Philip Morris Q3 Earnings Preview: Innovations Could Aid Revenues Even As Currency Headwinds Persist

Global tobacco house, Philip Morris International (NYSE:PM), is set to report fiscal third quarter earnings on October 15. In spite of disturbances across a number of mature and emerging markets, the company managed to post strong results in the first two quarters, with revenues growing 9.1% and 4.5%, respectively, on a currency neutral basis. We expect this trend to continue even in Q3. Here is an overview of what could play out in favor of Philip Morris, and what could threaten prospects.

Major Markets And Company Prospects

Since Philip Morris has diversified operations, developments in key markets are vital to the company’s performance. Here is a snapshot of the factors that could influence Philip Morris’ performance in the quarter.

— European Union (EU): Although the region witnessed industry volume declines in Q2, Philip Morris managed to stand its ground through share gains. This was particularly aided by key brands such as Marlboro, L&M, and Chesterfield. Going into Q3, the region could benefit from a slow down in industry decline as consumers move away from illicit products in the region. In fact, this, combined with microeconomic factors, could actually lead to a smaller degree of industry decline even in the full year. This slow down in industry decline rates, coupled with share gains through a strong brand portfolio, could aid segment sales for the company in the quarter and the full year.

— Eastern Europe, Middle East and Africa (EEMA): Russia, the biggest market in EEMA, faced trouble last quarter as industry volumes underwent a 6.5% decline on a year-on-year basis. Q2 was possibly a troubled quarter for Russia, with the economy shrinking 4.6% (a six year low). However, economists predict that the Russian economy may have hit the trough and the subsequent quarters could start showing signs of reversal. In this case, sales from the region for Philip Morris could actually start seeing improvements. Apart from this, Philip Morris managed to resist losses last quarter through share gains of key brands such as Parliament and Bond Street. Even in Q3, segment volumes could be safeguarded to an extent through share gains of key brands.

— Asia: Key markets in Asia that were previously growing also underwent industry volume declines in Q2. Last quarter, a number of markets such as Indonesia, Korea, and the Philippines saw declining market size, which was partially offset by volume increases in Japan due to favorable net trade inventory movements.  However, Philip Morris managed to stand its ground in the region against share gains, which was primarily driven by innovations. This includes new launches in the “machine-made full-flavor kretek” segment in Indonesia, and launches in the menthol segment in Japan. Going into Q3, these innovations could drive segment performance for the company.

What Could Be The Key Performance Driver In Q3? 

Given that many economies, developed and developing, are currently facing tough economic situations, we expect industry volumes in key markets to continue following the declining trend that it has exhibited in the last quarter. However, what could be of significance when it comes to securing volumes, could be innovations.

The fiscal third quarter could benefit from Marlboro 2.0, which is essentially a brand extension with improved packaging, filter, and blend. While Q2 saw a 0.3 share point increase in light of the product, Q3 could benefit even more since the brand has now been extended to 20 new markets, predominantly in the EEMA region. By the end of the year, Philip Morris expects to expand the product to 100 markets, which could guarantee share gains for the company going forward.

Apart from Marlboro 2.0, the company has also been innovating in the growing Reduced-Risk Product (RRP) space. This includes the launch of the iQOS, a type of smokeless cigarette. After the success of the pilot launch in 2014, Philip Morris is expected to be extending the product across Japan, Italy, and Switzerland. Philip Morris has also directed funds to further improve the appearance, texture, and functionality of the product, which could create appeal among customers.

A Note On Costs And Currency

While innovations could drive revenues in Q3 and ahead, Philip Morris’ prospects could be threatened by higher costs and currency headwinds, apart from economic turmoil in a number of markets. Q3 could see an increase in costs for Philip Morris, which could be associated with the new launches itself — particularly in distribution, branding, and marketing of the products. Apart from this, Philip Morris has indicated a 1% increase in costs in light of productivity and cost savings, which entails “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.” However, the costs incurred at this stage could, in fact, improve prospects for Philip Morris in the future.

Apart from this, there are currency related issues. Since Philip Morris functions in different geographical areas, the recent strengthening of the dollar has proved to be a drag on the company’s results over the last few quarters. This is essentially because a strong dollar implies fewer number of dollars in exchange for the local currency in which sales happen. Since there has been no sign of the dollar easing in the last quarter, Philip Morris’ results in Q3 could continue to see the impact of adverse currency movements. Furthermore, since the Federal Reserve recently resisted an interest rate hike, the dollar strength could increase in the near future as investors move funds towards the dollar in anticipation of the hike.

In conclusion, although Philip Morris could face challenges, both at the micro and macro levels, the company could see positive results against share gains and price hikes. The company’s share in a number of key markets could see an increase in light of innovations, in addition to strong sales of a number of key brands. However, currency related headwinds could continue to drag down results even in this quarter.

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 post the earnings release.

See Our Complete Analysis For Philip Morris International

Sources:

1. Philip Morris International (PM) Q2 2015 Results – Earnings Call Transcript
2. Russia Economic Outlook, Focus Economics
3. Philip Morris International Form 10-K, SEC
4. Philip Morris International Form 10-Q, SEC

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