Can Philip Morris Improve iQOS’ Performance This Year?

Philip Morris International (NYSE:PM) cut its earnings guidance earlier this year from $5.15 to $5.30 per share to $5.02 to $5.12, significantly lower than the $5.22 per share we had expected. While foreign currency translations are expected to be a $0.07 per share headwind, as opposed to a 6 cent benefit anticipated earlier, a combination of a lower than projected tax rate and better performance of the cigarette business should have offset some of the negative currency impact. Consequently, we can say that one of the drivers behind the guidance cut is the lower than predicted shipments of iQOS devices and heated tobacco units, predominantly in Japan. This does not bode well for a company aiming for a smoke-free future, and relying on iQOS for much of its long-term growth. While the company is undertaking certain initiatives to turn around the performance in Japan, any meaningful benefit won’t be expected to be felt until next year.

We have a $105 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 for our dashboard on Our Outlook For Philip Morris In FY 2018 to modify different drivers, and see their impact on the revenue, earnings, and price estimate for Philip Morris.

Why Did iQOS Sales Flounder?

Despite a 5% volume growth of iQOS in Japan in the second quarter, the company reported its first sequential market share decline of the device, when the metric fell to 15.5% from 15.8% reported in Q1. The company attributes this to a favorable impact in the first quarter as a result of an inventory reduction by one of its key competitors. The company had earlier blamed the slower than expected growth 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. Another factor hampering the device’s sales is the improved device reliability and longer life cycle, which has led to fewer iQOS replacement purchases.

An additional sore point was the device’s performance in Korea, which had been another high-growth market. HeatSticks’ (also called HEETS) market share reached 8% in the second quarter, an increase of 7.8 points when compared to the prior year period, but just 0.7 points sequentially. The company has stated the liability for this rests primarily on the actions of the Korean government and FDA, which has resulted in confusion among the adult consumers with regard to the heated tobacco category. The Korean government has commenced discussions on graphic health warnings for heated tobacco products, while the Korean FDA has mischaracterized the tar generated by the device, a claim the company has refuted based on scientific evidence.

As a result of the above, the company expects the heated tobacco shipment volume to be between 41 and 42 billion units in 2018. This includes a full-year net inventory reduction of 3 billion units – 4 billion reduction in Japan and 1 billion increase in other markets – which is expected to be concentrated in the third quarter, compared to an expected 2 billion net inventory increase.

What Is Philip Morris Doing To Improve The Sales?

Philip Morris is taking a number of steps to accelerate HeatSticks performance in the face of the weak growth and increased competitive pressure, though their impact is expected to be felt starting next year. These include:

• Introduction of the next-gen iQOS devices, with enhanced features, such as consecutive use.
• Launch of a stronger tasting HeatSticks’ variant to capture a greater share of the adult smoking population.
• Commencement of sales of a mainstream-price product for price-sensitive consumers.
• Simplification of the registration process for new consumers, which posed a barrier to entry, particularly for older smokers.
• Escalation of its loyalty program, and the establishment of a more targeted and relevant communication content.
• Addressing the reliability issues in the current generation of iQOS.

Was There Anything Positive To Look For?

Amid the doom and gloom of iQOS’ performance in Japan in the quarter, a few positives may get overlooked. The momentum of iQOS in Russia remains favorable, with the HeatSticks off-take share in Moscow reaching 4.4% in the quarter, up by 1.7 points sequentially versus the first quarter. This was the result of a successful rollout of the company’s digital initiatives in the country. The regional market share in the EU reached 1% in the second quarter, up by 0.8 points compared to the second quarter of 2017. This growth was underpinned by strong performance across the launch markets, particularly Greece and Italy, where HEETS shares have increased by 3.1 points to 4.1%, and by 1.3 points to 1.9%, respectively. As the marketing is limited to select areas in the EU launch markets, the market share is not really reflective of iQOS’ performance in the region. Instead, if we look at the number of iQOS users in the region, which has increased by more than fourfold over the past 12 months, to approximately 1.2 million, it can better indicate the device’s success.

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