Everyone knows tobacco kills. If there is one major flaw to the sale of this addictive product, whether from a moral ground or a financial ground, it is the death of the customer. This is a challenge that Philip Morris International (NYSE:PM) is tackling directly. They are doing this through the development, production, and sale of a product line referred to as iQOS. This is a RRP, which stands for "reduced-risk product". These products still have some negative health impacts, but according to the work done by Philip Morris the negative impacts are dramatically smaller than the impacts of traditional smoking.
Unlike Philip Morris International, the WHO (World Health Organization) would like to see smoking ceased entirely. The following chart demonstrates the expected health benefits under the WHO ideal regulatory scenario, which you can see represent only a moderate decrease in the negative Health impacts.
You can also see that if the smoker simply quit smoking they have a dramatic decrease in the risk factors. The benefits of quitting are demonstrated by the green lines.
Impact of the new product
The next slide incorporates an additional possibility. This is the possibility of the smoker switching to the new product from Philip Morris. The product, iQOS, is seen as a way to dramatically reduce Health implications. The yellow line on this chart demonstrates the health benefits from switching smokers from traditional cigarettes to the new iQOS product.
The reason this requires a separate chart is because the yellow line covers over most of the green line. From the research Philip Morris has done, it appears the new product will dramatically reduce risks. This is no small decline; the line is only slightly higher than the line created by quitting outright.
Odds of acceptance
That brings us to one of the most critical factors for any product designed to replace cigarettes. The chart below demonstrates the expected probability of adoption for new technologies. It also includes the probability for smokers to simply quit:
As you can see the odds of quitting without help are very low. The expected conversion rate for E-Vapor products is also terrible. When you look way over to the right on that bottom chart you'll notice that the expected adoption rate for iQOS is dramatically higher. Exact percentages are not given, but it is clearly materially higher than 50%. The impact from helping customers switch over to iQOS is huge. The benefits to Public Health could be incredible. Regardless, most legislation that targets tobacco products still targets alternative tobacco products as well.
Using the top line of the chart above, it is worth noting that iQOS does have a slightly higher level of negative health impacts then E-Vapor products. The health benefits of iQOS being slightly lower is more than made up for by the dramatically higher expected adoption rate. There is a potential benefit to Philip Morris from widespread adoption of their product. If Health policies are based on reducing risk factors for the population, then iQOS and E-Vapor products may receive more lenient treatment in the future. This is a questionable outcome. My belief is that most tobacco policies are designed to raise revenue rather than improve public health. The higher adoption rate of iQOS would allow Phillip Morris a huge advantage in competing for market share in the category of "alternative tobacco products".
The next slide deals with the commercialization progress. The major factor I want to address here is highlighted with a red square. See the slide below:
The results today have been stunted by manufacturing capacity. Think about that for a moment. The problem for Philip Morris in generating more widespread use of their new product is the difficulty of manufacturing enough of the new product. No one wants their company to have problems, but this is one of the best problems a company can have. Philip Morris expects to bring on dramatically higher production capacity within 2017. They are projecting $1.2 billion in total capital expenditures this year and $1.5 billion in total Capital expenditures for 2017.
Some shareholders have been concerned that Philip Morris was growing dividends slowly over the last few years. When you consider that Philip Morris was and still is funding a heavy program of capital expenditures to increase their production capacity on a very appealing new product, it may be easier to be patient with the tobacco Giant. When high levels of capital expenditures are finished, Philip Morris will have more room to grow dividends. The net cash flow impact projected by Philip Morris is very positive. Management estimates a payback period of less than one year from the start of production.
Positive for MO
Altria Group (NYSE:MO) and Philip Morris International were two parts of the same company. They split to benefit shareholders by allowing the investors to pick more or less of either part of the company. Consequently, they still have a great working relationship. The success of iQOS internationally should bode well for MO. Like many dividend investors, I own shares in both. PM has the heavier weight.
Philip Morris will always face international regulation. They understand how to navigate the situations. Even the new regulations in the Philippines hardly threaten their annual profits. An impact a less than a cent per share is not enough to concern me as a shareholder. On the other hand, seeing dramatic success in the new product line makes me feel quite bullish. The company offers an addictive dividend yield and the opportunity for more income growth after they finish capital expenditures.
My rating on PM remains a buy. Dividend growth is only delayed by investments in projects with extremely high expected returns. As much as I enjoy my dividends, I'll happily wait while they fund more production for iQOS.
Want to know more about my views on Philip Morris? Check out my recent article on why the market keeps overlooking the 4.2% yield on this dividend champion.
Disclosure: I am/we are long PM, MO.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. This article is prepared solely for publication on Seeking Alpha and any reproduction of it on other sites is unauthorized. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis. Tipranks: Assign buy rating to PM and MO.