Philip Morris International (NYSE:PM) announced its third quarter earnings on October 18. The global tobacco giant reported a weak quarter, although this was primarily due to a strengthening dollar relative to other currencies. Organic revenues for the quarter, which exclude the impact of currency movements and acquisitions, grew 3.4% y-o-y. Growth was driven by higher pricing in virtually all geographic regions but was partially offset by a major decline in shipment volumes in the EU. Overall volumes fell 1.3%.
Deteriorating situation in the European Union
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The EU has established itself as the company’s worst performing division over the past few years and is expected to remain that way going forward. This quarter was especially bad with quarterly revenues from the region declining over 15% y-o-y. After excluding the impact of currency and acquisitions, revenues fell 2%.
The company faces two major threats in Europe, which we believe will remain a problem. First, the persistent excise duty increases have forced consumers to switch to alternative products including fine-cut tobacco, which is cheaper as it is taxed at a lower rate, and illicit cigarettes, which are again cheaper as they are not taxed at all. Excise duties in the region currently stand at 69% of total revenues. We conservatively forecast this to remain relatively flat over the course of our forecast period.
Second, the deteriorating macroeconomic situation in the EU has led to a large number of consumers either switching to cheaper brands or cutting down consumption, which in turn have hurt the revenue mix and volumes respectively. Historically, Europe was market where the majority of consumers used premium brands such as Marlboro, but there now seems to be a shift in this trend.
Concerns in Russia
Another major concern for the company is the impact of tax amendments and anti-tobacco campaigns and regulations in Russia. The Kremlin has made it a priority to crack down on cigarette consumption in the country. The excise duty increase and tobacco ban proposals have yet to be reviewed by the Duma (they will be in November), but if they are approved, Philip Morris, along with other cigarette manufacturers, could witness substantial declines in revenue and income growth. 
Russia, the second largest cigarette market in the world after China, consumes over 390 billion cigarettes annually, accounting for 24% of total cigarette volumes in the EEMA. The EEMA division was the company’s strongest performer this quarter, and growth in the region was primarily driven by higher volumes and pricing in Russia.
Philip Morris has a market share of around 18% in the EEMA. We believe that a market size decline in Russia stemming from higher pricing to offset tax increases will have a major impact on Philip Morris’s revenues and income from the region going forward.
Growth from pricing unsustainable
As mentioned above, organic revenues grew 3.4% y-o-y. Pricing increases played a large part in the revenue growth. However, as is the case in the EU, pricing increases have a negative impact on volumes.
The company expects organic growth of its shipment volumes to be around 1% for the full year. This compares to volume growth of 1.7% in 2011 and 4.1% in 2010. A large portion of this volume growth decline stems from problems in Europe and a decline in overall consumption in Canada. Going forward, we believe that the company may face similar problems in the EEMA (due to Russia) and Asia (due to Australia) as well.
We will be updating our $89 price estimate for Philip Morris based on recent developments.Notes: