Why Philip Morris International Shareholders Have Something to Worry About

By Dan Caplinger Markets Fool.com

Among global tobacco companies, U.S. investors are most familiar with Philip Morris International (NYSE: PM). The stock has produced impressive returns over nearly a decade, and even with major currency-related headwinds in recent years, the tobacco giant has found ways to keep its core business growing from a fundamental standpoint. Yet that doesn't mean that Philip Morris is in the clear, and indeed, one of its most aggressive stances lately could backfire on the company if it can't follow through on its ambitious promises. Moreover, competitors lie in wait to try to steal Philip Morris' thunder even if the company is successful.

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The big bet on reduced-risk products

It's not often that a company torpedoes its most important product, but that's pretty much exactly what Philip Morris International has been doing over the past several months. Late last year, Philip Morris CEO Andre Calantzopoulos shocked the world by saying that he envisioned a time at the company would start phasing out sales of its traditional tobacco cigarettes. Given that the company gets almost all of its revenue and profit from tobacco sales, Calantzopoulos' comments certainly garnered a lot of attention.

Image source: Philip Morris International.

Calantzopoulos' prediction stemmed from the early success of Philip Morris International's push toward embracing reduced-risk products. The company has fought hard to establish itself as a key player in the cigarette alternative market, and in particular, it has chosen a direction that most of its competitors didn't embrace initially. Philip Morris didn't concentrate its efforts on the rapidly growing electronic cigarette market and most companies' use of chemical-containing liquids to produce an inhalable vapor that sought to match the experience of cigarette smokers. Instead, it looked for ways to use its existing supply and distribution network for tobacco, searching for how to keep using tobacco in a cigarette alternative that would reduce risks associated with conventional smoking.

The result was iQOS, the heated-tobacco technology that uses natural leaf tobacco rather than artificial chemicals to produce vapor that users can breathe in. Philip Morris has said that by heating the tobacco rather than burning it, the process produces just a tenth of the toxic materials found in regular cigarette smoke. Moreover, from a consumer standpoint, the experience of using iQOS more closely mimics a regular cigarette. Although the iQOS system involves using a specially made heating mechanism, the insertion of HeatSticks tobacco into the device emphasizes the natural tobacco element of the product, and that has appeal to customers who appreciate the flavor and aroma of tobacco.

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What happens if iQOS fails?

So far, reception for iQOS has been extraordinarily strong. Market share has reached nearly 7% in Japan, which was the first market that Philip Morris targeted. Other rollouts are ongoing and show promising results as well.

More importantly, Philip Morris applied to the U.S. Food and Drug Administration for approval of iQOS as a modified risk tobacco product. Many expect the application to take a while to work through the FDA bureaucracy but remain enthusiastic about its chances.

However, the danger for Philip Morris is that it has already made extremely lofty promises about the future of iQOS. FDA approval is far from a given, especially given the complexity of the product and the health claims that Philip Morris would like to make about heat-not-burn technology. The company has submitted huge amounts of documentation in support of its claims, and it hopes that the detailed application will help make approval easier. But more materials means more effort for regulators to review, and that could create delays that Philip Morris would prefer to avoid.

Competitive pressure is mounting

Time is also of the essence for Philip Morris because of threats on the competitive front. British American Tobacco (NYSEMKT: BTI) and Reynolds American (NYSE: RAI) have agreed to merger terms, and while the process of combining the two companies will itself take a while, the concern that Philip Morris investors have is that a combined BAT will make reduced-risk product development a priority of its own. With the combined power of the two companies working together, BAT could make a new push to catch up with Philip Morris on heated tobacco while also pushing other vapor products forward at a faster pace.

More fundamentally, Calantzopoulos' claims have started a longer-term clock for Philip Morris. Essentially, the CEO confirmed what many investors had long believed: That there's only so long that the regular tobacco business will continue to exist and grow. Having identified its escape route toward growth, Philip Morris could find it impossible to backtrack and embrace regular cigarettes again if setbacks on the reduced-risk front prove insurmountable.

Investors are excited about Philip Morris International and its strategic vision, and transformation in the industry could save it from eventual decline. But the stakes are high, and Philip Morris will have to stay smart in order to move forward and keep its rivals at bay.

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Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.