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Morningstar | Could Have Been Worse for PMI in 2Q, but We Think Strategy Is Shifting to Platform 2

Philip Morris International reported a second quarter that was in line with our forecasts on the top line, but narrowly missed at the EBIT margin line. Management lowered guidance for the full year to a range of $5.02 to $5.12, down from $5.25 to $5.40, in a move that reflects the customer acquisition cost in heated tobacco, which we think had hitherto been underestimated by the market. We think the earnings reset may be on the conservative side, but we will likely lower our full-year estimates when the company publishes its 10Q. This will not materially impact our fair value estimate, however, and we think the stock offers value at current levels. Our wide moat rating also remains due to PMI's brand equity and regulatory barriers to entry in the tobacco industry.

With growth in Heatsticks in Japan having slowed significantly this year, the second quarter could have been a lot worse for PMI. Instead, the top line held up reasonably well, with total adjusted volumes down 1.1%, and pricing in the combustibles business remains strong, at around 5% in the second quarter. Heatsticks volumes were again the downside, and although our forecasts were below consensus initially, we will modestly lower our estimates for total Heatsticks shipments to 42 billion, as the company implements a channel inventory correction in Japan.

A less profitable second quarter and an incremental $600 million in investment behind iQOS now means PMI will not meet our EBIT forecast for the year, and we will lower our estimate accordingly. We retain our belief that iQOS will ultimately generate margins roughly in line with cigarettes, and we believe a 42% EBIT margin is attainable in the medium term.

Management announced several steps to address the slowdown in RRP volumes in Japan, the world's largest heated tobacco market. New product launches will include a lower priced (but still above the average retail price in the country) Heatstick variant, a full flavour range of Heatsticks, and a next generation iQOS device that will sell at a premium to the existing 8,000 yen offering. To us, this sounds more like a strategy to optimize profitability and cash flow from the existing user base than it is to chase the late adopters in the market; a lower priced device would be more likely to achieve greater adoption. Instead, we think the slowdown in growth reveals a natural ceiling to the market for the current devices, and that PMI will likely try to capture the late adopters with its disposable heated tobacco product, which is currently in trial in the Dominican Republic. This lends support to our view that nicotine consumption will occur across an increasingly fragmented range of tobacco and nontobacco products a decade from now than at present, and that this could have a negative impact on margins. If we are correct, PMI's vision of a smoke-free world is now highly dependent upon the consumer adoption of its other platforms.