As cigarette sales fall and demand for heated tobacco electronic cigarettes grows, Philip Morris International (PM -2.96%) is scrambling to hasten the transition for the legacy traditional cigarette to the new smokeless variety.
Yet because combustible cigarettes still represent the vast majority of Philip Morris' shipments and revenues, the tobacco giant's stock will still feel the impact as it prepares to report second-quarter earnings on Thursday, July 18.
CEO Andres Calantzopoulos with an IQOS heated tobacco device. Image source: Philip Morris International.
Cigarettes still have a long tail
Data from market researcher Nielsen indicated traditional cigarette sales fell more than 6% in May, sending shares of Philip Morris and other tobacco companies tumbling because it was the biggest drop in sales in four years. Although everyone knows cigarettes are a long-term losing battle, and that far more people give up smoking each year than take up the habit, there are still billions of cigarettes sold annually, and any acceleration in the decline is worrisome.
Philip Morris International is trying to change the discussion by investing billions of dollars in cigarette alternatives, particularly its IQOS heated tobacco device. Sales of the device, which heats tobacco to the point of creating a vapor rather than smoke, have remained strong since its introduction several years ago, and Philip Morris is now moving into new markets and seeing device sales pick up.
In the first quarter, heated tobacco unit shipments jumped over 20% to 11.5 billion units, while traditional cigarette shipments were flat. Together, total unit shipment volume was up by 1.1% to 175.8 billion.
Yet the disparity in weighting between the two groups and the continued decline in smoking caused Philip Morris to lower its earnings forecast for the year, now expecting earnings of at least $4.87 per share for the full year, compared with its previous estimate of at least $5.37 a share. Projected adjusted earnings of $5.09 per share for 2019 remains in line with analysts' estimates though management forecasts cigarette shipment volumes will be down between 1.5% and 2% this year.
Heated tobacco is its future
Philip Morris is counting on the IQOS device to offset smoking's decline, only somewhat at first, but increasingly more in the future.
While some markets such as Japan and South Korea have been largely saturated with the device already, providing little room for additional geographic expansion in the countries, other locations give it plenty of room to grow.
Russia, for example, which showed strong IQOS sales growth in the first quarter, is only about one-third covered by the device, and Philip Morris has the heated tobacco unit in only about half of European countries. CFO Martin King told analysts on last quarter's conference call that "in just about every other country that we've launched in, we still have geographic expansion opportunities within the country." And that's to say nothing of the opportunities now in the U.S.
The U.S. market won't be a factor -- yet
Philip Morris finally received approval from the Food and Drug Administration earlier this year to have Altria (MO 1.45%) market and sell the IQOS in the U.S., fortuitously just as the regulatory agency launched a major crackdown on what will be its competition. Not only were tougher selling rules imposed, but the deadline by which manufacturers have to submit applications for review to keep their own devices on store shelves was also accelerated.
Manufacturers will have less than a year's time to get a pre-market approval application submitted or have their devices pulled from the market. Many probably won't be able to comply because of the complexity and cost of the process, meaning there's a good chance the IQOS could end up being one of the very few e-cigs left on the market.
The IQOS in the U.S. won't factor greatly in Philip Morris' earnings, though. Although it was approved at the end of April, Altria is introducing it only in the Atlanta market first, "to learn as much as possible, as quickly as possible," though it does intend to scale up very quickly.
Traditional cigarettes are still a drag
Lower cigarette sales will undoubtedly weigh on Philip Morris International's performance in the second quarter, with only a slight offset by heated tobacco sales. But more so than most other cigarette companies, Philip Morris International is truly a play on a smoke-free future, and as one that has advanced farther and more quickly than the competition, it's a company that still holds a lot of potential for investors.
