Description

Elevator Pitch

PM has the potential to generate a 75% return in the next 2 years as organic revenue and EPS growth accelerate.  IQoS (heat not burn cigarette alternative) is a game changing product that represents ~30% of revenue growing 25-35% per annum with a lower price to the consumer, 2x higher usage (double the revenue per use) and higher margins to PM. PMI presents a unique opportunity to invest in a large cap market leader that is disrupting itself with a more profitable innovation trading at 15x P/E. The terminal growth story is structurally changing and with a 5% dividend yield that the stock has strong downside support.

Thesis

The leading global tobacco company (with ~20% share) is disrupting the industry through its Heated Tobacco Product: iQOS (currently has an 80% share). The core cigarette business is a LSD volumetric decliner with MSD to HSD pricing power which drivers higher revenues and margins in the legacy business. iQOS is projected to be 50% of revenue within 3 yrs which should drive accelerated top line growth from 2025-2030 and beyond.  As PMI accelerates revenue growth to HSD and EPS growth to the mid-teens investors will likely re-rate the multiple higher.  

Business Description

Without spending too much time on the legacy cigarette business, Philip Morris is the clear international leader in the tobacco industry as the owner of the dominant premium brand, Marlboro. PMI has 25% cigarettes volume share outside the US & China with dominant (60%+) control of volumes in its core markets. Tobacco is one of the most consolidated industry in the world with 5 players controlling over 80% of the market outside of China. Accordingly, cigarettes are a excellent cash cow with significant pricing power, extreme brand loyalty, heavy regulation insulating incumbents, and 45%+ EBITDA margins. It is also well known that cigarette volumes have been in structural decline for decades which rightfully weighs on the terminal value of cigarette businesses.

In 2015, PMI launched the first Heat Not Burn (HNB) product, iQOS. The rollout was not without its hiccups and growing pains but now the segment is a well-oiled machine that makes up 30% of revenue and is on path to be 50% of sales by 2025. iQOS now has over 20M users worldwide and nearly 75% of them have switched over from cigarettes. iQOS is now the #3 brand globally in its launched markets after Marlboro and Winston. 70% of iQOS users are PMI cigarette customers and 30% are won over from competing brands. Regulators prefer iQOS and have limited the excise taxes which drives significantly lower pricing to the end consumer providing a strong incentive to switch.  Ironically, iQOS has a significantly higher margin and 2-4x the profitability to PM.

Variant Perception

PM is putting on a masterclass in incumbent innovation which will drive growth for years to come – It is rare to find market leaders who are the first movers in industry transitions outside of leading technology companies. It is even more rare to see the new disruptive technology / product come with superior unit economics. Just like with cigarettes, HNB is shaping up to be a winner-take-most market and quality of the product drives brand loyalty.

Framework: Late Stage Compounder / Turnaround

Value Proposition

Heat Not Burn is a next generation product (NGP) or Reduced Risk Product (RRP) that claims to be more than 90% healthier than traditional cigarettes. Heating the tobacco rather than burning it, as the name suggests, prevents many toxins from being released. Not only is it better for the smoker but it drastically reduces any secondhand smoke. For this reason, many restaurants and offices allow HNB products to be used indoors. The other key advantage to HNB products is that they are often ~20% cheaper for consumers in most markets, which is explained in greater depth below.

The other two NGP categories are e-cigarettes (vapes) and oral (chew tobacco). While some markets, e.g. UK, have taken to vaping, the overwhelming majority of global smokers have resoundingly said that HNB is the best substitute. PM recognized this early and went all in on this category while its smaller competitors have tried to build a portfolio of NGPs across product categories. Now with established branding and dominant ~80% share, it will be hard for any HNB competitors to take share even as the category continues to expand.

Total Addressable Market

While iQOS has already passed 20M users, volumes are still only a low teens percent of PMI’s total output. At a current run rate of ~100B units, the serviceable market in launched geographies is 8x (see chart above). Taking a step back, the total cigarette market outside of US & China is 25x the size of iQOS current volume. The product is currently live in over 64 markets with a plan to get to over 100 by 2025. Also it is worth noting that PMI has a licensing deal with Altria in place to eventually launch in the US, which would be a new market for them that with very health conscious and less price sensitive consumers and this would be high margin royalty income.

The volume potential for iQOS is not even the full story. Currently, revenue per unit on IQOS vs. cigarettes is ~2.5x so the volume conversion comes with significantly higher revenue for PMI. This ignores the additional behavioral aspect that often times converted iQOS users have to smoke more frequently to achieve the same level of nicotine intake as traditional cigarettes.

Superior Unit Economics

Higher net revenue per stick and moderate increase in usage frequency gives iQOS a much more attractive unit economics. This results in iQOS being 2-4x as profitable for PMI depending on the geography with under 1 year pay back I newly launched markets.

The key to iQOS being cheaper for consumers but also higher unit revenue for PMI is the rate that the product is taxed. Giant tobacco companies work closely together with governments as key tax revenue generators to plan out excise tax hikes on cigarettes. PMI has leveraged these relationships to establish iQOS / HNB products at a substantially lower tax rate than traditional cigarettes. For example, in most of the EU, while cigarettes often carry a ~75% tax, HNB products are only taxed at a quarter of that. Governments are on board with this because of the proven health benefits from smokers transitioning to a safer product. Morally, this is the correct incentive but the lost tobacco revenue is made up for on the back end in medical costs saved from the reduction cigarette smoking. 

Finally, PMI has said it plans to take price on iQOS sticks in the near-term to drive net revenue per unit even higher. In the majority of markets, iQOS was launched at a similar retail price as cigarettes, but then kept flat as cigarettes saw msd-hsd% price increases annually.

Competitive Advantage

Simply put, iQOS is the best HNB device on the market, was the first mover, and had the largest marketing and distribution force in the industry pushing it. PM started this push long before its competitors and has spent billions to drive superior technology. Along the way, the company was granted several patents around key components boxing others out. This has resulted in roughly 80% share across launched markets. PM is competing with inferior, subscale products from unfocused companies. This has resulted in iQOS gaining marginal share in recent years. We believe iQOS should be able to maintain 70% share of HNB markets at maturity.

Currently British American Tobacco (BATS), the number two in tobacco, is aggressively pushing their competing Glo HNB product. The physical device is being priced at an average discount of 70% vs iQOS and the sticks are roughly 20% cheaper. PM already sells the iQOS device at cost so BATS is likely selling the product at a loss. BATS venture into NGPs has been a disaster to date as its 2022 target of £5B segment revenue has been pushed to 2025. Furthermore, inside that ~$2B segment (vs. $7B for PMI), only 40% of that is HNB. BATS has had greater success with vapes in certain stronghold markets, namely the UK and US.

New CEO

In May, Jacek Olczak took over at CEO from André Calantzopoulos and should accelerate iQOS’ growth as the previous COO is known for his go-to-market prowess. While Andre was great at shifting the company culture and priorities to think beyond cigarettes when he took over in 2013, PMI is beyond the ideation phase and is in execution mode. They have established their vision for a cigarette free future and continue to push their ESG agenda.

Cigarette Outlook

Cigarette volumes are in structural decline and have been for decades so there is no reason to belabor that point. It is important to put numerical context to this decline though

·        Steady state volume declines are

o   -2.5 to -3% per year in developed markets

o   -0.5% to 1% in emerging markets

·        These figures are essentially double in markets where HNB products are present

o   The graph at the start of writeup shows this effect

Cigarette consumption will continue to decline but much like other game changing technologies such as EVs or green energy sources, the transition is likely to take longer than many realize, especially in emerging markets. While PM touts their vision to no longer sell cigarettes by 2030, we believe that it could take 2-3x longer.

Again, this is about volumetric decline. From a revenue perspective, we expect revenue to remain flat to up as PM takes price to offset declines. With >100% incremental margins, the price vs. volume tradeoff should drive continued margin expansion while PM manages the transition away from cigarettes.

Beyond Nicotine

At their spring investor day, PM laid out a goal to get to $1B of revenue from non-nicotine segments. This likely be be <3% of their top line so not a huge area of focus right now but does become increasingly important when talking about terminal value. Currently the focus has been on pharmaceutical acquisitions, particularly in inhalant categories. As of late, they have made a couple of acquisitions and are in the process of closing another

·        Fertin Pharma for $800M in July

·        OtiTopic this month

·        Upped offer for Vectura to $1.5B in bidding war against Carlyle

While these deals send the right corporate messaging, we believe the lowest hanging fruit for PM beyond nicotine is cannabis. While not a direct substitute for tobacco from a use case, the raw material, regulatory scrutiny, and distribution are similar. PM is in a perfect position to leverage its existing infrastructure to take part in rapidly growing cannabis market that is expected to be worth over $30B in Europe alone within 5 years. HNB technology should be transferable to cannabis and iQOS would only require minor tweaks to replicate its success with tobacco. There is no shortage of reports and anecdotes online of people retrofitting their iQOS devices themselves to work with cannaboid smokables. PM is likely to wait for sweeping federal approval to get involved in this industry but there is potentially massive upside here not in anybody’s projections.

Key Investment Factors

·        iQOS volume mix & market share

·        Legal affairs (taxes, patent litigation)

Risks / Pre-Mortem

iQOS Adoption

Japan is iQOS’ most mature market and growth has slowed to msd% after hitting roughly 30% of overall tobacco mix and this has caused people to question the notion of full cigarette conversion. Worth pointing out that at 2.5x the revenue per unit, PMI getting 30% of global volumes shifted to iQOS would mean ~75% of their revenue is coming from this segment. Additionally, as previously stated, when iQOS is not cannibalizing the cigarette market, the decline in legacy volumes is half as steep.

Tax Increases on HNB Products

Going hand-in-hand with adoption, there is growing concern that as governments lose out on cigarette revenue they will make it up through increasing the taxes on HNBs and other RRPs. Bears argue that this increase would kill the incremental profitability that iQOS brings in for PMI. While we expect taxes levied on iQOS to increase over time, we expect a materially lower rate vs. cigarettes will be maintained because governments still would rather have citizens switch to a healthier product. Additionally, PMI has room to raise prices along with increased taxes to grow net revenues, just like with cigarettes. Finally, as competitors struggle to gain footing in the HNB market, any increase in taxes that harms the unit economics insulates iQOS as the scaled leader and turns off new entrants

Accelerated Decline in Smokers

As populations increase their health education and taxes on cigarettes make them more expensive, there should be a continued decline in the number of smokers and while an accelerated drop is always a theoretical risk, there is no evidence or catalyst this should happen any time soon. HNB products like iQOS are the most pronounced accelerant of cigarette declines.

Competition / Litigation

The same way people have brand loyalty with Marlboro, the same applies to iQOS. BATS is the main threat here from a patent infringement and competition standpoint. The Glo product was discussed above as the #2 HNB product but it is worth reiterating that even with aggressive undercutting on price, BATS is making little headway. The most success they have had is in Japan with 20% volume (not revenue) share. Premium products have always dominated the tobacco space and ultimately consumers do not want the cheapest option. Quality is the priority and iQOS’ technological superiority and first mover foothold should shield its positioning. The new management team at BATS are short-term fixated and all allocating resources across their RRP portfolio. They have yet to prove they can build a strong brand in any category.

On the legal side, BATS brought cases against iQOS in Germany and the UK last year. In March, the UK high court ruled in favor of PM by revoking BATS’ patents stating that they were obvious and lacked an inventive step. BATS was also unsuccessful in Poland, Romania, the Czech Republic and Bulgaria. PM had sued BATS in Japan to little avail as well. The argument focuses on iQOS heating blade, a critical component that regulates the device temperature to prevent the tobacco from burning. While the companies await a ruling in Germany, it is worth pointing out that the new iQOS ILUMA, launching later this year, uses different heating technology.

BATS won the initial determination from the ITC in the US, saying iQOS may infringe on US patents. Altria is supposed to be rolling iQOS out in the US as part of a licensing agreement post FDA approval but this infringement case is a roadblock that may lead to a ban. The case is now in front of the full ITC tribunal with a ruling expected by September 15^th. Since PM does not currently operate in the US, this would just be lost upside from royalty revenues.

Valuation

Using a discounted cash flow model with an 8% terminal discount rate which implies a $180-200/share of fair value (assuming 0-1% terminal growth). At the high end of that range of $200, PM would be commanding a 15x EBITDA multiple, which is where it traded in 2016-2017 pre-iQOS rollout.

DCF assumptions include

·        Revenue grows at an 8.5% CAGR

o   iQOS sales growing >19% p.a.

o   Cigarette sales shrinking >-3% annually

·        This implies iQOS revenue becomes 78% of the revenue mix

·        EBITDA margins step up to 58% from 44% last year

PM currently trades at 15x FY22 EPS vs. its 7 year average multiple of 17.6x. Lower growth consumer staples trade at 25x which is more in line with PM’s historical peak. The same discount applies when looking at its 4.7% dividend yield. While PM trades at a premium compared to its subscale tobacco competitors on a P/E basis, it is actually the cheapest when adjusted for growth with a PEG below 1.5x which is towards its 10 year historical trough. PM is taking the steps to get meet ESG criteria in the debt markets which should help remove any remaining negative overhang as the stock looks to break out to 4 year highs

DISCLAIMER

The information in this presentation is for illustration and discussion purposes only.  It is not intended to be, nor should it be construed or used as, investment, tax or legal advice, any recommendation or opinion regarding the appropriateness or suitability of any investment or strategy, or an offer to sell, or a solicitation of an offer to buy, an interest in any security. This material does not take into account the particular investment objectives, restrictions, or financial, legal or tax situation of any specific investor. You should not rely in any way on this summary. Performance targets or objectives should not be relied upon as an indication of actual or projected future performance.  Actual returns will depend on a variety of factors including overall market conditions. No representation is made that these targets or objectives will be achieved, in whole or in part. This information is as of the date indicated, is not complete and is subject to change. Certain information has been provided by and/or is based on third party sources and, although believed to be reliable, has not been independently verified.  The preparer is not responsible for errors or omissions from these sources.  No representation is made with respect to the accuracy, completeness or timeliness of information and the preparer assumes no obligation to update or otherwise revise such information. 

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Catalyst

iQOS growth, M&A, ESG approvals