Recently, many Canadian provinces have initiated lawsuits against the large tobacco companies, apparently to recover healthcare costs that the provinces must pay to treat individuals with smoking-related illnesses at hospitals. There is little scientific doubt that smoking is not good for our health, yet many people still choose to smoke (or are addicted to smoking). This is relevant to accounting in two ways. First, since smoking is a tough habit to break, once the tobacco companies get you hooked they have a solid source of cash. Second, those tobacco/health lawsuits should have an impact on tobacco companies’ financial statements.
Whether you choose to smoke is not the point of this blog post. Rather, we should consider the business model behind tobacco companies. Take Phillip Morris International (PMI) as an example. From 2009 to 2011, PMI generated over $22B of net income and almost $28B of cash flow from operations. PMI has a gross profit ratio of over 25%, meaning that for every $1 of sales, the cigarettes cost PMI less than 75 cents. In fact, its overall profit margin is 11%. This means that every time someone pays $10 for a package of cigarettes (excluding taxes), $1.10 is pure profit for PMI.
What does PMI do with all this excess cash and net income that it generates? A quick look at its statement of cash flows suggests that virtually all of it gets returned to shareholders as dividends or share repurchases. In the past three years, nearly $30B has been returned to shareholders. No wonder some analysts are so keen on tobacco companies! Most mature, stable companies have similar cash flow patterns—positive cash flow from operations, negative cash flow for investing activities (as the company reinvests in its capital assets, etc.), and negative cash flow for financing (as it repays loans and pays dividends). The unusual thing about PMI is the scale of the cash flow and the fact that there is very little capital project investment, so the cash flow can all be returned to shareholders.
As Alberta, Quebec, and others have jumped on the litigation bandwagon to sue tobacco companies, I would have expected the financial statements of PMI to show substantial liabilities and provisions for potential payouts in case they lose the lawsuits. Given that many of the lawsuits are over $50 billion each, they are not immaterial. Surprisingly, virtually no lawsuit provision is shown on PMI’s balance sheet. There is plenty of disclosure in Note 21, but no actual liability has been recognized. Remembering that Note 21 is drafted by management and may be slightly biased, it explains clearly that PMI is confident that it will win virtually all the lawsuits out there based on its past performance. For the few it may lose, management claims that it is unable to estimate the amount of potential payment and therefore has not recorded anything. This article provides a quick summary of recent tobacco-related settlements. As you can see, some of the past settlements have been very significant—upwards of $100 billion. PMI did not have much equity at the end of 2011: merely $551 million. It wouldn’t take many unsuccessful (from PMI’s perspective) settlements to chip away at that equity very quickly.
Conclusion? While the machine is up and running, tobacco companies will likely generate a ton of cash and return it to their shareholders. When the gig is up and they start to lose their lawsuits, they won’t have any cash on hand anyway since they handed it all back to their shareholders. If you think that they’ve got a while before the gig is up and you can stomach owning tobacco stock, then you may do very well. I suspect that a tidal wave of unsuccessful settlements (from PMI’s perspective) is around the corner. Once it settles one suit, the tidal wave will break and the cash machine will collapse. It will be interesting to see if and when tobacco companies begin to record these likely settlements and how they disclose them in their financial statement notes. Let’s revisit this a year from now.
Note: this blog was originally posted on my site hosted by Pearson Education (http://php2.pearsoncanada.ca/highered/inthenews/accounting_in_the_news/)