EUR 850.00 For Business Accounts Only

Morningstar | PMI appears significantly undervalued as sentiment turns against tobacco.

2016 was a breakthrough year for Philip Morris International’s reduced-risk portfolio. Its first platform of the iQOS brand, a rechargeable heated tobacco product, gained impressive traction in many of its trial markets, particularly Japan, and made its first material contribution to the cash flow of the overall business. Regardless of the trial data, we think PMI is backing the right horse because we think heated tobacco is the category most likely to become a long-term mainstream alternative to smoking.Of all the e-cigarette incarnations, heated tobacco products most closely replicate the smoking experience and so should attract smokers looking for a less risky alternative. Furthermore, the competitive advantages in the combustible business that give PMI such a wide economic moat--brand loyalty, pricing power, cost advantage inherent in its vast tobacco leaf procurement, and regulatory barriers to entry--are all transferable to some degree to heated tobacco.Although we believe that a multiple premium over peers is appropriate for the manufacturers at the most advanced stages of heated tobacco technology development and commercialization, there are still many unanswered questions about the evolution of reduced-risk products. For example, much depends on the regulatory environment. We think the chances of heated tobacco becoming mainstream are much higher if regulatory bodies publicly acknowledge that the category is safer than smoking. In addition, we think that with scale, heatsticks can be at least as profitable as premium cigarettes, but margins will depend heavily on the level of taxation, an unknown factor at this early stage.Amid the excitement of a potentially lower-risk alternative to smoking, the combustible business still represented 93% of PMI’s volume in the fourth quarter. Currently, the business is performing almost on all cylinders, with price/mix of around 4%, below our medium-term estimate of 5%, but volume declines of over 4% could fade over time, particularly if iQOS generates strong uptake rates in markets outside Japan. This is likely to be tempered, however, by new entrants to the attractive category.