Ever since the separation of Philip Morris International (PMI) from its former parent company Altria in 2008, the scenic Marlboro Country promoted in the famous ad campaigns has in fact been two countries. On the one hand there is the United States, birthplace of the modern reincarnation of the Marlboro brand, and on the other hand there is the rest of the world. PMI owns the Marlboro brand, as well as several others, in all non-US markets, while Altria markets the Marlboro brand in the United States through its ownership of Philip Morris USA (PMUSA).
The separation of PMI from Altria was designed to untangle the international business from the tobacco litigation liabilities faced by PM USA, which weighed down the earnings multiple the market applied to Altria’s shares. Unmoored from Altria’s legal problems, the thinking went, PMI would be free to chase growth in emerging markets, unencumbered by the endless meetings focused on US legal strategy. After engineering and executing the PMI spin-off, former-CEO and chairman Louis Camilleri and then-PMI President Andre Calantzopoulos both left Altria to head Philip Morris International, then as Chairman/CEO and COO respectively, leaving Altria and its legal headaches behind.
The plan didn’t work out nearly as well as intended. Tobacco regulation spread much faster across the rest of the world than was anticipated at the time. In some cases, developing markets have become far more restrictive in their tobacco regulations than the United States. Steep and sudden excise tax raises have also surfaced with increasing regularity, disrupting consumer behavior by impairing affordability and giving rise to large illicit tobacco markets.
only A Fistful of Dollars
The most fundamental flaw in the separation of Altria and PMI, however, has been the lack of significant dollar earnings at Philip Morris International. For a company with its shares priced in US dollars, paying dividends in dollars and carrying part of its debt in dollars, the lack of a dollar earnings base should have been a serious concern before the separation. But with significant revenue streams in dozens of other currencies, PMI may have felt adequately diversified to withstand currency fluctuations. And this notion may well have been true if the company reported in any other currency than the US dollar.
Unfortunately, the US dollar is not just any other currency; it is the world’s de facto reserve currency. It is both used and held widely by commercial and government parties outside the United States. This reserve status means that other currencies have often shown significant correlation in their movements versus the dollar, oftentimes as a result of (changes in) US central bank policy. The correlated movements of dollar exchange-rates quickly exposed the lack of a US earnings base as a major underlying weakness of PMI. As visualized in the graph below by the yellow bars, foreign exchange movements served as a drag on PMI’s revenues every year between 2012 and 2020. In 2015 for example, PMI suffered a ~$4.7 billion hit to its topline from adverse foreign exchange movements, approximately -16% of its prior year revenues net of excise taxes. After a positive foreign exchange contribution in 2021, the issue resurfaced in 2022 when the Federal Reserve began to more seriously tighten its monetary policy, leading to a resurgent US dollar.
The foreign exchange headwinds have been exacerbated by declining cigarette volumes, which were a negative contributor for 7 of the 10 years since 2012. Together, those two headwinds more than negated that traditionally reliable staple of tobacco company resilience: pricing power. As evidenced by the blue bars, PMI managed to raise prices on its products every year during its existence as an independent public company, oftentimes substantially so, but because of the negative forex effect higher local prices still translated into flat, or lower, dollar sales and earnings. In dollar terms, cumulative upward pricing totaled roughly $15 billion over the 2012-2021 period, while volume/mix was negative by approximately $3 billion. Adverse foreign exchange movements meanwhile shaved a cumulative $11.6 billion off net revenues over this period, while other other factors (acquisitions/disposals/etc) were negative by $1 billion. The net result of these contributing factors has been a flat topline for PMI between 2012-2021, which serves as the major culprit in PMIs languishing share price.
I have made the argument before that the Altria-PMI separation was a significant strategic error, and have advocated a merger between Philip Morris International and Altria. PMI actually proposed an all-share merger transaction in 2019, with the support of Altria’s board, but the proposal was quickly withdrawn for lack of shareholder enthusiasm. Since then PMI has lost its appetite for a combination with Altria, at least according to its current CEO Jacek Olczak. Tobacco litigation risk in the United States apparently still sits in the back of PMI shareholders’ heads.
Once Upon a time… in america
Besides the lack of dollar-based revenues for PMI, there is another problem with the current situation. Lacking direct access to the US market makes the commercialization of PMI’s next-generation products substantially more complicated. This has become a more pressing issue in recent years because increasingly strict tobacco regulations globally have impaired the industry’s freedom to operate. Simply put, governments around the world are pulling the noose around the tobacco industry’s business model ever tighter. The uncertainty around the long-term viability of the industry’s current business model has put a substantial dent in the earnings multiples of tobacco company shares, which consistently trade at substantial discounts to consumer staples peers. This has made the transition to so-called reduced-risk products, such as heated tobacco products (HTP), far more urgent.
PMI and Altria have tried to work around this problem through a US partnership for PMI’s heated tobacco product IQOS, whereby Altria distributes and markets the product in the US while PMI continues to own the intellectual property and manages sourcing. However, the IQOS brand only achieved a tiny US foothold under this partnership, and its commercialization in the United States is currently on hold because of a ruling by the ITC. The ruling banned IQOS products from being imported into the United States because of a supposed infringement on patents owned by Reynolds American, a subsidiary of British American Tobacco.
The current situation is highly undesirable for PMI for a number of reasons. First, the US market is the world’s largest tobacco profit pool outside of China, which means PMI simply cannot afford to ignore the US potential for this product. Second, given the amount of R&D expenditures involved, heated tobacco products are a game of scale. Get to scale first and the virtuous cycle starts doing its work. Having the biggest revenue base means you can afford to have the biggest R&D budget, which significantly increases your chances of having the best product pipeline, which ultimately feeds back into your user acquisition, which feeds into your revenues etc. A significant US presence, through the sheer size of the American market, can significantly enhance IQOS’ global economies of scale.
Third, while PMI has a significant market leadership position in most heated tobacco markets, the US market is still up for grabs. Currently, PMI owns the only heated tobacco product with FDA-granted marketing authorisation. In other words, they could have the market entirely to themselves! But this window of opportunity will not last forever, as BAT filed a PMTA application with the FDA for its HTP Glo Hyper during 2021. Since BAT completely owns its US subsidiary Reynolds American, the company could move quickly to move its product to market once its PMTA application is approved. PMI is therefore operating under conditions of limited time if it wants to establish an early market lead for IQOS. This is important because an early market lead will likely prove to be a very valuable position as word-of-mouth endorsements serve as an important avenue for customer acquisition, especially since most advertising options are legally off limits.
Fourth, the United States functions as a significant exporter of Western culture around the world; IQOS could derive substantial marketing benefits in other countries from being a relevant factor in America. Think of (social) media coverage, celebrity usage, or exposure to the millions of people visiting America from abroad. Since most markets now have restrictions on tobacco marketing in place, making the introduction of new tobacco brands and products quite complicated, this kind of exposure could be very valuable.
A Fistful of Dynamite
Before the current halt of IQOS sales in the US, the product had only gained single digit market shares in a very limited number of metropolitan markets, primarily in eastern and southern US states. According to Altria the achievements made with IQOS in these markets met the performance targets agreed for IQOS under the joint marketing agreement. PMI however believes that Altria did not meet all of the performance targets, as surfaced in the fourth quarter earnings call (courtesy of Seeking Alpha).
Philip Morris CEO Jacek Olczak:
“I believe that that pre-ITC ruling IQOS performance in U.S. and you know how we perform with IQOS across all essential geographies. I mean it’s really well below what I would expect at this stage or characterize the potential of IQOS. And if I take into this, the fact that this is (an) inhalable FDA authorized product, you don’t really have a competition and the size of the market, et cetera, I think it’s fair to say that the expectations were much beyond where we are today.”
This rather unusual, public display of disagreement exposes an incentives problem underneath the US marketing partnership for IQOS. Whereas PMI has a clear incentive to maximize the addressable market for IQOS, and thus to establish a credible US presence for the product, Altria is looking at a very different strategic set-up. The latter is faced with a number of conflicting interests with regards to how it handles the IQOS partnership. First of all, the marketing of IQOS in the US creates a significant conflict with Altria’s existing cigarette business. After all, a majority of heated tobacco consumers around the world are converted cigarette smokers. Why would Altria want to convert smokers from its enormously lucrative Marlboro cigarettes to IQOS when the company has to share the margin with PMI?
At the same time, Altria has no incentive to decline the opportunity to sell IQOS in the US. This would only leave the product in the hands of a competitor, be it a US-based PMI-subsidiary or some other third party. This ties into the second consideration; like all cigarette companies Altria has an incentive to show regulators, and to some extent investors, that it is taking action to ameliorate the health impact of its business.
Third, developing a proprietary heated tobacco product would take Altria a lot of time and capital, of which at least the first is in short supply. Fourth, as Altria does not own IQOS in the US, and is dependent on its partnership with Philip Morris International, it has to at least consider the possibility that PMI at some point excludes it from the IQOS business. If Altria achieves significant success with IQOS, at the expense of its cigarette business, only to be excluded by PMI at some later point, that would obviously be a very bad outcome.
Weighing those four considerations, it seems logical to conclude that Altria has an incentive to achieve at least some success with IQOS in the US, but not altogether too much. A cynic might propose that Altria may be incentivized to achieve only the bare minimum of its performance targets under the partnership agreement, as it stalls for time to develop its own heated tobacco product. At the very least this line of thought indicates that, although they are in business together, Altria’s and PMI’s interests are not at all aligned when it comes to the commercialization of IQOS in the US.
For a Few Dollars More
I believe that PMI has reached the point where it no longer sees either a merger or a US partnership with Altria as credible ways of establishing a successful American presence for IQOS. In fact, it has already sought an alternative way of reaching the US market by launching a bid for Swedish Match, a company which is focused mostly on selling oral tobacco products in the US and Scandinavia. In my opinion the buyout proposal makes perfect strategic sense from the standpoint of Philip Morris, since it offers the potential to address three of PMI’s pressing problems at once. First of all, Swedish Match has invested a lot of effort in developing alternative nicotine products that align well with PMI’s stated objective of becoming a majority smokefree company by 2025. A buyout of Swedish Match would allow PMI to include all of Swedish Match’s oral tobacco products, and not just the new ones, in its smokefree sales, making it far more likely to achieve its objective. It would also establish PMI as the leader in modern oral nicotine products, a small but quickly-growing category in which it currently has no significant presence.
Second, Swedish Match’s substantial US presence would give PMI an existing and already profitable sales platform through which it can distribute its IQOS product. This would give PMI the opportunity to end the poorly-performing partnership with Altria, and to take the US commercialization of IQOS into its own hands. If PMI contracts an American manufacturer for the IQOS devices and establishes a US-based manufacturing facility for the tobacco sticks, it could also sidestep the aforementioned ITC ruling, which after all only bans imports. Proceeding through this track would allow PMI to move the product back to market relatively quickly. Direct control over US-based manufacturing and sales should make for much faster progress than through the partnership with Altria. Third, the American operation owned by Swedish Match would give PMI a modest but expanding dollar earnings base, which could grow quickly if it successfully plugs IQOS into Swedish Match’s existing US sales organization. This would have the potential to ameliorate the company’s current sensitivity to foreign exchange rate fluctuations.
Of course, the acquisition of Swedish Match has not been closed yet, and may still run into problems. At the very least, there is the possibility that PMI will have to raise its offer for Swedish Match as some shareholders and other financial parties have voiced their opposition to the current buyout proposal. Given that Swedish Match shares have now traded, albeit modestly, above the price offered by Philip Morris, there seem to be more than a few market participants who are betting on a higher offer by PMI. The argument employed by some of the objecting parties is that the price offered by PMI is simply too low, although in the case of others it looks more like an arbitrage play on the prospective buyer’s estimated willingness to close the deal.
From a financial standpoint PMI’s offer does not look particularly underpriced, especially not when we consider historical buyout valuations in the tobacco sector, the ever-present risk of regulatory disruption, and the fact that the multiple applied to the subject’s earnings includes not just the high-growth nicotine pouch business but also its profits from the more mundane cigars, moist snuff and lights business lines. Surely, PMI will not be particularly keen on paying a high multiple for profits achieved in those relatively small, moderate-growth businesses. It may even be considered likely that PMI will want to rid itself of Swedish Match’s cigars business, which would raise the effective multiple paid much further, since this business would probably fetch a much lower multiple on its own.
On the other hand of the argument; Swedish Match offers PMI at least three different avenues to create value from a buyout. First, the abovementioned option to use Swedish Match’s US sales organization as a distribution platform for IQOS. Second, by riding US market growth for nicotine pouches on the back of Swedish Match’s Zyn brand, the category creator. And third, but not last, by taking Swedish Match’s nicotine pouch products and plugging them into PMI’s international sales organization in those markets where market potential for these products may exist. First and foremost this would be a number of European markets, but in all likelihood this product can be introduced into many other markets over time. Taking all these things into consideration, my current estimate is that, given the amount of opposition to the deal at the current price, and the clear benefits PMI would gain from owning Swedish Match, the likelihood of a higher offer by PMI is significant.
The Not-so good, The Bad, and the Ugly
Of course, the current situation in the US with regards to IQOS is still a temporary halt in sales, and a partnership that by the original agreement will run through 2024 and is subject to extension. It is difficult to foretell what will happen to the partnership if and when the proposed acquisition by PMI of Swedish Match takes effect. Currently, PMI is planning for IQOS to return to the US market during the first half of 2023, presumably by using domestically manufactured products and through Altria’s sales organization. My guess is that PMI will plan to discontinue the partnership once it comes up for renewal in 2024, and to switch the commercialization effort to Swedish Match’s US platform.
Altria seems to have very few heated tobacco products alternatives to the IQOS partnership. It does not have a market-tested HTP of its own, and developing one would likely take at least several years and billions of dollars in expenses. And as Imperial Brands has learned in Japan, successfully launching a heated tobacco product as a latecomer in a crowded market is a very difficult thing to accomplish. Buying a heated tobacco product is also an unlikely alternative; apart from some unproven products sourced from China, there are very few companies with a credible HTP product in the marketplace. Altria’s acquisition of intellectual property with regards to a heated tobacco product marketed by Poda Holdings does not serve to inspire confidence in Altria’s position in this field. The product in question had achieved only negligible sales, and similar pod-based HTP products marketed by BAT and JT achieved very limited market success in Japan and elsewhere. The reason for that limited success is that pod-based HTP’s do not produce a strong enough tobacco vapor to adequately mimic the smoking experience. There is no evidence to indicate that any product developed from the intellectual property acquired from Poda would make for a more attractive user experience.
The only market-tested HTP’s that somewhat approximate IQOS in user experience are owned by BAT, Japan Tobacco and KT&G, all three of which are established tobacco industry players. Of those three, BAT is Altria’s largest competitor in the US cigarette market, while KT&G already has an international distribution agreement with PMI for its heated tobacco product named lil. This leaves Japan Tobacco as the only remaining option for Altria, if it wants to establish a heated tobacco presence of its own. While Altria and Japan Tobacco show very limited geographic overlap, and a merger is therefore unlikely to face significant regulatory scrutiny, an Altria bid for JT still seems like an especially unlikely scenario. Not in the least because the Tobacco Business Act requires the Japanese government to maintain a substantial shareholding in Japan Tobacco.
A more likely scenario is for Altria to acquire from JT the rights to manufacture and market the Ploom heating device and accompanying sticks in the United States. Another conceivable option is for Altria to expand its ownership stake in Juul from 35% it owns now to a controlling stake, and to then use Juul’s vaping IP as a bargaining chip in negotiations with Philip Morris International or other international players. This may be the most promising option for Altria to pursue given Juul’s currently weak negotiating position. Perhaps Juul’s other investors will even be glad to be offered an exit. The downside to this option is that Juul has a significantly impaired public image in the United States due to its controversial marketing practices. The regulatory interventions that followed from the ‘teen vaping epidemic’ included an FDA-issued ban on all vaping flavors other than tobacco and menthol, and a rather arduous application process to gain marketing approval from the FDA.
Not only is there a significant chance of products being denied FDA approval, but the controversy and the regulations that followed from the teen vaping fallout have caused Juul to lose a lot of market share in the United States, not in the least to disposable products not currently subjected to the FDA’s flavor ban. Acquiring a majority stake in Juul means its problems become Altria’s problems. Given the size of the impairments Altria has already taken on its investment in Juul, further increasing its ownership stake in Juul may not prove at all popular with its shareholders. It is undeniable, however, that despite all the controversy Juul owns very valuable intellectual property with regards to its vaping products. Also undeniable is that both the heated tobacco and the vaping market show significant market potential around the world. The next few years will show which companies have positioned themselves most favorably to capture that potential.
Disclosure: author owned shares in both Philip Morris International and Swedish Match at the time of publication.