iQOS: A Product Of Innovation Or Necessity For Philip Morris?

| About: Philip Morris (PM)
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Summary

Philip Morris aims to garner 10-15% of its sales from its Reduced-Risk Products (RRPs) portfolio within a decade. It is betting on one such product, iQOS, and feels it will become more popular than e-cigarettes sold by other companies.

Philip Morrris expects its RRPs to approach breakeven Operating Companies Income (OCI) in 2017, and to start contributing positively by 2018. It is targeting 30-50 billion units in incremental volume through RRPs, which would add an additional OCI of $0.7 billion to $1.2 billion by 2020, with an increasing confidence of reaching the upper end of the target range.

Conversion rates of iQOS purchasers who have fully or predominantly moved to the product have grown over time, and stood at approximately 70% at the end of 2016. As of year-end 2016, the company estimates that approximately 1.4 million adult consumers have quit cigarettes and converted to iQOS.

Philip Morris International (NYSE:PM) uses the term Reduced-Risk Products (RRPs) to refer to products with the "potential to reduce individual risk and population harm, in comparison to smoking cigarettes." The company has a number of products in various stages of development and commercialization, with numerous scientific studies being carried out to determine whether the claims for reduced risks can be substantiated. The firm's aim is to garner 10-15% of its sales from its RRPs portfolio within a decade.

The company is betting on one such product, iQOS, a black pen-shaped device that heats sticks containing tobacco, and feels it will become more popular than e-cigarettes sold by other companies. Philip Morris has collaborated with Altria (NYSE:MO) for developing its RRP portfolio, which includes joint research, development, and a technology sharing agreement, wherein the e-vapor products developed would be commercialized in the US by Altria and in markets outside the US by PM. The company is also leveraging the popularity of the Marlboro brand by deploying Marlboro heatsticks in iQOS.

Game Changer For Philip Morris

iQOS is the result of more than a decade of research on a range of potentially reduced-risk products, which can prove to be an alternative to traditional cigarettes. The research, conducted by over 430 scientists in Philip Morris' R&D facilities in Switzerland, involved an investment of $3 billion by the company. According to its research, the device yields, on average, less than 10% of the harmful constituents found in cigarette smoke. However, despite the growing awareness and publicity with regard to vaporizers and e-cigarettes, this segment still remains an insignificant part of tobacco firms' income.

PM expects its RRPs to approach breakeven OCI (Operating Companies Income) in 2017, and to start contributing positively by 2018. The company is targeting 30-50 billion units in incremental volume through RRPs, which would add an additional OCI of $0.7 billion to $1.2 billion by 2020, with an increasing confidence of reaching the upper end of the target range.

According to a Wells Fargo analysis of the future for the iQOS platform, the product has the potential for expanding the profit pool growth of combustible cigarettes and RRPs in the next decade by 400 basis points to a 12.5% CAGR for PM. Further, it was also found that iQOS could displace up to 30% of the cigarette industry in developed markets by 2025, speeding up the premiumization of the market. This lends credence to the fact that iQOS could be a game changer for Philip Morris in the years to come.

iQOS Market Share- Japan

Besides the product's impressive showing in Japan, it has performed favorably globally as well, serving as an indicator of the future potential of iQOS. Conversion rates of iQOS purchasers who have fully or predominantly moved to the product have grown over time, and stood at approximately 70% at the end of 2016. As of year-end 2016, the company estimates that approximately 1.4 million adult consumers have quit cigarettes and converted to iQOS. Moreover, during the fourth quarter, estimated offtake volume in all markets, with launches prior to mid-year, grew at a compound weekly rate of over 6%, comparable to Japan in the initial launch phase. This trend bodes well for the future national expansions, since in Japan, it resulted in an accelerated growth.

Till December end, iQOS had been launched in key cities in 20 markets globally, with aims to expand nationally in many of these markets this year. The company is also targeting additional launches in 10 to 15 markets by year-end, subject to capacity. Currently, PM has 15 billion units of installed annual HeatSticks capacity, and expects over 32 billion units in total capacity to be available for commercialization this year. It anticipates an installed annual capacity of approximately 50 billion units by year end.

Need For Cigarette Alternatives

According to WHO estimates, there will still be over a billion smokers by 2025. With such a huge demand for tobacco products in the future, the presence of less harmful alternatives to cigarettes is essential. For this, not only do alternatives need to be developed, but they also must be appealing to consumers. A significant health benefit can only be achieved when a large number of smokers switch from cigarettes to such products. The company's innovation pipeline includes four product platforms that can meet the varying preferences of adult smokers, aiding them in the switch.

Smokers 2025

Given this situation, Philip Morris, on January 25, reaffirmed its commitment to designing a smoke-free future. The company's momentum continues to grow behind a full-scale effort to market smoke-free products that can ultimately replace cigarettes, after a successful iQOS launch. According to Tony Snyder, Vice President of Communications, adult smokers are looking for products "that offer the satisfying taste, ritual, and pleasure they get from cigarettes, but with far lower amounts of the harmful compounds found in smoke."

PM also aims to transition its resources from cigarettes to smoke-free alternatives in the future, and has proposed regulatory policies that encourage the replacement of cigarettes with such alternatives. The company has recognized the serious health risks posed by cigarettes and other tobacco products. Hence, accordingly, it feels an obligation to develop and market products responsibly. Success in the cigarette business has given PM the resources to pursue this ambitious vision.

Disclosure: No positions.