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Large debt-equity ratio can be a byproduct of share repurchases
Posted by: Chandan Dubey (IP Logged)
Date: February 4, 2012 03:49PM

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)201020092008
Short term borrowings(9)246(449)
LT debt (net)9472,8866,156
Repurchase common stock (net)(4,801)(5,448)(5,138)
Dividends paid(4,423)(4,327)(2,060)

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)00
Additional paid-in capital1,2251,403
Earnings reinvested in the business18,13315,358
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)14,71210,228
Total PMI stockholders’ equity3,5065,716
Non-controlling interests427429
Total stockholders’ equity3,9336,145

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 share2.183.263.94

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.

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Re Large debt-equity ratio can be a byproduct of share repurchases
Posted by: Praveen Chawla (IP Logged)
Date: February 4, 2012 04:47PM

Great - Many other companies are doing the same - CSCO, IBM, ORCL etc. come to mind so this is nothing new. Share buybacks when the companies shares are undervalued is a better and more tax efficient way to return capital to shareholders.

Regarding PM - I feel the shares are modestly over valued. Still it is high quality company with good cash return.

Risk is the ever present litigation risk. There is an ethical issue as well. The company makes an highly addictive substance which is the greatest killer of mankind. About 5 million people die every year because of smoking - more than all wars and famines combined.

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Re Large debt-equity ratio can be a byproduct of share repurchases
Posted by: cdubey (IP Logged)
Date: February 5, 2012 06:16AM

Thank you for the comments.

The point of the article is to dig deeper before rejecting a company based on decreasing book value per share or increasing debt-to-equity ratio.

Your additions are most welcome. It is addictive and a killer. But people know before they get into it. It is a highly charged issue and both sides have valid points.

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Re Large debt-equity ratio can be a byproduct of share repurchases
Posted by: batbeer2 (IP Logged)
Date: February 5, 2012 06:51AM

You make a good point. Companies with lots of franchise value can have negative equity.

I find it amazing that there are companies out there that are able to buy back shares at a premium to book AND STILL increase book value per share... WPO, MSFT, CSCO.

That's incredibly tough.

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Re Large debt-equity ratio can be a byproduct of share repurchases
Posted by: Praveen Chawla (IP Logged)
Date: February 5, 2012 04:15PM

High payout to shareholders and taking on leverage, while reducing tangible book value. It is a logical response by a company which makes a addictive / killer product and faces massive litigation risk. Basically give out all the money to shareholders (and management) and not leave anything on the books. PM is paying out 65% of its income on dividends and 35% of in share buy backs. Plus it is taking on debt to do more payouts.

If the plaintiff lawyers were ever to bring it down - they would find an empty shell. This it self will ensure the company's survival. Its worth more "alive" than "dead" - so in the end a deal will be done wherein the company will agree to settle with the governments and continue its business.

This is what happened with the original Phillip Morris - they did a deal and spun out Altria and Kraft. PM was then set free to wreck havoc on the world's population. The company is pure evil but has a simple but genius strategy.

Regarding your comment that people know what they are consuming is not entirely true. Most people start young - in their teens or early 20's, socially and due to peer influences. Once a person gets addicted (this takes less than a week of social smoking) - they have little choice in the matter. They have to smoke. Basically they have contracted a disease which is very tough to cure.
As a medical researcher I have found that smoking tobacco is more addictive than cocaine. This is because nicotine inhalation causes a physiological addiction as well as psychological addiction. Cocaine causes psychological addiction only.

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Re Large debt-equity ratio can be a byproduct of share repurchases
Posted by: chihin (IP Logged)
Date: February 6, 2012 06:36AM

Focus on a company's return on capital, i.e., taxed operating profit divided by shareholders' equity plus net debt. This gives you an indication of the company's underlying fundamental performance that is not affected by its choice of capital structure.

On this basis, PM's ROC has historically been higher than 30%, suggesting a very attractive underlying business. An even stronger case could be made if we consider tangible capital, i.e., adjust for goodwill and intangible assets.

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