Philip Morris Plunge Is a Reality Check

(Bloomberg Gadfly) -- Philip Morris International Inc.'s shareholders needed a dose of reality.

The cigarette maker plunged as much as 18 percent on Thursday after reporting a slowdown in sales growth for its iQos devices that heat rather than burn tobacco. Particularly troubling was management's commentary on the conference call indicating that demand from Japan, a key market for so-called reduced-risk products, was disappointing, says Bloomberg Intelligence analyst Ken Shea. Philip Morris and its rivals have been counting on alternative smoking gadgets to compensate for weakening demand for traditional cigarettes, and they've spent heavily to invest here.

Philip Morris Plunge Is a Reality Check

Predictably, many analysts were still upbeat. Wells Fargo & Co.'s Bonnie Herzog said she's still optimistic on Philip Morris's long-term growth prospects, while Piper Jaffray Cos.' Michael Lavery said the drop looked excessive relative to the fundamentals, to name a few. The average price target is now almost 40 percent higher than where Philip Morris is trading after its slide. To a certain extent, these analysts are right. The sky is not falling at Philip Morris.

The company fell short of the $7.03 billion in first-quarter revenue estimated by a Bloomberg survey of analysts, but only by $130 million or about 2 percent. Heated tobacco unit shipment volume of 9.6 billion was down compared to the fourth quarter, but was up about by about 5 billion units compared to the same period in 2017.

Philip Morris Plunge Is a Reality Check

And yet, it's easy to see how some of the challenges Philip Morris is facing in Japan could be extrapolated on a broader scale and portend higher costs and weaker margins. The company blamed the underwhelming growth on the fact that it has moved beyond the easy converts to the IQos device (read: millennials) and is now having to target consumers aged 50-plus who tend to be more set in their ways. It's a lot harder to change the habits of someone who's been smoking for 30 years, and there may not be as much fresh blood to convert in the coming years if current trends hold. 

There is also quite a lot of competition for alternative smoking devices, given that Japan Tobacco Inc. and British American Tobacco Plc are facing many of the same pressures. On the call, Philip Morris executives said only an estimated 1 percent of converted iQos users fully switch to a competing product, something it saw as "remarkable" given its premium positioning. It will be interesting to see how long that statistic holds. Regulatory risks also abound.

At best, you could argue that the growth outlook for Philip Morris and other cigarette companies is hazy and getting hazier. On that basis, you could question whether the company really deserved a premium multiple in the first place, as my colleague Tara Lachapelle has pointed out.  Before Thursday's plunge, Philip Morris commanded a price to forward earnings multiple of about 19. That was akin to Facebook Inc. As much pressure as Facebook is facing these days, its growth prospects look more intact. Perhaps in this case, there is a fire behind all that smoke at Philip Morris. 

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

Brooke Sutherland is a Bloomberg Gadfly columnist covering deals and industrial companies. She previously wrote an M&A column for Bloomberg News.

To contact the author of this story: Brooke Sutherland in New York at bsutherland7@bloomberg.net.

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