Philip Morris: Prohibition On Flavored Heated Tobacco Product Pose Near-Term Risk (PM)

Philip Morris International (NYSE:PM) aims to achieve two-thirds of its total revenue from smoke-free products by 2030, reflecting the increasing trend of adult smokers transitioning to smoke-free alternatives. The acquisition of Swedish Match enhances PM’s position, particularly with the IQOS and ZYN portfolios, positioning the company to capitalize on the rapid growth of the e-cigarette market in both the U.S. and international markets.

The recent implementation of the prohibition on flavored heated tobacco in the EU on October 23rd, 2023, and the potential adoption in other countries by 2024, poses a near-term challenge for PMI’s IQOS products. Despite this, considering the overall outlook, I recommend a ‘Hold’ rating with a fair value of $105 per share.

Smoke-Free Products Drive Majority of Nicotine Market Growth

The volumes of traditional combustible products have been on a decline for years, reflecting a trend where more adults are quitting smoking for better health. The growth in traditional cigarettes is primarily driven by pricing.

As illustrated in the chart below, the volume of combustibles is estimated to decline by -4% to -2% from 2024 to 2026.

While smoke-free products currently represent just above 13% of the total retail value, they are projected to experience robust growth at an annual compound rate of 15-20%. In essence, smoke-free products are the primary drivers of growth in the nicotine market.

Currently, PMI generates over 67% of group sales from combustible tobacco products. However, the company is strategically shifting its focus by investing in smoke-free products through internal development and acquisitions, aiming to achieve two-thirds of total revenue from these products by 2030.

This transformation makes strategic sense for several reasons. On one hand, there is a limit to future price increases. At some point, these increases may not be sufficient to offset the declining volume growth. While consumers generally accept inflation-adjusted price increases, if the volume decline surpasses the inflation rate, the growth of the combustible tobacco business could decline. As shown in the table below, PMI successfully increased pricing and mix by more than 5% in the pre-pandemic period, effectively offsetting volume declines. However, sustaining a 5% price growth in the future is questionable.

On the other hand, Heat-Not-Burn, E-vapor, and pouches products are gaining popularity among adults. With these smoke-free alternatives, PMI can offer a diverse range of consumables and flavors, potentially appealing to a wide demographic. It’s important to note that while these versatile flavors can attract a broad audience, they may also pose regulatory issues and risks for PMI, a topic I will discuss later.

Swedish Match acquisition

In May 2022, PMI agreed to acquire Swedish Match for $16 billion, marking a strategic move to re-enter the U.S. market. The acquisition price was approximately 17x EV/EBITDA multiple. Swedish Match’s leading nicotine pouch product, ZYN, is set to strengthen PMI’s smoke-free portfolio, which includes heated tobacco products and e-vapor devices. This acquisition enables PMI to synergize the development of IQOS and ZYN in both the U.S. and international markets.

This historic acquisition positions PMI to enter the sizable and lucrative U.S. nicotine market, competing directly against Altria (MO). With the prominent brands ZYN and IQOS, PMI can enhance its strategic foothold in tobacco-free products, gaining a larger share in rapidly growing markets. Notably, as a consequence of the acquisition, PMI has temporarily suspended its share repurchase plan.

Regulations Headwinds: Prohibition on Flavored Heated Tobacco Products

EU member states implemented the prohibition on flavored heated tobacco products into national law by July 23, 2023, and applied the provisions on October 23, 2023. In the U.S., the FDA banned flavors in cigarettes in 2009, with menthol being exempt due to lobbying efforts. As media reported, FDA still plans to finalize rules that would prohibit the sale of menthol cigarettes and flavored cigars in 2023, but the agency is running behind schedule.

According to a CDC study, in 2023, 22.2% of U.S. middle and high school students reported ever using any tobacco product, with e-cigarettes being the most popular among students. Their preferred flavors include fruit, candy, mint, and menthol. Flavored heated tobacco products pose a higher risk of addiction for these teenagers, as they are attracted to the taste of flavors rather than the cigarettes themselves.

For PMI, these bans present short-term growth headwinds for their heated tobacco units (HTU). Additionally, PMI is likely to face inventory issues resulting from these bans. During the Q3 2023 earnings call, the company mentioned adjustments to their HTU portfolios as required by regulations, indicating the possibility of short-term volatility.

Another market of concern is Japan, where PMI’s IQOS products hold a significant market share of 26% in the HTU market. Menthol brands of regular cigarettes have been popular in Japan for decades, constituting around 30% of sales as reported by the media. Presently, Japan has not implemented regulations similar to the EU and the U.S. on flavored tobacco products. However, I anticipate that Japan may eventually follow suit, posing another potential material headwind for PMI in the future.

Recent Results and Outlook

As a tobacco company, PMI has demonstrated high profitability, boasting an operating margin of approximately 40%, with past growth predominantly driven by price increases. As PMI undergoes its smoke-free transformation, it is reasonable to anticipate that volume will play a more substantial role in overall growth as smoke-free products secure a larger share of group revenues.

The company exhibits a very high free cash flow conversion rate, standing at above 30%. Notably, a significant portion of the free cash flow is allocated to dividend payments.

Their balance sheet remains robust and healthy, with a target of around 2.0x net debt to adjusted EBITDA by the end of 2026. For mid-term growth targets, they aim for 6-8% organic revenue growth and 9-11% adjusted EPS growth. This overall growth rate appears quite aggressive, especially at the high end of the guidance spectrum. The tobacco industry as a whole is expected to grow at 3-5%, as indicated by PMI in their 2023 capital market day.

Achieving the high end of the organic revenue growth range necessitates gaining substantial market share in the smoke-free markets. While the Swedish Match acquisition could contribute to growth, particularly with nicotine pouches expected to grow at 30%+, re-entering the U.S. market may enable PMI to capture shares from its rival Altria. In summary, considering these factors, the low-to-mid range of their guidance appears realistic.

During Q3 FY23, they achieved a robust 9.3% organic revenue growth and an impressive 18.5% growth in adjusted operating profit. It was a strong quarter overall. For the full year, they anticipate a total cigarette and HTU shipment volume growth for PMI of 1.0% to 1.5%, with net revenue expected to grow around 8.0% on an organic basis. There won’t be any share repurchases this year, and they continue to guide $10 billion of operating cash flow and $1.3 billion of capital expenditure.

Key Risks

Ukraine and Russia: In 2022, Russia and Ukraine collectively contributed approximately 8% to PMI’s total net revenues. While PMI continues its commercial activities in select locations in Ukraine, the company is actively evaluating its operations in Russia. In their Q3 FY23 results, PMI disclosed an investment of $30 million in a new production facility in the Lviv region of Western Ukraine, signaling a commitment to certain regions.

The ongoing weakening of the Russian ruble against the dollar poses a significant foreign exchange headwind for PMI. Considering the geopolitical situation, it is conceivable that PMI may eventually exit the Russian market, aligning with the decisions made by many multinational companies in the wake of the conflict.

ESG Funds: As a tobacco company, the fact remains that it contributes to the harm to human health. In recent years, ESG (Environmental, Social, and Governance) funds have gained popularity. Tobacco and alcohol companies are often excluded from these funds during the screening process of their investment universe. Bloomberg predicts that ESG assets may reach $53 trillion by 2025, representing a third of global AUM. Therefore, the increasing popularity of ESG assets poses a structural risk for PMI.

Valuation

As discussed previously, I anticipate that traditional combustible tobacco products will experience low-single-digit growth, with price increases offsetting some volume declines. PMI’s future growth is predominantly driven by smoke-free products and their re-entry into the U.S. market. Based on my calculations considering their business mix, I assume a 6% normalized organic revenue growth in the coming years, with acquisitions potentially adding another 1.6% to topline growth. However, for FY24, I expect a growth headwind due to new regulations coming into effect.

Overall, my margin and revenue growth assumptions align with the low end of their officially stated mid-term growth rate. Unless they engage in stock repurchases, achieving double-digit EPS growth appears highly unlikely, based on my estimates.

The model employs a 10% discount rate, 4% terminal growth, and a 21% tax rate. Based on these parameters, the fair value of their stock price is calculated to be $105 per share in the DCF model.

Conclusion

As a tobacco company, PMI is highly profitable, but the new EU regulation and the potential U.S. ban on menthol flavors could lead to inventory disruptions and growth headwinds. Given these regulatory uncertainties, I am initiating PMI with a ‘Hold’ rating at a fair value of $105 per share.