Philip Morris International (NYSE:PM) made its reputation by selling cigarettes, but the company has recently done an about-face with respect to its long-term strategy. Unlike its competitors, Philip Morris has unequivocally embraced the idea that it will eventually stop selling traditional cigarettes, instead moving to reduced-risk products that it argues have more favorable health effects and will more easily pass regulatory muster. In its full-year 2016 financial report, Philip Morris showed just how successful reduced-risk products have been, with early results from its heat-not-burn tobacco system looking extremely encouraging. Demand for iQOS devices and the specially formulated HeatSticks tobacco that the devices use has been extremely strong. Let's look more closely at how iQOS helped Philip Morris over the past year and what lies ahead for the heated-tobacco product going forward.

iQOS and HeatSticks products producing rising revenue for Philip Morris.

Image source: Philip Morris International.

Why Philip Morris International is so enthusiastic about iQOS

Philip Morris International's attitude toward reduced-risk products stems largely from the potential it has already seen in the alternative-products market. For 2016, full-year total revenue at Philip Morris climbed 4.4% on a currency-neutral basis, and CEO Andre Calantzopoulos pointed to "the strong performance of [reduced-risk products], notably HeatSticks and iQOS devices" for the gains.

In particular, Philip Morris brought in $733 million in net revenue from reduced-risk products. Although the profit margin on that revenue was fairly low, Calantzopoulos explained that the primary reason was that Philip Morris priced the iQOS device itself at an introductory discount in order to encourage smokers to switch to the heated-tobacco system. Like a razor-and-blade model, Philip Morris anticipates that margin will be more favorable with HeatSticks, and the company can also work on maximizing profit on the iQOS systems once they've gotten to be more readily available through national rollouts.

Consumers have snapped up iQOS aggressively, and that has actually proven to be a bit of a problem for Philip Morris. The company said that its HeatSticks production volume reached 7.4 billion units, reflecting its full manufacturing capacity for 2016. The CEO noted that volume "would have been much higher absent this capacity restriction, which obliged us to limit iQOS device sales in Japan since June." Market share in Japan hit 5.5% in late December, with offtake share rising to an even higher 7% level.

Graph of iQOS offtake volume trends in various markets.

Image source: Philip Morris International.

As the chart above shows, Japan has been the biggest success story for Philip Morris and iQOS, but it's far from the only one. In every market with a launch prior to the middle of 2016, offtake volume rose at a compounded weekly rate of 6%, which is similar to what Japan showed early on. Indeed, results in Portugal, Italy, and Romania have been particularly encouraging, and Russia has also shown substantial promise as well.

How Philip Morris intends to grow iQOS

Philip Morris International is going to move full steam ahead with iQOS as the premier product in its reduced-risk portfolio. The company has already launched iQOS in key cities within 20 different markets, including 11 in the European Union, six in the Eastern Europe/Middle East/Africa segment, and Japan, New Zealand, and Canada. Philip Morris will expand its testing to go national in several of those markets, and it also intends to add another 10 to 15 new countries to the mix in 2017.

Moreover, Philip Morris is moving aggressively to meet anticipated higher demand. In 2016, the company had a capacity to produce roughly 15 billion HeatSticks. By the end of 2017, Philip Morris expects that number to have climbed to 50 billion, with 32 billion units available for commercial sale during the year. As Calantzopoulos explained, "We look forward to unleashing the true potential of iQOS once the pressure on HeatSticks capacity eases."

A big change for Philip Morris

After decades of success with traditional Marlboro cigarettes, Philip Morris is making a huge shift that shows how committed the company is to embracing the potential of reduced-risk products. A lot will depend on whether iQOS can continue to do as well as it has in early tests and get more smokers to switch from other manufacturers' cigarette brands to the heated-tobacco product in the long run.

Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.