduces equity hence increasing the debt-to-equity ratio.
- For companies doing share repurchases the decrease in book value per share is not a warning sign, the same goes for large debt-to-equity ratio. One needs to be careful when rejecting such companies using a screener or a black box method of not choosing companies with large debt-to-equity ratio and decreasing book value per share.