Philip Morris Heat-Not-Burn Marlboro HeatStick, A Potential Market Share Driver

Summary

• For over 10 years, PMI has anticipated the market need for reduced risk cigarette alternatives.
• PMI has developed reduced risk products that still preserve key aspects of the smoker experience.
• PMI has developed reduced risk products that will comply with existing and emerging regulatory regimes.
• PMI’s innovative reduced risk products are a potential opportunity for share gain.

In the last 20 years, the cigarette markets has been profoundly shaped by public health concerns over health effects of smoking. Governments have increased excise taxes, used minimum price laws and restricted smoking in public places or social locations. Smokers have faced greater expense, decreased liberty to smoke in many locations, and stigma.

The governmental push for curtailment of conventional cigarette use presented a challenge to cigarette makers to produce a cigarette alternative which is less harmful. Meanwhile, the growth of e-vapor cigarette alternatives is driven by lower price particularly for e-liquid products, and smoker desire to avoid the health hazards of smoking, the smoke, ash, and unpleasant smells associated with their habit. However, while smokers have shown interest, these devices do not fully respond to adult smoker preferences due to lack of taste and sensory satisfaction -- nicotine absorption is much slower than in traditional cigarettes.

PMI (NYSE:PM) has engineered a comprehensive and innovative response to these challenges. As recounted at the Philip Morris International Inc. Investor Day conference on June 26 2014, PMI anticipated the need for reduced risk products (RRPs) and pioneered their development, having set upon building their RRP capabilities in 2003. Their approach was not merely to build another e-cigarette. They understood that success depended on two factors. First, there had to be evidence of risk reduction based on sound scientific research. This would enable compliance with regulatory requirements. Second, they needed to preserve certain key aspects of the smoker's experience. Failure on either of these points would leave the new products vulnerable to regulatory curtailment, or would cause them to fall flat with smokers.

PMI built a unique capability to develop RRPs, investing $2B on research, development, scientific substantiation and adult smoker understanding. In addition to hiring over 300 world class scientists and engineers in key areas, they built a regulatory affairs group to guide their efforts in the emerging government regulation of RRP in all jurisdictions.

These comprehensive efforts resulted in a unique series of products. Like the makers of other cigarette alternatives, PMI's reduced risk efforts rely on the fact that it is not nicotine that is primarily responsible for the adverse health effects of smoking, rather, these are caused by the myriad substances contained in the smoke itself. But unlike current e-cigarettes, PMI's devices achieve a rate of absorption of nicotine which is as quick as with a combustible cigarette. This results in the anticipated "hit" that is key for smoker acceptance, and which current e-cigarettes lack. PM research suggests that while current smokers commonly try out e-cigarettes, few stick with them. This indicates a large potential market for PM's reduced risk products among smokers who are dissatisfied with current e-cigarettes.

The series of products that PMI has created will be released in the coming years. The first to market will be iQOS. This consists of a Marlboro branded tobacco "heat stick" similar to a cigarette that is heated but not burned in order to liberate inhaled nicotine vapor bearing the full tobacco flavor. A second heat-not-burn product termed Platform 2 is undergoing clinical studies and will launch as a pilot in cities in 2016. Platform 2 preserves even the lighting up phase of the cigarette ritual. It contains a capsule of pressed carbon which burns, but is separated from the tobacco stick portion of the cigarette-like design, which is heated without burning. Clinical studies are underway and city pilot studies are planned for 2016.

PMI also has two e-cigarette designs in development, using novel aerosolization technologies that give nicotine delivery profile superior to existing e-vapor devices. These will target current users of e-liquid or e-cigarettes.

PMI's aspiration is to demonstrate that their products have a risk reduction profile approaching that of cessation. Toxicological and short-term clinical studies for Platform 1 showed that biomarkers of exposure in users of Platform 1 were reduced and similar to smoking cessation. Longer-term reduced exposure studies are ongoing. These will measure the changes in clinical risk endpoints including biomarkers of exposure. Similar clinical studies for Platform 2 are planned.

Development of PMI's RRPs has been executed in accordance with the Modified Risk Tobacco Product Applications Guidelines of the U.S. Tobacco Control Act of 2009. This mandated the FDA to regulate product standards and require scientific evidence for claims of modified risk tobacco products. The more recent EU Tobacco Products Directive regulates e-cigarettes as tobacco-related products, and established a category of tobacco products, called "Novel Tobacco Products," requiring manufacturers to submit scientific data prior to marketing some of which are similar to the data required by the FDA in an MRTP Application.

Many public health advocates who have long opposed tobacco products are supporting tax regimes and marketing rules that would encourage switching from cigarettes to RRPs. As regulation applying to reduced risk cigarette alternatives evolves, PMI plans to be the leader in compliance, enabling early leadership in this emerging market which may represent the future of the tobacco industry.

The iQOS and other RRPs are not merely a response to the threat of regulation related to the public health concerns of governments. As Mr. Calantzopouolos stressed, they represent a potential paradigm shift for the tobacco industry, public health and adult smokers. In the new model, smokers will enjoy products with radically reduced or minimal risk to their health, but still enjoy the ritual and flavor of tobacco or satisfying e-cigarettes. This would be the first time in tobacco history that smokers switch to a product because it is in fact better, and in fact better for you than conventional cigarettes.

It seems likely that PMI will increase market share for two reasons. In accordance with the U.S. Tobacco Control Act Guidelines, the reduced risk products will be specifically targeted at smokers, they are not intended for non-smokers. Second, these products give smokers the key aspects of what they are accustomed to expect from smoking, without the unwanted aspects and stigma. PMI confirmed the potential of iQOS during our extensive adult consumer research conducted in several markets. For example in Japan and in Italy, after four weeks of usage, respectively 30% and 12% of the adult smokers who used the product, adopted it, strongly suggesting a success with smokers when introduced to market this fall initially in a testing phase in Italy and Japan. And, iQOS will have access to the large U.S. market. In December, 2013, PMI provided Altria Group, Inc. (MO) exclusive licensing to commercialize the heat-not-burn RRPs in the United States. Altria provided PMI with an exclusive license to commercialize Altria's e-vapor products internationally; both companies are to cooperate on scientific assessment, regulatory engagement and sharing improvements regarding those products.

In October, Andre Calantzopoulos, PMI's CEO, announced the opening of a pilot plant for producing RRPs. The full scale production facility currently in construction will be fully operational by end of 2016. Combined annual production will be up to 30B units (for perspective, PMI shipped 880B cigarettes in 2013). Sales are expected to potentially add additional margins of $720 million to $1.2 billion per year once volume of 30 - 50 billion units is achieved. (These additional earnings equal approximately 5.5% to 8.8% of 2013 operating earnings of 13.5$B).

For the past several decades, tobacco companies have relied increasingly on the price inelasticity of demand for cigarettes to continue increasing their revenue and profits. In the case of PMI, the upcoming reduced risk products represent a potential opportunity to increase market share and lead a new chapter in the tobacco history.

Summary:

For over 10 years, PMI has anticipated the challenge of reduced risk cigarette alternatives. PMI has developed reduced risk products that should be satisfying to smokers. It has invested substantially in development capabilities to bring these to market. Meanwhile, PMI's development efforts have been shaped by the need to be first to comply with emerging regulatory regimes governing cigarette alternatives, as these rules emerge. For the previous century, cigarette market share was achieved primarily by marketing art and distribution execution. For the first time, smokers will be offered a product that is actually better, as well as less harmful. In undertaking the prolonged and painstaking development of iQOS and other RRPs, PMI is extending its competitive advantages of brand market dominance and unparalleled research and regulatory compliance infrastructure into a key emerging tobacco market.

Analyst’s Disclosure: The author is long PM. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Disclaimer: This is not a recommendation to buy or sell any securities, and does not imply the acceptance of any responsibility for your financial well being. No guarantee is made as to the accuracy of the statements in this article.