Thinking of a tobacco company as a long-term investment idea is a bit counter-intuitive. The global smoking rate has continually declined over time, and it's a well-known fact that tobacco products like cigarettes are terrible for your health.
Yet global tobacco giant Philip Morris International (PM -0.27%) might be entering its best decade since being spun off from sister-company Altria 14 years ago. "Sin" stocks like Philip Morris that deal in markets like tobacco, alcohol, and firearms might not be for every investor. Still, if you're willing to consider the stock, there are three reasons to expect big things from the company moving forward.
1. Emerging market growth
Developed markets like the United States and Europe have aggressively adopted anti-smoking measures, like banning marketing or forcing tobacco companies to put graphic images and warning labels on cigarette packaging.
However, it's different in emerging markets, which aren't as regulated. Philip Morris doesn't operate in the United States; it sells worldwide, and can market in places like Africa, where smoking has dramatically increased between 1990 and 2019.
Smokers in emerging markets aren't as profitable as those in the U.S., because their disposable income isn't nearly as high. Still, it's helped slow the decline of Philip Morris' legacy cigarette business. If middle-class economies grow in these markets over the decades ahead, Philip Morris will have the opportunity to convert users to IQOS devices as it has in wealthier markets.
2. IQOS is raising margins
Philip Morris is building the company's future around IQOS, its heated-tobacco system that heats tobacco to the point of producing a nicotine-filled vapor without actually burning the tobacco leaf. The company claims that it's significantly less harmful than traditional cigarettes. Regulators like the FDA have backed these claims, approving the marketing of IQOS as a "modified-risk" product, meaning that it provides less exposure to harmful chemicals, but isn't deemed safe.
This leeway has given Philip Morris a wedge to market IQOS as something different than smoking, and it's working on getting the device approved for use in social settings where smoking cigarettes is banned. It's an ongoing marketing effort for Philip Morris; each country has different regulators and attitudes toward tobacco use. But every place where someone can use an IQOS device is a win for Philip Morris.
Philip Morris makes more money on IQOS than on traditional cigarettes, averaging 10 percentage points higher gross profit margin, so the company is more than happy to transition every smoker it can to IQOS devices. Through three quarters of 2021, IQOS has contributed 13% of the company's shipment volumes and nearly 30% of revenue. In other words, Philip Morris will grow and become more profitable as IQOS contributes more to the business over the years ahead.
3. Potential to capture future market share
Tobacco users have substantial brand loyalty; a study estimated that annual brand retention could be as high as 85% to 90%. Philip Morris has built this new customer base of IQOS users since it entered its first market in Japan in 2014. It now has roughly 20.4 million estimated IQOS users, a small drop in the bucket if you consider that a fifth of the global population smokes, putting the addressable market at as many as 1.6 billion smokers worldwide.
If you exclude China, which sells a state-run tobacco product throughout the country, Philip Morris currently owns roughly 28% of the global market share. There is still a long runway to convert existing Philip Morris smokers to IQOS, and potentially convert smokers from other brands to IQOS.
The growth of IQOS will tell the long-term story at Philip Morris, and is what investors ultimately want to monitor moving forward. IQOS is currently in about 70 worldwide markets, and management is targeting 100 markets by 2025. IQOS has a 20.8% market share of the tobacco category in Japan, which has taken almost a decade to hit. It will likely take many years for IQOS to penetrate the global market thoroughly. Still, the superior profit margins from selling IQOS could make it a journey that investors enjoy via earnings growth and dividend raises.