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Morningstar | Several Ways to Win With Philip Morris International After Volumes Stabilize in the First Quarter

Philip Morris International beat our first-quarter earnings estimates at the EBIT margin. Adjusted organic sales growth of 6.6% was in line with our forecast but driven more by volumes and less by price/mix than we had expected. This should be encouraging to investors worried about a global acceleration in the consumption decline rate. Philip Morris' wide moat was evident in several data points, including a robust performance in Japan, where iQOS returned to volume growth, and a strong performance in the European Union. The market reacted with disappointment after management lowered full-year guidance due to higher-than-expected costs of deconsolidating the Canadian subsidiary and a plant closure in Pakistan. Underlying business trends remain on track, however. We are making minimal changes to our estimates and retain our $102 fair value estimate. We continue to believe there is upside to the market value.

Volumes were strong across both combustibles and heated tobacco units (HTU), and across most geographies. The standout region was the EU, which comfortably beat our estimates in both categories with a 0.5% decline in combustibles and strong growth in HTU. In Italy, the government lowered the tax rate in non-combustible categories, and Philip Morris passed through the pricing benefit to consumers, which would have supported first-quarter volumes. Beyond the short-term impact, however, we believe this is a highly significant development. Our cash flow forecasts for the multinational tobacco manufacturers assume that governments implement tax structures on HTU products similar to those of cigarettes, meaning there is little positive mix effect from consumer migration. Italy, however, is apparently taking the opposite approach, a legitimate strategy to encourage the migration to alternative products. If this becomes common practice in key markets, we may revise our margin assumptions upward, and this would imply even more upside to current market valuations.

Japan is a closely watched market due to the strong adoption of heated tobacco, and after several stodgy quarters, Philip Morris reported a 3% increase in HTU volumes in the first quarter--after adjusting for trade inventory movements--in spite of a price increase last year. Volume share increased by over 1 percentage point, and we attribute this to a number of factors. First, the launch of HEETS heatsticks at a lower price point than Marlboro will have attracted new users. Second, the launch of iQOS 3 and Multi devices appears to have retained existing customers at a crucial point in the replacement cycle and also attracted new registrations. Third, commentary from the convenience stores in Japan suggests that first-quarter same-store sales growth has been relatively positive, boosted by promotions around cashless payments. It seems likely, therefore, that tobacco volumes could weaken when these promotions are scheduled to expire in the second half of the year.

Significantly, our cash flow forecasts currently assume no benefit from the launch of iQOS in the U.S., due to the lack of visibility into whether and when marketing approval will be granted by the FDA. Philip Morris reiterated that it remains engaged in the approval process and expect a decision this year. Through our Bass model analysis of innovation diffusion, we expect uptake in the U.S. to be fairly limited (perhaps more similar to Europe, where category share remains in the low single digits, than Asia) but with no combustible portfolio to cannibalize, any revenue generated in the U.S. will be incremental to the company and would also represent upside to our valuation.