Companies have to reinvent themselves constantly in order to keep up with the times. For tobacco giant Philip Morris International (NYSE:PM), concerns about the known health impacts of combustible cigarettes have led to a groundswell in demand for alternatives, and Philip Morris has responded by looking at reduced-risk products that it believes can become its sole business in the long run.

Investors haven't been as certain about the ability for products like the iQOS heated tobacco system to replace the huge amounts of revenue and profit that the Marlboro line of cigarettes brings in, and a hiccup in performance for iQOS in the first quarter sent the stock down sharply.

Coming into its second-quarter financial report in late July, Philip Morris investors wanted answers to their concerns, as the company had announced at its shareholder meeting in late May some future initiatives to establish a stronger strategic direction. Philip Morris' quarterly results were reasonably good, but what was more important was how the tobacco giant expects to move forward with a worldwide rollout of its next-generation iQOS line. There, Philip Morris will make its stand in defending its future hopes.

Conveyor belt carrying loose tobacco in a manufacturing facility.

Image source: Philip Morris.

The iQOS evolution continues

Philip Morris International's second-quarter results showed the continued growth that investors have come to expect regardless of the environment in which the company finds itself. Net revenue climbed 12% to $7.73 billion, decelerating slightly from its pace in the first quarter of 2018 but still sustaining a desirable growth rate. Net income jumped 25% to $2.30 billion, and that produced earnings of $1.41 per share, topping the consensus forecast among investors by $0.18 per share.

Once again, Philip Morris' numbers showed the evolution away from traditional cigarettes toward alternatives. Cigarette volume worldwide fell 1.5% to 190.7 billion units, although that was a less dramatic drop than the company has seen in recent quarters. Sales of heated tobacco units for iQOS consumption were up 73% on a unit basis, falling just short of 11 billion for the quarter. That number represented a nice bounce from a slow first quarter, but it was still short of the high of between 15 billion and 16 billion iQOS units sold in the last quarter of 2017. Regionally, sales of cigarettes in Europe and the Western Hemisphere were weakest, while Africa and Asia held up best. Overall, shipments of all products were higher by 0.9% from year-ago levels.

Currencies also gave Philip Morris a slight boost. Net revenue was higher by almost three and a half percentage points because of the weak U.S. dollar compared to key foreign currencies, and earnings got a $0.04-per-share bump up from currency impacts.

CEO Andre Calantzopoulos pointed to better conditions and pricing power in explaining the results. "We are seeing encouraging improvement in the markets we previously cited as challenging," Calantzopoulos said, "with a sequential recovery of volume in the [Gulf Cooperation Council nations in the Persian Gulf area] and an improving pricing environment in Russia." The CEO also noted that solid growth in operating income came independently of some favorable currency tailwinds.

What's next for Philip Morris and iQOS?

The most important part of the presentation, though, centered on the future of iQOS. In Calantzopoulos' words, "We are implementing the right market and product measures to reinvigorate growth in Japan, which is undoubtedly well below our initial expectation this year." These moves, which were initially announced at Philip Morris' annual shareholder meeting, will involve the transition to a next-generation iQOS 2.0 line.

That shift has immediate ramifications for 2018 earnings, and the company acknowledged that the positive effects of the strategy won't be fully realized until 2019. Meanwhile, Philip Morris will have to work on handling inventory levels of existing iQOS devices and consumable heated tobacco packs in order to make a smooth transition to iQOS 2.0.

Philip Morris cut its earnings guidance for 2018 in light of the additional costs of the next-generation iQOS rollout. The tobacco giant now sees full-year EPS of just $5.02 to $5.12, down by $0.23 to $0.28 from its previous range. A previous 8% growth forecast for net revenue will now be closer to 3% to 4%. However, the company hopes that between new marketing programs in Japan designed to attract a broader audience of customers, and the worldwide introduction of the new iQOS, it will be able to produce significant growth from its current projections of heated tobacco sales of 44 billion to 45 billion units.

Keep an eye on iQOS 2.0

Philip Morris shareholders took the news in stride, and the stock recovered quickly from its initial sell-off. With the tobacco giant having doubled down on the next generation of iQOS, investors will have to watch carefully how that part of the business performs to see if Philip Morris can sustain an orderly transition even amid all the uncertainty and doubt surrounding the company's long-term prospects recently.