iQOS To Continue Its Phenomenal Run For Philip Morris In The Third Quarter

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Philip Morris International (NYSE:PM) is set to report its third quarter earnings on October 19, before the markets open. Earnings of $1.38 per share are expected in the quarter, a rise of 13 cents from the year ago period. Meanwhile, a revenue growth of over 10% is estimated, reaching $7.71 billion. Price increases are expected to drive the top-line growth, with a boost given by the increased sales of its reduced risk products (RRPs). This pricing power and the presence of such next-generation products are a moat for Philip Morris at a time when taxes on cigarettes are rising while the cigarette volumes are declining at a significant rate.

iQOS’ Impressive Sequential Performance To Carry On

Philip Morris’ heat-not-burn tobacco product iQOS has witnessed phenomenal growth in the markets it has been launched in. As of July 2017, the product had been introduced in key cities in 27 markets globally, following city launches in South Korea and the Czech Republic in the second quarter. By the end of the year, the company is targeting the product to be present in 30 to 35 markets globally, subject to capacity. In Japan, the company’s first launch market, and the only country where a national roll-out has occurred, the brand’s shipments increased by 37% on a sequential basis, to reach 5.7 billion units in the second quarter. The weekly offtake share also trended upwards by 3.1 points to 12.7% nationally.

One key market for the brand, besides Japan, seems to be Korea, where the company has been particularly impressed by the performance and has announced increased distribution in Seoul, as well as further expansion into four additional cities. While the company has not disclosed the conversion rates or cannibalization rates for the country as of now, the management did say that the reaction in the region has actually been better than what was experienced when they entered Japan. According to the latest data supplied by the company, the weekly offtake share in the region is already above 5%, a tremendous achievement considering the product was launched in the second quarter. Given the strong showing of the product at the time of the launch, it will not come as a surprise if the results from the region surpass that of Japan in the future.

Globally, already over 3 million people have converted to iQOS from cigarettes, and more than 8,000 are switching every day. The company’s reduced risk portfolio (RRPs) recorded net revenues of $615 million in Q2, 8.9% of the total revenue, and iQOS contributes to 22% of this revenue. However, its margins continue to remain negative as a result of the introductory discounts offered to accelerate switching among adult consumers.

Margin Pressure To Remain

The increased investment into the company’s reduced risk products has consequently resulted in a rise in the marketing, administration, and research costs of the company. This has, in turn, put pressure on the margins. Moreover, as mentioned earlier, the margins of iQOS remain in the red due to the high promotional activities being carried out to improve consumer awareness. These factors jointly have resulted in lower margins for Philip Morris in the second quarter — the gross profit margin fell by 80 basis points — while the operating margin declined by 210 basis points.

Currently, over 70% of the company’s R&D budget goes towards these “smoke-free” products. Furthermore, 30% of the marketing and sales budget is devoted to these products, even though they represent approximately 4% of PMI’s sales volume. Meanwhile, in markets where these products have been commercialized, they account for between 50% and 90% of the total marketing and sales expenditure. Philip Morris has also committed a further $1.7 billion to build additional manufacturing capacity for smoke-free products. Such efforts, while necessary, may result in reduced margins for a few quarters.

See Our Complete Analysis For Philip Morris International

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Notes:

1) The purpose of these analyses is to help readers focus on a few important things. We hope such communication sparks thinking and encourages readers to comment and ask questions on the comment section, or email content@trefis.com

2) Figures mentioned are approximate values to help our readers remember the key concepts more

intuitively. For precise figures, please refer to our complete analysis for Philip Morris International.
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