iQOS: Set To Drive Growth For Philip Morris In The Future

by Trefis Team
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Philip Morris International
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Philip Morris International (NYSE:PM) uses the term Reduced Risk Products (RRPs) to refer to products with the “potential to reduce individual risk and population harm in comparison to smoking cigarettes.” The company has a number of products in various stages of development and commercialization, with numerous scientific studies being carried out to determine whether the claims for reduced risks can be substantiated. The firm’s aim is to garner 10%-15% of its sales from its RRPs portfolio within a decade. The company is betting on one such product, iQOS — a black pen-shaped device that heats sticks containing tobacco, and feels it will become more popular than e-cigarettes sold by other companies. The company is also leveraging the popularity of the Marlboro brand by deploying Marlboro HeatSticks in iQOS. Based on the response to the device in the markets it has been launched in currently, it can be safe to assume that the product will be a driving factor for growth in the long term.

iQOS Impressive Sequential Performance Continues

Philip Morris’ heat-not-burn tobacco product, iQOS, has witnessed phenomenal growth in the markets it has been launched in. As of mid-October 2017, the product had been introduced in key cities in 31 markets globally, with 4 million adult consumers already switching to the device. In Japan, the company’s first launch market and the only country where a national roll-out has occurred, the brand’s market share has trended upwards, reaching 13.3% in October. 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. According to the latest data supplied by the company, the market share has already increased to 4.5%, a tremendous achievement considering the product was launched in the second quarter. Furthermore, the conversion rate has already reached 83%, far higher than the company average of between 70% and 80%. 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.

In a number of markets where iQOS has been launched, its growth has been curtailed as a result of production constraints. The company started the year with 15 billion units of installed annual HeatSticks capacity, and expected over 32 billion units in total capacity to be available for commercialization this year. The company anticipates an installed annual capacity of approximately 50 billion units by year-end, possibly rising to 60 billion units. Philip Morris is also implementing its plans to reach an installed annual capacity of 100 billion units by the end of 2018, which would translate to 75 billion units in total capacity available for commercialization.

In support of these decisions, the company is increasing its planned capital expenditure in 2017 to $1.6 billion, up from the $1.5 billion estimated earlier. In March, Philip Morris announced its decision to convert its cigarette factory in Greece to a heated tobacco unit production facility. This would entail an investment of €300 million, and would involve the manufacture of tobacco sticks used in iQOS, called Heets or HeatSticks. In June, the company also announced the building of a new manufacturing facility in Dresden, Germany, to produce Heets, which would require an investment of €320 million. Construction of this facility is set to begin in late 2017 and will be fully operational in early 2019. Besides this, the company is also investing €500 million in order to increase the production capacity in its Bologna facility, in Italy. This expansion is expected to be completed by late 2018.

Game-Changer For Philip Morris

Given the lower risk profile of these products, the company expects to enjoy a reduced tax rate on them as compared to traditional cigarettes. Moreover, many consumers would not believe the reduced health claims provided by Philip Morris for its own products. Hence, the key to establishing the credibility of these claims would come from some sort of government sanctioning. In this regard, the US FDA should respond to the application filed by PM in the next 3 to 6 months. Further, the German Risk Institute is also considering the assessment of iQOS, while the UK Government has asked the independent Committee on Toxicity to look at the data provided by PM. These should help in building awareness among smokers who are unable to quit and are looking for better alternatives.

According to the company’s research, the device yields on average, less than 10% of the harmful constituents found in cigarette smoke. However, despite the growing awareness and publicity with regards to vaporizers and e-cigarettes, this segment still remains an insignificant part of tobacco firms’ income. PMI also stated that its heat-not-burn category attained break-even status in the third quarter, and expects to generate net profitability from the category in Q4. The company is targeting 30 to 50 billion units in incremental volume through RRPs, which would add an additional OCI of $0.7 billion to $1.2 billion by 2020, with an increasing confidence of reach the upper end of the target range. According to a Wells Fargo analysis of the potential for the iQOS platform, the product has the potential for expanding the profit pool growth of combustible cigarettes and RRPs in the next decade by 400 basis points, to a 12.5% CAGR for Philip Morris. Further, it was also found that iQOS could displace up to 30% of the cigarette industry in developed markets by 2025, speeding up the premiumization of the market. This lends credence to the fact that iQOS could be a game-changer for Philip Morris in the years to come.

The first part of our series can be read here.

We have a $118 price estimate for Philip Morris, which is higher than the current market price. The chart above has been made using our new interactive platform.

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 in 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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