菲利普莫里斯國際 (PM) 2017 Q2 法說會逐字稿

Good day, and welcome to the Philip Morris International Second Quarter 2017 Earnings Conference Call.

Today's call is scheduled to last about 1 hour, including remarks by Philip Morris International management and the question-and-answer session.

(Operator Instructions).

I will now turn the call over to Mr. Nick Rolli, Vice President of Investor Relations and Financial Communications.

Please go ahead, sir.

Welcome, and thank you for joining us.

Earlier today, we issued a press release containing detailed information on our 2017 second quarter results, and you may access the release on www.pmi.com or the PMI Investor Relations app.

During our call today, please note of the following, unless otherwise stated.

First, we will be talking about results for the second quarter of 2017 and comparing them to the same period in 2016.

Second, all references to total industry, PMI volume and PMI market share performance reflect cigarettes and PMI's heated tobacco units for those markets that have commercial sales of iQOS.

A glossary of terms, adjustments and other calculations as well as reconciliations to the most directly comparable U.S. GAAP measures are at the end of today's webcast slides, which are posted on our website.

Reduced-risk products, or RRPs, is the term we use to refer to products that present or likely to present or have the potential to present less risk of harm to smokers who switch to these products versus continued smoking.

Today's remarks contain forward-looking statements and projections of future results, and 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 Jacek Olczak, our Chief Financial Officer.

Jacek?

Thank you, Nick, and welcome, ladies and gentlemen.

We are pleased about our performance in the second quarter, notably reflecting strong currency-neutral financial results, including: growth in adjusted diluted EPS of 8.7%; sequential improvement in our total shipment volume declined compared to the first quarter; a market share growth for Marlboro across a broad range of geographies; and continued positive momentum for iQOS, not only in Japan, but also across other launch markets.

As announced this morning, we are revising, for currency only, our 2017 reported diluted EPS guidance at prevailing exchange rates to a range of $4.78 to $4.93.

Our guidance now includes approximately $0.14 of unfavorable currency.

Excluding currency and the favorable $0.04 tax item recorded in the first quarter, our guidance continues to represent a growth rate of approximately 9% to 12% compared to our adjusted diluted EPS of $4.48 in 2016.

As a reminder, we expect higher currency-neutral growth in the second half of 2017, mainly reflecting increased heated tobacco unit shipment volume, partly offset by continued investments behind the commercialization of iQOS.

The $0.06 increase in the unfavorable currency impact on our guidance as compared to our previous guidance on April 20 is due principally to the depreciation of the Japanese yen and Russian ruble versus the U.S. dollar.

Please note that the currency impact of the yen depreciation relates to the unhedged portion of our 2017 forecast sales to Japan and is amplified by the strong performance of iQOS.

Let me now take you through our second quarter results in more detail, beginning with our total cigarette and heated tobacco unit shipment volume, which declined by 5%.

The decline was due mainly to lower cigarette industry volume in the Asia and EEMA regions.

In Asia, this notably reflected a challenging consumer spending environment in Indonesia as well as ongoing declines of low-margin volumes in Pakistan and the Philippines.

In EEMA, this mainly reflected the 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.

In the case of Marlboro, the retail price increased by SAR 12 to reach SAR 24 or approximately $6.40 per pack.

The cigarette volume decline was partly offset by the strong growth of our heated tobacco product, principally in Japan, which increased by 5.2 billion units to reach 6.4 billion units in the quarter.

As expected, we recorded a sequential improvement in our total volume decline during the second quarter, driven by favorable evolutions compared to the first quarter in 3 of our 4 regions: EU, EEMA and Latin America and Canada.

Excluding the negative impact on our volume performance of industry-wide trade inventory movements, principally in Indonesia and Pakistan, the Asia region would also have recorded a favorable evolution.

For the full year, we continue 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.

In Pakistan specifically, we expect the recent fiscal restructuring, which introduced a new excise tax tier from lower-priced product, to ease the pressure on cigarette industry volume from illicit trade over the balance of the year.

We recorded strong currency-neutral results in the second quarter.

Net revenues increased by 7%, driven by higher heated tobacco unit and iQOS device sales, notably in Japan, as well as favorable pricing.

Adjusted OCI increased by 5.9%, primarily reflecting the impact of higher net revenues, partly offset by increased investments supporting the commercialization of iQOS, notably in the EU region.

Adjusted diluted EPS increased by 8.7%.

Net revenues for our RRP portfolio reached $615 million or 8.9% of total net revenues in the second quarter, continuing the strong sequential growth trend.

As we have noted previously, a portion of our RRP net revenues are from iQOS devices, which yield a negative margin due to introductory discounts offered in the initial commercialization phase to accelerate adult smoker switching.

For reference, iQOS devices contributed approximately 22% of our RRP net revenues in 2016.

Underpinned by the strong growth outlook for RRPs, we now anticipate total currency-neutral net revenue growth above 7% this year.

We recorded a pricing variance of $367 million in the second quarter, supported by all regions.

Our year-to-date June pricing variance of $775 million represents 6.1% of first half 2016 net revenues.

This is despite no net pricing in Russia, which I will discuss in more detail shortly.

Turning to market share.

We recorded strong sequential growth in the second quarter with our total international share, excluding China and the U.S., up by 80 basis points to 27.6%.

This growth was driven by both our cigarette and heated tobacco portfolio.

Within the cigarette category, Marlboro's international share increased sequentially by 10 basis points to 9.6%.

I will now discuss a few of our key geographies, beginning with the EU region.

Total industry volume in the second quarter declined by 1% with sequential improvement compared to the first quarter that included a higher recovery from illicit trade in Poland and the lower impact from the 10s packs ban in Italy.

June year-to-date industry volume declined by 1.8%, slightly better than our full year decline forecast of 2% to 3%.

Our regional market share was down by 20 basis points in the quarter, mainly due to Germany, Italy and Spain, partly offset by France and Poland.

In Germany, the lower share largely reflected the combined impact of price increases in March this year, which, for reference, saw the pack -- per pack price of Marlboro and L&M increased by EUR 0.30 to $6 -- to EUR 6.30 and EUR 5.90, respectively, as well as the later timing of competitors' price increases.

In Italy and Spain, the lower shares reflected the continuation of the pressures related to Marlboro price points discussed last quarter.

So it is worth highlighting that our shares for Marlboro in this market increased by 40 and 20 basis points, reflectively, versus the first quarter.

Regional adjusted OCI in the quarter declined by 3.7%, excluding currency, primarily reflecting higher investments behind the commercialization of iQOS.

These investments are supporting the encouraging market and offtake share trends in our launch markets, which I will cover later in the presentation.

Moving to Russia.

Total industry volume declined by 6.2% in the quarter, due primarily to the impact of excise tax-driven price increases.

For the full year, we continue to expect a decline in the range of 5% to 6%.

Our May quarter-to-date cigarette share increased slightly versus the same period last year and continued the fairly stable sequential share performance of the past 4 quarters.

Recently launched Philip Morris continues to grow share, reflecting the successful morphing of Optima and Apollo Soyuz as well as adult smoker down-trading in the market.

When the industry volume decline and market share trends have been in line with expectation, our price realization is lower than anticipated due to increased competitive pricing.

This is putting pressure on our ability to grow profitability in the market.

In the Philippines, higher pricing and favorable portfolio mix, reflecting the strong performance of Marlboro, drove another quarter of profitability growth.

While our cigarette share declined in the quarter, Marlboro share increased by 3.8 points, driven by in-switching from lower-priced brands.

Importantly, we are beginning to see a stabilization in our cigarette share, which increased by 20 basis points sequentially versus the first quarter.

The cigarette industry volume decline rate moderated sequentially with a decline of 5.7% in the second quarter, following a 15.3% decline in the prior quarter.

As we look towards the balance of the year, we are encouraged by the combination of recent competitor price increases and lower competitor discounting at the bottom of the market.

This has led to a reduction in the price gaps between our portfolio, notably Fortune, and lower-priced competitor brands, enhancing the overall competitiveness of our portfolio, particularly in the low and the super-low price segment.

In Indonesia, cigarette industry volume in the second quarter was adversely impacted by 3 main factors: a challenging comparison due to largely inventory movements mainly associated with the timing of Ramadan, above-inflation tax-driven retail price increases and the effect of higher utility prices on consumer spending.

We now anticipate a decline of around 3% this year.

Our cigarette market share declined by 60 basis points in the quarter, due mainly to the soft performance of our hand-rolled kretek portfolio.

The decline was partly offset by Marlboro, reflecting the growth of Marlboro Filter Black in the full flavor machine-made kretek segment and the strong early performance of Dji Sam Soe Magnum Mild, a lighter-tasting, machine-made kretek product that we launched in May.

These 2 offerings are driving our growth in the overall machine-made kretek segment, the largest and fastest-growing product segment industry-wide.

In Japan, the spectacular growth of HeatSticks continues to drive our results.

The brand's shipments in the second quarter increased by 37% on a sequential basis to reach 5.7 billion units, accounting for over 40% of our total shipments in Japan.

Total market share increased by 4.5 points to 32% with HeatSticks up by 7.8 points to 10%.

On a sequential basis, HeatSticks grew by an impressive 2.9 points versus last quarter.

During the second quarter, we expanded availability of 2 new HeatStick variants in the smooth taste and differentiated menthol-based segments, respectively, and both are performing very well.

Total industry volume declined by 3.2%, excluding inventory movement, consistent with the secular decline rate for cigarettes prior to the introduction of iQOS.

The strong performance of iQOS in Japan is further evidenced by our retail offtake shares, as seen on this slide.

HeatSticks closed the quarter with a weekly offtake share of 12.7% nationally, up by 3.1 points versus the last week of the first quarter.

This growth was achieved despite a continued cap on the number of iQOS devices supplied to the market as well as the increasing presence of competitors' products in select geographies.

Turning to the commercialization of iQOS more broadly.

We have now launched iQOS in key cities in 27 markets globally, following city launches in Korea in May and the Czech Republic earlier this month.

We are particularly pleased with the early performance in Korea and, last week, announced increased distribution within Seoul as well as further expansion into 4 additional cities.

We remain on track to be in key cities or nationwide in a total of 30 to 35 markets by year-end, subject to capacity.

Importantly, we continue to grow the national share of our heated tobacco portfolio sequentially in many of our early launched markets beyond Japan.

For example, in Italy, Portugal and Romania, our national share increased to 0.6% or above in the second quarter.

While we have expanded the weighted retail distribution of our heated tobacco portfolio across this market, Japan remains, for the time being, the only market with national coverage due to capacity constraints.

In many of our more recent launched markets, we are recording positive sequential quarterly offtake share trends within the current focus area, as seen on this slide.

Our performance in Greece, for example, has been particularly strong, reaching 2% share in the Athens region less than 1 year after launch.

To conclude, our second quarter results were robust, reflecting sequential improvements in total volume and market share compared to the first quarter.

Our currency-neutral net revenue growth in the quarter was strong, driven by the continued momentum of iQOS and favorable pricing.

We now expect full year currency-neutral net revenue growth of over 7% in 2017.

Our 2017 EPS guidance, revised today for currency only, continues to reflect the growth rate of approximately 9% to 12%, excluding currency and the favorable tax items.

This compares to adjusted diluted EPS of $4.48 in 2016.

Finally, we remain focused on generously rewarding our shareholders with our robust cash flow.

For the year, we continue to target operating cash flow of approximately $8.5 billion and capital expenditures of $1.6 billion.

Thank you, and I will be happy now to answer your questions.

(Operator Instructions)

Our first question comes from the name, Vivien Azer with Cowen and Company.

Our next question comes from Bonnie Herzog with Wells Fargo.

This is Patty Kanada calling in for Bonnie.

Just a quick question on South Korea.

Is there -- could you give us a sense of what you've learned so far with iQOS there in terms of conversion rates, cannibalization?

Any big surprises you could share?

Are you feeling incrementally more or less optimistic about the replicability of the Japan model there?

It's very early stages, but we -- for reasons we're not talking about the market share, et cetera.

But I think the first reaction of the Korean smokers are much better than what we experienced at the same period when we entered Japan, largely much better.

I guess, obviously, Korea benefits from the channel -- cross-borders' growing awareness coming from Japan.

So the grant at the consumer level clearly was better prepared.

But I think Korea made equally a better surprise out in terms of the results in Japan.

This will be my reading at this stage.

Okay.

Just one quick follow-up on Japan pricing.

Could you confirm that you applied to raise prices in September?

And if so, would that be absent of any sort of tax increase, which I think is more typically the time that we see pricing?

Finally, we have applied for the price increase of Marlboro and the conventional cigarettes, and the timing for the implementation is September this year.

I am not aware at this stage of any other competitor price changes in Japan.

Our next question comes from Judy Hong with Goldman Sachs.

So Jacek, a couple of questions first on your guidance.

First, just in terms of thinking about your revenue growth guidance FX-neutral, now you're expecting over 7%, but you haven't changed the earnings guidance FX-neutral.

So I just wanted to get a sense of why not higher in terms of earnings even with higher revenue.

And then even the 7% revenue growth guidance seems somewhat conservative in the context of iQOS likely to really build much more contribution capacity ramping up.

So just trying to get a sense of -- I know you said over 7%, but kind of what sort of contribution from iQOS in the back half should we expect in terms of the revenue?

Look, Judy, it all boils down to the available capacity, okay?

I think we observe, as we speak, a better productivity from the installed machines.

So we might be able to grow beyond the 32 billion, which we had initially announced available capacity for this year.

If this will happen, I mean, clearly, we'll be able to sell or to ship more.

What I can say, look, if we have that product available, I mean, we can actually do the revenue better than a 7%.

But at this stage, I would just say that we will be above 7%.

What precisely that number will be?

I think we'll update it -- that the view of that outlook in Q3 because we will know how much really the productions we had, capacity we had.

When it comes to the 1-point leap in our revenue guidance, if you like, they're not lifting the guidance.

I mean, we have a range 9% to 12%, so this is pretty relatively broad territory.

I have highlighted in my remarks that we actually have a pretty challenging situation, from a pricing perspective, in Russia.

So we have to be relatively cautious on this one, although, very recently, got some good news from the fiscal authorities with regards to the view on the potential excise increase in 2018, which will not materially impact -- or it won't change the 2017 but gives us a better outlook for '18, and we still have to see what is the total impact from this very high tax price increase in Saudi, okay?

And that's very much the Q2 -- sorry, Q3, Q4 type of event, which we'll have in front of us.

So we'll see what will happen.

We continue to investing behind the iQOS.

As you could see the growth rate in all geographies, very solid, very good, very encouraging.

We opened recently Korea.

We have a few other markets, which we will have very likely -- we'll have to very likely put up an investment to support that revenue level, which these markets are generating now.

So we'll see how we close.

But I think it's a nice problem to have as long as we see the good quality of the top line growth.

And you presumably noticed that, for the first time, we're not only driving the revenue by pricing variance, but there is a pretty good contribution at the revenue level from a volume mix, actually, or product mix.

So I think the quality very nicely comes through the top line, and I think it will, one day, also flow very nicely to the bottom line.

Okay.

And then just my second question is just in terms of thinking about iQOS and seeing, particularly in the markets where, obviously, some of the competitive products have launched.

So in Sendai in Japan, you obviously had a little bit more of a lead time in iQOS being in those markets before Glo came in.

In Korea, it sounds like you're going to have Glo going in more quickly.

Korea Tobacco talking about a competitive launch there, too.

So I'm just wondering from your perspective, just not having that much of a lead time in those markets, do you think that that's going to curtail iQOS performance?

Or if you kind of look at markets in Japan, just the broader category expansion could be accelerated and so for iQOS to continue to grow, how do you sort of think about the timing of some of these competitive launches now in some of the markets that could be sooner than what you saw in Japan?

Look, I think that we actually welcome the competitors entering the heat-not-burn category because, from a consumer awareness perspective, et cetera, it's actually sort of helpful, rather than us driving the -- building the awareness of the category, the product, the brand on our own.

We have been coexisting, at least at the city-test basis, with competitors' product, the [GET] product and the [BEG] product.

You see the trajectory of -- the growth trajectory of iQOS in these places and that we feel pretty comfortable.

But overall, I think it's actually not that bad with the competitors also coming to the market and the general awareness of the product you see -- of the categories, sorry, is growth.

iQOS, it's early days.

I mean, we'll have to look at the national expansion like here announced by the competitors in Japan.

I mean, how it is going to change the dynamics in terms of the growth rate of iQOS.

But at this stage, I think we feel pretty confident that consumer will -- we will continue having high conversion rates and, very importantly, higher stickiness rate for our product proposition.

Got it, okay.

And then just finally quickly on the hedging on the yen, because it sounds like second quarter, the FX was a lot worse than many people had anticipated.

So can you just give a sense of what happened in 2Q from a hedge perspective and where we are at this point?

Well, at the beginning of the year, I remember we said that we were covered with the yen for about 40%.

We obviously brought up the hedge ratio higher to about 50%.

But in the meantime, the cash flows and revenue from Japan start shooting higher also than we initially thought.

I mean, it's a little bit now of a moving target.

So therefore, we have to the exposure -- we have this exposure and still uncovered exposure on yen.

But yen in Q2, just Q2, if I take that actuals, right, the $0.11 which we had in the quarter, yen actually contributed net to the negative only by $0.01.

I think it's a more what we think will be the cash flows and our hedge ratios going forward than if we value this at the spot rate.

But this obviously changes the outlook, the guidance of $0.14.

The 2 currencies which moved us in this quarter were euro by $0.04 and Egyptian pound over $0.04.

And Egyptian pound is something, which we need to pay attention because we had -- last quarter of 2016, we had a quite big negative currency variance despite the fact that the majority of the currencies were actually improving versus dollar.

And these were the transactional losses, which we incur on Egyptian pound.

Now Egyptian pound is relatively pretty stable since then, after this massive devaluation.

So at the current spot rates, we should have a complete reversal of the negative variance on a currency line in Q4, which may lead to the -- should lead that the current spot rates to the situation that we will still have some negative currency in Q3, and we should flip completely to the positive currency in Q4.

And this, blended, will give us this $0.14, which we have announced today in the guidance.

Our next question comes from Matthew Grainger with Morgan Stanley.

I wanted to come back to the Russia pricing dynamic.

It sounds like this may continue for at least a few more months.

Is that going to have any impact on your expectations for 6% combustible pricing for the year or any impact on your ability to reach potentially the higher end of the EPS guidance range?

And when we think about potential offsets in the P&L to help compensate for lower pricing there, do you have sufficient flexibility in other markets to compensate for that without having to make any changes in your RRP investment plans?

Matthew, without going into the specifics in the pricing variance for the full year, which obviously Russia will wait because it's now for the 6 months, the quarters, we essentially have no net pricing despite the fact that for the first 2 quarters, PMI had about 6% pricing variance, but it's going to wait for the year.

I would rather focus that the pricing situation in Russia is, in fact, well factored in, in our net revenue outlook for the year by about 7%.

This is probably trying to manage the situations.

Clearly, if we would have had not a lot pricing opportunity to take extra pricing in Russia, I mean, at that revenue and a pricing variance corresponding behind.

But this is the situation in Russia today.

Remember, usually, as of Q2, us against industry, we're even at positive sort of a pricing situation in Russia, right, to generate tax increases, pass on a little bit ahead towards the back end of the year, the previous year and the current year.

And now we aimed in June, and if my estimates are correct, industry and us are presumably few rubles, maybe up to 5 rubles below the pass-on as of January this year.

So actually, the pricing which we in Russia today, is the fading out annualization of the past year, and you have no net pricing due to current year.

But then as I said, this is factored in at 7% or higher revenue growth for us.

That's the situation.

Okay.

And just in terms of the impact on the EPS outlook and where you might fall in that range, obviously, you don't want to pull back at all on spending behind iQOS in the broader RRP platforms.

Are there -- are you confident that there's enough additional offsets in the combustible business?

Maybe it's stronger profit performance in other combustible markets that could help compensate for that?

Or if pricing doesn't come through, does that limit your ability to maybe get to the higher end of the 9% to 12% range?

Well, I mean, a few factors, which we have for the Q3 and Q4 ahead of us.

First, I think we expect the correction of volumes in Indonesia due to the timing, right, because Indonesia alone, due to the timing of this inventory movements around the Ramadan, et cetera, I guess our estimate is about the 2 billion units in Indonesia, which then we should see the payback of that in Q3.

There is a bit lower growth in Indonesia compared to the last year, but pricing goes through the consumer.

It should be, there, softer than in the past years.

Philippines are going where we wanted Philippines to go.

So that's -- I wouldn't expect any surprises.

The price gap's getting close.

Marlboro performs well.

I think we might also improve our competitive situation and profitability situations at the bottom end of the market.

So I think Philippines should nicely be -- continue contributing.

Indonesia, I said, should have a better second half of the year than the first half of the year.

Pakistan, a little help on the volumes.

We know that Pakistan is not really the driver of the financial performance, but it's good to solve this problem.

Russia, I don't think -- I wouldn't count on any surprises on the pricing there on the top side.

And the question mark is how consumers going to take this 100% doubling the prices in Saudi.

And there are still a few other GCC states, which, as we understand also, planned to increase the taxes between now and the year-end.

So we'll have to see how this unfolds.

EU has a good strength, both on the underlying volumes.

Share is in a good shape.

It's more the questions how much we will put in terms of investment behind an iQOS, which we may -- and we may wish to sacrifice the profitability within EU for the sake of locking the -- building the right revenue opportunity, which lies in front of iQOS in the EU.

This is how we do it.

The range is 9% to 12%.

You know how we would deal with the reasons why we expanded that range.

I think we will deliver in the range.

That's clearly the report today we have to have.

We have not revised the range, the target EPS range for other factors than the currency.

We're confident about this that we will reach the high end of the range.

Look, I mean, the speculations, we'll have to see.

Okay.

I hope -- hopefully, Russia improves.

And then can I just ask about plain packaging in France and the U.K.?

U.K. is pretty recent, but France since the beginning of the year.

Can you just give us whatever observations you have at this point on consumer behavior and reaction, what the impact has been on mix dynamics, volumes?

Has there been any shift in pricing dynamics in the super low segment in the U.K. since May?

I think, you guys, a little bit still early to talk about this.

France is a few months longer with the plain packaging.

And I don't want to sound sarcastic, okay?

But remember when we had these discussions in Australia a couple of years ago, the early quarters of implementation, there was the market share erosions and the down-trading and people were trying to connect the dots between plain packaging and what is happening in the market, which we were arguing that this is correlation of quotation at best place.

In France, actually, Marlboro grew share in the quarter by 60 basis points.

This is the quarter post plain packaging implementation, and I'm not implying this has to do with the plain packaging.

I think it's another argument, which the market dynamics, at least in the short term, has nothing to do with the plain packaging implementation.

We always -- we're using this argument that the 2 things are somehow thought to relate.

And actually, my total share, if I recall the number correctly in the release, I think we grew the share, total PMI, by almost one full -- 90 basis points.

It doesn't seem that there is down-trading in the market.

It doesn't seem that the premium brands or premium segment at this stage is impacted by plain packaging.

But I wouldn't be surprised, frankly speaking, that it would be.

Our next question comes from Michael Lavery with Piper Jaffray.

With the question earlier, you touched a little bit on some of the awareness boost that it gets from having Japan right next door and some interaction there.

Can you just talk a little bit about, in other markets, how your spending for this year compares to what you had expected or thought that it would be?

And related to that, how much does national distribution really help in terms of just getting in front of that many more people and helping the word-of-mouth or sort of network effect?

And are you spending any to offset not having national distribution in some markets in Europe, for example?

Frankly, it's very good question, actually, because yes, the national distribution would help in building the momentum and to growing the awareness.

On the other hand, national distribution requires the full availability of full capacity, okay, to meet the very likely surge in demand.

So reasons why we're holding many of our markets, essentially all of our markets outside Japan to the city type of territories is for the reasons that we would create essentially unmanageable constraints on the supply chain.

We're barely still, until the end of this quarter, we're coping with Japan.

The capacity should start this in Q3, Q4.

But again, as we have highlighted to -- before already, I mean, the priority is to stabilize Japan from a supply chain perspective, okay?

And we need to leave the quarter for the devices.

We're also working on developing a second device supplier.

So we'll have a full flexibility on the devices, hopefully, full flexibility of the HeatSticks volumes for Japan, and then we can start leveraging the expanded distribution as the factor of increasing the awareness in other markets.

But you're absolutely spot-on in your questions.

There is some correlations between broader availability of the product and awareness.

It's a little bit uphill for us.

But in the territories, what we focus at this stage is even this restricted part of territories, as much as obviously one can restrict the territory in a given market.

But in these restricted territories, the growth trajectory acceptance conversions are very positive.

I mean, you see this on the charts.

We pretty regularly update this performance on every market.

They have differences between the markets, but they have the one common denominator.

They all have growth.

That's very encouraging for us.

And with regards to spending, we will maintain high level of spending in Japan.

That's pretty obvious.

But we're now serving Japan summer this year will close or bypass 3 million consumers.

So that obviously entails or requires some uphold, which we are willing to do and, obviously, building up or preparing the rest of the markets.

Mainly, you will see by the spending year-on-year in comparison behind the iQOS, in particular, in the EU region.

Obviously, Korea will come in Asia.

This is on the early stages so there will be investment, mainly Korea.

And then just on Indonesia, certainly, the machine-made kreteks have been gaining a lot of momentum, and you've typically been underrepresented there.

How significant do you think this Dji Sam Soe Magnum Mild launch can be?

And how do you see the portfolio evolving as far as where the consumer demand has been making shifts?

It can be very significant.

I mean, we try to compete on a full flavor part of the machine-made and the lighter, smoother part of that segment.

It is a growing segment, I mean, large and very fastly growing segment.

We obviously -- it's important segment for us It's a building block of our continuous leadership in the market.

So we'll be very focused there.

We're also very pleased with the Marlboro entrance to the kretek segment, if you like, very good results despite that there was some sort of a cannibalization between Marlboro Whites and Marlboro -- to the -- to Marlboro kretek, combined Marlboro Fresh, nicely grew this year.

I think there is still a distribution expansion ahead of this brand.

So despite that they are not in a national-wide availability, they very nicely buffed the new propositions already, contributing to the overall share of the Indonesian market.

So we're very pleased with this, and we want to continue focus on this.

There will be some [happening] from time to time, which is very much around the pricing.

There are some brands, which are sitting at around per pack price points.

But we had it in the past, so this is sort of a cyclical type of a thing, and -- but we'll focus.

To conclude the answering your questions, we'll focus on the machine-made segment going forward.

I think the Marlboro kretek launched about 8 or 9 months ago, and you said it still has some distribution upside.

How do you expect the distribution trajectory for Dji Sam Soe Magnum Mild?

Will that move a little more quickly or something similar?

Yes.

I mean -- yes, and then we'll be building this distribution.

Will it go faster than a Marlboro?

It's hard to -- for me to say now, but clearly -- I mean, that expansion.

The classical launch plan in Indonesia, which you start with x number of territories, you build that brand there and then you start going to a number of territories.

Pretty large market, right?

So we don't have -- despite the fact that we think we have a pretty strong capability to deploy deployment capability Indonesia, we don't have a capability to have our Indonesia in 1 month or 2 months in terms of a national distribution.

Our next question comes from Chris Growe with Stifel.

I just had a question for you, if I could, first on the volume performance in the quarter, particularly also around the combustible volumes.

Was this quarter in line with your expectations from, like, a -- so the sequential progress you made in volume.

There was some puts and takes this quarter, no doubt.

But does this put you on track towards your progress, towards that negative 3 to negative 4 for the year?

No.

It was iQOS could, I guess, by not better than we initially would have thought.

But this is more the function of how much product we have available.

So we just -- which has essentially sold those cheaper, what we could.

And on the combustible business, on a conventional businesses, not much actually surprises.

I mean, I -- we knew that it will have that -- not the (inaudible) but the timing in Indonesia.

I have quantified that it's roughly about the 2 billion for us.

So this growth should see in Q3.

So the Q3 should come stronger on a -- versus the Q3 last year.

Pakistan, I think authorities addressing this problem with illicit trade.

They're trying to help addressing this problem with creation of this extra tax tier.

It's very helpful.

I mean, that come as a surprise, but the results, volume-wise, I think, should start accruing Q3, Q4.

And we know that we're expecting the tax increase in GCC, okay.

Saudi started.

Okay, it's a little bit of an impact on the Q2 volume, but we sometime -- we somehow been factoring this in our projection.

So remember that during the first quarter earnings call, I said that we expect the total combined volume for the year to be 2% to 3%.

I think I hint that we might actually come -- sorry, 3% to 4% and that we may come to the -- closer to the 3%.

I'm actually pretty sure we're going to come closer to the 3% based on what we have achieved in Q2 and how we've seen our situations level off for the Q3 and Q4.

Okay, that's helpful.

When I think about -- sorry, go ahead.

Go on, go on.

Just a question in relation to your iQOS capacity.

And we know it, generally, what you have available for the year.

How big of a step forward do you make in Q3?

Is this the quarter where you're going to see a marked improvement in your capacity availability in the quarter?

Q3 is higher than Q2, but -- and then Q4 will be higher than in Q3.

But look, it's -- we're gaining -- we're taking the benefits now of a better productivity.

We can run the machine faster, and we can install machine faster.

So it's not necessary that we can accelerate the CapEx as such.

But once the machine arrive at the factory, we can put them in a production much faster than the first groups of machine.

So it's obvious gain on the timing of implementation.

And clearly, we have a gain that the factory people are doing a spectacular job with how well they start running these machines, and this is becoming material.

So I have said as answer to the one of the previous questions, we will end up with a higher volume than a 32 billion.

That's very clear to me.

But at this stage, I wouldn't like to commit to this because this is a productivity gain.

So the calculation is a little bit more complicated.

But for sure, we're going to end up with a higher volume than 32 billion guaranteed.

Okay.

And then just to be clear on that, are there any markets where you'd have a national -- you want to be national by the end of the year or it's just a matter of the incremental capacity being used for incremental markets to get to those 30, 35 markets?

I think we'll try to build a full -- we'll have to unblock the supply chain for Japan first, which includes a proper lifting, hopefully, the caps on the devices.

We have on hand in Japan, onshore, the right inventory so we can have a smooth operations from the supply chain perspective in Japan.

That's our objective number one.

So most of the capacity will be -- our priority on the capacity allocations would be for Japan.

So I don't think we might be in a situation to push any market outside Japan for the national distribution.

I don't think we'll be in a position to do so.

But then obviously is Korea, as I hinted, Korea started better than Japan, and we have to start factoring Korea in this calculations as well.

So I think -- so we will now go national outside Japan this year, like 99% guarantee.

We will not (inaudible).

Our next question comes from Vivien Azer with Cowen and Company.

So I did want to follow up on iQOS, please.

So my first question on Japan.

We noticed some e-commerce activity on Amazon Prime.

Is that something that you guys are pushing as an initiative?

Because it creates a little bit of a disconnect for me when I hear that you guys are still capacity-constrained.

Look, this unavailability or not the full availability of the devices has created a lot of opportunities for other people, completely not related to Philip Morris, and I guess this is from what you're referring to.

So we have a number of e-commerce sites in a various numbers of places, not only in Japan, but outside Japan, with our devices somehow are being sold.

And you know, Vivien, very well, we have a listed price of $110, plus/minus the currency in the different countries, and we ended up with the devices being sold on these various e-commerce site at the prices of $600, $800, even $1,000.

So that's the situation.

Until the moment when we'll completely lift the caps on the devices and we'll be in the -- in ability to supply fully the market, we'll have all of these things.

We have our online sales, our own online PMI sales in the different countries.

You can go to the iqos.com, korea.com (sic) [iqos.korea], et cetera.

But we are not pushing this for the third party channel.

Great.

My second question on iQOS development, recognizing the bulk of the business is still coming out of Japan.

But as you look beyond Japan, in some of these other markets, considering that you have made some adjustments to the product packaging and branding, have you noticed any differences in terms of initial cannibalization now that you've deemphasized or, in some cases, totally eliminated the Marlboro aspect of the HEETS branding?

No.

Where we see to -- no, there's no correlation.

Actually, where we're selling the product, there's a Marlboro and the Marlboro trademark in Japan or as the HeatSticks from Marlboro in other places, which is the [packet fresh] in other places.

There is no differences in the cannibalization between the 2 geography.

Your next question comes from Adam Spielman with Citi.

So my first question is about iQOS in Europe.

You said a couple of times that you're increasing the marketing there.

But when I look at Slide 20 and Slide 21, I see sequentially the growth is slower.

So it slowed a bit in Italy, in Switzerland, about the same in Portugal, but faster, I think in Romania; slowed in Germany, slowed in Greece in the second quarter, slowed in Russia.

And I was just wondering what I should make of that, particularly in light of the fact that you said that when you get to sort of 1% or 2% or 3% market share, you -- we should expect it to accelerate.

So that would be my first question.

Look, the characters which listing on the slide, okay?

You have to look that we still very much, focus depends on the country, on the cities, right, not even on the entire territories.

If I give example of Switzerland, right, because presumably, might, for some, look like a slowdown in the penetration of the growth of a market share.

I mean, you have to really assume what is happening in Geneva, Lausanne, Neuchâtel and Zurich, I mean, a few places where we're really focused, okay?

Some of these places, iQOS is already above 3% or 4%.

Some of the place, I think, is even closer to the 6%.

Obviously, in this territory, altogether, including the villages, you have to look at the urbanization, non-urbanization of Switzerland, I mean, this turns to the 0.9%.

We're not worried about this at all.

In every zoom in territory in which we are, we have a good trajectory, and therefore, the investment is behind these markets to have a right base going forward.

Plus also, remember that we're expanding other territories, which are not even in Europe, which are not even in this chart.

That is obviously entails the additional spend.

So I -- we don't read the chart in a way that -- Greece, in my opinion, have a very spectacular growth rate, and we know that the Greece could have gone higher if we would allow Greece to expand broader.

We're just focusing on what we focus.

It's good that we just run faster or slower, this famous 2%, 3% that which we think is the point from which the word of mouth, et cetera, start to help.

So just to be clear what you said about Switzerland, just zooming on that.

But in Zurich and Geneva, we're accelerating up to, I don't know, 3% or 4%.

But nonetheless, the rest of Switzerland is going backwards so fast that, overall, the market share has only gone up 10 bps on a nationwide basis.

No, I'm talking that the 42% weighted distribution on Switzerland, but the real focus is on a few cities.

And obviously, for the distributions, when you have a HeatStick available in the stores, et cetera, there is not much of the iQOS sales shop -- support, okay?

The focus is in the big cities relative to the size of Switzerland.

And there, if I look at the readings, as I said, in the places like Lausanne, Geneva, few others, I mean, they're pretty impressive.

That is what I mean.

Okay.

So moving on to the conventional business.

In the past, you used to have a target of 4% to 6% top line growth sales growth constant currency.

This half, you've done minus 2%.

You obviously said that it will accelerate a bit in the second half, helped by Indonesia, in particular, but also Philippines, for example.

The question is do you -- are you happy enough with the way the combustible business is going?

Do you feel that you are just happy to let it go at the current run rate?

Or do you think you need a total increase investments there?

No, we're happy with the progress we're making on the conventional business.

I mean, you have to -- that was the reason why we're talking about the total revenue line and the combined volumes, et cetera, because you have to now factor back the combustible business, the volumes and the margins and the revenues, which were cannibalizing on the way, okay?

So that's like pretty obvious.

Am I happy with the development of pricing in Russia?

Clearly not, okay?

It's my point.

Am I happy that the consumer -- are we happy that the consumer in Indonesia is a bit softer?

Obviously not.

Am I happy that Mighty was not really playing fairly or fair in the market?

No.

So we always -- we'll have a (inaudible) further the situation.

But I -- the way we look -- when I look at that thing is, actually, we can grow the revenue or deliver the pricing variance for the 6 months of 6%.

Despite the fact that we'll have this clear headwind, that we can deliver the good quality, in my opinion, very good quality, in my opinion, top line growth of 7% or above for the full year, which is a nice mix in our pricing and the volume rather than just the pricing, which used to be passed on (inaudible).

I'm very pleased with this development.

I mean, I -- we're very much looking at the quality of the top line growth, and you see this quarter in the revenue, at least.

I mean, for the first time, we turn it into a positive volume type of a territory in terms of the contribution from iQOS.

And then very quickly, any comment on the Platform 4 test in Birmingham?

And do you have anything sort of new or specific you can say about the -- I think it's going to be in 4Q of a Platform 2 test that you're thinking about?

The all platforms we said before, -- sorry, the 2 and 3 before the year-end should go to the test market, city test market.

And the Platform 4, the product growth is now sharing the comments of the feedback from which get from the consumers in Birmingham and is reincorporating or incorporating this feedback into the next version of the product.

This was the purpose of the test market.

I think the MESH delivered on what we wanted to deliver, but also the test was to see what else we should add to the product in terms of the performance, et cetera, to address part of the consumer need.

But that's the part of our -- you will see the moral of these thing, that the test market is for the purpose of really verifying and realize what we need to do and then go back quickly to the drawing board and follow up shortly with the new product release.

We somehow went through this very quickly in Japan.

But people may not remember that the version of the iQOS device, which we have sold initially during the test markets in Nagoya, is different product versions, which we have nationally expanded, and it is a different product versions what we are shipping to Japan right now.

So Japan is already at the third generation or release, if you like, of the devices, and they are incorporate the feedback from the consumers.

And I guess other platforms will follow the same sort of a pattern.

Our next question comes from Jon Leinster with Berenberg.

A few questions, if I may.

First of all, with regard to Japan.

What sort of inventory levels or trade inventory levels are there in terms of iQOS?

And given you just talked about still being sort of capacity-constrained and wanting to build out a supply chain and such, what level of inventory in a perfect world would you be looking at in that sort of environment?

Well, usually, we target inventory in terms of a duration, right?

So if I would compare the duration of inventories of iQOS compared to what we strategically or normally maintain for the conventionals, iQOS will be below conventional.

So that's clearly the level of inventories, which is not sufficient to maintain the current level of operation.

Now obviously, on a conventional business in Japan, even before the opening of a new product category, the market is in a secular decline rate, et cetera.

So from time to time, your inventories automatically have a longer duration if you're going to adjust the volume.

iQOS is a reverse situation, I mean, as result to -- on a projected volume what we think is the duration.

And if I don't ship the product next week, the inventory is going to grow dramatically because I am on the increasing shipments to the retailers.

So what we're thinking is we should end up in Japan with the inventories at minimum, duration-wise, with the level of conventional cigarettes.

And actually, if we could, we would like to build that inventory higher because let us remember, that we still, today, have one operation, one manufacturing center supply in the market.

So our dependence from risk perspective is -- risk management perspective is extremely high, completely different than what we have on the conventional cigarette.

But we have said it already that Q1 that if we can build inventory in Japan, which will allow us to operate smoothly the supply chain, we will do it this year.

Sorry, I missed the last one.

Did you say 10 billion?

I didn't say -- no, I didn't say 10 billion.

I was referring to the duration of inventories, okay?

So we now...

And what duration normally would that be on the [FMC] side then?

You're talking somewhere between up to about 3 months.

But you need to take into consideration that the shipments to Japan are literally taking by water.

So the inventories are essentially on the water.

So 2/3 of that duration is not accessible for sales in Japan because it's in the pipeline to Japan.

It's the part that which we're trying to (inaudible).

Okay.

And in terms of capacity constraints, I mean, how -- when we're into Q3, I mean, I think you're suggesting that you're still capacity-constrained in terms of Japan.

So does that mean you'll only come off now in Q4?

Well, we have increased sales and shipments to Japan because that capacity is -- we're producing more week by week and month by month.

But what we said that, hopefully, around Q4, we should be in that situations that we can ship to the shops what we -- what is required and somehow, in parallel, get the inventory rise, which would absorb any surge.

So we can leave the surge in demand.

So we can leave the quarter on the devices, and Japan will not be putting further constraints on the supply chain.

You'll have gradual expansion.

Okay.

Gradual expansion, okay.

I'll just say what -- in Japan, in terms of the Marlboro price rise, I mean, clearly, there were some [dare] that one of your competitors increased prices in one of its major brands last year and that there was not much of a response from anybody.

And conversely, in France, there's been a tax rise but there's been no increase in prices, including, obviously, Marlboro, which is the largest brand.

I mean, can you explain, first of all, what's the theory behind moving the prices for Marlboro in Japan?

And secondly, with regards to France, why has the industry decided to simply absorb the tax?

Not commenting on the pricing decisions I made to -- in our case, country-by-country basis.

I wouldn't link that price development on our side in France to what we have done in Japan.

We just think that taking into considerations the market dynamics, the projected elasticities, et cetera, that we could increase the prices in Japan.

As you might have heard, the initial attempt was to increase for the -- for more brands than just Marlboro.

We ended up with Marlboro increase.

So this is what it is.

And I have no clue whatsoever why the industry, as you phrase it, have decided not to pass on the tax in France.

I can speak for Philip Morris.

Again, as the case in Italy very often, we look at the tax structure, we look at elasticities and we're just running the numbers whether this makes sense or not in the current configuration to increase the prices.

On the deal of a growing to profitability, we're just moving to the pricing variance to the volume variance and vice versa.

That's the situation.

Having said that, as you noticed, despite the fact that we didn't have the pricing in France, there's no pricing still in Japan, et cetera, we still have the 6%, the pricing variance for the 6 months of the year.

So somehow, we have this factored into our models.

But just following on from that.

In Japan, you'd be quite happy if Marlboro is the only price that went up?

Well, we're always happy, if you like, if the prices are going up.

Okay.

And very lastly, what do you think the total sort of conventional cigarette volumes globally are likely to decline this year?

I guess somewhere this 2% to 3%.

I mean, I don't think we would-- even at Pakistan, we will have to now factor and gain this.

Russia, I think the 5% to 6% is about right.

In euro volume queue, which we have to forecast, should be around what we have said.

I think Indonesia should now have a bit of better volume.

The question is what's going to continue to happen in the Philippines, but we observed some relative moderations in the decline rate throughout it.

Pakistan, which is a big market, thinking the international volumes, I think it's 2% to 3% for the industry, and it seems like a right number for the year.

Our next question comes from Thomas Russo with Gardner Russo.

A couple of quick questions.

The first, I read the -- maybe your General Counsel is appearing before the FDA in light of the submissions.

I'd love to have an update on the submissions, their progress and then what the steps might be for Altria under your agreement with them, what opportunities they have to start to roll out iQOS, first question.

I guess you're referring to that Marc Firestone recent address regards to illicit trade.

I -- yes.

Yes.

Well, I mean -- look, I mean, the number of countries, which we see a pretty good improvement on illicit trade, but I think also Marc was trying to show our experience so one can help in a collaborations industry, in a collaborations with the governments continuing improving this trend.

So listen, the -- and as I said, I mean, if you follow us for a while, you see that over the last 2, 3 years, we've made a pretty, I would argue, significant improvement with regards to illicit trade.

There's still some pockets, which have to be addressed.

But globally, I think it's getting better.

And with regards to Altria, I think Altria waits, as we're waiting for FDA, premarket approval authorization with the FDA.

And counting just the calendar days, somewhere before the year-end, it should happen.

So Altria would be -- should be good to go, to launch the product in the U.S. And I know from our collaborations with Altria that Altria is working on the plans for this to happen, which is waiting for FDA.

Great.

Also, I read, Jacek, someplace reference to a new iQOS heat cigarette manufacturing facility authorized to get built in Germany.

What is the timing of that?

And what's the capacity of that?

Production of Germany will lead to the capacity beyond January 2019.

Our numbers for today, as we said, 50 are already installed this year, plus/minus now the productivity gains, which I highlighted in answers to the previous questions.

This obviously may leave the 100 year-end installed capacity to '18 and Dresden facility is to start contributing beyond.

So this is our second, if you like, greenfield operations after Cologne.

In the meantime, we talk about Greece, we talk about the Romania, et cetera, which are there retrofitting converting the conventional capacity into the RRP capacity.

So we...

Great.

And then what happens in the capacity at launch for Dresden?

How large would that start?

And how will it grow over time?

Well, we will build it to the appropriate level of capacity.

That's a good answer.

And then who will supply the actual products to the U.S. market?

Initially, PMI.

And then we'll have to see.

And with that, I'll hand the program back over to Mr. Nick Rolli for any additional or closing remarks.

Well, that concludes our call for today.

Thank you very much for joining us.

And if you have any follow-up questions, you can contact the Investor Relations team here in Switzerland.

Thanks again, and have a nice day.

Thank you.

Ladies and gentlemen, that does conclude today's conference call.

You may now disconnect your lines.