Altria Group, Inc. held investor presentations in New York City on 11 March 2008, and in London on 18 March 2008, in connection with the spin-off of Philip Morris International Inc. Louis C. Camilleri, Chairman and Chief Executive Officer, Andre Calantzopoulos, Chief Operating Officer and Hermann Waldemer, Chief Financial Officer, gave presentations on growth strategies, capital structure, cost savings and productivity initiatives, opportunities and outlook for Philip Morris International, followed by a question-and-answer session.
March 11, 2008
Remarks by Hermann Waldemer
Let me start first with a review of the evolution of our reported operating income per thousand cigarettes. This has grown since 2003 from $8.42 to $10.44, representing a compound annual growth rate of 5.5%. Marlboro’s marginal contribution increased at an even more impressive rate of 9.5%. Moreover, during this period, in spite of our strong growth in lower margin emerging markets, our operating margin has increased slightly, reaching 40% on an adjusted basis in 2007.
How do we stand today in comparison with our peers? Our adjusted operating margin is some ten percentage points higher than that of BAT and Japan Tobacco. Once Imperial has integrated Altadis into its numbers, we will be best in class and going forward our goal is to widen the gap further versus our peers.
On the cost side, let’s compare hard numbers that are not influenced by allocations or accounting treatments and therefore look at total operating cost straight from the respective reported income statements of the four major international cigarette companies.
Despite our focus on higher cost premium brands, we are already today almost at par with Imperial in terms of average operating costs per thousand cigarettes. Japan Tobacco’s costs are 12% higher and BAT’s costs are 21% higher than our $16.40.
My next point of comparison is efficiency in manufacturing. PMI has the best manufacturing footprint in the industry with an average volume of 18 billion units per factory today. This compares to 13 billion units per factory for BAT and Imperial.
We have achieved this through our sourcing strategy and restructuring actions that have included investments to expand and improve key factories, particularly in Asia, Central and Eastern Europe and Turkey, the consolidation of production in the Czech Republic, the closure of our factory in Hungary and the closure of our leaf processing facility in Virginia. We are currently in the process of closing our Munich factory.
Our top ten factories produce 60% of our worldwide volume and our top five factories have a capacity equal to the entire volume of Imperial and Altadis combined. Our state-of-the-art Western European factories in Bergen-op-Zoom (Netherlands) and in Berlin focus on long production runs. Our four low-cost Central European EU factories absorb the more complex and shorter production runs. The average output in these four factories will increase to 31 billion cigarettes by 2010 compared to 12.5 billion cigarettes back in 2004.
We have generated significant productivity gains in manufacturing and are relentlessly continuing these efforts. In spite of the resourcing of 57 billion units from PM USA to PMI, which by itself will generate $179 million of annual cost savings by 2009, we expect to have reduced our fixed manufacturing headcount by 30% over the 2004 to 2010 period. This will drive a forecast 14% reduction in our fixed costs per thousand over the same time period.
Major efficiency improvements are being generated by the implementation of what we call the “Clustering Model”, whereby we group specific activities, such as operations planning, procurement and supply chain and product development, in selected factories. This model enables us to provide better brand support and increase speed to market, to foster synergies and best practices, to eliminate duplication and therefore reduce manufacturing costs.
Going forward, we see significant productivity savings from a new focus on eliminating non-strategic SKU’s that do not provide adequate returns. Our aim is not only to reduce the number of variants, but also to streamline product specifications, blends and non-tobacco materials. In addition to generating cost savings, we will thus reduce working capital requirements as well as capital expenditures on equipment.
Overall, the net cumulative effect of these manufacturing initiatives and savings by 2010 is expected to be approximately $850 million. We, however, anticipate some offsetting cost increases. We project leaf costs to cumulatively increase by $425 million and direct materials increases of $125 million, totaling $550 million over the same period.
One issue is the indirect local currency impact on the Dollar-denominated price of tobacco leaf. For example, the strengthening of the Brazilian Real had a negative impact of $56 million on our 2007 cost basis, which was not captured in our currency variance.
Let me now turn to our third area of focus: G&A and procurement, where we are increasing organizational effectiveness and will deliver further cost savings in three main areas.
First, we have eliminated some 400 positions in Switzerland and our regional headquarters in Hong Kong and New York and have transferred 100 positions back out to the markets for a net saving of 300 positions, in line with our decision to empower the markets with greater resources and more decision authority. Second, we have developed and deployed Shared Service Centers for our Finance, Human Resources and Procurement functions. Third, we have deployed a standardized and worldwide integrated SAP network, combined with established centers of expertise. Fourth, we will further optimize our selling and promotional expenses. These four initiatives are expected to generate cumulative savings of over $450 million over the next three years.
Finally, let me share with you our three-year cost strategy for the EU Region. This strategy includes specific spending and cost saving targets for the region and each individual market to substantially reduce our back office infrastructure. This strategy is expected to generate $250 million of cumulative cost savings over the next three years.
These combined initiatives are expected to generate gross savings of more than $1.5 billion and net savings of $1.0 billion, which will allow us to judiciously re-invest into the growth of our business, cover other cost increases and deliver robust earnings growth.
Let me now focus on capital structure, cash flow and shareholder return.
We will pursue prudent financial policies to secure solid investment grade ratings. We have obtained PMI’s credit ratings from the agencies. I am pleased to inform you that they are A2 / A / A+.
PMI has secured committed revolving and term credit facilities of $9.1 billion in total. Shortly after the spin-off is effective, we will start our US and European commercial paper programs. We also intend to term out a significant portion of our debt by accessing the global capital markets in 2008 and 2009.
PMI is generating outstanding cash flows. Our operating pro-forma cash flow was $5.4 billion in 2007 and it is expected to reach a cumulative total of about $22 billion over the next three years, representing an average annual increase of 10% to 12% a year, driven by higher net earnings and tight management of our working capital requirements. In addition, we expect capital expenditures going forward to match our depreciation and amortization.
This strong cash flow, supplemented by borrowings, will be used to fund dividends, share repurchases, acquisitions and other investments in the business.
Our dividend policy anticipates a pay-out ratio of 65%. The initial quarterly dividend rate has been set at $0.46 per share.
The Board of Directors authorized in January a share repurchase program of $13 billion over two years.
As a result, in total, we expect to return approximately $21 billion to our shareholders over the next 2 years.
This brings me to one of the key areas that deserves repetition: our financial and volume growth expectations.
As announced in January this year, we project 2008 diluted earnings per share to grow by approximately 12% to 14% at the then prevailing exchange rates from a 2007 pro-forma adjusted base of $2.78. It is still early in the year, but if exchange rates stay were they are now, our EPS growth rate could well exceed our guidance by up to two percentage points. However, it would be imprudent to call this now and we will revise our guidance if necessary as the year unfolds.
Based on our strengths, our strategies and our assessment of the improving business environment going forward, we expect to achieve the following longer term growth rates:
- Revenue growth, net of excise taxes, of 4% to 6% a year on average with cigarette shipment volume increasing 1% to 2% a year;
- Operating income growth of 6% to 8% a year on average; and
- EPS growth in the range of 10% to 12% a year on average.
We strongly believe that these are realistic and achievable targets. I would nevertheless like to outline some of the potential upsides and downsides that go along with this outlook.
Exchange rates can have a substantial impact and, of course, are hard to predict. For example, every one Euro cent movement up or down has an impact of approximately $20 million on our OCI at today’s rates.
Potential threats or downside risks include:
- Temporary market disruption from an unexpectedly large excise tax increase, though we believe most governments have understood that more moderate excise tax increases promote market stability and revenue generation;
- More aggressive price competition; and
- Higher than expected raw material costs, particularly for tobacco leaf. As I mentioned earlier, we have built in $425 million in higher leaf costs in our forecasts.
We believe that these risks are balanced by a number of potential opportunities or upsides:
- First, margins could be enhanced by a more favorable pricing environment, faster than expected consumer uptrading in emerging markets or greater than expected productivity savings;
- Second, there remain a number of markets, where we have little or no presence, the largest of which are China and India; and
- Third, we see a number of attractive acquisition targets around the world.
Let me conclude by reiterating the key reasons why we believe that Philip Morris International represents a compelling investment:
- We are the global leader and have the greatest scale.
- We lead by every measure, be it volume, revenue, profitability or market presence.
- We have achieved an excellent geographic balance between mature and emerging markets, with clear opportunities for further profit expansion in the former and profit and volume expansion in the latter.
- We have a world class brand portfolio, led by the only truly global brand, Marlboro, and containing a total of seven of the top 15 international brands.
- With 15.6% of the world market, PMI has significant opportunities for further volume expansion, which will be driven by innovation, consumer uptrading to our leading premium brands in emerging markets and geographic expansion.
- I have described for you our productivity initiatives that we expect to drive net cost reductions of $1.0 billion by 2010.
- Our tremendous cash flow is forecast to reach around $22 billion over the next three years.
- We plan to return some $21 billion in cash to our shareholders over the next two years.
- And we expect to achieve 10% to 12% longer term growth in earnings per share, which we believe will measure up well not only against our tobacco peers but against other leading global consumer packaged goods companies.
Ladies and gentlemen, thank you for your interest in our company.
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