Philip Morris Posts Solid Earnings, but Future is Foggy

The maker of Marlboro and Virginia Slims reports strong earnings growth, but now faces a downturn in consumer spending.
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Updated from 9:20 a.m.

Philip Morris

(MO) - Get Report

is still considered a safe investment play -- but a downturn in consumer spending could be hazardous to its health.

On the face of it, the tobacco giant reported solid third-quarter earnings Thursday. The company posted net income of $4.36 billion, or $2.06 a share, up 87% from $2.33 billion, or $1.06 a share, a year ago. The results included a gain of $1.7 billion from its sale of Miller Brewing earlier in the year.

Yet in its upcoming quarter, the company expects to grapple with a weak economy, consumer frugality, an influx of illegally sold cigarettes and market-share growth of deep-discount cigarettes at the expense of the premium segment, the company said on its conference call with analysts.

"Historically, the mantra has been that tobacco is a defensive sector," said Robert Campagnino, an analyst at Prudential Securities. "But the old mantra might have to be rethought."

Since the $206 billion state tobacco settlement in 1998, Philip Morris has been forced to make a series of significant price increases that are now starting to hit the consumer where it hurts.

"If the economy were to continue to worsen, Philip Morris could be forced to increase promotional spending beyond what investors are thinking, in order to stem share losses it is seeing," said Campagnino.

Adding to Philip Morris' troubles was a recent California jury ruling that ordered the company to pay $28 billion to a woman with lung cancer for failing to warn her of the dangers of smoking. The company has appealed the verdict, and experts expect the penalty to be reduced dramatically.

"The decision is another data point on an already negative trend line," said Campagnino.

The company said Thursday that revenue fell 1.2% to $20 billion from $20.25 billion a year earlier. Underlying earnings, meanwhile, which exclude the Miller gain and other items, were $2.67 billion, or $1.26 a share, up from $2.57 billion, or $1.16 a share, a year ago, and in line with sharply reduced estimates.

In September, Philip Morris slashed its full-year outlook, as consumers abandoned its premium-priced brands for cheaper versions, forecasting 3% to 5% earnings growth instead of 9% to 11% growth. Nine out of 10 cigarette brands that the tobacco giant manufactures fall within the premium segment.

In the third quarter, Philip Morris had a slump in its U.S. cigarette unit, where earnings fell 3.7% to $1.5 billion, as lower volume and higher promotional spending were partially offset by higher pricing.

"The competitive environment continues to be very challenging," said the company's chief financial officer, Dinyar Devitre, on a conference call, noting domestic industry shipments were down 3.1% in the third quarter.

Domestic shipping volume decreased 6% to 49.4 billion units in the third quarter from a year earlier, as a result of volume growth of deep-discount cigarettes and sharp increases in state excise taxes.

Philip Morris managed to increase its domestic retail market share to 49.4% in September from a low of 49% in July. Elsewhere, earnings at the company's international tobacco division grew 8% to $1.6 billion, driven by higher pricing, lower costs and favorable currency of $11 million.

And earnings at

Kraft Foods

(KFT)

, in which Philip Morris owns an 84% stake, were up 73% in the third quarter.

Shares of Philip Morris were trading up $1.42, or 3.7%, at $40.04 in recent trading.