For tobacco-industry investors, Philip Morris International (NYSE:PM) has long held the promise of worldwide growth in cigarette demand as a larger consumer class in emerging-market nations gains enough disposable income to afford the smoking habit. Yet in its most recent report, Philip Morris earnings were lackluster, with declines in revenue and earnings coming from the weakness of several key foreign currencies against the U.S. dollar and poor volumes. Nevertheless, executives at Philip Morris remain upbeat about the tobacco giant's future. Let's take a look at a few things they said at the Philip Morris conference call last month following the company's earnings release.
Both the [Eastern Europe/Middle East/Africa] and Latin America and Canada regions had a very strong quarter. ... The results in the Asia Region, meanwhile, continued to be affected by challenges in specific markets, although we are making progress in dealing with them. -- CFO Jacek Olczak
The most important thing investors need to remember about Philip Morris is the huge impact currency fluctuations have on its results. When you dig deeper into the operating numbers, you'll find three of the company's four geographical segments posted gains on a currency-neutral basis during the second quarter, with both the Latin America/Canada and EEMA regions enjoying double-digit percentage gains. Moreover, in the European Union, drops in cigarette volume decelerated substantially, suggesting that even as the economy in Europe struggles, Philip Morris could see continued improvement as the cigarette market shows signs of hitting bottom.
Asia has been the thorn in Philip Morris International's side, with Japan in particular suffering from new consumption taxes that helped create a huge 16% drop in shipment volumes for Philip Morris. The company's market share rebounded somewhat in the second quarter, though, and Philip Morris expects more progress on that front. Meanwhile, a new product launch helped results in Indonesia, but Philippines results were also weak.
Overall, Philip Morris does a good job managing its business in markets with vastly different characteristics and conditions. Yet it's important to keep in mind the impact each of those individual markets has on the overall business.
We will face much more challenging comparisons during the second half of the year and in particular during the fourth quarter. In the second half, we will make investments behind the commercialization of reduced-risk products, roll out Marlboro Red 2.0, and incur some underlying costs related to the optimization of our manufacturing footprint. -- Olczak
Philip Morris is acutely aware of the trends affecting its industry, so it has been working hard to try to diversify its product line while also taking advantage of brand loyalty. The flagship Marlboro Red brand has achieved substantial success, so the 2.0 version will incorporate new package design in an effort to expand its appeal to the high-end consumer market. As the cigarette market gets more competitive, Philip Morris hopes to use this same approach to improve results with other key brands.
At the same time, though, Philip Morris recognizes the possibility of higher demand for alternatives to traditional cigarettes, and that is the driving force behind its reduced-risk product line. Combined with efficiency initiatives, Philip Morris is using every method at its disposal to boost revenue and profits.
[In Australia,] the combination of a certain commoditization of the market induced by plain packaging, large excise tax increases, and heavy price discounting particularly at the bottom of the market has accelerated down-trading to lower-price, lower-margin brands. -- Olczak
Australia has been the epicenter of the push toward increased regulation internationally, with moves requiring cigarette manufacturers to use plain packaging. Given the high recognition of Philip Morris brands, especially Marlboro, losing the ability to use branding images is a big blow, and competitors have seized on the opportunity to wage a price war in Australia as a result. The big question Philip Morris faces is whether smokers value the quality of its cigarettes enough for the company to maintain at least some pricing power. If smokers in Australia keep moving toward cheaper brands, though, it'll be hard for Philip Morris to regain its strength in the region.
On a global basis, pricing remained the key driver of our higher adjusted [operating companies income] during the second quarter. -- Olczak
One of the most encouraging things more broadly about Philip Morris is that worldwide, consumers appear ready to pay more for its premium products, Australia's experience aside. With volumes falling in most areas of the world, it's important for Philip Morris to be able to raise prices in order to keep revenue high, and so far, the company has managed to manage that balancing act fairly well. Competition in certain markets will always put pressure on pricing, but in the long run, Philip Morris will rely on its marketing efforts to drive the value of its products.
I think we will make it very clear that the reasons are well-known why we focus on an international market. We're not looking at a conventional business in the U.S. -- Olczak
When Altria Group (NYSE:MO) spun off Philip Morris International, there was a clear line between the domestic and international markets. Yet over time, some have speculated that Philip Morris might reenter the U.S. market, especially as Reynolds American (NYSE:RAI) poses a bigger competitive threat to Altria with its planned merger with Lorillard (NYSE:LO).
At least for now, though, Philip Morris International sees no such moves on the horizon. Given the company's cooperative efforts with Altria in areas like electronic cigarettes, Philip Morris doesn't want to endanger its partnership, and unless dramatic change occurs in the industry, it's unlikely you'll ever see Philip Morris back in the U.S. market.
Philip Morris International faces more challenges on the regulatory and competitive fronts than many investors expected when Altria first spun off the company. Nevertheless, investors should hope that when the strength in the U.S. dollar finally subsides somewhat, Philip Morris will remain in position to have price increases outweigh any continued pressure on cigarette volumes going forward.
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