The recent second quarter results released by Philip Morris (PM, Financial) were relatively mixed. Revenue increased by 8.3% on a currency-neutral basis to $7.7 billion. This was ahead of estimates, while earnings per share growth of 24% was also above market expectations. It came in at $1.41, which was well ahead of the consensus forecast of $1.23.
Although sales of heated tobacco units increased by 73% to $11 billion, the company continued to see a fall in cigarette volumes. They dropped by 1.5% to 190.7 billion, with further falls set to be reported over the medium term.
Guidance for the full year was lowered, with the company now expecting currency-neutral revenue growth of 3-4% versus a previous forecast of 8% growth. Earnings per share is expected to be $5.02 to $5.12 versus previous guidance of $5.25 to $5.40.
Growth potential
Since the release of its second quarter results, the Philip Morris stock price has risen by over 6%. This compares to a 1% gain for the S&P 500 during the same time period. The index has outperformed the stock over the last year, though. It is up by 14% versus a 25% fall for the tobacco company.
One potential catalyst for the company over the long term is reduced-risk products. Smokers across the globe continue to seek a less harmful alternative to smoking, with consumers generally becoming increasingly health conscious. So far, 5.6 million consumers have stopped smoking and switched to the company’s heated tobacco product, IQOS.
The reduced-risk product has enjoyed success in Japan, where it has a market share of 15.5%. Although this is down 30 basis points on the first quarter of the year, it is up by 550 basis points since the second quarter of 2017. It is also becoming increasingly popular in markets where it has recently been launched. For example, in the E.U. the number of IQOS users has increased by 300% in the last year. This is in spite of limited availability across the region. In launch markets such as Greece and Italy, the product has seen market share increases of 310 basis points and 130 basis points, respectively, in the second quarter of the year.
Looking ahead, IQOS could benefit from a shift in marketing strategy. The company is seeking to reach out to more conservative adult smokers who may require different communications and more time to switch to reduced-risk products. The company also plans to become increasingly innovative, with the launch of stronger-tasting variants of IQOS, while a mainstream price product could help to win over more price-sensitive consumers. A greater focus on its loyalty program may also act as a catalyst on its future growth rate.
Cigarette prospects
As mentioned, cigarette volumes continued to fall in the second quarter. This trend looks set to continue across the industry over the medium term, with the impact of tighter regulations across the developed and developing world negatively impacting on demand. Alongside this, consumers are becoming increasingly health-conscious. With Philip Morris still being heavily reliant on cigarette sales despite the growth potential of next-generation products such as IQOS, falling volumes could put pressure on its sales and profitability over the medium term.
The company, though, has been able to offset volume declines with price increases. Since it sells the biggest cigarette brand in the world, Marlboro, it may have greater pricing power than many of its rivals. It also operates in around 180 countries across the globe – many of which are emerging economies. This could mean that the regulatory risks facing industry peers such as Altria and British American Tobacco are lower for Philip Morris, which could help it to maintain revenue and profit growth from cigarettes over the medium term.
The company has also seen strong cigarette volume growth in a number of key markets such as Indonesia, North Africa and the Philippines. In fact, much of its volume decline in the second quarter was due to a tax increase in Russia, where it has raised prices significantly in recent months. With its international market share in cigarettes and heated products increasing by 80 basis points to 28.4%, its overall performance could remain positive and help to drive profitability higher.
Verdict
The stock price performance of Philip Morris has disappointed in the last year. Concerns surrounding cigarette volumes have hurt investor sentiment, while uncertainty surrounding the take up of its heated tobacco product have also weighed on its performance.
The future prospects for the business, however, seem to be positive. IQOS is likely to experience volatile growth from quarter-to-quarter, but its overall trend appears to be an upward one. It is gaining traction in new launch markets, while a shift in marketing strategy could help to attract more conservative smokers who are generally searching for less harmful products.
Cigarette volumes may continue to fall. The company’s pricing power remains high, while regulatory risk may be lower in emerging economies than in the developed world. Combined with a market share in cigarette and heated tobacco products that is continuing to grow, the stock could deliver a successful turnaround.
