Philip Morris Earnings Face Headwinds From Anti-Tobacco Laws

by Trefis Team
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Philip Morris International
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Quick Take

  • ‘Sin Tax’ law implemented in Philippines this year is expected to significantly drag Philip Morris’ volume growth from Asia
  • Australian Plain Packaging law is expected to have marginal impact on the company’s earnings
  • Russian Anti-Tobacco law expected to put further pressure on volumes during the later half of the year
  • Higher revenue per cigarette driven by lower volume growth and sharp price increases is expected to drive better operating margins

Philip Morris International (NYSE:PM) is set to report its first quarter earnings on April 18. One of the biggest factors driving Philip Morris’ success over the last five years has been its geographically diverse portfolio that has allowed the company to tap growth opportunities in the emerging markets, while it struggles to sustain volumes in the developed markets amid both, macroeconomic as well as industry-specific challenges.

However, the company has entered 2013 with vastly changed dynamics from the previous year. Firstly, on December 1, 2012, the Australian plain packaging law came into effect which requires standardized packaging for all the cigarettes with no branding. Secondly, the ‘sin tax’ law which was implemented in Philippines on January 1, 2013, sharply raising the indirect taxes on cigarettes. It is expected to drag volumes in Asia significantly. Lastly, Russia, the second largest cigarette market in the world, signed an anti-tobacco legislation into law which is scheduled to come into effect from June 1, 2013. Here, we’ll look into each of these stories in greater detail, while trying to assess their potential impact on the company’s business going forward.

See Our Full Analysis For Phillip Morris International

Philippines Set To Drag Shipment Volumes In Asia

Three markets make up more than 78% of cigarettes shipped by Philip Morris in Asia, namely Indonesia, Philippines and Japan. Almost one-third of shipments are made to the fastest growing market in the region, Indonesia. Then comes, Philippines, where the company delivered almost 22% of the total cigarette shipments made in Asia in 2012. As we mentioned in our earlier article, the ‘sin tax’ law, under which the Philippines government has abruptly increased taxes on cigarettes, effective January 1, 2013, and is expected to result in a sharp decline in the consumption of cigarettes in the country.

As a result, Philip Morris has increased prices of its Marlboro and Fortune brand by around 60% and 70% respectively. [1] Even a very conservative estimate of the price elasticity of demand for cigarettes (around 0.25) would imply over 16% shipment volume decline in the country during 2013. Under this scenario, Philippines is expected to result in around 4% y-o-y decline in Philip Morris’ total Asia cigarette volume. It should be noted that it is not just a one-time tax hike event as the law mandates further annual tax increases on cigarettes over the next four years, beyond which taxes will increase at a constant rate of 4% annually. In our opinion, this essentially implies one less growth engine for Philip Morris going forward, and the company’s Asia business will rely largely on its operations in Indonesia to drive future volume growth.

Australian Plain Packaging Law To Remain In Focus

In Australia, the historic Tobacco Plain Packaging Act became a law on December 1, 2011, and came into force exactly one year later. The law is designed to prevent cigarette manufacturers from glamorizing their brands through attractive packaging. However, Philip Morris has launched legal action against the Australian government related to some of the provisions of the law and has based its claims on the Bilateral Investment Treaty (BIT) between Hong Kong and Australia, one of the arguments being that the law is designed in a manner that expropriates its intellectual property. There is another case pending before the World Trade Organization (WTO) against the Australian government that has been initiated by three countries on the grounds that the subject law is contrary to the country’s obligations as a WTO member. While the actual results of these cases are not expected to be out anytime soon, what we would be focusing on primarily is the effectiveness of this particular legislation in terms of reducing the prevalence of cigarette consumption in Australia and the introduction of similar legislations in other countries.

In light of the pending legal challenges to the law form the tobacco industry, the New Zealand government deferred its decision to implement the law until the outstanding issues regarding it are resolved. Although, there have also been initial discussions on similar pieces of legislation in the UK, France and India, no official stance has been taken by any of these governments yet. (See More On This: More Trouble For Phillip Morris As New Zealand Introduces Plain Packaging Legislation) Based on the data collected from the Cancer Council resources and the company’s annual SEC filings, we estimate Australia’s contribution to the total volume shipped by Philip Morris in Asia to be around 3%. By that estimate, we expect to see only marginal impact of the new legislation on Philip Morris’ earnings.

Russian Anti-Tobacco Law Set To Thwart Volume Growth This Year

The Russian anti-tobacco bill was signed into a law on February 25, 2013. The law primarily aims at reducing annual smoking-related casualties in Russia by half over the next decade, by restricting the marketing and sale of cigarettes and their smoking in public areas. [2]

Russia, being the second largest cigarette market in the world by consumption volume, has been one of the key growth markets for Philip Morris International. In 2012, Russia contributed around 31% to the total cigarettes shipped by the company in the Eastern Europe, Middle East and Africa (EEMA) region. Helped by market share gains, Philip Morris’ 2012 shipment volume in Russia grew by 3.8%, while the total market volume declined by 1.3% y-o-y. However, after the implementation of the anti-tobacco law on June 1, 2013, we expect market volume to erode at a much faster pace (around 3% annually) over the next couple of years, which is also expected to translate into lower volume growth for Philip Morris International. (See More On This: What’s The Impact Of Russia’s Anti-Smoking law On Philip Morris?)

Overall, for the first quarter, we expect lower volume growth from Asia and higher consolidated revenue per cigarette backed by price increases, which is expected to drive better operating income margins with marginal impact on top tine growth. We currently have $86 price estimate for Philip Morris International, which is around 10% below its current market price.

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Notes:
  1. 2013 Consumer Analyst Group of Europe (CAGE) Conference, www.pmi.com []
  2. Russia Law Puts Limits On Smoking, www.wsj.com []
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