Killing Its Own Business — to Save It

Aug 30, 2024 7 min read

Patrick

“Giving up smoking is the easiest thing in the world. I know because I have done it thousands of times”

– Mark Twain

arvy’s teaser: Philip Morris is killing its own business — to save it. With a bold pivot to smoke-free products, the tobacco giant is leading a $30 billion market revolution. A risky plan? Sure. But the payoff could be considerable.

IQOS.

Or I Quit Ordinary Smoking.

These are heated tobacco and electronic cigarettes that were introduced in 2014.

The idea is to offer a lower-risk alternative to conventional smoking. Most IQOS models consist of a charger and a pen-like holder (chart 1). A disposable stick (called a “HeatStick” or “Heets”) containing processed tobacco and glycerin is inserted into the holder, which is then heated up to 350 °C for inhalation. This is primarily about “heating” and not “burning” the tobacco, which supposedly makes it “healthier”.

It is a $30 billion market that has grown by more than 20% annually over the last five years. It is therefore large and growing and is dominated by just a handful of players.

The pioneer with the ambitious and risky plans?

Philip Morris. One of them wants to replace cigarettes with these smoke-free products..

Chart 1: Philip Morris’ smoke-free product portfolio

Source: Philip Morris, annual report 2023

Big Tobacco

Let’s first look at the tobacco market.

For decades, companies in this sector have been much loved by investors as they have many attractive characteristics, such as strong cash flows and high dividends, pricing power, low competition due to very high barriers to entry and lastly, and most importantly, an inelastic demand due to an addictive clientele.

There are six major players in this industry, we call them “Big Tobacco”:

Philip Morris International (Spin-Off from Altria in 2008): Marlboro, IQOS, L&M, Chesterfield
Altria Group: Marlboro (US), Copenhagen, Skoal, Black & Mild, Juul (stake)
British American Tobacco: Dunhill, Kent, Lucky Strike, Pall Mall, Vuse (e-cigarettes)
Japan Tobacco: Winston, Camel (non-US), Mevius, LD, Logic (e-cigarettes)
Imperial Brands: Davidoff, Gauloises, West, Blu (e-cigarettes)
China National Tobacco: Hongtashan, Double Happiness, Shuangxi

For years, they have treated investors very well with decent performance and high dividends. In the recent past, however, they have struggled to keep up with their own history challenged by declining smoking rates, regulatory pressure, high taxes and litigation risks.

But now something has changed, and what has happened to the poster child Sweden in recent decades (chart 2) is also true for the rest of the world. The number of addicted smokers is shrinking by 2-3% per year, but the craving for nicotine remains.

Consumption is evolving due to changing consumer trends.

This speaks to a great opportunity.

If you are on the right side.

Chart 2: The significant decline of cigarette sales in Sweden

Source: Swedish Match

Transition to a Smoke-Free World

Let us now turn to Philip Morris, the true leader of “Big Tobacco”. Their goal is the following:

“If you could glimpse into the future, what would you want to see? A world without cigarettes. And it’s one we’re delivering today. Without willingness to change, there is no progress. That’s why we’re disrupting the tobacco industry and driving the transformation to smoke-free. We don’t need to imagine a future without cigarettes. We are delivering one.”

Yes, you read that right, Philip Morris is literally killing its own business – to save it.

Since 2016, Philip Morris has been at the forefront of the mission to move the world away from harmful cigarettes, investing in alternative nicotine products such as Heat-Not-Burn (IQOS). In addition, the company has made excellent strategic acquisitions, including the takeover of Swedish Match in 2022.

The company is the market leader in snus, nicotine pouches and moist snuff with the well-known ZYN brand. These products contain ~95% less harmful chemicals than cigarettes and offer smokers who want to quit smoking a legitimate alternative.

On a side note, the Velo brand, widely used in Switzerland, is owned by British American Tobacco.

Today, Philip Morris generates almost 40% of its sales from these reduced-risk products (chart 3) – significantly more than any other major tobacco company, and the growth rates are astronomical.

The icing on the cake of this strategic move?

These products are financially attractive for manufacturers, mainly due to lower taxes and low production costs. The net revenue per pack is 2.5 times that of a pack of cigarettes.

Let us raise our hats and bow.

Well played, Philip Morris.

Well played.

Chart 3: Philip Morris’ Smoke-Free Rapidly Approaching $15 billion in revenues

Source: Philip Morris, Annual Report 2023

Boring is Good

Last week we published our 11th article in The Market NZZ entitled “Boring is Good”.

The article looks at “in a world addicted to instant gratification, the greatest investment advantage lies in patience. High-quality, “boring” stocks are persistently undervalued and offer above-average returns over the long term.”

Philip Morris fulfills many of the criteria for a boring but solid company – a “Good Story”.

What makes the company so interesting in recent quarters is the clear return to growth with its newer range of smoke-free products, which is mirrored in a return on capital of mid-20% and a reasonable valuation alongside a dividend yield of 4.3%.

Now, not only is their pivot in the business model improving the health of millions of smokers worldwide, but they are also providing Philip Morris with significant revenue, margin and cash flow growth.

Improving the health of its shareholders at the same time.

Reflected in an improving “Good Chart”.

And we keep an eye on it.

Chart 4: Philip Morris over the last ten years, in $