Philip Morris International Takes a Big Step Forward

Tobacco giant Philip Morris International (NYSE: PM) has historically relied on cigarette sales for the vast majority of its overall revenue. Even in the face of challenges to cigarette smoking across the globe, Philip Morris has done well in its efforts to keep growing and tapping new opportunities. Yet a major part of the company's overall strategic vision for the long-term future has been to go beyond traditional cigarettes to embrace innovative alternatives that it sees as having reduced risks to health. In particular, Philip Morris has developed what it calls iQOS, a product that heats tobacco rather than burning it to produce an experience that is similar to but different from smoking traditional cigarettes. Earlier this month, Philip Morris announced that it had expanded its capacity to make iQOS products, and that could bode well for the company's efforts to grow that part of its overall business.

Image source: Philip Morris.

What Philip Morris did to expand production

In late September, Philip Morris inaugurated its first manufacturing facility for large-scale production of two of its heated tobacco alternatives to traditional cigarettes. Located in the Bologna region of Italy, the new factory received a visit from Italian Prime Minister Matteo Renzi, who has championed greater business investment in the country as a way to promote overall economic growth.

Philip Morris was happy to lend its support to the Italian economy. As CEO Andre Calantzopoulos noted, Philip Morris already has a key high-tech factory in Zola Predosa that makes filters, and Calantzopoulos pointed to "access to exceptional human talent" as a key driver in making the decision of where to put the iQOS plant.

Philip Morris said that the initial production capacity for the plant will be 30 billion units, and its CEO put the move in a proper strategic context. "Our ambition is to lead a full-scale effort to ensure that non-combustible products ultimately replace cigarettes to the benefit of adult smokers, society, our company, and our shareholders," Calantzopoulos said. "This factory is a milestone in our roadmap toward this paradigm shift."

What Philip Morris sees for iQOS

The 500 million euros that Philip Morris committed to the Italian factory shows just how important reduced-risk products are to the tobacco giant's overall vision. As the company's press release reiterated, Philip Morris has had good initial success with iQOS, which in less than two years has expanded to cities in 10 different countries and is expected to become available in 10 more markets by the end of 2016. The research that Philip Morris has done to look at whether iQOS reduces less risk of harm than traditional cigarette smoking has thus far produced what the company called "very promising results to date."

Market performance for iQOS has also encouraged Philip Morris' efforts. In its most recent quarter, the company reported that iQOS HeatSticks had gained a 2.2% market share in Japan, more than doubling its share from the previous quarter. According to the company, 70% of iQOS purchasers have fully or predominantly converted to using that product, and although that has raised concerns about cannibalizing Philip Morris' own cigarette smoking customer base, iQOS is also drawing smokers away from other cigarette makers. In addition, customers have been more willing to pay premium prices for iQOS, leading to higher sales from those who make the upgrade.

The situation has actually put Philip Morris in a position in which it needed to make moves like factory investment in order to ensure adequate supply. In its second-quarter conference call, CFO Jacek Olczak noted that the company has had to walk a fine line between pushing iQOS growth and running the risk of running out of products. The company doesn't want to put customers in the uncomfortable position of having switched and then not being able to get iQOS products, and the new factory will help alleviate that risk.

Moving ahead with reduced risk

Other markets, including Italy and Switzerland, are in earlier stages of commercialization. Yet Philip Morris also sees encouraging early signs from those markets, and having increased production capacity should help make those expansions easier to navigate as well.

Many investors find it surprising just how much Philip Morris has embraced the idea of reduced risk products. Yet given how well initial rollouts of the iQOS product have gone, Philip Morris shareholders can expect a firm commitment to the innovative product category well into the future.

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