Philip Morris International: Sparking A Smokeless Future
By: Vineet Gupta & Nistha Sharma
The Ivey Business Review is a student publication conceived, designed and managed by Honors Business Administration students at the Ivey Business School.
With 15 per cent of global market share and approximately $74-billion USD in 2015 revenues, Philip Morris International (PMI) is the world’s leading tobacco company with prominent brands like Marlboro and L&M. In response to government regulation, public backlash, and decreasing global demand, PMI announced a radical strategic shift in late 2016 to gradually phase out all traditional cigarettes using iQOS, its smoke-free tobacco technology. While this strategy has been successfully implemented in markets where smoking culture is generally condemned, PMI has yet to determine how to successfully execute it in developing regions where cigarettes are still dominant.
An impending merger between British American Tobacco (BAT) and R.J. Reynolds—PMI’s largest rivals—will replace the company as the leading international tobacco company by the end of the year. One of BAT’s goals for the merger is to “deliver a world-class pipeline of vapour and tobacco heating products...globally.” PMI must proactively consider a new strategy in entering these lucrative markets with its own iQOS product, or risk permanently losing its market position within a competitive and brand-loyal industry.
An Industry Up in Smoke
Tobacco is a highly regulated industry: since the implementation of controls like the Framework Convention on Tobacco Control (FCTC), the prevalence of smokers over the age of 15 has dropped to 22 per cent globally, and is projected to fall to 19 per cent by 2025. Although tobacco companies in many low and middle-income countries are still highly profitable, the sustainability of PMI’s cigarette sales is being put into jeopardy.
Currently, emerging markets in the Asia-Pacific region make up 65 per cent of the global smoking market. Nonetheless, an expanding middle class, increased education levels, and growing health consciousness among consumers are shifting this segment away from traditional smoking norms. PMI must seek alternative revenue streams by being proactive in offering smoking alternatives that are attractive to consumers while minimizing government and public backlash.
PMI should pilot its iQOS expansion into emerging regions through the Indonesian market, which represents 13 per cent of PMI’s total unit sales and is one of the argest regions the company serves. Predicted to be the world’s largest cigarette market by 2025, Indonesia is a tobacco “rogue state” where the government has yet to ratify the FCTC. With a significant Muslim population in Indonesia, social smoking often replaces the function of social drinking apparent in most Western countries. Consistent demand by consumers, coupled with less stringent regulations in this space, will allow for increased chances of success in introducing the iQOS in this market. PMI’s potential success in Indonesia will also provide validation for future implementation of the company’s strategy within similar markets. This will not only shield the company from the threat of a combined BAT-Reynolds company, but also against the risks of decreasing cigarette sales in developed economies.
Turning up the Heat with iQOS
E-cigarettes have failed in many markets due to their use of liquid nicotine solutions rather than the authentic tobacco users are familiar with. The iQOS uses tobacco “HeatSticks” similar to cigarettes, which are heated to release nicotine, resembling a traditional smoking experience without burning the tobacco. This allows the device to release vapour instead of smoke, which prevents the first and second-hand inhalation of harmful chemicals associated with smoking a traditional cigarette. The perceived health advantages of the device have contributed to the iQOS’ success in over 20 markets. For example, in Japan, the iQOS achieved over seven per cent market share within the first year. Users claim that phenomenologically, the iQOS experience is almost identical to traditional smoking, less the lung discomfort and odours associated with regular cigarettes. The HeatStick component of the technology is also sold at comparable prices to traditional cigarettes due to the similar production costs.
Regardless of these benefits, at a price of $80 per device, the initial investment of the iQOS is a large barrier to adoption for price-sensitive consumers in many emerging markets. Considering that the average price of a standard 20-pack of cigarettes is only $1.50 in Indonesia and lighters are widely accessible, the cost of the iQOS is not justifiable to the average smoker. Additionally, the health-focused value proposition of the iQOS that appeals to smokers in developed markets is less valued by the Indonesian population, where smoking permeates social and cultural norms nationwide.
Ultimately, despite its ability to provide an authentic smoking experience, the current price of the iQOS is financially inaccessible to the individual smoker within countries like Indonesia. In order for widespread consumer adoption to occur, PMI must consider a separate strategy from the one deployed in developed markets to capture smokers within emerging markets.
Clearing the Air in Indonesia
To encourage widescale iQOS adoption, PMI should establish a different distribution channel of business-to-business customers. As a reusable device, the iQOS has significant sharing potential between users. This market-entry business model would consist of selling iQOS devices to roadside stalls, mall kiosks, workplace cafeterias, and other high-traffic areas where people typically purchase and smoke cigarettes. Consumers would be able to purchase HeatSticks in packs from these retailers at comparable prices to traditional cigarettes, and use the iQOS device to consume the HeatStick at the point of purchase.
PMI should adopt a phased strategy whereby consumers can still smoke traditional cigarettes at home, but will be increasingly exposed to iQOS devices within social settings.Smoking is ingrained into many Indonesians’ daily lives: 84 per cent of Indonesians purchase cigarettes from the nearest retail location, establishing convenience as a major purchasing driver for cigarettes. As a result, it is vital for PMI to establish a widespread distribution network for its iQOS product.
There should be two components to PMI’s distribution strategy: the sale of HeatSticks and the iQOS device itself. Currently, the distribution network for cigarettes is fragmented and established widely across ubiquitous roadside stalls and grocery stores in Indonesia, making smoking an easily accessible activity. Forty-nine per cent of Indonesian smokers smoke whenever they can, reinforcing the fact that HeatSticks should be sold at the same convenient locations. This will allow PMI to leverage its existing Indonesian distribution network to drive mass adoption. Currently, these independent retail locations primarily purchase cigarette products from larger grocery chains, which PMI already has strong supplier relationships with; this increases the feasibility of introducing the iQOS on a local and national scale.
PMI’s second distribution imperative is to ensure that the iQOS devices themselves are widely accessible in areas where consumers typically smoke. In addition to locations where traditional cigarettes are retailed, the iQOS should also be to sold to restaurants, bars, and workplaces where smoking is still widely prevalent. Many public health groups advocate for smoking bans in these public areas due to the environmental impact of second-hand smoke, and the iQOS offers a smoke and odour-free incentive for institutions to invest in devices to share in designated smoking areas. Being the first company to establish enough iQOS devices to meet demand in these locations will render it difficult for competitors to push their own reduced-risk products in the future, setting PMI up for a monopoly over this market.
Igniting Government Interest
The tobacco industry plays a significant role in the Indonesian economy, employing approximately 4.5-million people nationally. While traditional cigarettes remain unregulated, this fact has led to the ban of imports and sales of e-cigarettes, which do not contain any tobacco. Since the iQOS runs on HeatSticks that contain a similar amount of tobacco as a cigarette, the product is uniquely positioned to be a potential cigarette substitute that does not disrupt the country’s established tobacco industry.
Furthermore, the iQOS’ reduced-risk status drives significant value for the Indonesian government. In 2014, the government introduced a compulsory national health insurance programme (JKN) to provide comprehensive medical access to all citizens. As an alternative that is 90 to 95 per cent less toxic than cigarettes and does not generate second-hand smoke, consumer adoption can provide significant savings on tobacco-related healthcare costs and loss of productivity. Revenues from excise taxes on cigarettes make up between 10 to 12 per cent of the state budget, but with the potential healthcare savings that the iQOS offers, it will be feasible for PMI to lobby for a decreased tax rate on its products.
Excise taxes currently comprise 45 per cent of the retail price of cigarettes, resulting in $10.3-billion in tax revenue for the government in 2016. After factoring in lost excise tax revenue from cannibalization of cigarette sales—even assuming a zero per cent tax rate on HeatSticks—the government can realize annual net savings of at least $14-million by the fifth year of introduction. On this basis, it is reasonable that HeatSticks will be able to achieve at least an excise tax rate reduction to 35 per cent of retail price.
Warming up the Retail Space
For PMI’s strategy to succeed, it is crucial to create buy-in from retailers. Push advertising from retailers at the point of sale coupled with the fact that HeatSticks are available in the same brands consumers are familiar and comfortable with will make an uptake in consumer adoption much more likely. Through passing on all excise tax savings on the sale of HeatSticks, PMI is able to create a higher-margin product that is much more attractive to sell.
If a roadside stall is able to sell four packs of HeatSticks instead of traditional cigarettes over the course of a week, representing at most five per cent of total units sold, it will be able to break even on an investment in two iQOS devices for on-site use at $80 each. These devices will be necessary to allow retailers to demonstrate iQOS’ experiential value proposition and enable customers to consume the product upon purchase. iQOS devices will be connected to the kiosk via a cord—similar to lighters—to prevent theft of the devices, while encouraging additional purchases resulting from additional time spent at the kiosk.
This is an easily achievable conversion benchmark that provides ample additional profit for retailers, of which a portion could be passed on to end consumers at their discretion to further encourage acceptance. Given that consumers are price-sensitive and currently spend five to seven per cent of their income on tobacco products, a cost leader strategy would be highly effective in driving adoption.
Blazing Ahead
To encourage consumer adoption of the iQOS, it is paramount for PMI to establish the device as one that provides a genuine, improved smoking experience within familiar social contexts. Tobacco advertising in Indonesia has traditionally been aggressive and widespread. Crafting iQOS as a novel, higher-quality alternative to cigarettes through advertising and retail promotion will be critical to driving adoption in a redefined market that currently does not have any direct competitors. This distribution model will allow PMI to initially enter the market through pre-established channels, and gradually increasing exposure and demand for the iQOS will eventually translate to end consumers demanding their own devices. This will place PMI in a strong position to sell iQOS via its traditional business model—one that the company has perfected many times in other markets—as a complement to this new channel in the future. Currently, cigarette margins in Indonesia are relatively lower than margins in other developing regions. Should PMI’s new strategy succeed in Indonesia’s regulation-light environment, PMI can apply similar approaches in other emerging markets where HeatStick margins are even more favourable.
By gaining nationwide adoption of the iQOS, PMI can prove its ability to establish its innovative, reduced-risk device as a staple part of Indonesian culture. This creates a sustainable opportunity for the company to become a pioneer of reduced-risk technologies in emerging economies, and sets PMI up to become a global leader for a smoke-free world.