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Morningstar | FDA Approves iQOS for the U.S. Market; Modest Valuation Upside for PMI

Altria and Philip Morris International, or PMI, are now able to market iQOS, the company's market-leading heated tobacco technology devices, in the U.S. after the FDA approved the sale of this product after a long-awaited decision. This is not a judgment on PMI's application to market iQOS as a modified risk product however, and the FDA's decision is still pending. Altria will market and distribute iQOS in the U.S., while PMI will retain the intellectual property rights. The two companies will share revenue generated from iQOS sales at undisclosed proportions. We think the economic benefit of this development is greater for PMI than for Altria, and we estimate the news adds $2, or 2%, to PMI's intrinsic value, in line with the market's early reaction. However, this merely offsets the effects of a weak first quarter and we reiterate our $102 fair value estimate and wide-moat rating for PIM.

The FDA said it believed iQOS produced lower levels of toxins than cigarettes, and the toxins that were detected were lower than that found in cigarettes. Significantly, it was also sanguine over the likelihood that the product would be attractive to younger consumers. Nevertheless, iQOS will be regulated as a tobacco product in the U.S., which in our view is positive for the tobacco companies because strict regulations are likely keep the barriers to entry high.

We carried out extensive analysis of the diffusion path of heated tobacco using the Bass quantitative model and the Rodgers qualitative model. We believe that because of similarities in the income of the smoking population and other cultural differences, adoption in the U.S. is more likely to follow the path of Europe rather than that of Asia. Hence, in the absence of a modified risk claim, we expect category market share gains to be limited. After more than four years of commercialization, the category share in Italy is about 3% and is lower in other EU markets, albeit after a shorter commercialization period.

There are many assumptions behind our iQOS cash flow forecasts that amount to little more than educated estimates. First, the timing of the roll-out. Altria will begin test marketing iQOS in Atlanta, Georgia this summer. We expect the broader roll-out of the product to be faster in the U.S. than other earlier markets, and it is not unrealistic to expect a multi-state roll-out by the end of 2019.

The second major assumption is the volume impact of Heatsticks. Taking into account the 3% market share in Europe as a benchmark for U.S. adoption, and assuming a 5% annual decline rate in the total market, we estimate Heatsticks could achieve volumes of 5.1 billion sticks in 2023. This would be entirely incremental for PMI, but would likely cannibalize Altria's cigarette brands.

More complex is the assumption of revenue share between the two companies. Using the assumption of 3% market share in 2023, and 4% annual pricing, below that of the cigarette segment to encourage migration, and assuming $3.50 revenue per pack in 2019 after excise taxes, we estimate the revenue from Heatsticks could reach $1.4 billion in the U.S. during 2023. Based on a cost-plus revenue sharing model, the bulk of that revenue would accrue to PMI. If PMI carries the cost of goods sold in full, research and development expenses, and the cost of shipping product to the U.S., and Altria assumes the cost of marketing and distribution in the U.S., as well as higher Master Settlement Agreement (MSA) and FDA user fees, the revenue split could be 2:1 to PMI. In reality, the agreement is likely to be more favorable for Altria in order to neutralize the economic impact of the cannibalization of the cigarette business. Assuming an equal revenue share therefore, PMI could benefit from a revenue increase of about $700 million by 2023. However, we expect Altria's revenue from Heatsticks to largely come at the expense of heavier volume declines in cigarettes. These figures will be distorted by revenue generated from devices, but because they are at a low margin (we estimate devices generate 10% EBIT margins at full price and approximately breakeven at the discounted price) such sales will have little affect on our valuation of the stocks.

Further assumptions are required to estimate margins. Much depends on the rate at which excise taxes are imposed on Heatsticks. In the most bullish scenario, Heatsticks are taxed at a lower rate than cigarettes, perhaps at a similar level to other consumer goods, to encourage migration from cigarettes. In this case, with a retail price in line with cigarettes, more of the margin is likely to accrue to the manufacturer. Our base case assumption however, is Heatsticks are taxed as tobacco products, and this is consistent with the FDA's regulation of the category as a tobacco product. Assuming a cigarette-type tax burden, it seems unlikely Heatsticks will replicate the margins of premium cigarettes in the medium term. Given the lack of visibility in the adoption path of the product, it seems unlikely PMI and Altria will build manufacturing facilities in the U.S. until the category grows to a scale that supports such an investment. Therefore, the cost of shipping finished products to the U.S. will mean the cost of goods sold is structurally higher in the U.S. than it is elsewhere. At an assumed 30% EBIT margin, and with low conviction given the wide range of assumptions at this stage, we estimate the sale of iQOS in the U.S. will generate $210 million in incremental EBIT for PMI, while it is likely to be immaterial to Altria's EBIT.