Philip Morris International, Inc

Oct 19, 2017

Philip Morris International, Inc. (PM-NYSE) $108.15

Note: More details to come; changes are highlighted. Except where highlighted, no other sections of this report have been updated.

Reason for Report: FLASH UPDATE: 3Q17 Earnings Release

Prev. Ed.: July 25, 2017; 2Q17 Earnings Update

Flash Update [Earnings update in progress; to follow]

On October 19, 2017 Philip Morris International, Inc. posted its third-quarter 2017 results. After reporting weaker-than-expected results in the first half of 2017, Philip Morris continued with its dismal performance in the third quarter. Both earnings and revenues lagged the Zacks Consensus Estimate in third-quarter 2017 results. Moreover, the company lowered its earnings guidance for 2017 due to higher impact of unfavorable currency.

Quarter in Detail

Adjusted earnings of $1.27 per share missed the Zacks Consensus Estimate of $1.39. While the company benefited from strong pricing and growth in Reduced Risk Products, lower cigarette volumes hurt its performance. Nevertheless, adjusted earnings in the reported quarter inched up 1.6% from the year-ago period.

Net revenue, excluding excise taxes, was $7,473 million, which increased 7% (up 9% excluding unfavorable currency of $136 million) in the third quarter. Favorable pricing and volume/mix in the quarter drove revenues. While, revenue increased across Asia, Latin America & Canada and the European Union (EU), the same had declined in Eastern Europe, the Middle East & Africa (EEMA).

During the quarter, revenues from combustible products declined 3.6% (down 4.6% excluding negative currency) to $6.5 billion. On the contrary, Reduced Risk Products (RRPs) reported a whopping increase from last-year quarter, stemming from the shift of customer preference away from tobacco products. The company generated revenues of $947 million from RRPs, significantly higher than $212 million reported last year.

However, net revenues lagged the Zacks Consensus Estimate of $7,616 million.

Total cigarette and heated tobacco unit shipment volume fell 0.5% to 208.2 billion units. The figures were unfavorable in the EU, EEMA region and in Latin America & Canada mainly owing to low cigarette shipment volumes. These were offset by increased volumes in Asia, as well as higher heated tobacco unit shipment volume across all regions. While cigarette shipment volume declined 4.1% in the quarter, heated tobacco unit shipment volume of 9.7 billion units, increased significantly from 2.1 billion units recorded in third-quarter 2016.

© Copyright 2017, Zacks Investment Research. All Rights Reserved. Adjusted operating companies income was up 2.2% year over year to $3.1 billion due to favorable pricing and growth witnessed in Asia. Excluding currency impact of $140 million, adjusted operating income increased 6.8%. However adjusted operating margin was down 190 basis points to 42%.

Financial Update

During the quarter, Philip Morris increased the regular quarterly dividend by approximately 2.9% to reach an annualized rate of $4.28 per share.

Guidance

Philip Morris lowered its earnings guidance for 2017 and now expects the same in range of $4.75 to $4.80, lower than the previous range of $4.78 to $4.93. The revised guidance depicts a growth of 9- 10% over the adjusted earnings of $4.48 delivered in 2016. The estimated earnings range, however, excludes the negative impacts of currency of 17 cents, and favorable tax item of 4 cents.

MORE DETAILS WILL COME IN THE IMMIMENT EDITIONS OF ZACKS RD REPORTS ON PM.

Portfolio Manager Executive Summary [Note: only highlighted material has been changed]

Philip Morris International is a leading international tobacco company that owns brands like Marlboro, Parliament, Virginia Slims and others.

Of the 9 firms covering the stock, seven provided positive ratings while two assigned neutral ratings. None of the firms rendered a negative rating to the stock.

Positive or equivalent outlook (7/9 firms or 77.8%) – The bullish analysts expect that Philip Morris has enough growth potential on the back of its solid brand strength, compelling opportunities in the emerging markets and robust financials. Further, these firms believe that the company is well-placed for its well-known brand Marlboro and other leading brands. Also, the firms remain impressed with the company’s shareholder-friendly moves. These analysts are also encouraged by the company’s collaboration with Altria Group Inc. to develop and promote its Next Generation Product as it will help it to maintain market share amid declining tobacco volume. These analysts are particularly optimistic about Philip Morris’ Reduced Risk Products (RRP) which should significantly contribute to revenues owing to their rising demand amid declining smoking rates.

Neutral or equivalent outlook (2/9 firms or 22.2%) – These firms are positive about Philip Morris’ strong portfolio of brands and pricing power. However, they believe that the impact of these positive will be marred by headwinds such as unfavorable currency translations, strict government regulations and diminishing social acceptance of smoking.

July 25, 2017

Overview [Note: only highlighted material has been changed]

The analysts identified the following issues as critical for evaluating the investment merits of Philip Morris:

Zacks Investment Research Page 2 www.zackspro.com Key Positive Arguments Key Negative Arguments Strong Presence in Emerging Markets: Philip Declining cigarette volumes: Philip Morris has been Morris commands a strong presence in several experiencing lower volumes for the past few quarters developing markets such as Korea, Philippines, mainly due to shift of consumption away from tobacco China, Latin America and Canada and the European products. region. This helps the company to maintain its sales and margins amid macroeconomic challenges in the developed economies. Price Leadership: Tobacco pricing is more important Regulation Risk: The FDA’s regulation of using than volume trends and Philip Morris is the market graphic warning labels on cigarette packs is expected leader in this respect. The company has remained to dissuade smokers. Additionally, it will lead to huge afloat amid unfavorable tax environment backed by its printing expenses, negatively impacting the industry. pricing power. It has increased prices several times without losing market share. Evolving with Demand: Philip Morris focuses on Higher taxes: Governments has imposed higher producing less harmful nicotine products to meet the excise taxes on cigarettes, as a result of which changing needs of consumers. Moreover, the tobacco companies are increasing their cigarette company’s technology and marketing agreement with prices. Hence, higher prices of cigarettes are leading Altria to combine their marketing power to ramp up to lower cigarette volumes. the market of non-combustible tobacco products.

Based in New York, Philip Morris, through its subsidiaries, engages in the manufacture and sale of cigarettes and other tobacco products. Philip Morris is legally based in the U.S. and listed on NYSE, but has no operations in the country. Philip Morris was spun off from Altria Group Inc. in Mar 2008 in order to protect it from U.S. litigation.

Its international product line comprises brands like Marlboro, Merit, Parliament, L&M, Chesterfield, Bond Street, Lark, Muratti, Next, Philip Morris, and Red & White. The company operates primarily in the European Union; Eastern Europe, Middle East and Africa (EEMA); Asia and Latin America & Canada.

Note: Philip Morris’ fiscal year ends on Dec 31. For more information, please visit the company’s website www.pmi.com. July 25, 2017

Long-Term Growth [Note: only highlighted material has been changed]

A superior brand portfolio, stable market share growth, a positive pricing environment and strong productivity gains are the major strengths of the company, which will help it to stay afloat in the challenging tobacco industry.

Philip Morris commands a strong presence in several markets such as Korea, Philippines, China, Latin America, Canada and European region.

Meanwhile, as smoking rates decline in developed countries, the race to replace cigarettes is putting pressure on the tobacco industry. Serious health hazards due to cigarette smoking have pushed consumers toward low-risk, reduced risk products. To cater to the new consumer preference, Philip Morris launched the much talked about iQOS, a smokeless cigarette in Nov 2014 aiming to lead the tobacco industry’s push into reduced-risk products that may eventually replace traditional smokes. Philip Morris’ iQOS smokeless cigarette looks a lot like a second generation vaporizer that uses actual tobacco in the shape of small Marlboro cigarettes called HeatSticks that are heated at high temperatures, but not burned. Since its launch, there has been a steady increase in the number of iQOS purchasers. iQOS are anticipated to boost market share and offset declining volumes in traditional cigarette business in 2017. During the second quarter, the company expanded availability of 2 new HeatStick variants in the smooth taste and differentiated menthol-based segments, respectively, Zacks Investment Research Page 3 www.zackspro.com and both are performing very well. The company has launched iQOS in key cities in 27 markets globally during second-quarter 2017, and remains on track to expand nationally in 30 to 35 markets by the end of the year.

Regarding HeatSticks, Philip Morris currently has approximately 15 billion units of installed annual capacity and continued to anticipate approximately 50 billion units of such capacity at the year end. It further anticipates to produce about 100 billion HeatSticks by 2018. The company expects both higher heated tobacco unit and iQOS device sales to drive growth in 2017.

The marketing and technology sharing agreement between Philip Morris and its peer Altria Group is also boosting the business of both the companies. Per the agreement, Philip Morris will market Altria’s MarkTen e-cigarettes internationally and Altria will distribute two of Philip Morris’ heated tobacco products in the U.S. The companies have also extended their technology sharing agreement in July 2015 to work on a joint research, development and technology-sharing framework for developing unconventional cigarettes. On Mar 31, Philip Morris has applied for pre-market approval of its iQOS heated tobacco product with the U.S. Food and Drug Administration, which will be sold by Altria in U.S., if the FDA grants Philip Morris’ request. Such collaboration is encouraging as it will help the participating companies maintain market share amid declining volume and growing awareness against tobacco products.

However, the tobacco industry faces many challenges which put margins under pressure. Governments around the world are imposing restrictions on tobacco companies which in turn are lowering cigarette consumption. The FDA has made it mandatory for tobacco companies to use precautionary labels on cigarette packets to dissuade customers from smoking. Moreover, the FDA put a ban on the menthol-flavored cigarettes as it has been noted that these are more lucrative to starters and hence, will trigger a rise in smoking population in the nation. Moreover, the U.K. and Australia governments have imposed regulations regarding plain packaging for cigarettes. This will also make the U.S. government impose plain packaging on tobacco companies, in turn affecting Philip Morris. Most recently, the state government in India's capital told Philip Morris and other tobacco companies to remove all advertisements from tobacco shops in the city, warning them of legal action if they do not comply.

After regular cigarettes, e-cigarettes have also come under the FDA’s review. It requires all buyers to be at least 18 years of age in both the U.S. and U.K. Moreover, buyers who are 27 year of age will require showing their ID card in order to buy e-cigarettes. Further, the rule bans free samples and requires companies to give ingredient details and warning labels as well as seek federal approval to sell e-cigarettes. However, the FDA does not recommend a restriction on flavored products or online sales and advertising of e-cigarettes.

Further, Philip Morris is trying to step into the $11 billion tobacco market in India. However, the Indian government is likely to put a ban on foreign direct investment in the tobacco sector. Although India had banned foreign investment in cigarette manufacturing in 2010, it still allowed tobacco companies to invest through technology collaboration and licensing agreements. Investments could also be made by forming a trading company. Over the past year, the government has been thinking whether to stop these, in a bid to safeguard public health interests. If such a thing happens it will be a major blow to Philip Morris’ plans on new product launches in the region. July 25, 2017

Zacks Investment Research Page 4 www.zackspro.com Target Price/Valuation [Note: only highlighted material has been changed]

Rating Distribution Positive 77.8% Neutral 22.2% Negative 0.0% Avg. Target Price $125.44 Highest Target Price $140.00 Lowest Target Price $106.00 No. of Analysts with Target Price/Total 9/9

Risks to the achievement of target price include high sensitivity of cigarette volumes to taxes/prices, government regulations (regulatory actions such as smoking bans, health warnings, packaging or display restrictions, additional disclosures or testing requirements, bans on advertising promotions), illicit trade of fake cigarettes and the increasing health awareness that is reducing tobacco consumption and leading to a switchover to alternative tobacco products. As most of Philip Morris’ operations are located overseas, a strong dollar may adversely impact its profitability.

Recent Events [Note: only highlighted material has been changed]

On Jul 20, 2017, Philip Morris reported weaker-than-expected second-quarter 2017 results, wherein both earnings and revenues lagged the Zacks Consensus Estimate. Moreover, the company lowered its earnings guidance for 2017 due to higher impact of unfavorable currency. Adjusted earnings per share of $1.14 per share missed the Zacks Consensus Estimate of $1.23 by 7.3% in 2Q17. It also dipped 0.9% from the year-ago quarter. While the company benefited from strong pricing, lower cigarette volumes led to the decline.

Net revenue, excluding excise taxes, was $6.917 billion, which were way behind the Zacks Consensus Estimate of $7.058 billion by 2.0%. Revenue was up 4.0% year-over-year (up 7.0% excluding unfavorable currency of $195 million) in 2Q17.

Revenue [Note: only highlighted material has been changed]

Provided below is a summary of total revenue as compiled by Zacks Digest:

Revenue ($M) 2Q16A FY16A 1Q17A 2Q17A 3Q17E 4Q17E 2017E 2018E Digest High $6,649.0 $26,685.1 $6,065.0 $6,917.0 $7,661.0 $8,462.0 $29,104.0 $31,880.0 Digest Low $6,649.0 $26,685.0 $6,063.4 $6,917.0 $7,515.0 $7,758.0 $28,254.0 $30,974.0 Total Revenue $6,649.0 $26,685.0 $6,064.0 $6,917.0 $7,588.0 $8,110.0 $28,679.0 $31,427.0 Y-o-Y Growth -3.1% -0.4% -0.3% 4.0% 8.7% 16.3% 7.5% 9.6% Sequential 9.3% -13.0% 14.1% 9.7% 6.9% Growth

The Zacks Digest average revenue of $6,917 million for 2Q17 was up 4.0% year over year (y/y). The increase in sales was driven by higher heated tobacco unit and iQOS device sales, notably in Japan,

Zacks Investment Research Page 5 www.zackspro.com as well as favorable pricing. Favorable pricing and volume/mix in the quarter drove revenues. Revenue increased across Eastern Europe, the Middle East & Africa (EEMA), Latin America & Canada and Asia regions but were partly offset by regions of European Union (EU).

Revenues from combustible products declined 3.4% (down 0.5% excluding negative currency) to $6.3 billion. On the contrary, Reduced Risk Products (RRPs) reported a whooping increase from last-year quarter, stemming from the shift of customer preference away from tobacco products. Notably, a portion of RRP net revenues are from iQOS devices, which gained popularity despite yielding a negative margin due to introductory discounts offered in the initial phase to accelerate adult smoker switching. Underpinned by the strong growth outlook for RRPs, the company now anticipates total currency-neutral net revenue growth above 7% in 2017.

Total cigarette and heated tobacco unit shipment volume fell 5.0% to 199.9 billion units. The volumes were unfavorable in Asia, due to a challenging consumer spending environment in Indonesia as well as ongoing declines of low-margin cigarette volumes in Pakistan and in Philippines. In EEMA regions, volume declines were due to impact of excise tax-driven price increases in Russia and an increase in illicit trade in Turkey. The decline was also due to lower volume in Saudi Arabia related to the introduction in June of an excise tax that resulted in a doubling of retail selling prices.

Despite a 5% decline in total volume in the second quarter, the decline was narrower sequentially from 7.8% decline in first quarter. For 2017, the company continues to anticipate a total shipment volume decline of 3% to 4%, broadly in line with last year. This reflects the further expected sequential improvement in the third and the fourth quarters, notably driven by the Asia region, with higher RRP volume and improved cigarette volume in markets such as Indonesia, Pakistan and the Philippines.

While cigarette shipment volume declined 7.5% in the quarter, heated tobacco unit shipment volume of 6.4 billion units increased significantly from 1.2 billion units recorded in second-quarter 2016.

Segments

European Union (EU)

Net revenue in the European Union region declined 2.1% year over year to $2.1 billion. Excluding the impact of currency, net revenue increased 2.2%, driven by favorable pricing in Germany and the United Kingdom, partly offset by unfavorable pricing in France and Italy. Favorable volume/mix in Italy, reflecting the performance of reduced-risk products, also led to revenue growth.

Eastern Europe, Middle East and Africa (EEMA)

Net revenue in EEMA region increased just 0.7% year over year to $1.7 billion. Excluding the impact of currency, net revenue grew 4.4%, principally driven by favorable pricing, mainly by North Africa, notably Egypt, Turkey and Ukraine. The favorable pricing variance was partly offset by unfavorable volume/mix, mainly due to lower total markets in Russia, Saudi Arabia, mainly resulting from the implementation of a new excise tax, and Turkey, partly offset by North Africa.

The company recorded net revenue growth of 11.8% to $2.4 billion in Asia. Excluding currency impact, revenue was up 12.8% from the prior-year quarter, despite a decline in cigarette revenues and shipment volumes.

Latin America & Canada

In Latin America and Canada, revenues increased 7.3% (up 10.2% excluding currency) to $748 million, primarily driven by growth in cigarette revenues and tobacco shipment volumes.

Zacks Investment Research Page 6 www.zackspro.com Please refer to the Zacks Research Digest spreadsheet of Philip Morris for specific revenue estimates.

Margins [Note: only highlighted material has been changed]

Provided below is a summary of margins as compiled by Zacks Digest:

Margins 2Q16A FY16A 1Q17A 2Q17A 3Q17E 4Q17E 2017E 2018E Gross Margin 64.4% 64.8% 64.1% 63.6% 64.7% 64.7% 64.3% 64.6% Operating Margin 41.4% 40.5% 39.5% 39.3% 43.1% 39.1% 40.3% 41.5% Pretax Margin 38.1% 37.2% 35.9% 36.3% 40.1% 36.3% 37.2% 38.5% Net Margin 26.9% 26.1% 25.2% 25.7% 28.4% 25.7% 26.3% 27.2%

Please refer to the Zacks Research Digest spreadsheet of Philip Morris for specific margin estimates.

The Zacks Digest gross margin contracted 80 basis points (bps) to 63.6%, while operating margin were down 210 bps to 39.3% in the quarter due to lower revenues from combustible products and unfavorable currency.

European Union: Adjusted operating companies income, excluding unfavorable currency, decreased by 3.7%. Adjusted operating companies income margin, excluding unfavorable currency, decreased by 2.9 points to 46.8%.

Eastern Europe, Middle East and Africa (EEMA): Adjusted operating companies income, excluding unfavorable currency, increased 3.3%. Adjusted operating companies income margin, excluding unfavorable currency, decreased by 0.5 points to 47.2%.

Asia: Adjusted operating companies income, excluding unfavorable currency, increased 15.0%.

Latin America and Canada: Adjusted operating companies income, excluding unfavorable currency, increased 31.3%.

Earnings per Share [Note: only highlighted material has been changed]

Provided below is a summary of EPS as compiled by Zacks Digest:

EPS 2Q16A FY16A 1Q17A 2Q17A 3Q17E 4Q17E 2017E 2018E Digest High $1.15 $4.48 $0.98 $1.14 $1.42 $1.37 $4.85 $5.50 Digest Low $1.15 $4.48 $0.98 $1.14 $1.35 $1.31 $4.85 $5.50 Digest Average $1.15 $4.48 $0.98 $1.14 $1.39 $1.34 $4.85 $5.50 Y-o-Y Growth -5.1% 1.4% -0.1% -0.7% 11.0% 21.7% 8.3% 13.4% Q-o-Q Growth 17.1% -10.9% 16.4% 21.3% -3.2%

Zacks Investment Research Page 7 www.zackspro.com The Zacks Digest average earnings per share for 2Q17 were $1.14, down 0.7% y/y from $1.15 in 2Q16.

Its adjusted earnings per share of $1.14 for the quarter also dipped 0.9% from the year-ago quarter. While the company benefited from strong pricing, lower cigarette volumes led to the decline.

Guidance

Philip Morris lowered its earnings guidance for 2017, including currency. The company now expects its 2017 diluted earnings per share in the band of $4.78–$4.93 as compared with $4.84–$4.99, expected earlier. Excluding adverse effect of currency of $0.14 ($0.08 per share expected earlier) in 2017 and favorable tax item of $0.04 reported in the first quarter, this guidance reflects growth of nearly 9–12% over the adjusted earnings of $4.48 delivered in 2016.

Please refer to the Zacks Research Digest spreadsheet of Philip Morris for specific EPS estimates.

Capital Structure/Solvency/Cash Flow/Governance/Others [Note: only highlighted material has been changed]

In 2Q17, Philip Morris announced a regular quarterly dividend of $1.04 per share.

Philip Morris consistently returns value to shareholders through dividends. In 2016, 2015 and 2014, the company paid dividends of $6.4 billion, $6.3 billion and $6.0 billion, respectively. During the third quarter of 2016, the company’s board approved a 2.0% increase in the quarterly dividend to $1.04 per common share. As a result, the present annualized dividend rate is $4.16 per common share.

July 25, 2017

Research Analyst Sneha Nahata Copy Editor Subhojoy Ghosh Content Ed. Sneha Nahata QCA Sumit Singh Lead Analyst Sneha Nahata No. of brokers reported/Total brokers Flash Reason for Update

Zacks Investment Research Page 8 www.zackspro.com Zacks Investment Research Page 9 www.zackspro.com