My recent article, Philip Morris On A Downhill Slope, pointed out the company has come dangerously close to having to cut its dividend, possibly as soon as this year or next. In response, some commenters have pointed out that Philip Morris is investing large sums in IQOS, an “advanced, smoke-free” product that uses “sophisticated electronics to heat tobacco in order to release flavors and nicotine.”
A bunch of smoke and mirrors if you ask me.
Take smoke out; leave nicotine in.
The company’s profits depend on its customers’ addiction to nicotine. This is why the company is trying to find new ways to heat tobacco, which contains the addictive chemical called nicotine, rather than burn it, which the company claims is the primary reason for the negative health effects of smoking cigarettes. The company claims in its latest Form 10-Q that studies “show a substantial reduction in relevant biomarkers of exposure to [harmful and potentially harmful constituents] in those adult smokers who switched completely to IQOS compared to those who continued to smoke cigarettes.”
The company later acknowledges, however, that “RRPs (reduced-risk products) contain nicotine and are not risk-free,” and later states that, “Some governments have banned or are seeking to ban or severely restrict emerging tobacco and nicotine-containing products such as our RRPs.”
I would recommend every Philip Morris investor to carefully read pages 42 through 47 of the latest Form 10-Q in order to understand the business potential and risks of RRPs.
What do we know?
Investors have very little information on the business potential of RRPs outside of what the company provides, which is not much. The company claims that:
- RRPs significantly reduce harmful and potentially harmful constituents found in cigarettes;
- In 1Q16, the company started large scale commercial production of heated tobacco units, and the demand for RRPs in test markets, especially in Japan, is surprisingly high;
- In response, the company expects to ramp up its production capacity from 15 billion heated tobacco units at 2016 year-end, to 50 billion units by 2017 year-end, and to 100 billion units by 2018 year-end.
For your reference, the company shipped nearly 813 billion cigarettes in 2016, down 4.1% or 34 billion cigarettes from 2015. As the following table from the company’s latest Form 10-K filing shows, the number of cigarettes shipped has been declining for some time.
It is not clear at this time if RRPs will grow quickly enough to mitigate the ongoing decline in number of cigarettes shipped. Readers should note that the primary target for RRPs are likely the people who currently smoke cigarettes, so I expect some Osborne effect on cigarette sales as RRP sales grow.
What do we not know?
In order to fully understand the business potential and risks of RRPs, the company should provide its investors with the following:
- How does RRPs’ profitability compare to the profitability of cigarettes? Even if the company is successful in moving all of its customers from cigarette smoking to RRPs, which is unlikely, how will the company’s future profits compare to profits it generated in the past?
- What has been the cigarette volume trends in test markets? Has there been a significant Osborne effect from RRP sales on cigarette sales?
- How do regulation and taxation of RRPs compare to those of cigarettes? Will excise taxes paid be any less for RRPs than the increasing amounts paid on cigarettes sales?
- What are the deterrents to consumer adoption of RRPs? Does the upfront cost of purchasing an IQOS heating device, as opposed to the low-ticket item cigarettes, slow down consumer adoption? Will RRP sales continue to enjoy the same level of impulse purchases from low-income smokers?
- Will the company’s revenues and profits become relatively more cyclical since the high cost of an IQOS heating device may prevent customers from purchasing new or replacement devices at times of economic stress? How would increased exposure to economic cycles affect the company’s credit rating, balance sheet exposure to credit cycles, and the discount rate investors use to value the company?
- Can the company retrofit its existing manufacturing facilities to produce IQOS and HEETS? If not, how much in capital expenditures is needed to bring production capacity up to 100 billion by end-2018?
- If the company cannot grow its production capacity of RRPs quickly enough to make up for the declines in cigarette shipments, how does the company plan to appease credit agencies that may point to the potential deterioration in interest coverage? Given the company’s dangerously high debt-to-asset ratio, as I pointed out in my earlier article, the company’s interest coverage is likely the primary reason why it still enjoys a favorable credit rating. As Standard & Poor’s noted in 2016, however, as it revised its outlook on the company’s credit rating to negative, this may change:
The negative outlook reflects our view that PMI’s credit metrics may remain weak for an ‘A’ rating. We could lower the ratings within the next 24 months if PMI’s credit metrics fail to recover. We consider Standard & Poor’s-adjusted debt to EBITDA of around 2.0x and free operating cash flow to debt of around 25% to be commensurate with the current rating.
There are too many unknowns around the business potential and risks of RRPs to conclude that RRPs will save Philip Morris from a potential dividend cut. Until then, investors are stuck with declining unit sales, increasing excise taxes paid, a dangerously high debt-to-asset ratio, negative credit outlook, and a management team that prioritizes dividend yield over the health of the company’s balance sheet.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.