How Philip Morris International Makes Most of Its Money

Tobacco stocks are going through a transformative event right now, as consumers have shifted away from traditional cigarettes toward alternatives like electronic cigarettes and other vaping products. For Philip Morris International (PM 3.83%), that has marked both a challenge and an opportunity, because it has firmly embraced the shift toward reduced-risk products but still gets most of its sales and profit from its traditional cigarette business. Philip Morris hopes that it can get smokers to migrate smoothly from cigarettes to alternatives in a way that not only won't disrupt its existing business but also will draw in smokers from competing brands. However, managing that transition will involve inevitable bumps in the road, and Philip Morris has to figure out how to sustain its big moneymaker as long as necessary, especially in the regions of the world where it gets the most money.

How much money Philip Morris makes

Philip Morris brings in substantial amounts of revenue. In 2016, the company had net sales of almost $75 billion, and that was relatively consistent with the $74 billion to $80 billion that it had made annually over the past several years.

However, much of Philip Morris' sales get siphoned away in the form of taxes. Philip Morris paid $48.3 billion in excise taxes on its products in 2016, or close to two-thirds of its top line. Nevertheless, when you take what's left and pay for operating and other costs, the tobacco giant posted earnings of $6.97 billion last year.

When you drill down into the numbers, you can see how geography plays a key role for the tobacco company.

Data source: Philip Morris International.

Europe is a vital part of Philip Morris' overall business, with the European Union in particular representing the largest portion of the company's sales. Yet the EU is where excise taxes are highest, taking fully 70% off the top from Philip Morris' revenue. Those figures are closer to 60% in the Asia and Eastern Europe segments, leaving more opportunities for profit and showing up in slightly higher proportions of operating income in those areas compared to the EU and the Americas segment.

Where tomorrow's profits will come from

At present, alternative products are a small portion of Philip Morris International's overall business. In the first quarter of 2017, Philip Morris shipped 173.6 billion cigarettes, compared to just 4.44 billion units of its iQOS heated tobacco product.

But the growth trajectory for iQOS has been impressive. First-quarter numbers reflected a nearly tenfold increase in heated tobacco volume, reflecting the expansion of availability in the key Japanese market, which was the first major test for iQOS. For a while, Philip Morris didn't have enough supply of heated tobacco to meet demand, but a new factory last year was dedicated specifically for large-scale production in order to facilitate a faster ramp-up for sales.

Image source: Philip Morris International.

That said, iQOS hasn't been entirely positive for Philip Morris. Cigarette volume declines in Japan have stemmed in part from existing Philip Morris customers moving to iQOS, meaning that the company is cannibalizing some of its cigarette business. However, the drop in market share for cigarette brands in Japan was less than a percentage point in the first quarter of 2017, compared to a more than six percentage point rise in market share for iQOS. That demonstrates that Philip Morris is also getting many customers from other brands to make the switch to heated tobacco.

Also, iQOS is still establishing itself, and that's forcing Philip Morris to make short-term concessions on price. CFO Jacek Olczak said in April that he expects Philip Morris to break even on iQOS in 2017, but that's a far cry from the impressive profit margin that the tobacco company gets on traditional cigarette sales. Nevertheless, what the Marlboro maker hopes is that once customers have the iQOS system in their hands, subsequent sales of heated tobacco will drive profit going forward.

Philip Morris International is positioning itself to take full advantage of the move away from traditional cigarettes. Volume declines in the traditional side of the business have been scary, but investors are optimistic that Philip Morris can use its first-mover advantage in heated tobacco to stay out in front of its competitors. Given the power of the Marlboro brand, that's a reasonable goal for shareholders to have for Philip Morris.