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Philip Morris (PM) Gains on Solid Pricing, High Costs a Worry

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Philip Morris International Inc. (PM - Free Report) has been benefiting from its solid pricing power for quite some time now. Also, a focus on reduced risk products (RRPs) has been working well, given consumers’ increased inclination to this category. That said, the company is battling supply-chain and regulatory hurdles in its Russian business due to the war. Philip Morris has taken strong steps to scale down its operations in the region. Certain pandemic-led hurdles and escalated costs are also concerns.

Let’s delve deeper.

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Factors Acting Well for Philip Morris

Robust pricing has been aiding PM for a while. Though higher pricing might lead to a possible decline in cigarette consumption, it is seen that smokers tend to absorb price increases due to the addictive quality of cigarettes. Higher pricing variance was an upside for the company’s performance across most regions in the first quarter of 2022. During the quarter, the top and the bottom lines improved year over year and beat the respective Zacks Consensus Estimate. The strength in IQOS and the combustible business drove Philip Morris’ first-quarter performance despite headwinds.  Pricing for combustible products rose more than 3% and by roughly 6%, excluding Indonesia.

The relaxation of device-supply limitations helped replenish channel inventories, which is likely to continue in the second quarter as well. Net revenues per unit rose 5.3% on an organic basis due to the higher proportion of heated tobacco units in the company’s sales mix, increased device sales and greater pricing. For 2022, PM expects proforma adjusted net revenues to increase by nearly 4.5-6.5% on an organic basis. For the second quarter of 2022, proforma net revenue growth is expected in the low single-digits on an organic basis.

The company is progressing well with its business transformation, with smoke-free products generating more than 30% of the company’s net revenues in the first quarter of 2022. The company is well-placed for becoming a majority smoke-free company by 2025. To this end, the company’s IQOS, a heat-not-burn device, counts among one of the leading RRPs in the industry. The company has been committed to expanding these products as part of its smoke-free transformation. The company started commercializing IQOS VEEV, its new e-vapor product. It also launched IQOS ILUMA in Japan.

In the RRPs category, revenues increased 22.8% to $2,145 million in the first quarter of 2022. Heated tobacco unit shipment volumes of 24.8 billion units rose 14.2% year over year. However, on Nov 29, 2021, an importation ban and a cease-and-desist order were imposed by the U.S. International Trade Commission concerning IQOS Platform 1 products. These include consumables and infringing components. The company expects an improving IQOS supply situation, while the timing of full availability remains uncertain.  Among other initiatives, Philip Morris announced a partnership with South Korea’s KT&G in January 2020 to commercialize the latter’s smoke-free products outside the country. 

Key Headwinds

On its first-quarter 2022 earnings call, management stated that its Ukraine manufacturing facility in Kharkiv remains suspended. Further, on Mar 24, the company stated that its team was exploring options to exit the Russian market in a planned way. The company has been facing several supply-chain and regulatory hurdles in its Russian business and has taken strong steps to scale down its operations in the region, including the cancellation of all new investments and product launches, such as IQOS ILUMA and IQOS VEEV. It is also delisting 25% of its cigarette products, including Marlboro and Parliament SKUs. The war has further disrupted the global supply chain and has increased inflationary pressure on certain materials and services.

On its first-quarter 2022 earnings call, management also highlighted that it expects continued uncertainty concerning the recovery pace from the pandemic-led operating landscape, especially in the South & Southeast Asia region, in 2022.  Management expects continued gradual recovery in the duty-free business outside Asia and no meaningful recovery in Asia.

Apart from this, the company is encountering cost escalations. In the first quarter of 2022, the adjusted operating income margin fell 30 basis points (bps) on an organic basis. The decline can be attributed to comparisons with the solid margin performance in the year-ago period, the increased initial cost of IQOS ILUMA devices, inflation across some key supply-chain elements like wage, energy and direct materials and higher air freight (which, in turn, was aggravated by the Ukraine war). In 2022, the gross margin is expected to be moderately low due to the increased initial cost of IQOS ILUMA, elevated logistic costs, growth-oriented investments in the smoke-free space and inflation related to supply-chain elements. Also, in the second quarter of 2022, the proforma operating margin is likely to decline further on an organic basis.

However, Philip Morris’ strong pricing efforts and advancements for becoming a smoke-free company are likely to help it continue with its growth story. Shares of this Zacks Rank #3 (Hold) company have risen 5.1% in the past three months compared with the industry’s rise of 3.9%.

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