@BillBrewsterSCG highlighting $PM as an under-discussed quality growth company encouraged me to further share my thoughts on their transition towards Reduced-Risk Products.

I will discuss the background, ESG angle, and why I am bullish on this growth story.

As an intro, I encourage anyone interested to learn more about the industry to listen to this Odd Lots episode where @TheStalwart & @tracyalloway discuss w/ Gene Hoots & @lhamtil how tobacco stocks became one of the greatest investments in history.

Everyone is not comfortable investing in tobacco & that's fine. In the podcast, @lhamtil makes a great case on "where to draw the line". I would add that smokers didn't wait for Big Tobacco to get their nicotine fix, with consumption dating back to 5,000 - 3,000 BC.

With that out of the way, let's deep dive into the development of Reduced-Risk Products (RRPs) at $PM. You may remember that there was a lot of buzz on vaping in the early 2010s, and Big Tobacco wasn't particularly big in it.

Vaping was quite the disruptor: no regulation on marketing & distribution, no excise tax. Easy to launch a new brand w/ minimal investments. It gained traction w/ consumers looking for safer alternatives, but plateaud as the experience was not satisfactory for most.

Enter Philip Morris International, the largest tobacco company in the world ex. China, with no presence in the US following the spin-off from $MO in 2008. Brands include Marlboro, L&M, Parliament, Chesterfield, etc; and the co has a strong presence in emerging markets.

At the 2014 investor day, $PM highlighted its goal of "developing & commercializing Reduced-Risk Products", while maintaining its combustible leadership, and declared that commercialization for "Platform 1" was on track for city test phase, along with E-Vapor products.

Platform 1 (known as IQOS) is an electrically-heated tobacco system, where real tobacco sticks are heated by a resistor to generate tobacco vapor. $PM created this category, betting big on it to get the reduced-risk benefits of vaping, but w/ much better XP for smokers.

Indeed, with a consumption experience replicating that of a cig and with real tobacco rather than e-liquid, IQOS could provide smokers with much more satisfaction than vaping, while providing similar risk-reduction. This was later referenced as "Heat-not-Burn" (HnB).

This was a bold move as no other similar product existed on the market (although I remember reading of similar developments in the 80s in "Barbarians at the Gate"!), but approached prudently with a small-scale, test & learn commercialization approach through city tests.

2 years later, at the 2016 investor day, $PM showed that it took this category very seriously, highlighting its Business Model evolution from the attractive, linear combustible category to the exponential, disruptive growth potential of RRPs.

First results were encouraging: 1 million consumers had already switched to IQOS in less than 2 years, so geographical expansion could begin.

By 2018, IQOS had reached over 15% share of market in Japan (the first test market) in less than 3 years. This is a huge achievement, as consumers are very loyal to their brand and reluctant to switch to new products, and underlines the potential of the HnB category.

HnB is great for consumers, who have access to a very satisfactory and much safer than cigs. But is it great for $PM as well? Of course, and this is why I think this is a great opportunity. Let's have a look at unit economics.

First, the marginal contribution on converted IQOS users is much higher than what $PM generates on its premium brand Marlboro: from +20% to +333% in selected markets. Not only is $PM winning smokers from competition, but switching its own smokers is margin-accretive.

Why is that? Most of cigs revenues go to government as excise tax. HnB is also subject to it. By highlighting the reduced-risk potential of HnB, $PM can negotiate better excise tax terms on IQOS consumables, giving it higher margins and better price productivity.

As an added bonus, IQOS allows them to create new revenue streams through e.g. accessories sale for the IQOS device. Along with services, this helps lock-in smokers into the IQOS ecosystem.

To date, $PM has invested more than $8B in RRPs. In product development of course, but also in toxicological & clinical assessments (much like pharmaceutical companies) to prove the risk-reduction potential of its platform.

Results for IQOS have been incredible: 19m users in 66 markets to date. HTUs (IQOS consumables) are already the third largest brand in markets where IQOS is present...

... and market share is growing fast across all market archetypes, highlighting the value proposition of IQOS, not only for tech-savvy Japanese consumers, but for all smokers around the world.

HnB already reached 24% of $PM net revenues and consumables 13% of total volumes, yet it is barely scratching the surface: HnB is still only 4.5% of the nicotine retail sales (but already surpassing E-Vapor at 1.6%). $PM is targeting >50% of revenues from RRPs by 2025.

The attractive economics of IQOS start reflecting in the income statement: better gross margins (remember those attractive unit economics?), and leverage on the fixed infrastructure costs kicking in.

Also, learnings and experience from first markets improve efficiency for new markets, with months to break-even reduced from 25 to 11. In more mature markets, acquisition & retention cost per user drops year after year, demonstrating the operating leverage.

What about competition? $BTI, $IMBBY and $JAPAY have been more focused on e-vapor so far. British American Tobacco has launched Glo, an HnB product, but $PM is leaving everyone behind and maintaining over 80% category share in HnB since 2018...

... and $PM expects to maintain its leadership in RRPs, leveraging its first-mover advantage, better innovation, and existing user base. The company is about to get serious in e-vapor, and will also launch 2 new RRP platforms in the coming years.

To conclude, $PM is turning into an ESG/growth story, largely dominating the RRP product category through its big bet on HnB. This is great for consumers, who have access to very satisfactory reduced-risk products, and for $PM, which benefits from better unit economics.

At 15x EPS, this is an attractively valued consumer defensive stock, insulated from risks impacting traditional CPG names (private labels, DTC brands, etc). $PM targets >9% EPS growth, which I believe it can achieve given the superior economics highlighted above.

Add in a 5% dividend yield, and one could expect >14% annualized. Main risks include currency (EM exposure), and regulation/change in taxation regimes on HnB.


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