Philip Morris International Inc

Good day and welcome to the Philip Morris International fourth quarter 2018 and year-end earnings conference call. Today's call is scheduled to last about one hour, including remarks by Philip Morris International Management and the question and answer session. In order to ask a question, please press the star key followed by the number one on your touchtone phone at any time. Media representatives on the call will also be invited to ask questions at the conclusion of questions from the investment community. I will now turn the call over to Mr. Nick Rowling, 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 2018 fourth quarter and full year results. You may access the release on www.pmi.com or the PMI 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. 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 of forward-looking statements. It's now my pleasure to introduce Andre Kalanzopoulos, our Chief Executive Officer. Martin King, our Chief Financial Officer, will join Andre for the question and answer period. Andre.

Thank you, Nick, and welcome, ladies and gentlemen. I would like to begin with some general thoughts on our performance in 2018. We achieved robust results from our combustible tobacco portfolio and nearly doubled our heated tobacco unit in-market sales volume, driven by growth in all ICOS markets. We fell short of our initial full-year net revenue growth target, provided in February last year, which was almost entirely attributable to lower than anticipated ICOS consumer acquisition in Japan. and related distributor-heated tobacco unit inventory adjustments. In our view, this overshadowed an otherwise robust financial and strategic performance across the business. Clearly and understandably, this contributed to the overall decline in our share price, which was also pressured by broader market concerns surrounding the industry and the consumer staples sector generally. While we recognize that the market is the ultimate judge, we find it difficult to understand the share price impact of certain developments in the industry last year, particularly those that were very U.S.-centric and arguably less relevant to our international business. Entering 2019, I believe that we have laid the foundation for a better business performance this year and beyond. thanks to significant investments in product portfolio development and organizational capabilities, including a state-of-the-art digital infrastructure to fuel our expansion. As I will cover in my remarks in a moment, the underlying strength of our combustible product portfolio remains undoubtedly intact, and our smoke-free products are the catalyst to accelerate our overall business growth. Let me now take you through the main elements of our full year results, starting with volume. Our total cigarette and heated tobacco unit shipment volume declined by 2.1%, notably reflecting the reduction in distributor heated tobacco unit inventory in Japan, which we explained during a third quarter 2018 results call. Excluding estimated net distributor inventory movement, Total shipment volume was flat, our best annual performance since 2012, with strong growth in heated tobacco units offsetting a decline in cigarettes. This performance compares favorably to an estimated decline in total industry volume of 1.6% on the same basis. Our cigarette shipment volume declined by 2.8%. The decrease was due mainly to lower industry volume, notably in Russia and Saudi Arabia, coupled with the impact of consumers switching from cigarettes to heated tobacco products, particularly in Japan, Korea, and the EU region. Increased shipment volume, notably in Pakistan and Turkey, driven by higher industry volume, and in Thailand, driven by higher market share, served as a partial offset. Heated tobacco units' shipment volume increased by 14.2% to 41.4 billion units, despite estimated net distributor inventory movements in Japan of approximately 17 billion units. More importantly, our in-market sales volume for heated tobacco units nearly doubled, reaching 44.3 billion units, a significant achievement driven by all ICOS launch markets, including Japan and Korea. Turning to our 2018 financial results, Net revenues increased by 3.4% excluding currency, driven by strong pricing of our combustible tobacco portfolio and heated tobacco unit shipment volume growth. Reducers' product net revenues reached 4.1 billion, or 13.8% of total net revenues, with high-cost devices and accessories accounting for approximately 0.9 billion, or 22%. For reference, last year's distributor investment adjustment in Japan of an estimated 4.5 billion units adversely impacted our total net revenue growth, excluding currency, by approximately 1.2 points. The move to highly inflationary accounting in Argentina further impacted growth by approximately 0.6 points. Our 2018 combustible tobacco pricing variance represented 7.6% of prior year combustible tobacco net revenues, with positive contributions from all six of our regions. Pricing was particularly strong in Canada, Germany, Indonesia, the Philippines, and Russia. The strong pricing performance in Russia benefited from a very favorable comparison following essentially no net pricing in the market in 2017. Also in the Philippines, we benefited from improved industry pricing dynamics following the significant decrease in non-tax product availability. On a currency-neutral basis, adjusted operating income was essentially flat, while our adjusted operating income margin decreased by 1.3 points. The margin decline primarily reflected the impact of our net incremental RRP investments of approximately $600 million. For reference, the factors mentioned previously for Japan and Argentina had an adverse combined impact on our currency-neutral adjusted operating income growth and margin of approximately 3.3 and 1.1 percentage points respectively. Our adjusted diluted earnings per share of $5.10 increased by 8.1%, driven by both a lower effective tax rate and net interest expense. Excluding adverse currency of 11 cents, which occurred in the second half of the year, adjusted diluted EPS increased by 10.4%. The lower effective tax rate and net interest expense were both driven by the 2017 U.S. Tax Cuts and Jots Act. Our 2018 effective tax rate decreased to approximately 23%, slightly better than the 24% that we had assumed as part of our guidance in November. and around five to six points below our effective tax rate in the years prior to tax reform. The decrease in net interest expense resulted from greater flexibility on cash repatriation and capital structure optimization provided by the reform. Our operating cash flow of $9.5 billion increased by over $500 million, or 6.4%, principally driven by higher net earnings, partly offset by unfavorable currencies. Capital expenditures of $1.4 billion came in below our full-year assumption, primarily reflecting continued improvement in heated tobacco unit investment efficiency as equipment productivity rises. Turning now to market share, a total international share of 28.4% increased by 0.5 points, our highest organic growth since 2008. 2008, driven by heated tobacco units which reached a share of 1.6%. Remarkably, share grew in all six of our regions, underlining the strength of our combined portfolio. Our share of the international cigarette category was flat at 27.4%, demonstrating our success in maintaining cigarette market leadership while transitioning our product portfolio and transforming our overall organization. Further, despite over-indexed ICOs out-switching and the impact of the sizable volume contraction in Saudi Arabia during the first half of the year, Marlboro's international share of the cigarette category was also flat, reflecting share growth in a number of markets, including France, Indonesia, Mexico, the Philippines, and Turkey. With the performance of IQOS being top of mind for investors, let me also highlight some of the latest results and developments, beginning with an overall view followed by some market-specific commentary. As seen on this slide, the total estimated number of IQOS users reached 9.6 million in the fourth quarter, continuing the positive quarterly sequential growth trend. Importantly, Nearly 70% of the total, an estimated 6.6 million users, have already stopped smoking by switching to IQOS, while the balance are in conversion. IQOS user growth in the quarter was especially driven by the EU region and Russia. Approximately one third of the total IQOS user base is now in markets outside Asia, which highlights the broadening geographic success of the brand's proposition. As announced last year, we began the global launch of our IQOS 3 devices in mid-November, starting with our own retail and e-commerce channels. Though still early, as full device availability and expansion to our main distribution channels has only occurred in the past couple of weeks, we are very pleased with the initial consumer reaction to the new device lineup across IQOS markets. I will now turn to the performance of ICOS in specific geographies, beginning with Japan. As discussed during our earnings call in October, there were sizable trade and consumer purchases of both cigarettes and heated tobacco units across the industry during the third quarter, in advance of the excise tax-driven price increases on October 1st. This led to a distortion in heated tobacco unit in market sales in both the third and fourth quarters. The same distortion is reflected in our share progression between the third and fourth quarter. When equalized for the purchase patterns, our estimated share in each quarter was approximately 15.4%. Looking to 2019, we are encouraged that the favorable heated tobacco unit weekly offtake share trend that we observed during the fourth quarter continued in January. We anticipate increased competitive activity this year, including new heated tobacco product launches. This may accelerate overall category growth, in part by reducing the consumption dilution observed with current competitive device ownership, which I will show shortly. In this context, we believe that the new ICOS III and its continued superior sensorial experience, in combination with the range of initiatives that we rolled out during the later part of last year, including the mid-price hits brand, will allow us to restore growth. Importantly, the convenience store channel, which accounts for the vast majority of our volume, began selling ICOS III and ICOS III Multi as of last week. But already, ICOS III has significantly increased the number of new users acquired by ICOS compared to the 2018 monthly average prior to ICOS III launch. Furthermore, the national rollout of the HEATS brand, which is currently only available in geographies with approximately 25% of the country's tobacco consumers, will begin in the coming weeks. We remain optimistic about the long-term growth potential of the heated tobacco category in Japan, and of our brands specifically. Japanese adult smokers continue to show a strong and growing interest in heated tobacco products, as demonstrated by device ownership and past seven-day usage trend. Based on the latest available data, over 45% of Japanese tobacco consumers owned at least one device while over 40% reported using a heated tobacco product over the past seven days. While these indicators of category interest are not yet fully reflected in the latest category share of consumption of around 23%, this is understandable for a couple of reasons. First, switching takes time, with a lag between device purchase, use, and the full conversion that maximizes heated tobacco share. This is easiest to see through the end of 2017, when ICOS was essentially the only product on the market of the case. Second, and more importantly, other hit tobacco products, which became broadly available over the course of 2017 and 2018, have been far less effective than ICOS in fully converting adult smokers. This is due to relatively low taste satisfaction, leading to mainly situational use that further dilutes the category share relative to device ownership. Lower conversion effectiveness is also generating some hesitation among more conservative cigarette smokers to enter the category at this stage. Many users of competitive devices have never tried IQOS, and certain IQOS users also own competitive devices. Both groups represent great opportunities for us with ICOS III and ICOS III Multi. Over time, as competitive products improve and more heated tobacco users experience the relative benefits of ICOS, particularly those who began their heated tobacco journey with a competitive product, we expect the gap between total category share and the level of device ownership to narrow. Turning to Korea, fourth quarter share for heat. of 8.5% increased by 3 points compared to the same period in 2017 or by 1.1 points sequentially. It should be noted that our share in the quarter was distorted by trade inventory movements ahead of the change in health warnings on heated tobacco products in late December. We are pleased with our share performance. particularly given the backdrop of additional competitive activity in the heated tobacco category as the year progressed, as well as the confusion among some adult smokers caused by the Korean FDA's comments last year regarding the tar generated by heated tobacco products. In-market sales volume for heats increased slightly on a sequential basis to 1.5 billion units. Looking to 2019, ICOS remains the preeminent brand in the category, with hits holding over 75% category share in the fourth quarter. This position has been reinforced by the launch of our new devices, giving us confidence in our ability to grow hits volume and share further. In the European Union region, fourth quarter share for hits reached 1.7% of total cigarette and heated tobacco unit industry volumes. an increase of 1.1 points compared to the fourth quarter of 2017, supported by all ICOS markets. On a sequential basis, share growth accelerated in the quarter, increasing by 0.5 points. It is worth noting that ICOS is only present in geographic areas, representing approximately 47% of industry total volume in the region. The favorable share momentum reflects continued growth in the total number of ICOS users, which reached nearly 1.8 million by year-end. Importantly, as of late January, ICOS III is finally fully available in essentially all ICOS markets across the region. Our hit share growth in the EU region was driven by a number of markets, notably Greece, Portugal, the Czech Republic, Italy, Poland, and Germany. As we have said before, the speed of ICOS adoption will vary by market. This reflects factors such as the underlying disposition of adult smokers to use and recommend innovative tobacco products, as well as the regulations that apply to reduced-risk products, such as those that impact our ability to communicate with adult smokers about better alternatives to continued cigarette smoking. Despite related constraints in certain geographies, ICOS is growing across all EU launch markets, and the fourth quarter accelerations occur well for 2019. In Russia, the strong sequential performance of ICOS continued in the fourth quarter, with its market share up by 0.7 points to 1.8% of the total number of ICOS users, reaching 0.8 million. This performance is impressive given the fact that ICOS is present in only seven cities, where the average fourth quarter share for heat was nearly 8%, with share in Moscow approaching double digits. This primarily reflects increased adult smoker interest in and understanding and acceptance of ICOS, as well as our targeted approach to geographing and channel expansion, which has underpinned an improvement in ICO's conversion rates and consumer experience. Given our success in the existing large cities, we are now expanding into additional geographic areas. Before I turn to our 2019 outlook, let me remind you of the three-year financial growth targets that we outlined during our Investor Day last September. For the 2019 to 2021 period, we are targeting currency-neutral compound annual growth of at least 5% for net revenues and at least 8% for adjusted diluted earnings per share. As detailed in today's press release, we have adjusted the formulation of our annual EPS guidance to reflect the difficulty in determining with precision the speed at which adult smokers will adopt reducerous products. At the beginning of each year, we will now forecast our annual reported diluted EPS and the related currency neutral adjusted diluted EPS growth rate by reference to a minimum threshold of expected performance. As each year unfolds, we intend to provide greater detail. For 2019, we forecast reported diluted earnings per share to be at least $5.37 at prevailing exchange rate compared to reported diluted earnings per share of $5.08 in 2018. Excluding an unfavorable currency impact at prevailing exchange rates of approximately $0.14 per share, this forecast represents a projected increase of at least 8% versus adjusted diluted earnings per share of $5.10 in 2018. Our 2019 forecast assumes currency-neutral net revenue growth of at least 5%, which includes an expected adverse impact of approximately 0.6 points due to the move to highly inflationary accounting in Argentina. We expect ICOS and heated tobacco unit volume growth in particular to be the key driver of this growth. Combustible tobacco pricing will remain an important contributor, underpinned by the broadly rational tobacco excise tax environment, and mitigating the impact of the anticipated combustible product volume decline. As noted earlier, we recorded an exceptional pricing variance in 2018 that creates a challenging pricing comparison this year. We expect our average pricing variance over the 2018 and 2019 two-year period to be in line with our average annual pricing variance from 2008 to 2017. We anticipate a total cigarette and heated tobacco unit shipment volume decline of approximately 1.5 to 2% in 2019. This compares favorably to an estimated total industry decline of around 2.5 to 3% for the year. Given the challenge of forecasting with precision, heated tobacco unit shipment volumes we are not providing a specific 2019 target at this early stage of the year. That said, we expect positive volume contributions from all ICOS markets in 2019, and we remain confident in our shipment volume target of 90 to 100 billion units by 2021. Turning to our cost base, our efforts to deliver over 1 billion in annualized cost efficiencies by 2021 are already underway, led by important initiatives related to productivity, zero-based budgeting, a project-based organization model, and other cost reduction opportunities. We expect our progress on this front to contribute to an increase in currency-neutral operating income margin of at least 100 basis points in 2019. We anticipate a full-year effective tax rate of approximately 23%, consistent with last year, and a relatively stable net interest expense compared to 2018. We are targeting 2019 operating cash flow of at least $10 billion, subject to year-end working capital requirements. We project total capital expenditures this year of approximately $1.1 billion, reflecting further investment behind RRPs, in particular to support our Platform 4 eVapor manufacturing capacities. I will close our 2019 outlook with some comments on the first quarter. While we don't provide quarterly guidance, I believe that it is appropriate to share some additional visibility related to phasing. We currently anticipate reported diluted EPS of approximately $1 in the quarter, or flat compared to last year, subject to the timing of commercial spending associated with some of our IT related projects. Excluding approximately 9 cents of adverse currency at prevailing exchange rate, this represents a growth rate of 9% compared to adjusted diluted EPS of $1 in the first quarter of 2018, which itself included a positive contribution from currency of 3 cents, or approximately 3 percentage points. I will conclude with a few key takeaways from our 2018 performance. As evidenced by our total share growth internationally and our stable share of the cigarette category, we are successfully managing our transition from cigarettes to reduced-risk products. Our combustible tobacco portfolio remains the foundation of our business and is delivering robust performance and pricing power. Furthermore, the international cigarette industry volume decline was broadly in line with historical trends. ICOS continues to grow globally, nearly doubling heated tobacco unit in market sales volume in 2018, and increasing the number of markets, making important contributions to its success. We estimate that, as of year-end, over 6.6 million adult smokers around the world had already stopped smoking and switched to ICOS. We estimate a retail value of approximately $18 billion for the combined heated tobacco and e-vapor category outside China and the U.S., with heated tobacco representing approximately 70% of the total. ICOS alone accounts for an estimated 57% of the combined retail value, with unit margins and switching rates superior to any other nicotine product. We expect to increase our share of the eVapor market through further development and deployment of our product portfolio. Turning to 2019, we anticipate better underlying business fundamentals, driving currency-neutral net revenue growth of at least 5%. Our 2019 EPS forecast reflects a growth rate of at least 8%, excluding currency, compared to adjusted diluted EPS of $5.10 in 2018. Finally, we remain confident in our strategy for a smoke-free future and are convinced that our ROP portfolio continues to provide us with the single largest opportunity to accelerate our business growth and generously reward our shareholders over time. Thank you for listening. Martin and I are now happy to answer your questions.

Thank you. We will now conduct the question and answer portion of the conference. Again, in order to ask a question or make a comment, please press the star key followed by one on your touchtone phone. Our first question comes from the line of Bonnie Herzog of Wells Fargo.

Hi.

Hi, Andre.

I actually first wanted to ask you about Altria's decision to take a stake in Juul. I'd really love to hear your thoughts on this and, you know, if you think this was a good decision for them. And also, you know, given the rapid growth of e-cigs and several markets internationally, you know, would you guys consider some type of distribution agreement with Juul? You know, I think you will answer. You believe your technology is superior, but, you know, couldn't there be a case for you to do both, especially, you know, you're still not at a point really to fully roll out your technology.

Well, I will start by, you know, reminding everyone that because, you know, there is a lot of discussion amongst investors and in the media in general, what is the potential of X product, Y product, Juul, ICOS, and so on. And we have to understand that this is not a binary or a zero-sum game or winner-takes-all kind of situation. I think you can say there are some form of parallelism with intersections in the trajectory of consumers between evapor products, later pure nicotine products, and heated tobacco products. We know that heated tobacco products have the highest conversion ability. But there are people that in markets where ICOS doesn't exist that have already switched fully to eVapor products. And there are people that use both. So we are going to see very different behaviors that are sometimes complementary and non-exclusive. We will see, we know that there is dual usage of eVapor and cigarettes. We have people that may continue using the same amount of cigarettes and have a few additional e-vapor products. And you will also see heated tobacco products like Icos and e-vapor being used simultaneously. That's why we developed a portfolio of products that can cater to all consumers and We'll see all kinds of combinations going forward. So we are ready to compete with everybody, and I think competition in the category and the ability to switch people out of cigarettes is very important. I mentioned in my remarks Japan, where we see that not superiorly performing products in terms of sensory experience, dilute the category and we welcome products that can. I think for us, as a matter of principle, there is room for all products and there will be no one exclusive user or one competitor in any category. I think we know sufficiently and we've demonstrated over the past year that we understand all the categories and we understand all the consumers. And our situation, to a certain degree, were not in the same market as Altria, and I will not comment on the Altria decisions because they have to look at their own portfolio and situation, and they took the decision to make the investment, which I respect. I think nothing has changed. in the relationship we have with Altria in preparation of the ICOS launch in the US. And I think Altria confirmed that they are fully ready once we get FDA approval to go for ICOS. And, you know, we are looking forward to this moment. As far as Juul is concerned, clearly Juul benefits from a certain degree of awareness due to the U.S. market in certain English-speaking countries. So we'll see some initial success, for sure, because there is awareness, as we had with ICOS, for example, in some markets when we acted like Korea. But then we have to see the sustainability of the product proposition, both from a marketing and product performance point of view. But again, there is no one winner takes it all, okay? So I think we have to go over this initial excitement and discussion, who is going to be the winning technology, who is going to be the winning brand. I think there will be many brands. I believe ICOS is already a very well-established brand, as I said in my remarks. If we combine the vapor and heated tobacco category, and the vapor category internationally is essentially in the EU and has been fairly stable, ICOS has 57% of the entire retail value of both categories combined, and we're not even in the EVAPOR category. We plan to enter significantly the EVAPOR category as of the end of this year, including with the devices we showed in Investors Day that are smaller devices to cater to different consumer needs. That's why we also said we increase a little bit the capex so that we have capacity to commercialize this product. And I think we're ready for competing. The only thing I would say is, you know, Juul, I hope they learn the lessons regarding certain undesirable target audiences that, you know, we're very careful and extremely careful. wise about. And I hope that the Altria participation will increase their attention to unintended audiences. That's all I have to say.

No, that was helpful. And then if I may, I wanted to ask a little bit more about the new innovation you just put into the market in November that you discussed a bit. But if you could drill down a little bit further for us and talk about if it did in fact meet your expectations or possibly exceed your expectations so far. And then what will the rest of the rollout schedule look like? For instance, I think you're still planning to do a phased rollout, but will the bulk of the new devices be in the market by the end of Q1 or is it by the end of Q2? And then last point on this, I'd like to hear from you just a little bit more about the cannibalization process You might have been seeing, you know, you mentioned, I think, it's been quite incremental, but just kind of wanted a better understanding of that. Thank you.

Okay. We're talking about two different things, if I understand. The first is a rollout of what we call ICOS-3 devices and ICOS-MULTI, and the other is what happens with the second line up of consumables we have in Japan. Is that correct?

Yeah. Okay. Yeah.

So... We were a bit limited initially on IQOS 3 and IQOS 3 Multi in many markets, so we made the product available only through our own retail and e-commerce. And we also made the product, you know, so we had limitations. And I have to say we're very pleased with the initial reaction. People understand and appreciate also the IQOS Multi because that was a clear consumer need. We have combined sales of both, and that's very good. And we also continue selling ICOS 2.4. So, you know, although it's a limited sample, I would say, because we are not national and in every retail channel with ICOS 3, the first indication is things are happening the way we had foreseen are happening. And the Comments from the consumers are good. And if you look at more, you know, to use net promoter scores, we have improved also significantly the net promoter score of ICOS in Japan in particular and in other places. And at the same time, we see new user acquisition, even with this limited availability of ICOS-3, increasing. So it's early indications, but they are good indications. And we see the same in other markets. We'll give a bit more color and granularity in Cagney because we will have a bit more weeks behind us with full availability. But so far, so good. Now, regarding hits, our reading is they help from the limited markets, again, we're in. They help increase consumer acquisition because we cater to people that are a bit more price sensitive. We have incremental share if you combine both Marlboro-hitted units and hits. in the places we were, and that's why we decided to extend. There is obviously a certain cannibalization because we're essentially the only product, but overall we have share increase, and that's the encouraging part.

Okay. Thank you. Our next question comes from Line of Duty Home. We're almost done.

Judy, are you on the call?

Hello, can you hear me?

We can hear you now, yes.

Okay, sorry. Sorry about that. So, Andre, I guess I wanted to ask a little bit more about the volume outlook for 2019. I know you're not giving specific volume target for ICOs, but, you know, clearly you're giving the consolidated volume guidance of down 1.5% to 2%. So, I think we can kind of back into what you're at least high level, expecting for ICOs if we assume combustibles down somewhere around 3, 3.5%. So maybe a little bit more color just in terms of at a high level, how do you see volume kind of playing out for ICOs and combustibles? And then more specifically in Japan, just based on JT's comment earlier today that they're expecting only 3% category growth for the heat not burned this year, I'm just wondering if you think that the growth rate could be more robust, or is that kind of a more prudent assumption at this point in the year?

Look, we see clearly growth in all the markets where IQOS is present, okay, volume growth. I mean, I would not read too much in the forecasts of global combined cigarettes and everything because, frankly speaking, you know, we're We were positively surprised last year by the combustible category as well with more positive volumes than we initially anticipated. All I would say is we are in line with the projection I gave for three years down the line, $90 to $100 billion, and I would not venture in more precise volumes this year because they are baked in at least 5% revenue growth, okay? In Japan in particular, if you have noticed from the slides, I don't know if you had the opportunity to see them, we see growth in the share of ICOs. Actually, in Japan in January, the share of ICOs was 16.5%. So that's very nice compared to 15.4% we had in the previous quarters. I would not, you know, it's in one month, and I would not read anything into this, but it's a positive development. And EU and Russia, as you have seen, we have very positive trends. So we are, you know, very optimistic, but we'll keep you abreast on what's happening as the year unfolds.

Got it. Okay. And then maybe just a little bit more specific to Russia, because, you know, obviously that's one market where clearly you've seen improvement sequentially, both on the volume side and market share side. Okay. I guess my questions are, number one, is that starting to have a bigger impact on the broader combustible category volume, certainly in markets like Moscow where you've got a pretty sizable share with ICOs? And then just broadly speaking, as you kind of roll out ICOs into additional cities in Russia, kind of the cadence of volume trajectory that you're expecting as you implement that strategy going forward?

Look, I mean, as we expand different cities, we'll see additional volume, obviously. We also need to understand we are in the richest and more affluent cities, and we see continued growth. As we expand over time, maybe the growth trajectories will be a bit slower because we are reaching lower-income consumers. But overall, I think Russia piloted a number of projects practices including using digital tools that show that we can scale up efficiently without necessarily expanding manpower everywhere. That's something, now that we have the digital platforms, as I said, and infrastructure available and we're rolling it out as we speak, should be an accelerator this year and most importantly in the years to come. with also much more cost efficiency underlying the growth trajectories of ICOS. So I see, I mean, we're very pleased with what's happening in Russia. I think it's a very clear demonstration that ICOS has potential everywhere, even in markets that have less purchasing power. And the testing of the tools shows that we can scale with much more efficiency than before. So it's all very positive signs. Got it. Okay.

And then just my last question, just in terms of your profit guidance or the operating margin being up about 100 basis points, it seems like that's mostly around the half of kind of the incremental spending that you put into place in 2018 kind of not growing again. So I'm just curious if that's sort of the correct interpretation. And I know that ICOS has been pretty volatile just in terms of thinking about the profit performance. So when you kind of look at that 100 basis points target, how comfortable are you that you should be in position to deliver on that target even if volume slows or other things happen from an ICOS kind of volatility standpoint? Thank you.

We're fairly confident we can deliver on this. It's a combination of As we said, lower spending, much lower spending than last year, but still incremental spending. And the second one is an increased volume contribution of ICOS to the overall earnings. And as we know, ICOS has better margins. So that's the way I would read it.

Okay. Thank you.

Our next question comes from Adam Spielman of Citi. Thank you very much.

So, first of all, can I just follow up on... Hi, can you hear me?

Yes.

Yes. So, can I just follow up on the answer you gave to Judy, just to make sure I got it absolutely right? With respect to the 100 basis points, it sounds like the majority of that is coming from the efficiencies of rolling out ICOS, that you always said you were going to get. We're talking about right at the beginning of last year. And less of it's coming from the relatively new news of a $1 billion... ZBB savings. Is that the correct way of understanding that lost answer?

That's correct. We started the ZBB project, but as you can understand, it's not going to deliver big amounts of money the first year because we have to go through the whole process and do it properly, okay? So I see this participating as of the next year. And, you know, we never said, just to be clear, that the $1 billion we are targeting is all money that you're going to see on the bottom line, but you should see a portion of that to the bottom line. The other helps the incremental investment. So the deltas are not as big as they used to be in the previous years.

Okay, thank you very much. So the real question, or the more important question, is around ICOS. And I was surprised, frankly, how strong it was in this quarter relative to the third quarter. And I was just wondering if there were any shipping effects we should be calling out. Clearly, Japan was harmed by shipping effects. You called out a positive one in Korea. But, for example, in Italy and in Russia, were there any shipping effects that somehow artificially boosted your ICOS volumes?

Okay. There was some shipment in Russia ahead of, you know, we're expanding in different cities. So there is, you know, it's preparation of the expansion, okay? I don't remember exactly how much that was. Around 1.8 billion, something like that, if I can recall correctly, okay? Okay. It was planned from the beginning, so it's not something. But there is nothing else in there. The rest is direct in market sales.

And so, for example, if you focus just on Italy, there was a huge jump in market share in Italy in 4Q, even relative to 3Q. And I was just wondering if you can explain what caused that and how we should think about it going forward as well.

That's a very good question. First of all, You know, I think we see momentum in Italy. It took a lot of time, if you remember, Adam, to get Italy moving given the restrictions. And I think it's just the fact that, you know, there are more consumers of ICOS in Italy, so we start having word of mouth, okay? Again, I wouldn't read one quarter as the proxy for the acceleration, but the momentum is there. So I think in Italy, finally, we start seeing this better than slow linearity of growth, and that's exactly what's happening. And this is ahead of us, you know, ahead of us deploying further of the sufficiency tools I described. But this is what you read in Italy is share of the market. It's nothing to do with inventories and shipments and all these things.

And then one final question from me, and this is about the guidance. Am I correct to understand you're giving guidance in sort of two different sorts of ways? Firstly, you're giving floor guidance. So it's a minimum of 5% sales growth. It's a minimum of 8% constant currency EPS. But then when you're talking about things like the volume, the combined volume figures, that's more of an expectation. It's not a flaw. Is that correct, that it's more in the style you used to give guidance of this is really what you expect to happen? And it might be a little bit worse, it might be a little bit better. But the EPS is really an absolute flaw in terms of constant currency.

Yeah, I mean, look, volume for the year is a bit difficult to estimate. So we gave a range of 1.5% to 2%. That's our estimate. It can come better or slightly worse. It depends on the combustible as well. So just to give you a flavor of what we see compared to total market, which means we expect share growth in this whole context, you know, helped obviously by the ICOS units as well. But, I mean, the key guidance is more than 5% and more than 8%, and, you know, that's what we see. At least. Sorry? At least. At least, yes.

Can I tempt you to sort of give a sort of upper range so that you'd be really surprised if, let's say, it was more than 12% on EPS? How big is that, at least? I mean, how, because to me, it's very conservative.

Well, as the year goes ahead, I think, depending on what happens, we'll give you a better forecast for the remaining year. I would stay to what I said at this stage. You know, and that's all I can tell you at this stage, Adam. Thank you. I failed to tempt you.

Thank you very much.

Our next question comes from one of Vivian Azar of Cowan & Company.

Hi, thank you. Good afternoon. So I wanted to follow up on the ICOS-3 launch in Japan, and I appreciate you want to hold some of this detail back for when we see you in Cagme in a couple of weeks. But can you offer any color around, like, the underlying consumer demographics of the new users that you indicated you've been acquiring? Is it, you know, kind of going deeper into that market? kind of first tranche of consumers, kind of younger, more affluent, or are you finally starting to see early success in terms of penetrating that 55-plus market that had proven a bit elusive? Thanks.

Well, clearly we made, first of all and foremost, we made these devices available as an option to existing users of ICOS, especially part of what we call the ICOSphere and exclusive users, okay? because I think that's fair to people to have first access. But we also see now sales from people that have never bought IQOS before. I don't have the demographics to be fair with you with me, but we'll provide them in Cagney. And I would not like, you know, I wouldn't provide statistics just with one or two weeks of rollout, okay? So... I repeat what I said before. We also see sales of 2.4 plus, surprisingly, because people knew that the new device is coming and still bought 2.4, especially the more price-sensitive consumers, which in my view shows that the strategy works and that there will be people that they will enter the category also through 2.4 plus. Don't forget we kept the previous version at a lower price, and we sell the new devices at a higher price, so we have a dual strategy. And I think this, in combination with the heats that are at a lower price than the Marlboro consumables for ICOS, will help us increase the penetration of the more price-sensitive consumers.

Okay, that sounds great and totally reasonable, and look forward to hearing more about that at ACAGME when you have more data. My other question on the RRP category in Japan, just to kind of follow up on Judy's question, I certainly appreciate your point that with a host of product activity from you and your peers, that that should engage more Japanese consumers. The The question, though, that I have is do you have adequately embedded in your guidance increased spend? I know you've got a really favorable comp, but given that you've got new products from a host of competitors hitting in 2019, how are you thinking about incremental investment spend in Japan specifically? Thanks.

Well, we have embedded overall. I will not make specific comments for markets. incremental spending as I said is much less than last year but it's still a lot of incremental spending and I think we're adequately equipped to compete in Japan at the same time as I said we're also rolling out digital tools and CRM platforms we didn't have before and that should help both the retention which we should not forget including you know making existing IQOS users that own multiple devices to go back and exclusively use IQOS, which IQOS 3 helps significantly in achieving this. So overall, I think we're in good shape. We knew the competition is going to come. And I think at the end of the day, a better product will increase the Full conversion over time and then over time also the best product will win. But as I said many times, we're not going to have 80% of the segment forever in Japan. What is important is that the entire category grows over time and I see no reason why the category will not grow. Every indication from what we showed is with the right product portfolio, the category will continue to grow.

Okay, thank you very much.

Our next question comes from one of Michael Lavery of Piper Jeffery. Hi, Michael. Thank you.

You have several markets in Europe now that have around a mid-single digit or even higher ICOS share, but typically those countries still don't have national expansions. Can you give us both a sense of when that might come and also in some launch cities or launch areas? what the share might look like if you're giving it to us now on a national basis? What does it look like where it's a little bit more concentrated?

Well, I mean, as I said, if you take the European Union, we're roughly at 50%, 47% of volume weighted, if you want, present. So our share in the European Union would be double in the places where we're present, roughly speaking, okay? So it's 1.7, I think it would be 3.4. I understand that math.

I guess more specifically, some of the places you've launched first, like Milan, Rome, Prague, Athens, not necessarily first, but where there's been either a longer history and or a more rapid acceleration and better awareness. What does the share look like in some of those places that are your better performers that when you give a national share might be masked a little bit by places that in that country you still haven't launched yet or that are just getting started?

Look, I don't have all the numbers. If I recall correctly, Athens is well above 10 because I know it's my home city. Actually, yeah, the whole region of Attica, including Athens, is 14% now, which is pretty high and growing. Milano, I don't have it. If somebody can help me here. Just one second. Milano actually is an interesting experiment because, you know, it's where we tried the first ways in the past. It was very flat. It took us a lot of time to make consumers try the product again. But if I'm not mistaken, it will be Milano and Roma. Okay. Okay, sorry, but in Milano and Rome, it's 5.3, something like that. Okay, we'll give you a bit more color in terms of all this. But for me, Milano is probably the most important because it was the most difficult city because of the previous princess of Icos to regain momentum, and we did. So that's a very good sign, actually.

Okay, no, that's very helpful. Thank you. And then just on your thoughts on more national expansions in any of the European markets? Or you've already talked about Russia expanding a little bit more. Is that one that you would expect to go national as well?

Look, we go gradually in most of the markets. As I said previously, our objective, I mean, we're in 43, call it, markets today. The priority is to expand nationally to see the full potential in these markets now that we can scale up efficiently. And You know, during the year, we may open new markets if there's strategic opportunity or the regulation changes, but the focus is to expand nationally in the markets where we are, and that's where we're following.

Okay, that's great. And then just a little bit more of a housekeeping question. You talked about the 100 basis points, margin expansion, X currency. Do you have any sense of what the transactional currency impact might be that we should have in mind or to factor in there?

I don't have the calculation, but traditionally a transactional currency is 10% of the total currency impact. If I can use this as a rule of thumb, I don't think it's more than that.

Okay, that's helpful. Thank you.

Our next question comes from one of Pamela Kaufman of Morgan Stanley.

Hi, thank you for the question. You made comments at the beginning of the call about the share price performance, which has partly been impacted by industry concerns that are more U.S. specific. I wanted to get a sense if this influences your view on timing for reinstating share buybacks.

We look at the share buyback, you know, regularly. And I think for the moment, the conclusion is that We follow the plan. I think Martin explained that if we look at the three-year period, including this year, it's in the outer years that we will be in a position without losing a rating to restore share buybacks. I understand it may be tempting to do this, but I think we have to stick to the plan because I believe that some of the impact on the shares, as I explained is due to our lower than expected initially performance, but the reality is also there is a lot of uncertainty that I've been trying to clarify and will clarify even better e-cigarette categories, e-vapor worldwide, and heat not burn and all the interactions in Cagney. I think it's a necessary anxiety there. In this context, I think for us our focus is to deliver the results quarter after quarter and get the growth of the products. And I'm sure investors will appreciate this and have the share going up rather than doing, you know, very opportunistic share repurchases rather than based on a clear plan when the time is right for that.

Okay. And you mentioned that combustible pricing growth should moderate towards more in line with the historical pricing growth in 2019. What do you see as the puts and takes contributing to your outlook, and are you still anticipating a relatively benign excise tax environment this year?

I think the excise tax, if you look globally, the excise tax environment is fairly stable. I mean, yes, there are occasionally the one or two markets that have more than regular increases. On the other side, we had the positive surprise of Indonesia, where the government decided not to increase excise taxes, okay, so which would help volume. What I was trying to say in my remarks is we have to see 2018 as a very exceptional year because of Russia comparisons. That's a major contributor to pricing, obviously, given its volume size. Russia 2018 comparisons were compared to zero almost pricing in 2017. Also, in the Philippines, because the illicit trade went away, we had the opportunity to get very significant pricing in 2018. Obviously, there will be more regular now that we rebased our pricing in the Philippines. So the overall environment, I think, of pricing has not changed. It's very robust. It's there, but all I said is we have to look at 2018 and 2019 as two, and if you add the two, we're very much in line with the rest, okay? And we have already taken 60 plus percent of the pricing so far. You know, there's still a few markets that the price tax situation has not settled, but this is not anything major. I think overall pricing is very much in place and intact.

Okay, and thank you. And just lastly, how is Icos Mesh performing? And can you provide an update on what progress you've made on your Platform 2 and 3 products and timing?

Look, Icos Mesh is only in our own e-commerce and a few stores, actually our own stores in London. For us, it was the experimenting again to see whether the flavors we offer are acceptable to consumers. whether the product itself is acceptable and then improve before we go for much more widespread expansion of the product. So it's very difficult to judge what is the potential. I think we learn what we need to learn. Obviously, we're there with a device, as you've seen, that caters more to the pod and mod, big vape or bigger vape consumers. In Investors Day, we explained to you that we have also smaller devices that cater to different consumers, and we are investing in manufacturing capacity for those devices and related cartridges. Overall, I would say the consumer feedback we receive is very good. They recognize the product is better, much more robust, batteries, detection of end of liquid, and all these things. Now we need to integrate them in the smaller devices. And that's what we're doing just now for rollout. P3 is a bit, we are preparing the industrial designs for the product. The product is stabilized. Clearly here, I see the potential more longer term and more situational use of the product, that full conversion at this stage. So it's not something we'll roll out immediately, but or in very selected places in order to get better understanding. And in platform two, which I think is very promising, as we know, we're working on resolving one problem that in humid climates, We had some problems with the heat source. There were some fall-offs occasionally, and even if it's very small, it's not acceptable. So we are now working. I think we have a solution at lab level. We're working on how to industrialize the solution before rollout. So that's where we stand on all this.

Great. Thank you.

Our next question comes from the line of Robert Ramson of UBS.

Hi, thank you for taking my question. The first question I have is, you mentioned ICOS has better margin. Could you talk about which markets you've reached break-even and in which markets or cities you've achieved profit per stick, which is equal or better to cigarettes? Thanks.

Well, ICOS in every market we're in has better margins than cigarettes, as a matter of fact. There is no one single market where we have lower margins than cigarettes. including acquisition costs and retention? We're talking about marginal contribution here. As we explained many times, in all major markets, clearly we are breakeven or above, but it takes, depending on the market and the difficulty of consumer acquisition based on the restrictions, we're between one year to two years before we get to breakeven point. That's how I would read it. I think Jacek showed all the details during investors day or how to do at the different markets. But that's the rule of thumb if you wish.

Okay, great. Thank you. And in terms of the upcoming menthol ban in Europe, how is ICOS treated under that and how are you guys thinking about that?

Well, heated tobacco products are excluded from the menthol ban. So We don't see a problem with this. Of course, we need to maintain it. And for cigarettes, we are ready, clearly, to offer consumers some alternatives. But what we saw from markets where there is a menthol ban, nothing happened, actually. People switch to the same brands very often with different variants of the brand. So I don't expect any major thing to happen in Europe, even with a menthol ban.

Superb. Thank you. And sorry, my final question, in terms of the latest evidence on the ICOS quitting rates and human trials, can we get an update on that, or is that something you'll give at Cagney?

Thank you. I don't know. Nothing new in there. I mean, conversion rates are the same. And, you know, in terms of quitting rates, We don't see any change in the trajectories in Japan, which is the biggest market. You know, if you look at cigarette or ICOS, the advent of ICOS has not changed the trajectories of people quitting smoking. So I think we're on the right side there in terms of concerns of regulators and public health people.

Superb. Thank you very much.

And ladies and gentlemen, we have time for one more question. Our final question will come from the line of Gaurav Jain of Barclays.

Hi, thank you for the opportunity. Your view on superiority of heat not burn over e-cigarettes is clear due to the high conversion rates. Do you think regulators prefer e-cigarettes over heat not burn on the risk continuum of risk reduction, which is then getting reflected in higher excise taxes on heat not burn versus e-cigarettes in different markets?

That's a big question. I think, you know, in principle, my belief has always been that this product should be not taxed at all, okay? I'm just trying to be real because, you know, a reduction of 95% or 98% is a humongous reduction, okay? If you talk heat not burn versus e-cigarettes versus everything. Now, we have to be also realistic. That's why, you know... there will be some taxes. There are taxes on heated tobacco products. Some countries tax evapour products because at the end of the day, ministries of finance need money. What is important is that there is a differential and substantial differential between the two and that's something we have achieved so far in all the markets where ICOS is present and I think that's something that in the foreseeable future should be maintained. So now if we look at the two categories, as I explained, consumers will decide at the end of the day how they will behave. The important thing is they move out of cigarettes. Because the only way to achieve harm reduction in global is to have a very high degree of people switching out of cigarettes and sticking 100% to the product. So far, you know, hit the tobacco products have proven to be much more efficient in doing this, but also e-cigarettes play the role. And then there will be people that can use both. And when we have nicotine products, maybe they use all three of them depending on the situation they are. So you will have exclusive category users and you have dual category users as we can see already. And that's why there is room for everybody. On IQOS, we have various platforms under the IQOS brand. We focused initially on the heated tobacco product because we thought and we have the proof that it has the highest efficiency. And now time has come for us to offer more products to consumers. And as we explain also in Investors Day, Eventually, we will also have a product that has used the same device with different consumables, evaporated, heated, and potentially nicotine, so consumers have absolute choice without the hassle of changing devices all the time. Now, that's a bit more future music, but that's where we go. And that's why I say there is room for all kinds of products in the consumer journey over years and within a day. And that's how I see the categories.

That is very, very helpful. And if I can have a follow-up on this. So the guidance you have given for 2021 on ICOS volumes, does it include ICOS mesh volumes as well, or that is just the heat, not burn product in your view?

Well, it will include eventually evapor products, but the essence of our projection was based on ICOS, to be frank with you. Okay. So maybe vapor will become incremental on top of this volume.

Okay. This is very helpful. Thanks a lot.

And that was our final question. I'll now turn the floor back over to management for any additional or closing remarks.

Well, thank you very much for joining us today. That concludes the call. And if you have any follow-up questions, please contact the Investor Relations Group. Have a great day. Thank you.

Thank you, ladies and gentlemen. This does conclude today's conference call.