Is The Market Overreacting To Philip Morris’ First Quarter Results?

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Philip Morris

Philip Morris International (NYSE:PM) reported its first quarter earnings on April 19, and saying investors weren’t quite pleased with the results would be an understatement. The shares of the company plunged 16% in the aftermath of the results announcement, its biggest one-day drop since 2008 when the company split from Altria. The decline has not let up till now, with the stock price falling from $101.44 on April 18 to $79.42 on June 8, a fall of roughly 22%. The main reason for all the negativity was the disappointing quarter for iQOS, its heat-not-burn device, which had been delivering heady growth up till Q4 2017. A seemingly plateauing market in Japan, the biggest market for iQOS, was the main cause for worry. However, the device’s tremendous growth potential globally needs to be considered, besides the fact that growth is still possible in Japan.

We have a $114 price estimate for Philip Morris, which is substantially higher than the current market price. The charts have been made using our new, interactive platform. You can click here to modify different drivers, and see their impact on the revenue, earnings, and price estimate for Philip Morris.

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What Happened In Japan In The First Quarter?

Shipment volume of HeatSticks in Japan had been curtailed up till the fourth quarter of last year as a result of capacity limitations. This restriction was lifted in the first quarter. However, the device’s sales growth was lower than the ambitious target that the company set for itself. So why did this happen? While a small blame can be attributed to the lack of awareness regarding the increased availability of iQOS, much of the liability rests on the fact that the company may have largely met the demand of the so-called “innovators” or “early adopters.”  Meanwhile, the more conservative consumers, especially those who are aged 50 years or more, are a more difficult segment to capture. These consumers represent a mammoth 40% of the total adult smoking population, and hence, the commercial plans, in terms of timing, intensity, and content of communication, needs to be looked into and altered, keeping this segment in mind.

HeatSticks have captured 15.8% of the national market share in the country, representing a growth of just 1.9 points versus the fourth quarter of last year, and lower than the 16.3% share disclosed in January at the CAGNY conference. On the other hand, what was probably overlooked is that in such a short time HeatSticks has already become the second largest tobacco brand in Japan, having a share that is nearly double that of Marlboro cigarettes. Moreover, iQOS is the undisputed heated tobacco segment leader, with an estimated 5.4 million consumers, representing around 76% of the category. Moreover, while the “innovators” may have been experimenting with other heat-not-burn devices in the market, less than 1% of them actually end up switching, which is quite impressive, given the premium positioning of PM’s device.

 

Is iQOS Really The Future?

When a cigarette combusts, it burns tobacco leaves to generate smoke, which contains nicotine, naturally found in tobacco, as well as many harmful chemicals. According to PM, it is these harmful chemicals, and not the nicotine, in cigarette smoke, which is the primary cause of smoking-related diseases. It is for this reason that the company is developing alternatives to cigarettes, products without the smoke, but with nicotine and taste that can satisfy the existing smokers. In a recent press release by the company, it was stated that the results of over 20 government reports and independent, peer-reviewed studies already published on PM’s smoke-free products are pretty much in-line with the company’s conclusions: iQOS generates significantly reduced levels of toxicants as compared to cigarette smoke.

According to WHO estimates, there will be over a billion smokers by 2025. With such a huge demand for tobacco products in the future, the presence of less harmful alternatives to cigarettes is essential. For this, not only do alternatives need to be developed, but they also must be appealing to consumers. A significant health benefit can only be achieved when a large number of smokers switch from cigarettes to such products. Currently, the cigarette alternatives available in the market have centered on liquid-based products that produce a vapor, and contain no tobacco. The lack of tobacco may not give the same experience as cigarettes that many consumers look for, and, in this regard, since iQOS uses tobacco, it may appeal to such users.

What Is Expected in 2018?

In its annual shareholder meeting, CEO Andre Calantzopolous stated that the market reaction to Philip Morris’ stock post the declaration of the Q1 results was “tantamount to assigning a zero – or even negative – value to iQOS and the entire reduced-risk product portfolio of PMI.” In fact, the CEO spent much of the shareholder meeting discussing iQOS and its RRP portfolio.

While iQOS was launched in late 2014 in Japan, by 2017, the RRP net revenues have already totaled $3.6 billion, and have started positively contributing to PMI’s total profit growth, notwithstanding the considerable sales and marketing expenditure undertaken on the product. Despite the blip in Q1, the company anticipates the sales of HeatSticks to more than double in volume in 2018, along with a substantial rise in its profit contribution, even though the company is expected to continue its sizeable investments. PM remains fairly certain that the product will grow in every market it has been launched in, including Japan. The company has also laid out its target for 2025 – achieving 30% of its volume from RRPs. This could potentially represent $17 to $19 billion of RRP net revenues, or 38% to 42% of total PMI net revenues. A promising factor for PM is that the switching rates for iQOS are pretty high, with full and predominant conversion usually ranging from around 70% to 90% across markets.

See Our Complete Analysis For Philip Morris International

 

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