Philip Morris International Inc (PM) — Q3 2019 Transcript

Welcome and thank you for joining us. Earlier today, we issued a news release containing detailed information on our 2019 third quarter results. You may access the release on www.pmi.com, or the PMI’s Investor Relations app. 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, 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. Comparisons are presented on a like-for-like basis reflecting pro forma 2018 results, which have been adjusted for the deconsolidation of our Canadian subsidiary, Rothmans Benson & Hedges, Inc. or RBH, effective March 22, 2019. 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 Martin King, our Chief Financial Officer. Martin?

Thank you, Nick, and welcome ladies and gentlemen. Our third quarter results continued to reflect strong underlying business performance. The results include the better-than-anticipated timing of pricing and costs compared to our previously communicated assumptions for the quarter. Our reported results in the quarter were impacted by an after-tax charge in Russia of $315 million, related to a final assessment by the Moscow Tax Authorities on excise taxes and VAT for the 2015 to 2017 period. Additional detail on this charge is provided in today's press release. Total shipment volumes in the third quarter declined by 1.4%. Excluding the net favorable impact of estimated distributor inventory movements due primarily to the heated tobacco unit inventory reduction in Japan during the third quarter of 2018, our total in-market sales volume declined by 3.6%, reflecting lower cigarette volume, partly offset by strong heated tobacco unit volume growth. Approximately two-thirds of the total in-market sales volume decline was due to three markets, in two of which, the decreases were largely timing related. In Pakistan, our cigarette volume was down by approximately 50%, broadly in line with the industry decline reflecting the timing of excise tax increase announcements compared to last year, as well as the impact of price increases. In Turkey, our cigarette volume decline was due mainly to the impact of two price increases this year, totaling TRY5 per pack or roughly 44% on a weighted-average basis, which disproportionately impacted our share, given the timing of our price increases vis-à-vis the competition. In Indonesia, our cigarette volume declined, mainly reflected lower share, primarily due to widened price gaps between our brands and the competition’s, as well as a lower total market. Heated tobacco unit shipment volume reached 16 billion units in the quarter. Excluding the net favorable impact of inventory movements, primarily related to third-quarter 2018 inventory reduction in Japan, our HTU in-market sales volume increased by 28.3%, driven by the EU and Eastern Europe Regions. HTU shipment volume in the quarter was in line with our HTU in-market sales volume of 15.9 billion units. Third-quarter net revenues increased by 7%, excluding currency, driven by higher HTU shipment volume and favorable pricing for our combustible tobacco portfolio, partly offset by lower cigarette shipment volume. RRP net revenues reached $1.3 billion in the quarter, or over 17% of PMI's total net revenues. It is worth noting that our year-to-date September RRP net revenues of $4.1 billion have essentially reached the full-year 2018 total. We recorded a strong combustible tobacco pricing variance of 5.9% in the quarter, driven notably by Germany, Indonesia, Mexico, the Philippines, Russia, and Turkey. On a currency-neutral basis, adjusted operating income increased by 8%, while adjusted operating income margin grew by 40 basis points. This margin expansion was achieved despite net incremental investment behind RRPs in the quarter of approximately $170 million and was driven primarily by favorable geographic mix related to HTUs, reflecting the increased contribution of volume from IQOS geographies with relatively high unit margins, notably markets in the EU region. Our adjusted operating income and margin also benefited from the timing of costs as certain expenditures initially planned for the third quarter were not incurred by quarter-end. Adjusted diluted EPS increased by 5.9% excluding currency. The lower currency neutral growth in adjusted diluted earnings per share compared to adjusted operating income notably reflected the high relative growth contribution in the quarter from markets with sizable non-controlling interest, for example, the Philippines with a non-controlling interest of 50%. Our total international market share, excluding China and the U.S., was essentially stable in the third quarter, reflecting lower share for cigarettes, offset by higher share for heated tobacco units, which reached 2.3%. Our share of the cigarette category declined by 0.4 points, reflecting continued adult smoker out-switching to IQOS, particularly in the EU region, Japan, and Russia, coupled with lower share, notably in Argentina, Indonesia, Korea, Mexico, and Turkey. Importantly, Marlboro's share of the cigarette category increased by 0.2 points to 10.2%, driven by Germany, the Philippines, Russia, Saudi Arabia, and Turkey. The share decline in Indonesia primarily reflects the impact of widened price gaps between Sampoerna A, notably a mild and competitive brand, particularly at the bottom of the market. As you may recall, we increased our prices in Indonesia late last year in anticipation of a 2019 excise tax increase that ultimately did not materialize. Our competitors largely maintained their prices, particularly following the government's decision to leave cigarette excise taxes unchanged, leading to the widened price gaps with our brands this year. Although no formal regulation has yet been issued, the government recently outlined a 2020 cigarette excise tax with an average increase of 23% in exercise and 35% in the minimum band roll price. As the government has not yet announced the increase for each individual tax year, it is difficult to accurately gauge the anticipated volume and share impact in 2020. We do note, however, that while the potential tax pass-on is relatively steep in the context of the two-year stack with no excise tax increase in 2019, the average percentage increase is broadly in line with historical levels. Turning now to a more detailed discussion of RRP performance. We estimate that there were approximately 12.4 million IQOS users as of quarter end. We further estimate that 71% of the total or some 8.8 million IQOS users have stopped smoking and switched to IQOS, with the balance in various stages of conversion. IQOS is now commercially available in 51 markets, following recent launches in Belarus, the United Arab Emirates, and in the United States. We are particularly excited by the launch of IQOS in the U.S. through our commercial arrangement with Altria. The first IQOS retail store has opened in the initial lead market of Atlanta, Georgia, marking a historic milestone in providing better alternatives to the 40 million men and women in the U.S. who smoke. IQOS is currently the only heat-not-burn product on the market authorized through the U.S. Food and Drug Administration's PMTA pathway as, "appropriate for the protection of public health." As you are aware, the merger discussions with Altria have ended. Although this chapter is definitively closed, we have an ongoing relationship with Altria, and both companies will focus on maximizing the IQOS opportunity in the U.S. market. Last month, we took another important step in our journey towards a smoke-free future with the launch of IQOS 3 DUO. This latest edition to the IQOS family was designed with enhanced features to help adult smokers switch more seamlessly from cigarettes. IQOS 3 DUO allows two consecutive uses without recharging the holder. While its charging time is significantly faster compared to IQOS 3 and IQOS 2.4 plus, IQOS 3 DUO is currently available in Japan and will be rolled out in most markets where IQOS is commercially available by the end of this year, further strengthening our smoke-free leadership position. Let me now take you through the performance of IQOS in the quarter. In the markets where IQOS has been commercialized, excluding the U.S., our HTU brands recorded a total combined share of 5.1% despite not yet being nationally distributed in many of them. At this share level, our HTU brands would collectively be the fourth largest tobacco brand in these markets, up from number six in the third quarter of last year. In the EU region where we are commercializing IQOS in areas representing approximately 57% of total industry volume, share for each more than doubled in the quarter to reach 2.5%. This growth reflects continued strength across a broad range of markets as detailed in the HTU market share appendix included at the end of today's presentation. On a sequential basis, share increased by 0.1 point compared to the second quarter. Given the impact of higher industry cigarette sales volume reflecting summer seasonality, we believe that this sequential share performance understates the favorable momentum of HEETS. To this point, the end-market sales volume for HEETS increased by over 9% sequentially versus the second quarter. IQOS continued its strong performance in Russia in the quarter with HEETS share up by 2.9 points to reach 4%. On a sequential basis versus the second quarter, HEETS share increased by 1.1 points while in-market sales increased by over 40% to reach 2.4 billion units. HEETS share growth in the quarter was consistent with the pace of adult smokers and our geographic expansion. We are now commercializing IQOS in cities representing approximately half of the market by total industry volume compared to an estimated 40% at the end of the second quarter. In Japan, our total share for HeatSticks and HEETS increased by 1.5 points to reach 17% in the quarter. The initiatives that we introduced during the second quarter of last year continued to pay off and drove a step up in our share performance. On a sequential basis, the share for our HTU brands was up by 0.4 points or stable after adjusting for the estimated impact of trade loading in advance of the October 1st tax and price increases. Importantly, our weekly off-take share increased sequentially during the quarter, reaching over 18% by the end of September. While we acknowledge that our off-take shares toward the end of the period may have been favorably impacted by consumer loading ahead of the October 1st, our share growth continues in the first week of this month. We are encouraged by our HTU share performance in the face of increased competitive activity as the year has progressed. While the growing number of smoke-free devices and consumables has contributed to competitive churn, IQOS remains the market leader with approximately 73% of HTU category share despite accounting for only around 20% of category SKUs. We believe the launch of IQOS 3 DUO will further reinforce the IQOS family's leadership position. This will be complemented by recent line extensions in our HeatSticks and HEETS line-ups. In Korea, the heated tobacco category remains highly competitive, particularly in the area of non-menthol flavors and related new taste dimensions that are also present in the cigarette category. HEETS share in the third quarter declined by 1.2 points or by 1 point on an adjusted basis. Share for HEETS was also down sequentially versus the second quarter. However, we began to see early signs of stabilization in HEETS off-take segment share over the course of the third quarter, supported by recent launches that expanded the flavor line-up. While we are encouraged by this trend, we have a lot of work to do to reinforce the heated tobacco category's benefits and build upon IQOS's leadership position. In this regard, we look forward to the upcoming roll-out of IQOS 3 DUO. Turning now to our full-year outlook. As announced in today's press release, we are revising our 2019 reported diluted EPS guidance at prevailing exchange rates to be at least $4.73. The $0.21 decrease, compared to our prior guidance on July 18th of at least $4.94, was predominantly due to the $315 million after-tax charge in Russia, noted earlier. Our guidance continues to include an unfavorable currency impact at prevailing exchange rates, of approximately $0.14 per share. After excluding the reporting adjustments and tax items outlined on this slide, our forecast continues to represent a projected currency-neutral increase of at least 9% versus our pro forma adjusted diluted earnings per share of $4.84 in 2018. Our guidance continues to assume an industry total volume decline in 2019 of approximately 2.5%, excluding China and the U.S. As a result of recent cigarette price increases in selected markets, notably the Philippines and Turkey, we now assume a full-year total shipment volume decline rate of 1% to 1.5%, versus approximately 1% previously. This revision solely reflects changes to our full-year cigarette shipment volume outlook. We continue to anticipate full-year HTU shipments volume broadly in line with our HTU in-market sales volume with any inventory movements this year in individual markets, essentially offsetting on an aggregate basis. We are maintaining our full-year assumption of currency-neutral net revenue growth of at least 6%. This now reflects a higher combustible tobacco pricing variance of approximately 6%, compared to above 5% previously, which is effectively offset by the impact of our revised total shipment volume target. While we continue to anticipate net incremental investments behind RRPs of approximately $400 million, excluding currency, we are refining our currency-neutral adjusted operating income margin expansion assumption for the year to approximately 150 basis points from at least 100 basis points previously. In addition, please note that we now expect the full-year contribution of IQOS devices to total RRP net revenues to be approximately 15% compared to below 20% previously. This primarily reflects the favorable geographic mix impact of greater HTU volume in relatively high-margin geographies, notably markets in the EU region, the longer lifespan of the latest IQOS devices compared to prior versions, and the impact of IQOS device retail price changes in select markets. We now anticipate full-year operating cash flow of approximately $9.2 billion subject to year-end working capital requirements. The change, compared to our prior assumptions of approximately $9.5 billion, reflects the impact of the after-tax charge in Russia. Separately, we now expect 2019 capital expenditures of approximately $1 billion, compared to approximately $1.1 billion previously. Dividends remain the primary use of our operating cash flow after capital expenditures. Last month, we increased our quarterly dividend rate by 2.6% to $1.17 per share. This equates to a total quarterly dividend of approximately $1.8 billion, or approximately $7.3 billion annually. To close on our full-year guidance and assumptions, I would like to touch on our anticipated fourth-quarter performance. Importantly, we expect currency-neutral net revenue and adjusted operating income growth to be in line with our year-to-date September results. However, our currency-neutral adjusted diluted EPS growth will be lower than our year-to-date September performance due to the following factors. An unfavorable income tax rate comparison of roughly 4 percentage points versus the fourth quarter of 2018, during which our three-month tax rate benefited from the full-year impact of further clarifications related to the U.S. tax reform. And a continued high relative adjusted operating income growth contribution from markets with sizable non-controlling interest. We expect these two factors to serve as a drag of approximately 9 percentage points on our fourth-quarter currency-neutral adjusted diluted EPS growth rate compared to our pro forma adjusted diluted earnings per share of $1.17 in the fourth quarter of 2018. To conclude, we recorded strong underlying business performance in the third quarter, reflecting the quality of our execution against each of the key metrics of net revenues, operating income, margin, and diluted EPS on a currency-neutral adjusted basis. The fundamentals supporting our strong combustible tobacco portfolio are intact. The favorable momentum for IQOS continues across geographies, further supporting our confidence in our HTU shipment volume target of 90 billion to 100 billion units by 2021. We are excited by the recent launch of IQOS in the U.S. and the global launch of IQOS 3 DUO. Finally, on a currency-neutral basis, we are maintaining our full-year 2019 growth assumption for net revenues of at least 6%, and our anticipated full-year 2019 growth rate for adjusted diluted EPS of at least 9%. Thank you. I'm now happy to take your questions.

My first question for you is about the implications of the pricing changes in the combustible business, which you explained well at a high level. This quarter certainly saw a negative impact on volume. Was this primarily due to the timing of tax increases, or are there specific markets you would highlight? I apologize if you mentioned those, but I would appreciate more detail to understand how this affects your guidance for the year and the volume.

The two markets to highlight are Turkey and the Philippines. In Turkey, we faced a tax increase in April with a pass-through of approximately TRY4.20. Shortly after, we implemented a TRY2 increase, which drew significant scrutiny from the government regarding inflation. Other competitors did not raise their prices at that time, causing us to lose market share. However, in August, we managed to take another TRY3 increase, which our competitors also quickly matched. This situation illustrates our ability to adjust pricing in Turkey, though we were somewhat delayed in our actions. We have successfully passed on the full tax increase and even a bit more, so we are now back on track. In the Philippines, a tax increase was announced for January 2020, raising the tax from 35 pesos per pack to 45 pesos per pack. We began adjusting our pricing in late August, now that we have clarity regarding the new tax, and typically, once the tax is clear, the trade in the Philippines tends to purchase more volume, taking advantage of the tax increase benefits. Overall, we managed to maintain strong volume through the first half of the year, and in the second half, we are adjusting our pricing in a couple of markets. For the full year, we expect a volume decline of 1 to 1.5 percent, with pricing at 6 percent, which balances well. We anticipate our overall market share for the year to be positive, despite an industry decline of 2.5 percent. Taking a longer-term view, we have a healthy balance of volume, share, and pricing.

I have a second question regarding IQOS and RRPs. If my calculations are correct, it seems that you have experienced inventory builds in RRPs year-to-date. Will this impact your shipments for the year in the fourth quarter? You did mention that in-market sales should be roughly aligned with your shipments, so I want to connect those two figures. Additionally, have you provided any insight on your RRP revenue for the fourth quarter, specifically in terms of growth and how potential inventory changes might affect that in the quarter?

Let me be clear about RRP HTU inventory. There has been no inventory build and none is expected for this year. Our in-market sales and our shipments for the full year will be roughly the same. For the quarter, we had 16 billion in shipments and 15.9 billion in in-market sales. It seems there may be some confusion, as last year in the third quarter, we reduced inventories in Japan by around 4 billion units. The mention of ex-inventory is to help you make an apples-to-apples comparison; essentially, you should add 4 billion to last year's figures for accurate comparisons. However, this year, our inventories for HTUs are steady. We do not foresee any inventory increases for HTUs or cigarettes by year-end, and we expect to finish the year with relatively low inventory levels.

Looking at Indonesia, you've called out the volume headwinds in this quarter, but on a year, you're slightly up. How do you reconcile that with the price gaps that you've cited as a headwind for the quarter? And then just looking ahead, what should we think for the outlook for the market? I know you don’t have some of the tax tier detail yet, but in terms of just where you sit from the category standpoint, can you give a sense of what 2020 might look like?

In Indonesia, the market is up slightly this year. However, with no tax increase and limited pricing changes, we are losing some market share. The price disparity between our premium brands and the lower end is negatively impacting our share and causing a shift in our product mix as volumes decrease. We have introduced new initiatives at the lower price levels that are performing well, but overall, our portfolio is affected by changes in the mix and share loss. Consequently, our shipments for the year are slightly negative so far. Looking ahead, the government has announced a potential tax increase of 23%, although this has not been finalized. They also indicated a 35% increase in the minimum price, which could alleviate some of the mix issues by pushing the lower end of the market upward, thereby addressing problems related to government revenue and our product mix. It is difficult to predict total volume until we have more detailed information on these changes. While a 23% tax increase over two years could be manageable, we will face challenges next year with limited annualization of pricing due to the incremental price hikes typical in the Indonesian market. Overall, the long-term perspective suggests resetting price gaps may provide opportunities to improve our mixed issues, but the immediate challenge will be navigating the lack of annual pricing adjustments and the potential impact of a significant price increase all at once on volume. We will monitor how the situation in Indonesia develops while recognizing it also presents some opportunities.

And just on Japan, you've called out some headwinds from down trading as well for the cigarillos. Can you just give a sense of how to think about that segment? And is there more of a headline from that going forward we should anticipate?

Yes, there are a couple of things to know about the cigarillos segment. One is it's not considered in the cigarettes and HTUs to overall cigarette volume that we've been using as the basis. So as cigarillos grow, we may have some distortions coming from that that we'll have to explain in quarters going forward, and we'll break that out for you. The cigarillo category benefits from a preferential tax, if you will. We don't know whether this will last. Likely, I think eventually, the government will close this situation, because cigarillos, for example, can be priced below cigarettes at the bottom of the market and still have higher margins. Now, it was initially a category that was opened and JT, when the Class D product separate tax category phased out, they actually transferred some of the Class C brands over into cigarillos. So we would guesstimate that, probably by the end of this year, it could be $3 billion to $4 billion total year number for cigarillos. So it's starting to get big enough to have an impact on the total market. Obviously, we all think this category should have preferential tax going forward. But we'll have to monitor this situation and decide we ourselves would have to compete in it at some point in order to not be at a disadvantage. But overall, I think the situation in Japan with our focus being on heated tobacco and IQOS, and the real benefits coming from our gains in those categories, are a net positive right now.

One quick last one. You mentioned in duty-free some headwinds from China, in particular, having a little bit more enforcement on what people are allowed to bring into that market. Clearly, there's some consumer interest in that country. Can you give an update on what if any status change you may have had in your negotiations with CNTC to potentially launch with some sort of joint venture, or something in China?

I do not have any updates regarding our collaborations with CNTC. We continue to see potential for cooperation, particularly with RRPs and IQOS, but there hasn't been any new progress on that front. You are correct that duty-free sales have been impacted because the quantity of products that travelers can bring back into China has been reduced and enforced more rigorously. This has affected what was previously a very strong duty-free market for HTU, not only for travelers from China but also from other countries. The numbers for the Middle East and Africa show that duty-free sales for HTU have declined this quarter. This decline is partly due to comparisons with last year when we were increasing our inventory in response to higher sales. This year, we are reducing our volume to adapt to the new traveler limits. While this is a significant shift, it is not a major concern in the larger context. As I mentioned earlier, total sales and shipments of our heated tobacco units worldwide were stable for the quarter.

I have a question on your guidance for Q4. You mentioned EPS growth will be below year-to-date trend. So just wondering how much lower? You talked about, I think, a 9 point drive from the factors you mentioned, Martin. But shouldn't that be offset by your expectations for stronger margin expansion? So just trying to get a sense if you're expecting Q4 EPS growth closer to your full-year guidance of 9% or below? And I guess I'm really trying to get a sense of how conservative this might be, especially given the momentum you're seeing in your business?

The answer is we expect it to be well below the EPS number, or below where we have been year-to-date. We would expect the operating income and revenues to be in line with where we are year-to-date. But the drop-off from operating income to earnings per share is quite steep, driven primarily by this big difference in corporate tax rate. Last year in the fourth quarter, we were catching up on positive news and interpretations of the U.S. tax act, and we have the benefits for the full year hitting in one quarter. So we had a relatively low corporate tax rate in the fourth quarter last year. This year, it's little bit of a different story that we're slightly behind our 23% projection for the full year so far through the year. So in the fourth quarter, we would expect the tax rate to make up that difference and bring us back to 23%. So the gap between the two years is 4 percentage points, which is a pretty big impact. And then on top of that, you have this non-controlling interest line, which is being as effective as it's already even in Q3 you see it, but it's even more pronounced in Q4. The two markets we called out with significant pricing, just to put it in perspective. In Turkey, the pricing was over 40% and in the Philippines, it was just below 40% at 37%. So these two markets with very significant pricing are bringing bigger increases than other markets obviously in operating income, etc. However, they have non-controlling interest. We called out the Philippines with 50% non-controlling interest. So you're sharing some of that big increase with your partners. And therefore, the step down of those two, the tax and the non-controlling interest, we call that as a 9 percentage point drag versus the number last year, which was $1.17 on the adjusted pro forma basis. So it's a very large gap between the OI and the EPS number, Bonnie.

And then actually I wanted to ask you about the deal talks with Altria, if I may. I know they've ended. But I'd be curious to hear why you considered merging with Altria to begin with? And then why the timing was right? And I guess when the talks started, I'd like to hear from you how you were thinking about the U.S. market, and then how that in fact maybe changed given of course, the talks have ended? And then just in terms of talking with some of the investors over the last month, month and half. There was a fair amount of concern that maybe you were seeing something in your business that made you feel compelled to maybe seek a deal. So if you could just touch on that, I think that would be really helpful. Thank you.

The discussions with Altria were a logical development, especially since we were launching IQOS in the U.S. and had received PMTA approval. It was reasonable for us to explore whether a partnership or other options, such as a merger, would be beneficial. When considering a merger, the primary focus is on the strategic advantages, particularly in terms of revenue synergies. For us, this was about aligning our reduced-risk product (RRP) portfolios and ensuring we had an optimal product mix for a potential combined company, which would provide us with a better opportunity through a wider range of products. We recognized the U.S. market as very profitable, with an estimated profitability of $20 billion and increasing over time. While cost synergies are usually considered, they weren't a significant factor in this discussion. We also factored in regulatory synergies, as the U.S. market plays a crucial role in shaping global regulatory standards. During our discussions, the rapid evolution of the market, especially regarding e-vapor and the FDA's regulatory stance, was an important consideration. We received clear feedback from our shareholders, who had numerous questions about the rationale behind the merger and felt they could access the U.S. market independently through Altria. We took their concerns seriously, as well as the potential distractions management would face in navigating the environment and shareholder sentiment. Ultimately, both management teams concluded that our best course was to concentrate on ensuring the success of IQOS in the U.S., which, increasingly, became a significant opportunity since it is the only heated tobacco product with FDA PMTA authorization. Thus, we've decided to move away from merger discussions and focus our efforts on collaborating with Altria for IQOS. The merger is no longer on the table, and we're optimistic about our chosen direction. Concerning any concerns that this shift might be a response to business performance, I believe this quarter's results and our outlook for the entire year should reassure stakeholders. Our overall situation is positive, with projections showing a decline of 2.5% in the total industry, which aligns with historical trends for tobacco outside of the U.S. and China. We're estimating our volume growth between 1% and 1.5%, indicating that we're gaining market share, alongside a price increase of about 6%. Revenues are expected to grow by at least 6% on a currency-adjusted basis, particularly in high-margin markets like the EU as we manage our costs and investments effectively. Our margin is projected to expand by 150 basis points for the year, and our earnings per share guidance suggests growth of at least 9% despite the challenges with non-controlling interests. This paints a strong picture of a well-managed profit and loss statement and positive business momentum. I hope this clarifies our situation and dispels any notions that the discussions with Altria had implications for our core business.

Three questions for me, if I may. The first is on Japan. I'm interested to know what the cap rate, in particular versus 2Q. I mean, I can see that your share has improved and you've had competitive launches over the same period, and there are more coming. So some color on the overall category will be great.

Okay, do you want to take one at a time, or…?

Yes, that would be great.

So overall, the heat-not-burn category for Japan continues to grow. From the end of last year till now, it's up about 2 percentage points. We're at about 25% for the total category. We've gained most of that. So we're maintaining, in fact, improving a little bit our segments share. But sequentially, it's not quite so smooth. There was a bigger step up in Q1. It continues to grow. But I think if you look at it more from the beginning of the year, you can see the overall picture with, of course, as you mentioned, additional product launches coming from various other competitors. So we're gratified by the category growth and our ability to grow within the category is intact as well. Our segments share is solid and you see that from our exit shares from C-stores at over 18% for this quarter. So I think we're on a steady trend of Japan continuing to grow. It's not as fast as, say, our Russia, which is growing spectacularly right now. But its good solid growth given the total size of the category and our share are already very substantial in Japan. And we're also gratified by the DUO. I think the launcher DUO can be underestimated. This product is very positive from the point of view of consumer experience. Those that have been using it, we're surprised at how much of a difference it made, being that you have the tubes experience as anytime you want and the very fast charging time to come back to the first experience. It just makes it seamless. And you don't have to worry about the charging or waiting, or the device. It's really a very nice step forward as far as the overall consumer experience. So we have high hopes for DUO, particularly in Japan and Korea, where we will focus on the first of volumes as we ramp up production.

In East Asia and Australia, the revenue per pack for the region has significantly declined both sequentially and year-on-year. What factors have contributed to this decline? You mentioned some price and inventory write-downs; can you clarify what the current run rate is in that market?

Well, we did have some device price adjustments in the quarter. In Japan, we used to have a pricing ladder. There was more or less ¥1,198 for three multi and 2.4 plus. Now in Japan, 2.4 Plus is almost gone very, few people buy it. It's doing very well in other markets. But in Japan, we now have DUO coming in at 10,000 essentially and then multi three and multi fill out the pricing ladder down from there. And one of the consequences of reducing the pricing for the existing inventories of three and multi and a little bit of 2.4 Plus is yes, we did have to revalue the inventories in Japan. So you see that one-time effect hitting the quarter. So it's probably disproportionate to what's really happening with pricing, because you're taking an inventory and revaluing it as opposed to just having the effect of the sales that you actually made in the quarter. Does that make sense?

It does, yes. Can you provide a quantification of that number?

No, I mean I think you see it in the pricing line and in that line there if you can try to pick out the effect. So we haven't given individual inventory revaluation type numbers.

And my last question. Just can we get a color market share in the UK and specifically London? I mean, just anecdotally. I've seen a lot of it around and obviously, the market where e-cigarette use is very high and we've also cut prices. So I'm curious to hear how IQOS is doing in this market?

Yes, IQOS is doing better in London and the UK, admittedly from a relatively small base. But it's up itself over 1% in London, depending on how you define the city, right? But it's doing much better. It's grown at a much faster rate in the last few months than it was before. And we're encouraged by the pickup that we're seeing in the UK and in London, in particular. Now it's from a small base and we have obviously many other markets where the share is much higher. But it's very good to see it moving and we anticipate better results coming forward.

I have a follow-up question on your discussions with Altria. Were there any changes to your agreement with Altria on IQOS that emerged from the merger discussions that more closely align each of your interests? And is there sufficient incentive for Altria to invest behind and push the product?

Yes. I mean, I think one of the benefits of the merger discussions and going through all the discussions about how we would align, etc., is that we came out of this period with better understanding of each other and better alignment, both regulatory and how we would go about IQOS, etc. The current agreement is the one we had before that we're continuing to commercialize under. But I think we did come out of this whole thing with better alignment, better understanding, and better push for IQOS in the U.S. And I think given the news flow around the e-vapor and everything else, I think we both agree that there is even more of an opportunity for IQOS in the U.S. than we might have understood a few months ago. And if there were any doubts about Altria's alignment and interest behind IQOS, I think it's very clear they are fully focused on it. They were before but even more so perhaps now that IQOS has even bigger opportunity in the U.S., given the news flow and the whole situation around e-vapor. Now, I mean, we haven't disclosed the terms of the agreement. But Altria has very good incentives to make sure that IQOS does very well. And we're very happy with the arrangement, the agreement, their execution in Atlanta, so far has been excellent. And we look forward to some good success coming out of that.

And just related to that. Are you seeing any impact from the healthcare around vaping in the U.S. on consumer attitudes towards our view outside of the U.S, given the potential for this issue creates confusion among consumers? Do you want to see any impact on IQOS's performance?

We don't. Although, we are working hard to make sure that IQOS is distinguished from the issues in the U.S.; making sure it's understood that this is not an e-cigarette, this is a heated tobacco product; making sure it's understood our track record. We have 12 million plus users now. We have very good conversion practices to make sure that we're focused on adult smokers. We have lots of experience in over 50 markets, with making sure that the people that convert to IQOS are former adult smokers. We also emphasize that this is a scientifically substantiated product. We've got the FDA authorization. So we're able to really make sure that the IQOS heat-not-burn is in a different category. At the same time, when we're engaging with regulators and others, we're very clear to say that the issues that they're hearing about in the U.S. are not coming from authentic properly manufactured closed-system e-cigarettes. In other words, it would be unfortunate for a properly manufactured, properly regulated e-cigarette to be caught up in this issue around the unfortunate illnesses and very unfortunate deaths that have been reported in the U.S. We understand that this is a different issue from a properly done e-cigarette, like we will have or do have already, but we will have better versions of with our MESH. And so we have worked hard to both make sure that it's understood what e-cigarettes are and how they can be properly regulated to make sure these issues don't evolve. But also to make sure that they understand the heat-not-burn and IQOS are truly a different category and shouldn't be even in the discussion around the issues they're hearing about from the U.S. I mean, when it comes to the youth access issue, this is where we focus on our good conversion practices and are very stringent focus on adult smokers.

And should we expect you to file any PMTA applications next year, maybe related to IQOS MESH?

With regard to IQOS MESH, as you know we have the improved device. We are working very hard to ramp up our production. We are on track to be able to launch in a market this year. And we are very much focused on expanding production and capacity so that we can satisfy a number of international markets next year. So our full focus with MESH is in international markets. Obviously, we're focused in the U.S. on IQOS heat-not-burn and the agreement with Altria. Now, with regard to MESH, we are putting together a package of scientific substantiation which we could use in the future with a number of different regulators and that work needs to happen regardless. So that's our plan for MESH is to get it into as many markets internationally as we can. At the end of this year starting, but really next year is the big ramp up.

I want to ask you sort of more general question, because this is not I didn't understand about these results. The first thing was that the margin was substantially better than certainly I was expecting. Are the two key results you said you'd be investing much more heavily in the first quarter but that you said that didn't seem to come through, and I was just wondering why? You also said that part of the reason for the good margin growth was that you've actually done very well in high-margin markets for RRP, specifically the EU. And yet at the same time, the market share growth in the EU, as you said yourself, was a little bit disappointing. So I'm wanting if you can sort of bring all those things together. Why was the margin so strong? When frankly, you said it probably wouldn't be in 3Q. And if you can give a little bit more color about what you sort of think the underlying market share for such a thing in the EU is for IQOS? Thank you. That would be the first question.

First of all, with regard to why the margin was better, it's two things. One is additional pricing, which we called it out for Philippines, Turkey as two examples. The other piece is costs were lower into the third quarter shifting to the fourth quarter. You're right, the $170 million for RRP related investment compares to the $200 million that we have said and planned. But there are also some additional costs throughout various areas of the company that shifted. The total impact is probably about $30 million for the RRPs and about $40 million or $50 million for all the other costs, netted together. So when you move that from one quarter to the other, it has a pretty significant impact. And I would emphasize, this isn't spending lower spending, primarily it's just movement from one quarter to the next, hence the fourth quarter impact. Now as far as talking about when we called out the EU impact of higher margin volume coming from HTUs that was more of a total year picture when we were explaining the device weight in the margin, I mean, in the RRP revenues being around 15% to help folks with their modeling and so forth. Now for EU, growth during the quarter, you're right. Sequentially, the share growth was about 0.1, which was not as much as you might expect, especially since the end-market sales were up 9%. So you have a seasonality impact where cigarette volume sales are higher in the summer. And that obscured the fact that HTUs were actually up very nicely at 9%. And if you look at the year-over-year, the share was up more than doubled from 1.2 to 2.5. So the EU growth rate is continuing at a very nice clip. It's obscured a bit just when you look sequentially in the quarter. And we always said share, in particular, tends to be a little bit lumpy. When we look at user acquisition, we look at in-market sales, those are more direct leading indicators of where it's going. And the momentum in the EU is very solid, very good. And that will eventually of course lead to continued improvement in margin as the volumes in the EU are already very significant by the way. If you look at the number of units shipped, but they're growing at a very nice pace. And of course, they're coming with substantially higher margins than the average elsewhere.

The movements in the fourth quarter are quite minor, and I might not even need to ask this. A quick follow-up question: why does seasonality seem to impact cigarettes more than HTUs in the EU? More importantly, could you provide some insight on Russia? Things are clearly going well there, but it appears to be very volatile. There was excellent growth in Q1, followed by a decline in Q2, which was surprising, yet there was sharp growth again in Q3. How should we interpret this pattern? Additionally, congratulations on the EU performance. Should we expect around 20 to 30 basis points of market share growth each quarter, and will this be similar in Russia? How should we approach this, considering the volatility in the market shares you are reporting?

The seasonality of heated tobacco units differs from that of combustible cigarettes, particularly in Russia. One reason for this difference is that heated tobacco units can be used indoors, leading to less fluctuation in their consumption compared to cigarettes, which see increased use outdoors during summer months. In the first quarter, we noted that the share of heated tobacco units in Russia was positively impacted because cigarette consumption decreased significantly due to extremely cold weather, making it less appealing to go outside to smoke. This pattern was reversed in subsequent quarters in Russia. We observed a similar dynamic in the EU, where warm summer months affected consumption patterns. These seasonal impacts can account for some of the variability in market share. We are focused on how quickly we are acquiring new consumers, which has increased to over 12 million this quarter. While we have provided regional breakdowns, that consumer growth figure serves as our best indicator for future trends this year.

In Japan, you mentioned that the underlying market share was essentially flat. However, it isn't possible to discuss similar figures in the EU or Russia, as they involve adjusted figures that try to account for some volatility.

I mean, we went down that path in Japan because of the heightened concerns and because of the issues we'd had about shares and being impacted by competitor inventories and so forth. I mean, I hesitate to get into that sort of reporting everywhere in the world. We've done it sort of on a temporary basis to try to give people more transparency on the Japan situation, given where we were last year. But I don't think we need to go into that with EU. We're growing very nicely. We're delivering the results. We see this strong year-over-year. There's no slowdown in momentum in the EU. So I think we will stick with what we got. And eventually, even in Japan and other places, we may stop doing that extra transparency once it's no longer needed.

So I wanted to touch on IQOS in the U.S. please. In looking at the introductory bundle that's being sold, it seems like it's a very attractive proposition for the consumer at $80 for a carton of consumables plus advice. Would you be able to comment at all on who is funding that promo? Because it seems like the implied price of the device is $25, which is far lower than what I've seen even on a promoted basis in international markets.

Yes, I think I'm going to leave those sorts of questions to Altria who is commercializing IQOS in the U.S. The answer is funding it. I mean, they are responsible for the commercial expenditures around the launch. And so the answer would be, it would be their program and their funding, and their decision on how to approach the consumer in the U.S. Obviously, we've shared with them and continue to share with them all of our experiences from around the world, and what we've seen in the many markets we've launched in. But it's their program and their decision on it. And I think I'll leave it to them to answer those specific questions like that.

And then my second question also on IQOS in the U.S., I can certainly appreciate the optimism that you're expressing on the call today, in particular in light of growing concerns around potential health effects with liquid e-vapor, but as I reflect back on some of the pre-marketing consumer work that you guys did in the U.S. relative to some of the other countries where you were running similar consumer trials. If I recall correctly, U.S. trial and conversion looks closer to Italy, or Switzerland than it did, even in Germany but certainly not Japan, or South Korea. But if you could just remind us why you have so much confidence? Because yes, like Italy certainly, at this point in a 4.6% share, is clearly a success story, but it was five years in the making. Thanks.

We have previously indicated that consumer readiness for reduced-risk products shows significant openness to switching from smoking. In the U.S., our ability to connect with consumers is quite strong, despite the FDA's pre-market authorization requirements. Compared to many other countries, our communication capability in the U.S. is very effective. Regarding any studies you mentioned, they are likely outdated, possibly as old as five years, particularly if they were conducted in Italy and Japan. There has been a notable shift in the U.S. concerning people's acceptance of reduced-risk products and their understanding of smoking issues. We are confident that the U.S. market will perform well. Historically, it seems to be positioned between the EU's more cautious approach, which is due to consumer receptiveness and communication challenges, and the rapid acceptance seen in Japan and Korea. While it’s still early, our expectations are optimistic due to recent developments in the U.S. market for smokers exploring alternatives. Our product is the only one with PMTA authorization in the heated tobacco sector, and it performs excellently in terms of taste. This should contribute to its strong consideration, perhaps even more so than a few months ago. This reflects our current perspective on the U.S. market.

So on the CapEx decline of $100 million for this year. Is it because it shifted to us by '20, or there is a change to growth expectations?

We have improved our efficiency in utilizing existing assets, especially in the production of heated tobacco units. Our operational uptime is increasing, and waste rates are decreasing. Our factories are producing more efficiently than we originally anticipated, allowing us to reduce some investments. At the start of the year, we outline our capacity plans as accurately as possible, but as we near the end of the year, we have found opportunities to refine our estimates. We have adjusted our numbers to reach a billion, but this does not mean a shift to next year or imply a lack of needed capacity. In fact, our capacity aligns with our projected estimate of $90 billion to $100 billion by 2021, and we are on track to achieve that figure. This is the capacity we are focusing on for heated tobacco units, along with preparations for the MESH and e-cigarette platforms as previously mentioned.

Now coming to the new product categories, so there is a lot of discussion around modern oral. Do you have any plans in that category?

I mean we continue to monitor. We look at it very closely. But yes, right now, we don't have a modern oral product on the market. But we certainly have studied it and looked at it. And most of our markets right now today, we don't have huge oral category. But we are interested in that product because it is a reduced risk product category and we think it may play a role in the future.

And my last question is just on the stock price, so you know your stock is where it was in 2011. Can you do something to change the trajectory? Like launch a share buyback, such as Progressive. Now that your balance sheet is more under control, you're not planning M&A. There doesn't seem to be any obvious escalation for you out there.

Regarding stock buybacks, our focus over the next 18 months is to achieve leverage ratios that correspond to our mid-single A credit rating, and we are fully committed to this goal. You may have noticed that we have been gradually deleveraging and will continue this process. Once we reach the appropriate range for a mid-single A rating, the board will consider initiating stock buybacks. I believe that there is a strong sentiment that our stock is a good investment, but we need to ensure our leverage ratios align with our mid-single A rating before we can implement a buyback program.

Just one question for me then, so on the earnings guidance you called out the higher growth in markets with sizable non-controlling interest. I was just hoping you could provide a bit more specifics here in terms of which markets they are, what sort of growth you're actually seeing in operating income and also what is driving the strong growth? Thank you.

The one we called out and it's probably the best explanation for this, is the Philippines with 50% non-controlling interest in the Philippines. And we haven't given the specific market profitability. But you can see from the pricing and from the fact that our Marlboro share, for example, is way up as we get up trading. Marlboro has now hit a 40% share this quarter. So, you can see in the Philippines, I think, or you can sense in the Philippines that the profitability is up substantially. Obviously, we share that with our partners with 50%. So when your overall growth in the operating income line is being boosted by an affiliate like the Philippines and then half of it goes to the non-controlling interest, when you go to the EPS, that growth there is not obviously as pronounced. Turkey is another example where there is a non-controlling interest. And there are others, I'm not going to go through the whole list. But you can see, I believe in the P&L, you see the non-controlling interest line and you see this being growing. And it's pretty substantial in the third quarter and we expect it to take another significant step up in the fourth quarter as the full impact of the pricing in countries like and affiliates like Philippines and Turkey kick in since their pricing only started partway through the second quarter, I mean, the third quarter. In the case of the Philippines, it was the end of August. In the case of Turkey, it was in August as well. So the fourth quarter will see another step up in non-controlling interest.

Yes, I mean, I think I just like to close with the thought that our overall year is showing very good momentum. We pointed a little bit to the fourth quarter, and that we expect the currency-neutral growth of net revenues and adjusted operating income to be in line with our year-to-date. However, the impact of the non-controlling interest and the tax rate differential leads us to about a 9% drag at the EPS line. Nevertheless, I think if you stand back and look at the big picture, we have a very positive year with good momentum going forward with nice balance between volume, share, pricing, margin expansion and the growth of heated tobacco units, especially coming from some higher-margin locations like the EU. We're seeing broad geographic success of heated tobacco units and our smoke-free future strategy is paying off throughout the results of the company as well. So I think that would close it. And thank you all very much for listening.