Why Philip Morris International's New Heated Products Will Do Better Than Its Last Attempt

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Philip Morris International (NYSE: PM  ) is coming out with new heated tobacco products that may provide a much-needed source of growth amid declining cigarette sales. Altria Group (NYSE: MO  ) licensed the products for distribution in the United States. However, Philip Morris has released heated products before, so investors are not sure if the new products will be a game-changer or another flop.

Philip Morris has tried this before
The key to developing a replacement for cigarettes is to make the new product taste and feel as close to a real cigarette as possible. It also has to be safer for the smoker than a regular cigarette. Philip Morris completely ignored these rules when it developed Heatbar, a "battery-powered plastic device about the size of a mobile phone" released in 2004. Users would insert a regular cigarette into the Heatbar, which would then heat the tobacco and deliver a flavored aerosol to the smoker.

Perform a Google image search for "heatbar" and you will understand why these things did not catch on. Not only do they look unappealing, the only benefit of the Heatbar is to reduce secondhand smoke -- not a good enough reason for consumers to adopt them or for governments to encourage them. As a result, Philip Morris quickly abandoned the Heatbar.

Can Philip Morris' new heated products beat the Heatbar?
Altria and Philip Morris are betting that the new heated products will outperform their predecessor. In exchange for the right to sell Philip Morris' heated tobacco products in the United States, Altria gave Philip Morris the right to sell its MarkTen cigarettes outside the United States.

Philip Morris' heated products are referred to as Platform 1 and Platform 2. Platform 1 is closest to commercialization, due out in 2015 after pilot tests are concluded in 2014. Like Heatbar, Platform 1 heats tobacco and delivers a cigarette flavor and nicotine, but -- unlike the Heatbar -- it does not produce smoke. In addition to being safer for the smoker, Platform 1 is "smaller, better designed, and less awkward looking" than the ill-fated Heatbar. 

Platform 1's initial trials are promising. Philip Morris conducted a month-long usage study and found that 30% of users adopted the product, and 54% said they intend to purchase it -- blowing away management's wildest expectations. The company is so excited about Platform 1's prospects that it accelerated the launch date to 2015, well ahead of the original 2016/2017 target date.

Furthermore, Philip Morris estimates that if the adoption rate of its heated products and e-cigarettes is 5% of the potential user base, it could add up to $1.2 billion to the bottom line -- a 9% increase in annual operating profit based on the company's last four quarters.

For it to achieve that success, however, Platform 2 will also have to be a hit product. Platform 2 is a low-smoke product with an internal heat source that smokers use a lighter to ignite. This functionality makes the experience of smoking a Platform 2 more like the real thing. This is similar to Reynolds American's Eclipse cigarette. Eclipse contains even more carcinogens than low-tar cigarettes already on the market and has not become one of Reynolds' major brands. It is not yet known how much Platform 2 differs from Eclipse, but Platform 1 has better prospects than either one.

Foolish takeaway
Like all tobacco companies, Philip Morris is scrambling to find a new source of growth to offset a secular decline in cigarette volume. While most companies are focused on the emerging e-cigarette market, Philip Morris is placing its bet on heated tobacco products. Altria, too, could use a lift from heat-not-burn products, given that its MarkTen e-cigarettes have yet to roll out nationally.

Based on management's comments, Platform 1 could be a hit with consumers. At the very least, it will outdo the Heatbar. However, despite decades of trying, no innovation in the tobacco industry has been more successful than the regular old cigarette. Investors should watch for confirmation of consumer adoption before factoring Platform 1 into Philip Morris' valuation.

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Ted Cooper

Ted Cooper is a value investor based in Texas. He does not ride a horse to work.

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