Philip Morris International Inc

Good day and welcome to the Philip Morris International Second Quarter 2019 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 1 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 Rowley, Vice President of Investor Relations and Financial Communications. Please go ahead, sir.

Welcome. Thank you for joining us. Earlier today we issued a press release containing detailed information on our 2019 Second Quarter results. You may access the release on .pmi.com or the PMI Investor Relations app. A glossary of terms, including the definitions for reduced risk products or RRPs, as well as adjustments, other calculations and reconciliations to the most directly comparable U.S. gap measures are at the end of today's webcast slides, which are posted on our website. Unless otherwise stated, all references to ICOS are to our ICOS heat not burn products. Comparisons presented on a -for-like basis reflect pro-former 2018 results, which have been adjusted for the deconsolidation of our Canadian subsidiary Rothmans, Benson & Hedges, Inc., 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 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. Building on our encouraging start to the year, we delivered very solid performance in the quarter, notably reflecting positive momentum for both our combustible tobacco and smoke-free product portfolios and strong currency-neutral adjusted financial results. Key among our strengths in the second quarter was our volume performance. On a -for-like basis, total shipment volume declined by 0.7 percent in the quarter and increased by 0.1 percent June year to date. This performance was better than we had anticipated, notably driven by the EU region. Heated tobacco unit shipment volume increased by 37 percent to 15.1 billion units in the quarter, driven by the EU region, Eastern Europe region, and Japan. Second quarter net revenues increased by 9 percent, excluding currency, on a -for-like basis, driven by higher HTU shipment volume and favorable pricing for our combustible tobacco portfolio. Our performance was flattered by the timing of pricing in certain markets compared to the prior year, which contributed an estimated two percentage points to net revenue growth. Our RP net revenues reached nearly $1.5 billion in the quarter, or nearly 20 percent of PMI's total net revenues. IACOS devices accounted for approximately 14 percent of our RP net revenues compared to approximately 19 percent in the second quarter of 2018. We recorded a strong -for-like combustible pricing variance of over 6 percent in the quarter, driven notably by Germany, Indonesia, Japan, the Philippines, Russia, and Turkey. We have recently increased our cigarette prices in markets such as Mexico and Ukraine, which should further contribute to a positive pricing variance over the balance of 2019. On a currency-neutral, -for-like basis, adjusted operating income increased by 15.7 percent in the second quarter, while adjusted operating income margin increased by 240 basis points. The strong margin expansion was driven primarily by favorable geographic mixed related to HTUs, reflecting the increased contribution of volume from IACOS geographies with relatively high unit margins, notably markets in the EU region. -for-like adjusted diluted EPS increased by 15 percent, excluding currency, driven by our strong business performance. Our total international market share, excluding China and the U.S., increased by 0.1 percentage point to reach 28.3 percent in the second quarter. This growth was driven by heated tobacco units, which increased by 0.5 points to reach 2.1 percent, reflecting broad-based share gains across the EU region and in Japan and Russia. In the markets where IACOS has been commercialized, our HTU brands recorded a total combined share of nearly 5 percent in the quarter, despite not yet being fully distributed in many of them. Our share performance for cigarettes in the quarter reflected continued adult smoker out-switching to IACOS, as well as an estimated adverse impact of approximately 0.2 points related to Turkey due to the timing of price increases -a-vis the competition. We expect our share performance in Turkey to improve over the balance of the year. Turning now to RRPs, we surpassed 11 million IACOS users as of quarter end. Approximately 70 percent of the total, or some 8 million IACOS users, have stopped smoking and switched to IACOS, with the balance in various stages of conversion. In the EU region, HEATS continued its sequential quarterly share growth, increasing by 0.3 percentage points to reach 2.4 percent. This growth reflects success across a broad range of markets, with varying regulatory frameworks and adult smoker preferences. We have achieved significant progress with IACOS across the region over the past year, as evidenced by the HEATS market shares shown on this slide. This includes strong growth in some of our larger markets, such as Italy, Poland, and Germany, as well as even faster growth in other markets, such as the Czech Republic, Greece, Latvia, Lithuania, and the Slovak Republic. HEATS continued its strong performance in Russia in the quarter, with sequential in-market sales growth of over 23 percent and national share of 2.9 percent. As a reminder, our first quarter HEATS share was flattered by the impact on the total market of seasonally lower cigarette industry volume. The in-market sales volume progression, therefore, remains a more realistic indicator of the brand's trajectory. For reference, we estimate a first quarter adjusted share of 2.3 percent, implying sequential share growth of 0.6 points in the second quarter. We continued our geographic expansion during the quarter and are now commercializing IACOS in cities representing an estimated 40 percent of the market by total industry volume, compared to approximately 32 percent at the end of the first quarter. In Japan, our total share for HEATS sticks and HEATS increased by 1.1 points versus the second quarter of 2018 to reach 16.6 percent, further demonstrating that the initiatives we introduced during the second half of last year are paying off and driving a step up in our share performance. After adjusting for the impact of estimated trade inventory movements, which benefited our first quarter share this year, our share was stable on a sequential basis. We continue to anticipate greater competitive activity in the category as the year progresses. While this may increase competitive churn among adult consumers over the short term as they try new products, we ultimately view this as a positive development for the category overall and for IACOS in particular. As I will cover later in my remarks, we are investing behind further enhancements to the IACOS 3 device in 2019 to reinforce the brand's leadership position. Importantly, share for both the heated tobacco category and our heated tobacco brands continued to grow sequentially in the quarter, based on the latest consumer off-take share data. In Korea, the heated tobacco category continues to be highly competitive, particularly in the area of non-menthol flavors and related new taste dimensions. Share for heats declined by 0.7 points and was stable on a sequential basis at 7.3%. This performance was flattered by the impact of inventory movements as seen from the adjusted market share progression. We attribute the current share dynamics mainly to competitive churn as new devices and consumables from the competition have entered the market and experienced initial trial. We plan to broaden our portfolio of heats to better address the unique taste preferences of adult tobacco consumers in Korea and have related launches scheduled for the second half of 2019. In addition, like Japan, Korea will be an initial focus geography for the upgraded IACOS 3 device. It is important to remember that, aside from Japan and Korea, our focus for IACOS across most launch markets remains targeted to key cities. These city-level shares compare very favorably to the corresponding national shares and provide an encouraging indicator of the greater opportunity that can come with broader focus and support in IACOS markets. Before closing on IACOS, I would also like to reiterate our excitement over the prospects for IACOS in the U.S. As a reminder, on April 30th, the U.S. Food and Drug Administration confirmed that the marketing of IACOS is appropriate for the protection of public health and authorized it for sale in the U.S. We are excited to bring IACOS to the U.S. market through an exclusive license with Outyear Group Inc., whose subsidiary, Philip Morris USA, has the market expertise and infrastructure to ensure a successful launch, beginning with the initial lead market of Atlanta, Georgia. Turning to our full-year outlook, we are raising our 2019 reported diluted EPS guidance at prevailing exchange rates to be at least $4.94. The $0.07 increase compared to our prior guidance on May 1st of at least $4.87 was driven by stronger business performance, primarily reflecting better shipment volume, and a tax benefit of $0.04 related to a reduction in estimated U.S. federal income tax on dividend repatriation for the years 2015 to 2018, partly offset by asset impairment and exit costs of approximately $0.02 per share related to a plant closure in Columbia as part of our global manufacturing infrastructure optimization. Our guidance continues to include an unfavorable currency impact at prevailing exchange rates of approximately $0.14 per share, with just $0.01 in the second half of the year. After excluding the $0.20 per share of reporting adjustments and tax items outlined on this slide, our forecast represents a projected currency-neutral, -for-like increase of at least 9% versus our pro forma adjusted diluted EPS of $4.84 in 2018. Our increased guidance now assumes a total shipment volume decline of approximately 1% on a -for-like basis versus a decline of .5% to 2% assumed previously. We continue to anticipate full year HTU shipment volume broadly in line with our in-market sales volume, with any net inventory movements in individual markets essentially offsetting on an aggregate basis. For the industry, we now estimate a total volume decline in 2019 of approximately 2.5%, excluding China and the U.S., which is at the low end of the previously communicated decline range of .5% to 3%. Our increased guidance further assumes -for-like net revenue growth excluding currency of at least 6% compared to the assumption of at least 5% in our prior guidance. We also now expect ICO's device net revenues to account for less than 20% of our total RRP net revenues in 2019. The change from the previously communicated range of 20% to 25% primarily reflects the favorable geographic mix impact related to HTU shipment volume that I noted earlier. We continue to anticipate a full year -for-like combustible pricing variance above 5%, supported by our June -to-date variance of 5.2%. This positive top-line momentum provides us the opportunity to further increase or advance investments behind ICOs in order to accelerate product and commercial development, expand distribution in both existing and new geographies during the second half of 2019, further enhance the ICO's 3.0 device in 2019 to reinforce the brand, and strengthen our category leadership as competition intensifies. Consequently, we now anticipate net incremental investments behind RRPs this year of approximately $400 million compared to our previously disclosed estimate of approximately $300 million, with the majority of the $100 million step-up in investment expected to occur in the third quarter. We believe this increased investment will reinforce the positive momentum behind ICOs heading into 2020. Despite the increased investment, we are maintaining our assumption of currency-neutral adjusted diluted EPS for operating income margin expansion of at least 100 basis points on a -for-like basis. While we don't give quarterly guidance, I believe it is appropriate to provide some additional visibility on the third quarter, in which we expect currency-neutral adjusted diluted EPS to be essentially flat compared to our pro forma adjusted diluted EPS of $1.35 in the third quarter of 2018. This estimate assumes a -for-like currency-neutral net revenue growth rate in the quarter, slightly below our full year assumption. As I noted earlier, compared to last year, our second quarter net revenue growth benefited from the timing of price increases in certain markets, and some of this benefit will be offset in the third quarter. We also face a challenging combustible pricing comparison versus the third quarter of 2018, our strongest quarter for pricing last year. Coupled with our top line assumption, our third quarter EPS estimate also reflects higher expected costs on a -for-like basis. This is primarily due to our net incremental investments behind RRPs, with about half of the full year total of approximately $400 million expected to come in the quarter. Turning to cash flow, we continue to anticipate full year operating cash flow of approximately $9.5 billion, subject to year-end working capital requirements, as well as capital expenditures of approximately $1.1 billion. In conclusion, we're building upon our promising start to the year and delivering a very solid performance in the second quarter. The fundamentals supporting our strong combustible tobacco portfolio are intact. The favorable momentum for ICOS continues across geographies, further supporting our HDU shipment volume target of 90 to 100 billion units by 2021. Finally, on a currency neutral -for-like basis, we have increased our full year 2019 growth assumption for net revenues to at least 6%, and our anticipated full year 2019 growth rate for adjusted diluted EPS to at least 9%, further demonstrating our overall confidence in PMI's short and long-term growth prospects. Thank you. I'm now happy to take your questions.

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

Hello. Thank you very much. I guess I have two questions. Clearly, you've guided both the better volumes for the market and a bigger improvement for yourself. I was just wondering what has surprised you and what geographies you're talking about particularly, both in terms of the market and in terms of your own volumes as you think about 2019. That's my first question.

Thank you. It's fairly broad-based, but I would call out the EU as the one area that is exceeding its previous run rate and maybe surprising us a little bit to the positive this year. Poland is one market that's doing well. I mean, you know, its overall EU run rate used to be around 2 to 3 percent, and now we're seeing it running more like 1 to 2. So far, this year, it's been quite encouraging. But we're also seeing pretty good volumes across a number of other geographies. The Turkish market in the first half of the year is still up. Indonesia market has started to grow again with no tax increase and with limited pricing this year because of not having the tax. And you have a couple other markets, at least for the first half of the year, that are benefiting from lapping some previous big tax increases and so forth. Like Saudi is up compared to last year. Thailand is up pretty strongly even though it's not such a big market, but it's a pretty strong size growth there. So I would pick out the EU as the one that's probably a little bit more than what we expected.

And that's the market. And for you specifically, is it just, I guess, RRP is doing better than expected or is there anything else? Or is it just that those are favorable markets to you, Indonesia, Turkey, EU, Saudi, or big markets where you have decent market shares?

Yeah, well, I mean, you see our overall share is benefiting from heated tobacco units.

And

even within the cigarette category, we're doing pretty well. We called out, you know, this quarter wasn't quite as favorable as last quarter on a cigarette share, but Turkey was one of the main reasons. And the issue in Turkey was that we increased prices and were the only ones in the market with the higher prices for about a month. The competition lagged a bit. And so we lost quite a bit of share in the second quarter. However, that is now reversed as the competition has also passed the prices. And we don't expect that to continue. We have great brands in Turkey with Marlboro and Parliament. They're recovering quite quickly. So that was a bit of a Q2 anomaly. So overall, our share in cigarettes, within cigarettes, is holding up very nicely. And of course, we're benefiting from the overall strategy of leading the heated tobacco space as, you know, approximately two out of every three consumers coming into the category, coming from the competition. So overall, our share is holding up very nicely. We're quite pleased with it.

And just very quickly, a second point. You mentioned at the beginning a couple of times that you had more pricing variance this quarter. And I guess you implied that it's going to be sort of slightly reversing Q3 because the impression you gave was you took earlier prices in 2019 than you did in the corresponding markets in 2018. But I was just wondering, sort of, can you be a little bit more specific about what markets you're talking about? And so why did you do that? It seems a sort of, well, a slightly strange thing to do. Is there a bit more color around that pricing variance being moved a bit further forwards in the year?

Yeah, I mean, first of all, with pricing, you kind of take it when you can get it. It's not that we try to stick to a certain schedule. We read the competitive situation and the overall gaps and various other measures, and we take the pricing as we think we can achieve it. One market to call out as having shifted from where it was in Q3 last year into Q2 this year is Mexico. So you had the trade movements benefiting Q2 and the pricing benefiting Q2 this year, where it was in Q3 last year. And the other piece on the comparisons to last year is last year's pricing variance in Q3 was very large. It was the biggest of any of the quarters. It was $483 million. So just because of the way the timing works out and the different sequencing, you get some quarters that are bigger than others. And when pricing moves from one quarter to another, it can have a pretty significant impact on the total revenue line. So yeah, 9% total revenue growth in quarter two, X currency, like for like, is very, very strong, but it is flattered by these movements by about 2%. So we wanted to call that out and also make sure people understood the impact as we make the comparison against Q3 coming up.

Okay, I've got lots more questions, but I'll leave it there to let the other folks have a go. Thank you.

Okay. Thanks,

Adam. Our next question comes from Judy Hung of Goldman Sachs.

Thank you. Hi, Martin.

Hi,

Judy.

So my first question is just your decision to spend incremental $100 million behind ICOs this year. I know you kind of gave the big buckets of where you think the investments will go, but I guess I just wanted to get a little bit more clarity around, you know, just some of the specific programs in mind for the spending. And then if we should think about this as more of a pull forward from, you know, kind of the planned spending next year as the underlying momentum has come in a bit better than expected.

Okay. Yeah, I mean, there are a couple of broad areas where this spending will help us maintain our momentum going into next year and really beyond. I mean, one is to accelerate the development of innovation of both the product side and on the commercial side, and that'll have more of a long term benefit. I mean, that's something where it's not likely to help us this year, but it will help us next year with some of our innovation coming out at a faster pace and some additional projects that we can accomplish. So that's more of a long term investment and very much a confidence on our strategy and realizing that in order to stay ahead of the competition, we've got to continue with our innovation pipeline. The second piece is around geographic expansion. You know, we've had great success in Russia and the EU, and we've pointed out that geographically we still have opportunities to expand in both areas. So accelerating those plans ahead of more competitive presence is prudent. And then we also have some new geographies that we will open in the second half of the year and funding that appropriately to get off to a really good start is, I think, an excellent use of additional investments to get momentum going into next year. And that's really what I would sort of say staying ahead in the areas where we're doing well and opening up some new areas. And then the third bucket is investments to address intensifying competition. I mean, I guess the best examples of that are going to be Japan and Korea. We do have new innovation improvement on our ICOs 3 device, and we want to get that out there in a big way and benefit from it. It's an excellent innovation and it helps us have news and a reason for ICOs users to really stick with ICOs in the face of having lots of other products being offered to them and so forth. And then there's also in that same bucket, I think, commercial activities, which I won't specify, but which we will put aside some additional investments for given that the competition is putting more intensity into these markets as they realize that they need to try to catch up in the reduced risk space that we've built. So those are, I think, prudent investments. It's about momentum and it's a bit of success breeds success because we've been able to do well this year and get ahead. And then that allows us to up the ante and keep our momentum going, not just finishing this year well, which we need to do, but more importantly for next year and beyond. These are long-term plays. So I hope that covers it, Judy.

Yeah, that's helpful. I guess a bit of a follow-up and my second question was actually going to be on Japan and Korea and some of the competitive dynamics that you've talked about. I guess in Japan, you've had some new activities in place now for, I guess, six months plus. Market share being kind of flatish. How would you think about that in the context of some of the investments that have already been made? And then can you be a little bit more specific in what the improvement on ICOs3 devices that we'll see with the launch in the back half? Thanks.

Okay. So for Japan, I mean, you have to keep in mind that we're up 1.1 SharePoints year to date over last year. So yes, sequentially, we only had very slight growth on an off-take basis from Q1 to Q2, but that's already on a base that's well stepped up from our run rate last year. So our initiatives are clearly working. The introduction of heat at the different price point and with the different taste lineup to attract a different consumer group is definitely working. It's incremental share we're getting and it's a more mainstream brand that opens its access to more consumers. We've had very good feedback on the ICOs3 and Multi. The battery works better. It charges between usage for ICOs3 much quicker. The design is well received and the evidence is that despite the price tiering where 2.4 plus is available in the market at a lower price, nearly all of the purchases and all the volume, the vast majority have gone to ICOs3 and Multi. So it shows that the consumer there has appreciated that innovation. And our sales force is working effectively to convert adult smokers. The overall category has grown and I mentioned before our heats and heat stick share has grown, and we expect that to continue going forward. Now obviously, there is going to be some more competitive activity in the second half. So we'll see how that plays out. There may be some short-term impacts of consumers trying other products and so forth. But we're convinced that our product is still the best choice in the marketplace and we're going to keep investing behind it. And the ICOs3 improvement we think will help consumers see new innovation from us as well as the competitive offerings. I'm not going to give any further details on what that improvement is. As you can imagine, we'd like to keep it as a surprise for now. But I think it's a significant improvement that consumers will really appreciate. So we're actually pleased with Japan's performance. Obviously, we're watching very closely the competitive situation. And that's certainly the first half of the year only behind us. We still have the second half to go. And I think we're going to make sure we're addressing the competitive situation in Japan as well as in Korea. Great.

Thank you so much.

Our next question comes from one of Bonnie Herzog of Wells Fargo.

All right. Thank you. Hello, Martin. Hi, Bonnie. Hi. I wanted to also ask about a little bit further on some of the things that you were just discussing. And I kind of wanted to hear maybe more specifically how consumers have been responding to more of the competitor innovation that's been rolling out in the market. Are they simply trying the new innovation and then possibly coming back to ICOs? Or do you think you're experiencing some share loss as these consumers are switching? Or is it possible that some of the new innovation by your competitors is helping to convert more smokers and driving a larger, reduced-risk market?

I would say that it's different between the two markets, between Japan and Korea. In Japan, I think we have seen the period of churn and we have more consumers that are actually settling back with ICOs. Obviously, there will be a new wave of expansion coming from some of the device sales, especially from JT. So there may be another phase. But overall in Japan, I think the initiatives we took are having a good effect. Our share growth is up from last year nicely. And we see that our position is pretty firm and that we're growing the category and growing our share moving forward. So in Japan, while obviously we'll keep an eye on the competition, we feel pretty confident going forward. In Korea, it's a little bit more intense competition. KT&G's device has a lineup of consumables in a taste direction, non-menthol flavors that are kind of unique to Korea, if you will. Korea is a country that has an overall trend, not just in tobacco, but in other categories of all kinds of exotic flavors. And it's present in the tobacco area as well. And KT&G has done a very good job of capitalizing on this. It's not just, by the way, in the area of heat not burn. It's also in the cigarette category that they have put out a large number of new offerings with all kinds of exotic flavors. But within the heat not burn area, we feel more confident to respond and offer some additional flavors in our lineup. And we will come with that in the second half of the year. So we'll have to see how those competitive responses get traction. We think we will do better going forward and we're also putting more attention to conversion and some of the other activities in the marketplace in Korea. But right now our results in Korea are in need of some remedial action. And that's what we're taking going forward in the second half of the year. Whereas in Japan, I think we're on firm footing and we're quite confident going forward.

Okay, that's helpful. And then in light of all of this, the competitive landscape intensifies you know, how or where are you seeing pricing heading for reduced risk products? You know, how concerned are you that pricing is going to start to roll back, you know, in an effort for possibly you to defend share, just trying to get a sense of the evolution of pricing in the reduced risk market over time?

Well, I think we need to separate out consumable prices. There's absolutely no indication of any sort of pricing issues or skirmishes. And in fact, for example, in Japan when overall prices went up last year with the tax increase, the pricing went through on RRPs as well as on cigarettes. And we don't see any sign anywhere of the actual consumables being a big issue from the pricing's perspective. Now on the devices, there are some countries where the competition has offered very low prices on devices. We are always priced well above competition and surgically and where necessary, we have and will continue to offer discounts or promotions to keep our devices from being too high on price. And you know, we will need to keep doing that. But that's a much more manageable issue. I mean the value of converting a consumer, it's really in the consumable and making sure that you're in the mix for devices on device pricing is a relatively more manageable economic challenge than having to deal with the consumable side. So overall, I would say pricing in the category is not a major issue. It's small skirmishes in certain countries, certain places with the devices where we're going to have to continue to make sure we're being competitive.

Okay, that's helpful. And just one final quick question on your guidance from me. You're increasing your spending slightly, but you noted you still expect your margins to be just as strong. So can you highlight for us what the key offset is or what is expected to perform better specifically as it relates to your margins?

Well, I mean I think the top line increase allowed us for a bit more spending while keeping the margins still where it was before. And I think that if you put that through the model, I think you'll see that that's more or less what it is. I mean obviously we're very mindful of our spending and working hard to get efficiencies. You see us moving forward on our footprint as we've announced some factories. We did Pakistan before, we're doing Columbia now. We've announced the intent and the beginning of consultations on Berlin. We're working hard internally on our cost categories and ringing costs out and so forth. But most of those benefits you'll see more going forward in the next few years. It's not showing up so much already this year because you have to take the actions and of course incur the costs and treat people fairly and properly. And then you get the lower cost space in the out years. So I think the 100 million is really within the realm of that higher revenue and keeping the EPS growth 1% higher as well.

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

Hi, thanks for the question. In your comments about step up investment in Q3, you alluded to accelerating investment behind innovation. Will this happen specifically within heat not burn or will you be investing more behind vaping products? And also what are your thoughts on M&A and vaping to extend your presence in the category?

Yep, Pam. The investments are across several platforms including eVapor. We continue with our plan to roll out the first initial market with the improved e-cigarette with the mesh technology and the improved form factor. And we're very confident that that product will be superior to what's in the marketplace. So we're continuing to invest behind the capacity, ramp up for that. And we want to ramp the capacity as fast as we can and get to as many markets as we can next year. As far as timing on spending, if you take the total 400 million that we're now communicating on spending, about 120 million has been spent in the first half leaving us about 280 million. And then we said about 200 or half of the product category is not just the innovation you're asking about, but it's a broad based commitment to the smoke free future and all of our activities across commercial as well as product platforms as well as commercialization.

Thanks. And how are you thinking about Icos's ramp in the U.S.? Can you help us think about the potential contribution to your results as it scales?

Well, I mean, I think you start with looking at the prospects for Icos in the U.S. And I think it starts with the consumer receptivity. And in our estimation, U.S. consumers are very open to trying new products, not just in the area of reduced risk tobacco products, by the way, but also all products in general. As compared to many other countries, U.S. consumers tend to embrace innovation pretty readily. And you certainly see it with the cigarette category and some of the other categories in the U.S. where consumers are trying new products. So that's a plus. There's a pretty clear regulatory approach. And we got clear guidance from FDA on some of the aspects of introducing this product in the U.S. There's good communication freedom that will help build awareness and trial amongst the adult smokers. And then you've got Altria and PMUSA. They have excellent execution ability. They're well prepared. They've got a very strong plan. We've been working with them to share all the learnings. Very good cooperation. So we expect the U.S. to perform quite well. I mean, we would expect it to be faster on average than the EU has developed. I mean, I think you have to be realistic. I wouldn't assume that it's going to take off like Japan did or Korea initially, et cetera. But we expect U.S. to have very solid results. Now, of course, it has yet to be started. We'll find out a lot from the Atlanta beginning and then we'll take it from there. But we have very high hopes and we're working very well together with Altria to make this a success.

Thanks. And one last question for me. Just curious about your early read on the competitive dynamics from Juul's international expansion in Europe and Asia.

Well, it is early days for Juul. We're not seeing certainly any impact from Juul on our overall results. As you can see, there's really nowhere that we're having any issues with it. But it is early days. We're watching it closely. You know, I mentioned staying ahead of competition with expansion and staying ahead of competition. It's mostly we're talking about heat, not burn, but it's also quite frankly with an eye towards Juul as well and making sure that we get as much awareness and trial and presence throughout the EU and Russia and places like that as we have this great momentum and we're doing extremely well. And it's with an eye also to the fact that others are coming amongst them, Juul. So we have our eye on it. We're taking steps, including with the e-cigarette platform for investment and rollout that we've talked about and I mentioned earlier to make sure that we're going to compete well with Juul. Nonetheless, of course, there's room for more than one successful product in this category and Juul will likely get some success. So we're realistic about it as well. Thank

you.

Our next question comes from Robert Rampton of UBS.

Good morning. Three questions from me, if possible. The first question is, so your disclosed markets are down around 1%. If you could help me with the bridge to the 2.5 for the full

market. The 2.5 is a reference to the total market for tobacco and heated tobacco units worldwide and the 1% is our shipment rate. So I'm not sure if you didn't get your question.

So I'm referring to your key market data at the back which says the total market units were down 1.1%. I appreciate that. It doesn't cover 100% of your total market. Yeah. I guess what I'm asking is what did the industry do in 1H and then how do we bridge from that to the full year?

The total industry in the first half was down a bit less than the 2.5 and would be down a bit more than the 2.5 obviously in the second half to bring it back to that. I don't have the exact number of... Yeah, I mean there's going to be pricing

throughout

the year and you have normal decline rates throughout various countries. Turkey's going to... Pricing that went into effect in April in Turkey, Turkey was growing quite rapidly last year and into the first quarter but obviously there was a pretty big tax and we've now taken pricing to Turkish lira per pack so that market probably won't grow quite as fast as it was. I mean there are various market events that infer that the second half will be a bit weaker than the first half for both total market and for our own shipments too by the way because we're more or less flat in the first half. We're saying we're going to be down one for the year so obviously our second half shipment volume will be down roughly the 2%.

Does that

help Robert?

That's very helpful indeed. The next question was on inventory in Japan. Last year there was a 4 billion gap between your shipment number and your in market sales. I mean clearly some of that will be loading ahead of the tax change but how should we think about the lapping of that in the context of the difficult pricing comparative you flagged?

Yeah I mean there are a couple moving parts in Japan that have impacts on inventories especially one quarter of the next. I mean as you point out we had the pricing last year. We obviously drew down the inventory because we had a different projection for the market than what we started the year. This year you have a VAT increase expected October 1st going from 8% VAT to 10% VAT. That's across the whole market not just tobacco but all products. But obviously consumers are going to expect that and there might be some panchee loading and trade movements from that. There's also a health warning change coming next year so inventories have to be managed to deal with that. So there are quite a few moving parts. I mean obviously we made the statement that overall worldwide we expect total heated tobacco unit shipments to be more or less in line with in market sales. In other words if there's inventory up in one market down in another market but overall it should be more or less flat. I can't really give you the individual where each market is going to end up even Japan given these many moving parts. And you have to remember inventories are really set as we go into the end of the year with an eye towards what we think is going to happen in the next year. That's the whole reason to have the inventory is to size it to what's coming and what events are coming as well. So it's a bit difficult to give you any more details on what's coming up for inventories other than that broad statement that we expect in market sales and shipments to be approximately the same this year and not have big inventory differences.

Okay that makes sense. Sorry one last question. Just in terms of Icos share in Greece and Bulgaria that moved backwards quarter on quarter. Obviously I'm not trying to say anything about proposition but I'm just wondering in those markets is that a function of the bigger weight of two Q versus other quarters or is it a case that you get to a certain point in the development of a market where you start getting the initial churn or is it you've redirected the resource away from those markets?

Well you have to keep in mind there's some volatility in the numbers but if you look at Greece the share is 8.1 up four from the prior year so it's doubled. So there might be just like we saw in Russia for example where the overall IMS is growing at a very steady very nice rate but you saw the share moving around Q1 was overstated because of the spread seasonality and now when you look at the underlying and understand the situation the Russia share growth has been growing and growing steadily but it's distorted by these other movements and similar things happen in other markets but when you look at the longer term both you called out Greece it's doubled in the last year to 8% up four. Bulgaria is more than doubled it's grown two and a half to four and a half so when you look at one quarter to another quarter with those kind of growth rates I mean I don't think that's really the best way to look at it but we're growing well in both of those locations.

Okay great thank you very much appreciate the time.

Our next question comes from one of Michael Levery of Pepper Jeffery. Thank

you. Could you just unpack the third quarter a little bit more and especially in light of the VAT increase in Japan and what should be relatively profitable for trade loading how should we think about the revenues still in the quarter being below your full year range and why would that be the case?

Well I mean one of the biggest impacts is the timing that we talked about where the Q2 is benefiting by about two percentage points and that's obviously going to drag on Q3 on the top line and then when you look at it year over year we had this very large pricing variance last year of 483 million and while we'll have decent pricing this year as well it won't be nearly that big in the quarter and you add to that this spending step up which is very much concentrated in that quarter and that's how we get to the overall picture of essentially flat with the pro forma from last year at 135. I mean that's pretty much the basics of it. I mean obviously there are individual events in certain countries like Japan and so forth that one year the next year but if you look at the bigger picture those are pretty big movements and significant numbers that affect it. I remember last year Japan had a price increase in the same pattern right it was October 1st so you had trade loading and etc. so when you do it this year you have the VAT instead of the tax but you have a similar potential for trade dynamics at really the same date so I don't think that that's going to be a big driver of

it. And do you expect you could get, are you anticipating having pricing go through with this tax hike as well?

We never discussed forward pricing. You know the VAT is going to go up that's all we can really know at this point in time we'll have to see what happens as far as anything else. And just on that you usually have to discuss with the government your pricing ahead of time and so forth so it's not always very clear as to what's going to

happen. Yeah, no of course and just back on the spending piece of it can you unpack the incremental 100 million a bit? You mentioned that half of it is going to fall on the third quarter is the rest in the fourth or has some of that already happened?

Just to be clear we took the 100 million increase added it to the 300 million that we had already said would occur that's a total of 400. Half of that i.e. 200 million step up will occur we believe in the third quarter. That's why it's a pretty big impact. It's not just the 100 million. It's 200 million of step up out of the total of 400 million that we expect to hit in Q3. That's why it's a pretty big impact.

No, that's helpful clarity and is some of that timing just driven by opportunistic ability to reinvest some of the momentum ahead of your plans? Is that how the 3Q surge hits from the pacing perspective?

Yeah, I mean we've only spent 120 million so far this year in the first half. Some of it was by design and some of it was some timing slipping and some things like that. As it turns out Q3 is actually a very good time for us to step up this investment because we get some time during the year to benefit from the geographic expansions that we're going to do. We've been planning them already now. Much of that is out of the original 300 million. The 100 million on top as we go and try to address better some of the competitive situations and work on our longer term innovation. Q3 is when we can get things rolling and get the commensurate spending that goes with it hits the timing. Yeah, it just so happens that the concentration of the 200 out of the four falling into one quarter but it's a variety of different things driving that.

No, that's helpful. Then just one more on the UK. Obviously there's some severe restrictions on your ability to communicate and market much about Icos but you're starting to expand into Bristol and Manchester now. It also was in the news that there's been 100,000 devices sold in London over the last couple of years and some of those obviously could be in the hands of multiple. Some people could have more than one, no question, but that might be something in the neighborhood of a high single digit share of London smokers. How is your progression in London? Is it gaining a little bit more traction and starting to have some good share run with it?

Yeah, I mean our share in London is relatively small. It's above 1% but it's relatively small. It's bigger in certain pockets like around Canary Wharf, West London. We have pretty significant share. We have really good conversion rates in UK and London at 70% so the people who do buy the devices successfully convert and for the most part quit smoking and switch completely to heat not burn. We're continuing to invest as you pointed out by opening stores in Bristol and Manchester so we're making headway. As you pointed out, it hasn't been easy due to the regulatory set up and some other issues. You have to keep in mind London is like a crossroads of the world so you have a lot of people that visit London that might buy a device but not actually consume heat sticks in London so when I give you market share I'm talking about heat stick off take share but obviously you would have devices that would be purchased by people visiting London from various countries. You might have also Londoners who travel quite a bit buying heat sticks in the EU and bringing them back as long as they stay within certain limits they can do that. Prices are much lower say in Italy. Your price for heat sticks in Italy is significantly lower than what it is in London so you get a lot of that going on so I think probably London is a bit of a unique situation where the number of devices sold doesn't match up as closely as you might think with the off take share of the consumables but I think it's a worthwhile endeavor for us to keep working on awareness and conversion of people in London because it is a leading city in the world and one that helps set worldwide trends so we keep chipping away at it and we are making progress and we will continue to do that.

That's helpful, thanks a lot.

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

Thank you for taking my question and this is a follow-up on that question that was earlier on the sequential market share in Bulgaria and Greece. So if I look at Japan, Icos stalled after having penetrated the early adopter market and the overall HTU category share has been stable at around 21-22%. Now in Vilnius and Lithuania you were already at 20% share in Q1 and if we look at the Lithuania market share they are up very slightly so what I'm trying to ask is are you hitting the limits of early adopters in some of these Eastern European cities and countries already?

The only one that would be kind of at the level where you might think that there might be some challenges would be Vilnius which is as you said 20% and it really all depends on the dynamics of the pricing of the offer if you are running out of people that are in the premium category that can sometimes have an effect but overall when you look at EU and even Russia we still have quite a bit of runway to go before I think we will start to hit issues where you say I have converted the vast majority of premium smokers or I have converted the vast majority of the early adopters and innovators and even now even when that starts to happen we are now much more prepared for that because we know obviously you need to be prepared to make sure you have offerings that span the different price tiers you need to be prepared to have the messaging in place for different groups so obviously it's something we keep an eye on and we build the toolbox to be able to move to a different strategy when you start hitting those levels but in the EU frankly I think we're still aggregate anyway far far away from it keep in mind Lithuania and Vilnius are relatively small geographies within the EU so I don't see it as an overall issue for our growth rates in the EU we're on a good trajectory and I expect us to continue to be growing nicely for for quite some time to come but we are prepared and aware of it and have have the toolboxes and and and strategy for those sorts of situations thank you for your question

okay yeah okay can I ask one follow-up question you are increasing your revenue growth kind of this year to six percent but not the three-year guidance from greater than five percent so shouldn't that be also increased a bit now because you're increasing the guidance in the first year itself

well that's not how we've set the three-year we we gave it as a compound annual growth rate obviously when we get into next year we'll give some guidance for for next year and we'll see how things are going before we do that but we're not prepared to do that and we wouldn't change the three-year overall based on you know just this just this period

sure thank you thanks a lot

thank you very much

and that was our final question I'd like to turn the floor back over to management for any additional or closing remarks

yeah I just wanted to leave three key takeaways first one being you know we've got very strong momentum as evidenced by our total volume which is which is actually slightly positive on a -for-like basis in the first half and it's both the conventional and the heated tobacco units which are performing well second is that our strategy is working for the shareholders we've got the top line benefits that are flowing through with our margin expansion of at least 100 basis points currency neutral that we expect for this year and this has given us the confidence to increase our investment to maintain this momentum into 2020 and beyond we're focusing on the longer term with the product and commercial development we're focusing on geographic expansion we're addressing competition to to maintain our favorable competitive lead and when you put all three of those things together we're in pretty good shape for the first half of the year we definitely have still the second half to go and there's some countries and areas that we have to make sure we're we're keeping an eye on amongst them Turkey with the pricing and Indonesia with some down and so forth we've got the increased competition on heat not burn but when you put it all together we're we're confident in the future and we're ready to have a good second half and move into 2020 so thank you very much for listening

thank you very much for joining us today on the call if you have any follow-up questions please contact the IR team again thank you very much and have a

second quarter 2019 earnings conference call you may disconnect at this time and have a wonderful day