Philip Morris International (PM 0.08%) surprised the markets with the strength of its third-quarter earnings report as its heated tobacco IQOS product saw sales grow in every market except Japan. This was coupled with a boost in pricing, and revenues and earnings beat analyst expectations.

The tobacco giant also reiterated its full-year earnings guidance, maintaining a range of $4.97 to $5.02 per share, or an 8% to 9% increase over last year's adjusted earnings. But that came only after cutting guidance twice before, and following the robust performance whereby it handily exceeded analyst expectations by 12%, it suggests the fourth quarter could be very difficult. 

Philip Morris International CEO Andr Calantzopoulos

CEO Andre Calantzopoulos at IQOS 3 launch event. Image source: Philip Morris International.

IQOS heating up

Revenue for the third quarter came in at $7.5 billion, a 0.4% increase as currency fluctuations took their toll, but it still beat analyst forecasts, which had predicted $7.17 billion. Similarly, earnings came in strong at $1.44 per share, well ahead of the $1.27 per share Philip Morris reported a year ago and outstripping the $1.28 per share Wall Street had anticipated.

It also reported total shipment volume for cigarettes and heated tobacco units at 203.7 billion, a 2.1% decrease, as distributors reduced their inventories in anticipation of Philip Morris shipping its next-generation IQOS devices, the IQOS 3 and IQOS 3 Multi. Excluding the impact of those distributor inventory movements, volume actually rose 1.1%.

Philip Morris heated tobacco devices are finally gaining the traction that's been expected for some time. The IQOS is available in 43 markets, and shipments surged in the third quarter, more than doubling in the European Union; eastern Europe; the Middle East, and Africa; and Latin America and Canada. The only market where they fell was Japan, which saw shipment volumes nearly cut in half.

That wasn't necessarily unexpected, as Philip Morris had previously warned it had quickly burned through the early adopters and faced the more difficult task of converting older, more conservative smokers to using this newfangled device. But worldwide, it forecasts shipment volumes will double to 41 million to 42 million units.

Although the third quarter is when the vast bulk of the inventory adjustments occurred, it's in the fourth quarter that Philip Morris earnings look likely to take a hit.

Deteriorating expectations

A year ago, the tobacco giant had a number of moving parts in its fourth-quarter results, but adjusted earnings came in at $1.31 per share. Since Philip Morris reiterated its guidance for the full year, and year-to-date earnings total $3.85 per share, the fourth quarter will probably come in at around $1.12 to $1.17 per share, a 11% to 15% decline from last year.

The global cigarette manufacturer had started off 2018 with a much grander vision for the year, forecasting earnings of as much as $5.35 per share and increasing the top end to $5.40 per share after the first-quarter report. However, a month later currency exchange rates were clearly moving against Philip Morris, and it reduced its guidance to $5.30 per share followed by a more dramatic reduction to $5.12 after the second quarter, again due to foreign exchange rates. Then in September it narrowed the range even further to its current level as the currency situation did not improve.

That sets Philip Morris up for a difficult fourth quarter. While its stock has gained 16% since those September lows, it may revisit them when it reports earnings early next year. 

Possible reversal

Yet there are two factors that could mitigate that blow. First could be the introduction of the IQOS 3 in Japan. The new, sleeker device has the potential to win over more smokers because Philip Morris has undertaken extra marketing to educate them on the benefits of switching from traditional cigarettes to its vapor product. 

Second is that Philip Morris expects a long-awaited decision this quarter from the Food and Drug Administration on its application to market the IQOS in the U.S. Considering how tough the regulatory agency has gotten with electronic cigarette manufacturers over teen usage of the devices, and the agency's advisory committee recommending it not get a reduced-risk label, it seems unlikely Philip Morris will be able to market the IQOS as a healthier alternative to cigarettes, but it will probably get the go-ahead to sell it without that claim.

This gives Philip Morris an opportunity to take market share, particularly with the intense scrutiny market leader Juul Labs has received from the FDA. The JUUL e-cig has been extremely popular with teens, and the FDA recently seized records from the company to see how it is making and marketing the e-cig.

But there are no guarantees the IQOS will be a hit, although the new models are sleeker and look more like the Juul. That means the fourth quarter may cloud things for Philip Morris International investors before the smoke eventually clears.