Cigarette volumes are down, FX dynamics continue to depress earnings, and there is a long list of margin headwinds. On almost every level, Q1 2023 results show Philip Morris International under pressure. Yet, I don’t think there has been a period in which the company has been better positioned than now.
While deserving of our attention, the majority of pressures PMI is facing shouldn’t be a surprise at all! I point to comments made by the company’s management during the Q4 2022 call (emphasis added):
Jacek Olczak, PMI CEO:
"Logically, the international expansion of pouches, U.S. IQOS penetration, and the replacement of IQOS 3 with ILUMA entail additional investments this year which combined with inflationary pressure will weigh temporarily on our margins."
Emmanuel Babeau, PMI CFO:
"A few words now on 2023 phasing. We expect margin pressures to be weighted to the first half, particularly given the challenging Q1 2022 comparison, a progressive decrease in air freight costs throughout the year. In addition, investments are expected to be front-loaded, and we know that the rollout of ILUMA can lead to a short period of slower user acquisition as consumers wait for the launch. Combined with the timing of shipment and cost savings, we expect our 2023 top and bottom-line delivery to be heavily H2 weighted."
And sure enough:
Mind you, while pressures stemming from RRP growth and transition are pronounced, there have been other large contributors, including energy and COGS headwinds affecting cigarettes such as tobacco leaf and acetate tow (the material used in filters, yes really). For context, the last time acetate tow was mentioned during a quarterly call was briefly by an analyst in Q4 2015. Moving forward, there is good reason to expect many of these pressures will lessen. And focusing on heated tobacco becoming a larger group contributor, my perspective on margins remains unchanged from last quarter
"However, this continuation is absolutely welcomed. One of the greatest difficulties for new products in the nicotine space is convincing users to try them. With legacy products carrying tremendous loyalty, it can be painstakingly time intensive and costly to convert. As IQOS ILUMA continues to take share, it will automatically act as social proof, validating the platform for others. It’s important to note that the growing number of IQOS users is a lagging indicator for volumes since there is usually a ramp time between trial, adoption, and fully switching to the device. Today’s margin loss is tomorrow’s gain."
Volumes and values
In Q1 2023, Heated Tobacco Unit volumes grew by ~10.3%, with volumes of 27.4 billion being comfortably at the higher end of the previously guided 26-28 billion range. Q1s, historically, are a weaker volume quarter than Q4, and this year had a notable impact from wholesaler and distributor inventory movements. Even so, PMI has maintained previous full-year guidance of 125-130 billion HTU volumes, suggesting a notable acceleration in the second half of the year.
I believe the most intuitive and meaningful metric currently available to gauge IQOS success is simply the number of users.
IQOS user growth is followed by sustained associated HTU growth and reflects the cadence of trial, adoption, and shift from poly-usage to exclusive usage. Investments in ILUMA have been well-deserved, as PMI CFO Emmanuel Babeau illustrated during the call (emphasis added throughout):
"IQOS ILUMA has been a positive catalyst for volume and share growth across a broad range of launch markets, both supporting our strong position in the heat-not-burn category with a superior user experience and fostering further category growth.
For existing IQOS users, ILUMA drives an accelerated upgrade cycle. This enhances retention and full conversion for the future with a temporary margin impact from concentrated device sales. Indeed, we are now approaching an estimated 10 million ILUMA users with ILUMA taking over 85% of HTU volume in the first launch market of Japan, Switzerland and Spain. ILUMA is also enabling better acquisition and conversion of legal age smokers with market share acceleration visible in both earlier and more recently launched markets, such as Italy and Korea."
ILUMA’s claimed superior user experience continues to be substantiated by reviews highlighting consistency, intuitive design, and critically, its ability to best replicate the experience and ritual of cigarette usage. As HTP begins to emerge as a premium category, IQOS is best positioned at the top.
The discerning eye might notice that the IQOS user growth data provided by the company this quarter looks different than the last few reports, such as the aggregated data through FY2022
PMI has shifted away from segregating operations and presenting data pro forma with the exclusion of Russia and Ukraine. It only makes sense for PMI to continue to abstain from a Russian exit. The current climate guarantees any potential sale price for its related operations would be equivalent to theft. However, I think it is somewhat disappointing to not have greater granularity provided in reporting. The unique challenges facing Russian operations paired with the halting of further major investments in the country only obfuscate the resulting consolidated numbers.
Disappointment aside, hitting the midpoint of guided HTU volumes would result in full-year shipments of 127.5 billion. This would represent a y/y growth rate of 16.8%. With the continued success of ILUMA, a double-digit (teens) growth rate could be maintained on HTU volumes for years even without successfully reintroducing IQOS into the United States, which PMI continues to invest in and plans past 2024.
I remain guarded towards IQOS’s reentry into the U.S. and feel that the company is actually in a more awkward position than most want to admit. Yes, there is the allure that HTUs would take share from cigarette volumes, of which PMI has no share in the United States, thus capturing purely incremental volumes. But HTP, as a category, is not established in the United States and only
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