Categories Consumer, Earnings Call Transcripts

Philip Morris International Inc. (PM) Q2 2022 Earnings Call Transcript

PM Earnings Call - Final Transcript

Philip Morris International Inc. (NYSE: PM) Q2 2022 earnings call dated Jul. 21, 2022

Corporate Participants:

James Bushnell — Vice President of Investor Relations and Financial Communications

Emmanuel Babeau — Chief Financial Officer

Analysts:

Pamela Kaufman — Morgan Stanley — Analyst

Bonnie Herzog — Goldman Sachs — Analyst

Chris Growe — Stifel — Analyst

Vivien Azer — Cowen — Analyst

Gaurav Jain — Barclays — Analyst

Presentation:

Operator

Good day, and welcome to the Philip Morris International Second Quarter 2022 Earnings Conference Call. Today’s call is scheduled to last about one hour, including remarks by Philip Morris International management, and the question and answer session. [Operator Instructions]

I would now like to turn the call over to Mr. James Bushnell, Vice President of Investor Relations and Financial Communications. Please go ahead, sir.

James Bushnell — Vice President of Investor Relations and Financial Communications

Welcome. Thank you for joining us. Earlier today, we issued a press release containing detailed information on our 2022 second quarter results. You may access the release on pmi.com. A glossary of terms, including the definition for reduced risk products or RRPs as well as adjustments, other calculations and reconciliations to the most directly comparable U.S. GAAP measures and additional heated tobacco unit market data are at the end of today’s webcast slides, which are posted on our website. Unless otherwise stated, all references to IQOS are to our IQOS heat-not-burn products and all references to smoke-free products are to our RRPs.

Growth rates presented on an organic basis reflect currency-neutral adjusted results, excluding acquisitions and disposals. Consistent with last quarter, figures and comparisons presented on a pro forma basis entirely exclude PMI’s operations in Russia and Ukraine. As mentioned previously, starting in the second quarter of 2022, and on a comparative basis, PMI will exclude amortization and impairment of acquired intangibles from its adjusted results. Today’s remarks contain forward-looking statements and projections of future results. I direct your attention to the forward-looking and cautionary statements disclosure in today’s presentation and press release for a review of the various factors that could cause actual results to differ materially from projections or forward-looking statements.

It’s now my pleasure to introduce Emmanuel Babeau, Chief Financial Officer. Over to you, Emmanuel.

Emmanuel Babeau — Chief Financial Officer

Thank you, James. Welcome to you in your new role, and welcome, everyone. Before I begin, I want to reiterate our focus on supporting our employees and their families affected by the war in Ukraine and above all on the safety of our people. We continue to deploy pledge humanitarian support and additional benefits for our Ukraine employees. As previously announced, we intend to exit the Russian market in an orderly manner, as the complexities of continuing to operate in Russia increase such as supply chain challenges and financial and banking sector restriction.

We continue to actively work on options for doing so in the context of an increasingly complex and rapidly changing regulatory and operating environment, including the requirement to obtain certain governmental approval for any transaction. Turning to our business. We demonstrated strong underlying momentum in the second quarter of 2022 with another quarter of positive volume supporting better-than-expected top and bottom line growth. Most impressive was the continued excellent IQOS performance and strong Q2 pro forma user growth of more than 1.1 million, demonstrating further sequential acceleration compared to Q1 as device limitation and COVID restrictions continue to ease.

This reflects strong momentum in the EU region, Japan and developing market. Q2 RP pro forma net revenues grew by plus 11% despite the adverse shipment timing impact due to supply chain constraints highlighted last quarter, while HTU IMS volumes grew by plus 20%. IQOS ILUMA delivered further impressive results in its first three markets of Japan, Switzerland and Spain. The acceleration in category growth in these diverse geographies highlight the exciting future growth opportunity across the world, including in the latest launch market of Greece.

In combustible, robust Q2 pro forma volume growth of plus 2.4% and organic net revenue growth of plus 4.2% were driven by Marlboro share gains, stronger pricing and the continued recovery of the markets. Maintaining leadership of the cigarette category allows us to maximize the switching of adult smokers to smoke-free alternatives and accelerate our transformation into a predominantly smoke-free business by 2025. We expect the strong underlying momentum of our business in H1 to continue, and we are from an organic growth outlook for the year. We are now well on track to deliver two consecutive years of volume growth, confirming our status as a growth company in terms of volumes, organic net revenues and margins.

Despite a substantial currency headwind in 2022, we expect to deliver full year adjusted diluted EPS of around $6, including Russia and Ukraine. The proposed addition of Swedish Match would further boost our future financial profile. This is a value-creating offer for both set of shareholders with a compelling strategic and cultural fit, providing an additional opportunity to accelerate our smoke-free future. Turning to the headline numbers. Our Q2 volumes grew by plus 3% on a pro forma basis and by plus 1.1% in total, including Russia and Ukraine. Pro forma net revenues grew organically by plus 6.2% and by plus 5.3% for total PMI, reflecting both the continued strong growth of IQOS and the ongoing recovery of the combustible business in many markets against a pandemic affected comparison.

As we anticipated and indicated previously, less unfavorable timing of cigarette shipment also played a role, notably due to replenishment of duty-free inventories. Our total organic net revenue per unit grew by plus 3% on a pro forma basis and by plus 4.1% in total despite the expected delay of HTU shipments to Japan as we manage through global supply chain disruption. This incorporates combustible pricing of plus 3.5% on a pro forma basis or almost plus 5% excluding Indonesia. Our Q2 adjusted operating income margin declined organically by 190 basis points on a pro forma basis and by 150 basis points in total. As expected and communicated in our Q1 quarterly results, this reflects four main factors: first, investment to further expand and match the speed of growth in our smoke-free portfolio.

This includes the initial higher cost of ILUMA devices and HTUs and the transitory dilutive margin impact of higher device sales as we roll out ILUMA and replenish distribution channel as device constraint ease to support reaccelerating IQOS user growth. Second, the impact of supply chain disruption, notably due to the war in Ukraine, including around $80 million in additional air freight expenses. Third, inflation of around 4% in our cost of goods driven by the global pandemic recovery and exacerbated by the war, notably for certain direct materials, wages, energy and transportation costs. And last, a challenging prior year margin comparison, which included substantial cost of goods sold productivity savings.

Despite these typical margin challenges, our robust top line growth and ongoing cost efficiency enable us to deliver plus 5.6% growth in pro forma currency-neutral adjusted diluted EPS ahead of expectation to $1.32 and plus 3.8% growth for total PMI to $1.48, including Russia and Ukraine. Looking at the first half of the year now, our volumes grew by plus 4% on a pro forma basis and by plus 2.2% for total PMI. Pro forma revenues grew by plus 8.1% and by plus 7.1% in total, also driven by strong IQOS performance and the recovery of the cigarette category. We delivered organic net revenue per unit growth of plus 4% on a pro forma basis and plus 4.7% in total, again, reflecting the positive impact of growing HT volumes and pricing.

Our H1 adjusted operating income margin contracted organically by 110 basis points on a pro forma basis and 90 basis points in total, driven by the factors mentioned previously. We expect better margin performance in H2, a topic I will review it shortly. Currency-neutral adjusted diluted EPS grew by plus 10.4% to $2.79 on a pro forma basis and plus 9.2% in total to $3.06, an excellent performance given the circumstances. Reflecting this strong momentum, we have our guidance for 2022. With strong IQOS growth and robust trends in combustible, we foresee an acceleration in our currency-neutral growth expectation relative to our previous forecast.

First, we now expect to grow our total pro forma shipment volume by plus 1.5% to plus 2.5% for 2022, achieving another year of volume growth. For pro forma net revenue, we expect to deliver between plus 6% and plus 8% organic growth as compared to the plus 4.5% to plus 6.5% announced previously, despite a greater-than-anticipated drag from hyperinflationary accounting in Turkey. With a strong recovery in device volume, the increasing contribution of ILUMA with initially higher unit cost and ongoing global inflation, we are narrowing our forecast for pro forma adjusted organic OI margin expansion to between zero and plus 50 basis points. We are also raising our growth outlook for pro forma currency-neutral adjusted diluted EPS to between plus 10% and plus 12%.

This reflects a range of $5.23 to $5.34, including an estimated unfavorable currency impact of $0.80 at prevailing rates notably due to the euro and Japanese yen. We’ll include a slide in the appendix with further detail on this estimated impact. For total PMI, which assumes a full year contribution from Russia and Ukraine, we expect adjusted diluted EPS of $5.90 to $6.05, reflecting similar dynamic to the pro forma basis and including an estimated $0.69 unfavorable currency impact. Please note our 2022 forecast assumes no contribution from the proposed combination with Swedish Match which is expected to close in the fourth quarter of this year, subject to Swedish Match shareholder acceptance and the necessary regulatory approvals.

The outlook for IQOS growth is excellent, and we now expect to deliver full year pro forma HTU shipment volume of 90 billion to 92 billion units, representing the upper half of our previous forecast range. With growth momentum very strong, the main constraint for not further raising our HTU volume target is our production capacity, notably for ILUMA HTUs due to their outstanding initial success and the cancellation of production in Russia as we convert existing production line for induction consumable. We continue to expect excellent HTU growth in the coming quarters with a progressive improvement in ILUMA HTU capacity through the first half of 2023.

We are prioritizing ILUMA launch markets accordingly with further launches plan in Q4 as communicated previously. A notable further update to our outlook is an increase in our operating cash flow forecast to around $10.5 billion as compared to around $10 billion previously despite notable currency headwinds. This includes our accelerated pro forma earnings growth forecast and an assumed full year contribution from Russia and Ukraine. We delivered robust operating cash flow growth in H1 of plus 14%. And as shown through the challenges of recent years, the cash generation capacity of our business remains exceptional.

While flatted somewhat in 2021 by favorable timing and one-off impact, our revised full year forecast demonstrates underlying growth against this exceptional year after also accounting for higher inflation driven working capital requirements and currency. This underlines our ability to maintain a strong balance sheet, pay down debt and invest in the growth of our business. Our net debt of $23 billion on June 30, 2022, decreased compared to both June and December 2021, despite H1 capital expenditure of $0.5 billion and ongoing dividend payment. Our commitment to our progressive dividend policy is unwavering and we look forward to the additional cash flow, the proposed combination with Swedish Match would bring.

We also continue to expect around $1 billion in full year capital expenditure. Moving now to the pro forma outlook for the second half. We expect to deliver strong top line growth, organic adjusted OI margin expansion and further acceleration in bottom line growth. For Q3, we expect mid-single-digit organic top line growth driven by IQOS with around $22 billion in pro forma HTU shipment volumes. While there is a tougher comparison for cigarette and a modest negative impact expected from shipment timing, we expect combustible volume trends to remain resilient by historical standards.

Net revenue growth will also continue to be impacted in both Q3 and Q4 by the shift to hyperinflationary accounting in Turkey. While the temporary cost headwinds in Q2 are expected to ease somewhat in the third quarter, we expect this to be broadly offset by a step-up in smoke-free commercial and R&D investment as compared to a device constraint in Q3 2021. This results in an expected Q3 pro forma adjusted diluted EPS range of $1.23 to $1.28, including an estimated adverse currency impact of $0.24 at prevailing rates. We expect a strong Q4 with a rebound in HTU shipment volume due to phasing to the most pronounced as HT capacity constraint improve.

The H2 recovery in our pro forma adjusted OI margin is also expected to be Q4 weighted. Turning back to our results. Pro forma HTU in-market sales volume grew strongly by plus 20% for both the second quarter and the first half, notably driven by strong performance in the EU region. As expected, Q2 IMS pro forma growth was significantly ahead of shipment volume growth reflecting the later timing of shipments I mentioned earlier. Our total pro forma shipment volume increased by plus 3% for Q2 and plus 4% for H1. As I touched on earlier, this put us well on track to deliver total volume growth for the second consecutive year on both a pro forma and total PMI basis.

With the impressive performance of IQOS, heated tobacco units comprised 12.6% of our pro forma shipment volume in H1 or 14% in total despite the anticipated HTU shipment timing impact in Q2. Our sales mix is also changing rapidly as we aim to become a majority smoke-free company by 2025. Smoke-free net revenues made up almost 30% of our pro forma total and exceeded 30% for total PMI in the first half of the year. IQOS devices accounted for approximately 5% of the $4.2 billion of pro forma H1 RRP net revenues. This reflects higher device volume at a lower average price than last year as we expand our device portfolio with VEEV and ILUMA ONE and price ladder, our blade device portfolio in preparation for the launch of premium position in ILUMA.

The positive momentum of IQOS continues and is further accelerating in many geographies, providing a powerful driver of revenue and margin growth. We delivered organic growth of plus 8.1% in H1 pro forma net revenues and shipment on growth of plus 4%. This reflects between engine driving our top line in addition to volume. The first is pricing led by combustible. The second is the increasing mix of RRPs in our business at higher net revenue per unit, which continued to deliver substantial growths. This is an increasingly powerful driver as our transformation accelerate. Let’s now turn to the drivers of pro forma adjusted OI margin which contracted organically by 110 basis points.

Pro forma gross margin decreased by 280 basis points organically, reflecting the factors I mentioned previously, as we invest in our smoke-free business and manage temporary supply chain disruption and cost inflation. This margin headwind was partially offset by better pro forma adjusted marketing administration and reserve costs, which improved by 160 basis points organically. This was driven by the positive operating leverage of RRP growth and successful cost efficiency program where we generated around $420 million in gross cost savings, of which approximately $170 million came from COGS productivity and over $250 million from SG&A.

With more than $1.2 billion of savings realized by this halfway point, we are well on track to deliver cost savings of $2 billion for 2021, 2023. This allows us to reinvest in top line growth and mitigate inflationary pressures while continuing to deliver margin expansion. We continue to accelerate investment in our commercial programs, digital engine and R&D for long-term growth as well as a number of growth opportunities across categories and geographies. As reflected in our full year outlook, we expect our operating margin trajectory to improve in the second half of the year as temporary headwind and tough comparison in.

Focusing now on combustible, our portfolio again delivered growth in pro forma volume and organic net revenue in Q2. Our pro forma shipment volume grew by plus 2.4% against a pandemic affected comparison notably driven by Indonesia, Poland and Turkey. In addition, we saw a continued recovery in international duty-free outside Asia as passenger traffic increases. Pro forma combustible pricing of plus 3.5% was slightly ahead of our expectations. And while we remain cautious on the economic outlook, the pricing environment has been gradually improving. We expect to deliver a similar level of pricing for the full year. Our leadership in combustibles helps to maximize switching to smoke-free product and both the positive Q2 and H1 segment share demonstrates the strength of our portfolio.

We continue to target a stable category share over time despite the impact of IQOS cannibalization. This year marks the 50th anniversary of Marlboro becoming the world’s leading cigarette brand. With the return of social consumption occasion, Marlboro volumes grew plus 7% year-over-year in H1, with category share again surpassing 10% on a pro forma 12-month rolling basis. Of course, our long-standing success in building Marlboro’s brand equity is the strength we are now a smoke-free product as we make excellent progress with IQOS as the undisputed global smoke-free leader. The positive combination of a stable share in combustible and the continued growth of IQOS positions to deliver total market share growth over time.

We capture plus 40 basis points of pro forma share gain in Q2 including gains in duty-free, Italy, Japan and Turkey. Moreover, PMI HTU strengthened their position as the second largest nicotine brand in markets where IQOS is present with a 7.5% share, excluding Russia and Ukraine. Moving now to IQOS performance. We estimate there were approximately 19 million IQOS users as of June 30 on a pro forma basis. This reflects very strong growth of over plus 1.1 million users in Q2 and plus 2.2 million in H1, a record first half high on this basis. The acceleration of IQOS user growth compared to both Q1 and last year was driven by the reactivation of acquisition and retention program in many markets as device supply constraint receded as well as the impressive start of IQOS ILUMA.

While device supply constrained has eased in recent quarter, this is largely due to the success of our own proactive effort. The global supply of semiconductors remain tight, and we continue to closely monitor and manage the situation. In the EU region, we are now approaching the milestone of nine million IQOS users, reflecting stepped-up commercial activities to drive acquisition and retention, along with the launch of ILUMA in Switzerland and Spain. Our second quarter HTU share increased by plus 1.6 points to 7.1% of total cigarette and HTU industry volume. As noted in prior years, sequential share compared to Q1 was affected by the usual seasonality of the combustible market with the additional element of a strong year-over-year combustible recovery this quarter.

Most importantly, IMS volume continued to exhibit robust sequential growth, and we expect this to continue in the second half. The strong performance includes excellent user and volume growth across the region with notable contribution from Italy and Poland. Now to give some further color on our progress in the region. This slide shows a selection of the latest key city of Texas in Q2. Despite the denominator effect of the combustible category I just mentioned, share results remain very strong. Most impressive is Vilnius, the first city in the world to surpass 40% share while Athens, Budapest and Rome are in the mid- to high 20s. Elsewhere, we are especially pleased by the results in London, Vienna and Zurich.

In Japan, IQOS ILUMA is driving and our share of market continues to increase in key cities such as Tokyo. Most importantly, our IMS volume trends remain strong with continued sequential growth. As indicated last quarter, Q2 shipments were lower due to timing factors and should recover in the second half with a weighting towards Q4. The adjusted share for our H2 brands increased by plus 1.9 points to a record 22.9% in Q2 despite seasonality. While we are very pleased with these results, our share performance could have accelerated even further. The combustible category was notably resilient in the quarter and our rollout of mainline price entire HTUs for use with ILUMA was slightly slower than initially planned.

However, early results were encouraging. Sensia is designed to cater to its consumers switching to ILUMA and more price-conscious legal-age smokers. We also observed an increase in legal-age users switching from low price competitive heat-not-burn product. We estimate users of competitive offering to have less average daily consumption due to lower full conversion, which we believe ILUMA should improve over time. The heat-not-burn category now represents around 1/3 of total tobacco in Japan with IQOS increasingly driving this year’s growth. In addition to strong progress in developed countries, we continue to see very promising IQOS growth in low and medium income market.

The pro forma share of our HTU brands in the 28 such markets launched by December 31, 2021, continued to grow and reach 2.9% in Q2, reflecting sustained growth in IMS volume. Given the large size of this market, the premium positioning of the existing IQOS portfolio and the relatively early stage of commercialization, this represents outstanding progress. A prime example of this are Lebanon where Q2 of take share in Beirut increased by plus 8.1 points to 17.4%, and Egypt where offtake share in Cairo reached around 5% after launching less than one year ago. Other notable successes include the recently launched market of Morocco and Tunisia, as well as Georgia, Jordan, North Macedonia and the Philippine despite pandemic restriction in Manila.

Moving now to IQOS ILUMA, which continued to drive increased conversion and retention rate across initial launch market. In Japan, ILUMA continued to exhibit strong growth with premium priced TEREA HTUs growing rapidly to become the second largest tobacco brand, reaching an offtake share of 14.6% within nine months of national launch. Encouragingly, SENTIA offtake share has already surpassed the level of HEETS in non-perfect covering around 45% of industry volume. The expansion of our device portfolio with ILUMA ONE in Q1 has also seen robust traction with legal-age smokers.

We exited Q2 with a record high of tech share and continue to see a long runway of growth in Japan for ILUMA over the coming quarters. ILUMA and TEREA HTUs also continue their superb start in Spain and Switzerland. We launched ILUMA in Spain in March 2022 with very positive initial results, notably in key cities such as Barcelona and Madrid. Sequential IMS volumes grew by 27% in Q2. TEREA exited the quarter, making up over 50% of HTU sales only four months after commercialization and our national HTU share has grown to plus 1.7%. This is especially encouraging as Spain has been a market where regulatory restriction had limited the speed of IQOS growth. In Switzerland, the demand for ILUMA remains very strong.

IMS volume continued to grow sequentially, increasing plus 13% in the second quarter. A significant proportion of existing users have upgraded to ILUMA and the offtake exit volume of TEREA now exceeds 70% of our HTU sales. We continue to expand our global smoke-fee portfolio through our rich pipeline of innovation. We launched ILUMA in Greece in late June with further market launches planned for Q4. With regard to our new heat-not-burn device tailored to low and middle income market, we continue to plan pilot launches in the fourth quarter, further expanding our portfolio to serve different consumer needs and segment the market.

In e-vapor, IQOS continued to deliver encouraging results, and for example, is now the established number two closed pod brand in Italy with offtake share growing sequentially to around 20%. This is a premium proposition with an average price premium to competitive devices of 20% to 30% as we pursue differentiated and profitable category leadership position over time. In Q2, we expanded into three additional geographies, including France, and are now present in 10 markets. The latest addition to our e-vapor portfolio is the Viva disposable device, responsibly marketed disposable e-vapor product can play an important role as a convenient hassle-free entry into the smoke-free category for legal-age smokers.

Viva was recently launched in Canada with nine varieties. Our geographic expansion of smoke-free products also continued in Q2 with the launch of IQOS in Bahrain. Of course, the biggest potential near-term addition to our smoke-free portfolio is the proposed combination with Swedish Match. This would deliver a major acceleration in our transformation to becoming a smoke-free company. The visions of our two companies are aligned in working towards a smoke-free future without cigarette and would create a global smoke-free champion. If completed, we would have a comprehensive global smoke-free portfolio with leadership position in heat-not-burn and the fastest growing category of oral nicotine with potential for accelerated international expansion.

Another competing rationale for this deal is a large, attractive and growing U.S. smoke-free market. Swedish Match as the leading nicotine pouch franchise within and a substantial U.S. operational platform, which would help us unlock the significant polity across other smoke-free categories over the coming years. This would be a strong strategic and cultural fit, offering significant shareholder value creation over the medium and long term. As stated in the offer document published on June 28, the waiting period for the transaction under the U.S. antitrust process has expired, meaning that we have satisfied our requirement in the U.S. to proceed with the transaction.

We expect the transaction to close in the fourth quarter of this year, subject to Swedish Match shareholders acceptance and the necessary regulatory approvals. Moving to sustainability. I want to first draw your attention to our 2021 integrated report published in May which outlines our new sustainability strategy and ESG performance in detail as we continue to transform for good. Included in the report is our new sustainability index comprised of 19 KPIs across our most material sustainability issues. The index is weighted towards product transformation and now represent 30% of our long-term performance-based equity executive compensation.

The definitions, methodology and scope of each of these KPIs are included in our recently published ESG KPI protocol providing further transparency on how we define success and major ESG performance. With regard to tackling climate change, I am delighted to report that the science-based target initiative as today validated our 2040 net-zero target. The initiative also revalidated our near-term 2030 target for reducing greenhouse gas emission and our new 2025 target for 15% of our suppliers by then to have their own science-based target by 2025 a very positive development, given that Scope three remains the most challenging aspect of any company decarbonization strategy.

To support the achievement of these targets, we are accelerating progress to decarbonize our chain, and we have made eight more factory carbon neutral this year, more than doubling from last year and placing us on track to meet our goal of all factories by 2025. Finally, product health impact remains one of our most critical ESG priorities. There is a growing body of scientific and real-world evidence of the substantial risk reduction potential of smoke-free product compared to smoking. We continue to support policy and fiscal framework that recognize a positive impact tobacco harm reduction policy can have on public health.

Recent examples include a further multiyear tax plan with differentiated treatment for smoke-free products in Romania and statement from the Belgian Super Health Council on the whole e-vapor product can play in switching adult smokers away from cigarettes. To conclude today’s presentation, we have delivered a strong first half despite some challenging headwinds, placing us well on track to deliver robust volume growth and an accelerated currency-neutral pro forma financial performance in 2022. We remain excited by the promising results of IQOS ILUMA. Increased consumer satisfaction is driving higher retention and conversion, and we look forward to further market launches later this year.

Our combustible business continues to perform well with pro forma volume and organic net revenue growth, maintaining our share of market over time despite the impact of IQOS cannibalization allows us to accelerate further switching of smokers to better alternative and to invest for long-term growth in the development of innovative wellness and health care product will seek to deliver a net positive impact on society. We continue to enrich our pipeline of smoke-free innovation, such as ILUMA and Viva to expand and grow across new and existing category and geography. We are raising our pro forma growth guidance for the full year and expect to deliver around $6 in total adjusted diluted EPS, including Russia and Ukraine despite currency headwinds.

Importantly, with an excellent 2021 performance and our strong 2022 outlook, we now expect to comfortably exceed our 2021-2023 minimum CAGR target on a pro forma basis of more than plus 5% in organic net revenue growth and more than plus 5% in currency-neutral adjusted diluted EPS growth. Our ambition to become a majority smoke-free business by net revenue in 2025 also remains fully intact. We are confident in the rapid pace of our transformation. Finally, we continue to be steadfastly committed to returning cash to shareholders. Our top priority for capital allocation remain reinvestment in the business and our progressive dividend policy, underpinned by strong cash flow generation.

Thank you, and we are now more than happy to answer your questions.

Questions and Answers:

Operator

[Operator Instructions] Our first question comes from Pamela Kaufman from Morgan Stanley. Your line is now open.

Pamela Kaufman — Morgan Stanley — Analyst

Hi, good morning. Good morning. I wanted to get a sense for what’s contributing to the strong IQOS new user momentum that you’ve experienced in the last two quarters. Is there anything that you’re doing differently? And where are you adding these users geographically? How much is driven by ILUMA versus prior IQOS devices? And then related to that, what do you estimate new user growth would be if you were not constrained by production capacity?

Emmanuel Babeau — Chief Financial Officer

Thanks, Pamela. So we are obviously — and I said it very pleased with the performance of IQOS, and that is certainly being reflected in the very strong user growth of more than 1.1 million in the second quarter. We said that for H1, it’s a record growth. The good news is that we are really growing across geographies. So of course, we have a number of countries such as Italy, Poland, Japan, because their size, of course, they contribute more in the quarter. But the reality is that we see very good trends across geographies. And I could mention countries such as Romania, Portugal, Hungary, I mean, these are all countries of smaller size, but where the growth is really impressive.

So I think it’s a tribute to the fact that IQOS is making some clear customer expectation, the fact that people realize all the benefits they can get by switching from combustible cigarettes to the IQOS product. There is certainly ILUMA contributing. But as you know, we are unfortunately today, limited in the number of geographies where we propose ILUMA, it’s Japan, Switzerland and Spain. We’ve been launching Greece. So that is certainly in this country, helping the performance. But to be very clear, the performance is across the board, as I said, and including country where we haven’t launched yet ILUMA.

So certainly, we are improving the way we deliver a great customer experience, including digital customer, how we contact smokers, how we get in touch with them, how we start the dialogue, how we explain the benefit of IQOS and how we are leaving them in the journey from moving away from combustible products to IQOS. So no doubt, we continue to improve our commercial engine, and that is helping. There is probably the impact of awareness, visibility that is growing. There are markets where when you start to reach a certain market share, IQOS become visible, more visible you go in bars, you go in events, you go in social gathering, you see more and more people.

And that triggers what we call organic growth, people who wants to discover by themselves about IQOS. They want to learn, friends explaining how it works and why they really enjoy IQOS. We are also accelerating innovation. We have been proposing new devices. We are proposing new type of references. So we are enlarging the choice and that make probably IQOS even more desirable and attractive. So that’s really, I think, all the powerful driver behind the success of IQOS. Now if I focus on ILUMA and what is the potential with more ILUMA capacity, we see it in the three markets where we have been launching. ILUMA is resolving the remaining pain point that was — that are existing on the previous version of IQOS.

It’s certainly coming with a great customer experience. It is increasing the conversion, the loyalty. We expect it to increase the average daily consumption as well and to significantly reduce our abandonment. We see the customer net promoter score improving in the countries. So that is obviously bringing more momentum in the country where we are launching ILUMA. And I think we should see it as a kind of second stage of the rocket that we are going to launch in the various countries to send IQOS even higher, and that’s what we expect in the various countries where we’re going to launch in the coming quarters.

Pamela Kaufman — Morgan Stanley — Analyst

That’s very helpful. I also wanted to get a sense for how you would characterize your current appetite for additional acquisitions in the near term in light of the Swedish Match transaction. There are additional assets for sale in the U.S. market. Are you in a position to consider more acquisitions?

Emmanuel Babeau — Chief Financial Officer

Yes. Today, we are focusing on Swedish Match. The time line is the one we were expecting at the beginning. We continue to expect the closing of the transaction in Q4, of course, subject to Swedish Match shareholder acceptance. Nothing has changed. We are focusing on that. Am I closing the door in the future on other things that would further accelerate our journey to become a leading and successful smoke-free company? No. But clearly, the priority and the focus today is on Swedish Match.

Pamela Kaufman — Morgan Stanley — Analyst

Thank you.

Operator

We will take our next question from Bonnie Herzog with Goldman Sachs. Your line is open.

Bonnie Herzog — Goldman Sachs — Analyst

Thank you. Hi, Emmanuel.

Emmanuel Babeau — Chief Financial Officer

Yeah, hi.

Bonnie Herzog — Goldman Sachs — Analyst

I have a question on your pro forma adjusted OP margin in Q2. It declined on an organic basis. And you did highlight that the drag on your margins, at least partly was from the higher cost of ILUMA devices and then HTUs. And then you also lowered your full year OP margin guidance. So just hoping you could give us a sense of how long margins could be negatively impacted, I guess, from the rollout of ILUMA. And just based on your FY ’22 guidance, which does imply lower year-over-year EPS growth in the second half. I assume the drag on margins could be a key driver of this in the second half, but I just wanted to verify that. And just kind of thinking out into 2023, should the drag sort of ease? Or will that continue as you keep pushing on ILUMA?

Emmanuel Babeau — Chief Financial Officer

Yes. Thanks, Bonnie for the question. So I mean, that’s true that in H1, we’ve seen a number of headwinds on the margin. Needless to say that inflation, of course, is one. And we said that we are seeing around 4% inflation on our input cost. So I guess it’s probably lower than inflation that we see in many countries, but that’s significant. Obviously, we have costs that are coming from the disruption in the supply chain, notably coming from the war in Ukraine. We have a dramatic acceleration of air freight that is, of course, temporary. We’re not going to keep air shipping on the long term.

But during a period of time, we need to do that, and it’s very costly at the time where the cost of freight is globally, not only for air, but globally going up. So we are obviously being impacted. So that is having an impact here. And then there is a launch of ILUMA at the beginning, notably in Japan, where we had a very, very strong investment, which was really important to make on the device. And we have two devices now offering — three device, actually, three models in Japan, and the strong volume in device has an impact on the margin level.

On top of that, we said it since the beginning, we don’t start the launch of ILUMA with optimized cost and weight on the consumable on TEREA and on SENTIA. And that is coming at the beginning with a negative impact on margin which something that is temporary as well. So we expect in the course of 2023 seems to gradually improve. So inflation is not temporary. I think for the rest, a lot of the headwinds that we are seeing in H1 are temporary, and there will be a recovery in the future. I’m not able at that stage and we do that, of course, as we are gaining visibility to phase it in the coming quarter, but that’s certainly what we are expecting.

And then clearly, for H2, we are expecting an improvement on the margin. Certainly, that would be skewed to a large extent to Q4, but already the deterioration in Q3 on the gross margin would be lower, but there will be more investment as we grow. We are just following the growth, and we are putting the right level of investment to cope with the growth. Q4 we’ll be clearly seeing a better improvement with the better mix. Remember, we’ve been impacted also on the margin by the fact that the volume that we should have been shipping, that should have been the P&L to Japan, and that are having a very nice margin are not in the P&L.

And so of course, it’s another one-off that was impacting H1, but we will have the compensation in H2. So yes, difficult beginning of the year. It doesn’t mean that everything will be back to normal in H2. That will be still with some headwind. But clearly, most of what we are facing is temporary, and they will be over time, a recovery on the margin.

Bonnie Herzog — Goldman Sachs — Analyst

Okay. That all makes sense. And yes, definitely a lot of moving parts. So that was helpful. And then just my second question is on your proposed acquisition of Swedish Match, I guess, could you give us a little more color on where things are? And then maybe what you see as potential risks of this transaction not happening? I guess I’m asking, thinking about the activist involvement, in other words, I guess, I’d like to hear how committed are you to this transaction?

And how much flexibility do you have in terms of your leverage? I don’t think you have a target leverage ratio, but you’ve stated in the past you want to maintain your investment-grade ratings. So just maybe wanted to get a sense from you of what the rough, I guess, threshold for that leverage would be to maintain that.

Emmanuel Babeau — Chief Financial Officer

Thank you, Bonnie. What I can tell you on Swedish Match is, first of all, to repeat that we have cleared the U.S. requisite in terms of regulatory approval. So that is behind us. For the rest, the processes are still ongoing in several jurisdictions according to plan. And we are confirming the fact that we expect what we said in closing in Q4, of course, subject to Swedish Match shareholder acceptance. And here, I would like to reiterate the fact that we believe that this is a very compelling offer for Swedish Match shareholder.

Can I remind everybody that we offered a 40% four-zero premium at the time of the announcement in May. Since then, the markets have been quite volatile, most of them going down and that this offer has been approved by the Board of Swedish Match, which was confirming the fact that they thought it was compelling for their shareholders. So that’s what I have to say on Swedish Match. And I have no other comment to make.

Bonnie Herzog — Goldman Sachs — Analyst

Yeah.

Operator

We will take our next question from Chris Growe with Stifel. Your line is now open.

Chris Growe — Stifel — Analyst

Hi, good morning.

Emmanuel Babeau — Chief Financial Officer

Hi, Chris.

Chris Growe — Stifel — Analyst

I just had a question for you first on the timing of shipments across the second half. You’ve talked about the — just over two billion sticks that shifted to the second half of the year. Does that shift mostly to the fourth quarter as we’re thinking about your guidance for IQOS shipments in 3Q versus what’s implied for the fourth quarter?

Emmanuel Babeau — Chief Financial Officer

Yes, Chris, if I can try to help you, what we expect in Q3 is shipment to be much more in line with the underlying growth that we have seen on the IMS in H1, which was around 20%. So that’s what we expect in shipment, but we don’t expect the recovery of the shipments that have been missing in H1. We expect this recovery in Q4, where we continue to expect very strong dynamism of IQOS consumables. But then the shipment will be in Q4 above IMS to broadly align for the year, shipment and IMS. So that is the phasing that we expect for the year.

Chris Growe — Stifel — Analyst

Okay. And just one other question on relation to device sales. They’ve been a little elevated here as you had more availability. Does that remain elevated even in, say, the first half of ’23 as you continue to build your availability of devices? And is that the right time line to think about the point where you’ll have, let’s call it, full availability of devices is in the first half of ’23 based on the chip shortage?

Emmanuel Babeau — Chief Financial Officer

I think you have two elements, Chris, here. The first one, remember, we had some constraint on device availability that started in Q2, some impact in Q3 and H2 last year. So of course, there is an increase in the device level this year based on low comps. So that’s the first element. And I think it’s really important to realize how important it is to make sure that smokers can have access to IQOS device to get converted. So I think it’s important that we make commercial effort here. And I think we’re doing that well. And we see that our device versus maybe some device from the competition is clearly getting to a better conversion.

On top of it and then the second element, it is clear that with ILUMA, there is a wave of replacement. So we see in the markets where we launched ILUMA, a rapid replacement of existing IQOS blade device by IQOS ILUMA. And that — this wave of replacement is creating a very strong one-off acceleration in the level of device. When people will be equipped — when the core consumer will be equipped that will be behind us, but we have to go through that. And that is having, again, on a temporary basis, a negative impact on the margin.

Chris Growe — Stifel — Analyst

Thank you.

Emmanuel Babeau — Chief Financial Officer

Thank you.

Operator

We will take our next question from Vivien Azer with Cowen. Your line is open.

Vivien Azer — Cowen — Analyst

Hi, good morning.

Emmanuel Babeau — Chief Financial Officer

Good morning.

Vivien Azer — Cowen — Analyst

So my first question has to do with the proposed elimination of menthol variants in the EU for heat-not-burn products. Could you please offer some color on your menthol mix in that geography? And then secondly, an outlook on the timing of that proposal.

Emmanuel Babeau — Chief Financial Officer

Look, I’m not sure we disclosed the component of menthol. Of course, that’s a minority of our business. What I can say about that is that we have to understand that this is a move in application from the TPD in Europe. So it’s not a decision. It’s an application based on the TPD of 2014, which in certain circumstances was planning for a kind of automatic ban to be implemented. Now this still needs to be approved by the parliament and by the European Council that will be in front of this two bodies later on in 2022, and we’ll see what is the final decision. To be very clear, it already has happened on a combustible business with almost no impact or very limited impact. So the consumer reorganize their taste and they switch to other products, but very limited impact.

And therefore, it isn’t clear that this will have a meaningful impact if it happens on our heat-not-burn business. In addition to that, we believe that we have superiority in our tobacco taste versus competition, and that’s the superiority of our technology with IQOS versus the technology of the competition. So that will mean if we are left with tobacco taste that our product will look great versus competition for people who may decide to go for new product if they have to abandon on flavor. So we are, of course, waiting to see what are the development. But as you can hear, I guess, from my comments, we have limited concern on that matter.

Vivien Azer — Cowen — Analyst

Certainly. And my follow-up question is on IQOS in the U.S. If we can just revisit the timing of reintroducing that product into the marketplace, please?

Emmanuel Babeau — Chief Financial Officer

Yes. We expect to be in a position to introduce IQOS in H1 of 2023. I cannot be more precise at this stage. We continue to work on the plan to be able to do that. And of course, we’ll keep you posted when we have more clarity and more precise reintroduction date.

Vivien Azer — Cowen — Analyst

Thank you.

Emmanuel Babeau — Chief Financial Officer

Thank you.

Operator

And we will take our last question from Gaurav Jain with Barclays. Your line is open.

Gaurav Jain — Barclays — Analyst

Hi, good morning.

Emmanuel Babeau — Chief Financial Officer

Hi, Gaurav.

Gaurav Jain — Barclays — Analyst

Hi, thanks a lot of Emmanuel, so a couple of questions from me. One is on Russia. So the way you’re now guiding, you are including Russia for the full year and earlier, you had included Russia just for Q1. So can you still export devices into Russia, IQOS devices because you still have IQOS shipments there? And also, can you take cash out of Russia to pay the dividends, which you are paying in USD?

Emmanuel Babeau — Chief Financial Officer

Thank you, Gaurav. So yes, I confirm that we can still export our device, not covered by sanction. And therefore, you have many parts of the business that are disrupted on the supply chain, but that one for the time being because, of course, you never know how this can evolve is not impacted. On the payment of the dividend, I’m not able to tell you because we did not try to pay a dividend. So I’m not able to answer. What I can tell you is that for the time being, we’ve been making the usual payment between our subsidiary and in terms of procurement, in terms of any kind of royalties or intercompany normally. So that’s what I can tell you at that stage.

Gaurav Jain — Barclays — Analyst

Okay. And my second question is on the Canadian market. So clearly, you do not consolidate Canada, but you give the volume numbers. So the market is down 16% in 1H ’22 and 19% in Q2. And the retail pricing, I think, is 6% to 7%, which is not out of ordinary. And then you have been mentioning this e-cigarette cannibalization and you have launched Viva, the disposable device in Canada. So what’s exactly happening in Canada? Is it that e-cigarettes are now growing very fast and cannibalizing the market? Could you just help us understand that?

Emmanuel Babeau — Chief Financial Officer

Yes. I think that is a market where you may have some basis of comparison and some one-off element, but the trend is clearly don’t take the minus 60% as a reference for the market. But clearly, the trend is for combustible business to go down and for smoke-free product, including vaping, but our ambition is also to grow fast heat-not-burn to develop nicely as a substitute to combustible. That’s a market on which things are moving rapidly.

Gaurav Jain — Barclays — Analyst

Okay. Sure. Thanks a lot.

Emmanuel Babeau — Chief Financial Officer

Thank you.

Operator

I would now like to turn the program back over to management for any additional or closing remarks.

Emmanuel Babeau — Chief Financial Officer

Well, thank you very much for participating to this call today. We were delighted to share the very good progress that we are making on IQOS and on becoming a smoke-free company despite of fact, of course, the challenges that you all know. And we look forward to talk to you soon. Thank you very much.

James Bushnell — Vice President of Investor Relations and Financial Communications

That concludes our call today. Thank you again for joining us. If you have any follow-up questions, please contact the Investor Relations team. Thank you again, and have a nice day.

Operator

[Operator Closing Remarks]

Disclaimer

This transcript is produced by AlphaStreet, Inc. While we strive to produce the best transcripts, it may contain misspellings and other inaccuracies. This transcript is provided as is without express or implied warranties of any kind. As with all our articles, AlphaStreet, Inc. does not assume any responsibility for your use of this content, and we strongly encourage you to do your own research, including listening to the call yourself and reading the company’s SEC filings. Neither the information nor any opinion expressed in this transcript constitutes a solicitation of the purchase or sale of securities or commodities. Any opinion expressed in the transcript does not necessarily reflect the views of AlphaStreet, Inc.

© COPYRIGHT 2021, AlphaStreet, Inc. All rights reserved. Any reproduction, redistribution or retransmission is expressly prohibited.

Most Popular

Here’s a look at Dollar Tree’s (DLTR) expectations for the remainder of the year

Shares of Dollar Tree Inc. (NASDAQ: DLTR) were down over 1% on Wednesday, a day after the company reported earnings results for the third quarter of 2022. Revenue and earnings

Target Corporation (TGT): A look at how the retail giant is shaping up against an inflationary backdrop

Shares of Target Corporation (NYSE: TGT) were up over 1% on Wednesday. The stock has dropped 30% year-to-date and 35% over the past 12 months. Last week the company reported

Is Zoom Video Communications (ZM) a good investment after Q3 earnings?

Zoom Video Communications (NASDAQ: ZM) expanded its customer base at an accelerated pace during the COVID crisis and soon became the preferred video conferencing platform for businesses and millions of

Add Comment
Loading...
Cancel
Viewing Highlight
Loading...
Highlight
Close
Top