Philip Morris' Diversification Guarantees Long-Term Success

Philip Morris' recent update regarding its reduced-risk products is highly encouraging.

Jul 17, 2014 at 2:00PM

When Philip Morris (NYSE:PM) cut its full-year earnings forecast at the end of last month, much of the market concentrated on the headline figures.

However, some investors failed to spot management's comments about the company's upcoming release of reduced-risk products. These products could be game changers for the company.

The warning
Philip Morris' management revealed at the end of last month that the company was not going to hit the earnings targets it set out at the beginning of the year. Specifically, management warned that the company's diluted per share profit would fall in the region of $4.87-$4.97 for the full year. It had made an initial forecast of $5.09-$5.19 per share earlier in the year.

Excluding the effect of currency, management expects earnings to expand 6%-8% from the figure reported at the end of 2013 -- Philip Morris reported currency adjusted earnings per share of $5.60, up 8.3% year on year.

Not limited to currency
Still, it's not just unfavorable currency effects which are set to impact Philip Morris' earnings this year. Philip Morris' lower forecast also includes a pre-tax charge of $495 million related to the closure of a factory in the Netherlands.

This charge works out to $0.24 per share, which reflects approximately $356 million in employee separation costs and $139 million in asset impairment costs .

Much anticipated
However, alongside this profit warning Philip Morris revealed to investors that the company's much anticipated reduced-risk product will start contributing to its earnings within the next three to four years.

The new product, entitled iQOS for the time being, heats rather than burns tobacco. The company will introduce it within Japan and Italy later this year, the locations of its initial production facilities. The company will align the launch of this device with its introduction of Marlboro HeatSticks, which can be inserted into the device to give a sensation of tobacco flavor .

Plenty at stake
Philip Morris has staked a lot on these reduced-risk products. The tobacco giant has spent about $2 billion over more than a decade on the development of HeatSticks and the iQOS devices.

Put simply, these products are designed to be reduced risk as they heat the tobacco at a lower temperature that traditional cigarettes -- the burning of tobacco at a high temperate releases more toxic chemicals. Philip Morris' new device heats tobacco to around 400 degrees Fahrenheit instead of the 1,600 degrees of a conventional cigarette.

Philip Morris believes that it will be able to sell around 30 billion units of iQOS, which would add around $700 million per annum in profit.

Not just Philip Morris
But it's not just Philip Morris that is working on a reduced risk device; the company's Anglo-American peer British American Tobacco (NYSEMKT:BTI) has also been working on a similar device .

British American is adapting the technology found in asthma inhalers to produce an adaptable device which will produce results similar to those desired by Philip Morris for its product. Additionally, British American is developing e-cig devices after the company's management identified "failure to progress in non-tobacco products" as one of the company's key risks going forward.

The Anglo-American company hopes to have its new reduced risk and e-cig products approved and on the market by mid-2015.

Foolish summary
Philip Morris' recent profit warning was worrying, but the company's guidance and update on the progress of its reduced risk products was encouraging.

It's no secret that the volume of cigarettes sold around the world is in terminal decline and big tobacco is being forced to adapt, or die. Philip Morris' proactive decision to get ahead in the reduced-risk market should benefit the company in the long term.

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Rupert Hargreaves has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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