Philip Morris International's (NYSE: PM) disappointing first-quarter earnings report has weighed heavily on the tobacco industry, after the company experienced a dramatic drop off in sales of its next-generation heat-not-burn tobacco system in Japan. The worry is that the device won't be able to offset the secular decline in traditional cigarette sales.
Now that British American Tobacco (NYSE: BTI) has seen its own results confirm the slowdown Philip Morris felt in Japan, this could be a more worrisome development than originally believed.
Image source: Philip Morris International.
The electronic cigarette revolution
The rollout of the iQOS heat-not-burn device marked a significant change in how Philip Morris looked at itself and the industry. It would become a force for change that encouraged people to quit smoking by switching to its electronic cigarette that, although it couldn't be marketed as a healthier alternative, was seen by many as a safer choice than combustible cigarettes.
The future, Philip Morris said, was going to be smoke-free, and the company took out full-page ads in newspapers calling on smokers to quit and switch.
Japan was a seminal point for iQOS, and after rolling it out nationwide, it captured 80% of the e-cig market in the country. In fact, Philip Morris ships more e-cigs into Japan than it does traditional cigarettes, yet its earnings report indicated it had burned through all of the early adopters of the new technology and now faced the prospect of convincing older, more conservative smokers to switch, a more difficult and costly task.
That British American Tobacco sees the same trend is a problem. Having gained a 4.3% share of the market, the tobacco giant admits "the growth of the Tobacco Heating Products category has slowed."
Japan Tobacco, the country's largest tobacco company, is also signaling problems as it slashed the cost of its own heated tobacco device by 25% in an effort to boost sales. Philip Morris International has cut the price of its iQOS device as well.
A portent of things to come
Data from Euromonitor International says Japan accounts for 90% of the entire $5 billion global heat-not-burn market, and already, competitors are finding they may have hit a wall. But the problem Japan presents is much deeper than that and may mean the tobacco companies are in trouble.
Unlike in other cigarette markets, where the iQOS and British American's glo device have been introduced, Japan is unique because it categorizes the e-liquids used by traditional electronic cigarettes to deliver nicotine as a pharmaceutical ingredient, meaning they are tightly regulated. It also effectively serves as a ban on sales of other electronic cigarettes.
Image source: Getty Images.
This essentially makes heat-not-burn devices the only alternative to traditional cigarettes in Japan, and if manufacturers are already experiencing a slowdown, then the concern is that they may not see much, if any, uptake at all when the devices are introduced into other markets.
The U.S. is the world's largest cigarette market, ahead of even China and the U.K., and Philip Morris is awaiting word from the FDA on whether it can sell the iQOS, with or without a reduced-risk label. But all varieties of electronic cigarettes are on the market here, primarily those that use e-liquids, as well as the JUUL device from Juul Labs, which takes a slightly different approach to delivering nicotine. JUUL is the biggest e-cig on the market, with a better than 50% share, and even with the FDA giving it closer scrutiny because of the JUUL's supposed popularity with teens, Philip Morris won't necessarily have an easy time if the iQOS is allowed to hit the market.
Shares of Philip Morris International have lost a fifth of their value since it reported earnings, and it's dragged other tobacco companies down with it, including British American, which has lost 16%, and even Altria (NYSE: MO), which is down 11% because it's Philip Morris' iQOS marketing partner in the U.S.
The heat-not-burn product line is a unique way for tobacco companies to offer a healthier, safer alternative to traditional cigarettes while keeping their tobacco base intact. Yet if they can't even break out much beyond their current base when they have little product competition, it may spell bigger trouble for them in other markets, where there are lots of choices for smokers to choose from.
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