Philip Morris Earnings Review: Strong Q2 Results Although Currency Headwinds Persist

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Global tobacco giant, Philip Morris International (NYSE:PM), reported Q2 2015 earnings on July 16. Post a stellar currency neutral performance in Q1, the company raised their full year EPS forecasts by $0.05, and Q2 did not disappoint. In the quarter, net revenues increased 4.5%, with operating income increasing 6.1% on a currency neutral basis. [1] In spite of declining overall industry volumes, Philip Morris saw flat or very marginal declines in year-on-year volumes against share gains in a number of key markets across Asia, EEMA,  Latin America, and Canada. In this case, Philip Morris may be well on its way to achieve its new guidance figures. Here are the key take aways from the company’s second quarter earnings and what may be in store for the rest of the year.

Top Insights From Key Markets

European Union (EU): Although the region experienced overall volume declines, Philip Morris’ market share remained stable at 40.4%, with key brands (Marlboro, L&M, and Chesterfield) gaining share. The company used strong pricing to offset declining volumes, which led them to achieve a 4.9% increase in operating income excluding currency and acquisitions.

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Eastern Europe, Middle East and Africa (EEMA): Russia, the biggest market in EEMA, faced trouble as industry volumes underwent a 6.5% decline on a year-on-year basis. Furthermore, as the economy continues to remain sluggish, Russians have been trading down to less expensive options. Even against these circumstances, Philip Morris managed to deliver strong performance against share gains, driven by Parliament in the premium, and Bond Street in the value segments. Philip Morris also benefited from wider distribution in the Eastern part, which helped drive a 1.7% volume increase over the first half of the year.

Asia: Key markets in Asia that were previously growing also underwent volume declines in the quarter. For instance, Indonesia saw a 4.6% decline in industry volumes in the quarter. In spite of this, Philip Morris managed to secure share gains of 0.5 points against new launches in the fast growing “machine-made full-flavor kretek” realm. In the Philippines, although prevalence of smoking remained constant in the quarter, daily consumption took a hit against higher prices particularly in brands at the lower end. However, this hit was not sequentially worse than what was observed in Q1, indicating that  smokers may be getting accustomed to the new price points. Although, Philip Morris faced modest declines in share in markets like the Philippines and Japan in the quarter, they remain optimistic on brands such as Marlboro that has continued to perform well to secure shares going forward.

What Could Work Going Forward? 

At a time when overall industry volumes for cigarettes have been declining, Philip Morris has managed to deliver promising results predominantly driven by share gains and stronger pricing. However, the company continues to have one more tool up its sleeve, which could help the company secure both volumes and share — Innovation. Here are the top product launches and plans for the company going forward.

Marlboro 2.0: The quarter has benefited from the strong performance of Marlboro, which experienced a 0.3 share point increase. This gain in share was particularly aided by Marlboro 2.0, a brand extension with new pack design, filter, and blend. In Q2, the product was expanded into another 20 markets, particularly in EEMA. Going forward, this brand could help Philip Morris gain shares especially as the company expects to expand the brand to close to 100 markets by the year end.

Reduced-Risk Products (RRP): Apart from cigarettes, Philip Morris has been dabbling in the growing RRP segment. This includes the launch of the iQOS, a type of smokeless cigarette, in Nagoya and Milan in 2014. Owing to the success of the pilot launch of the product, Philip Morris will be seen expanding the product, with a national roll-out in Japan, launch in other cities in Italy, and in Switzerland. Furthermore, the rollout will include a modified version of iQOS, which includes more colors, textures, and improved functionality, to create better appeal among consumers.

A Note On Associated Costs

Given that Philip Morris has been dabbling in new product launches and dealing with market specific risks, they could be incurring costs in relation to this, as well. For instance, in Indonesia, Philip Morris has directed significant resources from the production of hand-made to machine-made kretek cigarettes, which have had an impact on Asia segment costs to contribute to an approximate 11% decline in operating income. Furthermore, the company expects to incur additional expenditure in relation to the expansion of iQOS to additional markets, with respect to branding and marketing the product. However, these costs could be one-time costs that might go on to improve prospects for the tobacco house going forward. Furthermore, excluding RRP related expenses, Philip Morris anticipates costs to increase about 1% when it takes account of its productivity and cost savings initiatives that broadly includes, “continued enhancement of production processes, the harmonization of tobacco blends, the streamlining of product specifications and number of brand variants, supply chain improvements, and overall spending efficiency across the company.” [2]

Currency Headwinds Persist But Fundamentals Seem Strong

In spite of strong results, currency headwinds continued to weigh in, eliciting an adverse impact of $1.6 billion on free cash flows in the first half of the year. Although the composition changed in Q2, with positive developments on the euro being offset by negative movements in the Russian Ruble, the dollar still continued to remain strong. However, for now, Philip Morris has been delivering strong currency neutral results, which shows strength in the crux of the business.

We have a price estimate for Philip Morris’ stock price of around $81, which is lower than the current market price. We will be revising our price estimate in light of the recent earnings release.

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Notes:
  1. Philip Morris International (PM) Q2 2015 Results – Earnings Call Transcript []
  2. Philip Morris International – Second Quarter Earnings Results []