Philip Morris International - Q1 2023

Transcript

Operator (participant)

Good day, and welcome to the Philip Morris International first quarter 2023 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 star followed by the number one on your touch-tone phone. Media representatives on this call will also be invited to ask questions at the conclusion of the questions from the investment community. I will now turn the call over to Mr. James Bushnell, Vice President of Investor Relations and Financial Communications. Please go ahead, sir.

James Bushnell (VP of Investor Relations and Financial Communications)

Welcome. Thank you for joining us. Earlier today, we issued a press release containing detailed information on our 2023 first quarter results. You may access the release on pmi.com. A glossary of terms, including the definition for smoke-free products, as well as adjustments, other calculations, and reconciliations to the most directly comparable U.S. GAAP measures for non-GAAP financial measures cited in this presentation and additional net revenue data are available in the exhibit to the Form 8-K published this morning and on our Investor Relations website. Growth rates presented on an organic basis reflect currency neutral adjusted results, excluding acquisitions and disposals. As such, figures and comparisons presented on an organic basis exclude Swedish Match up until November 11th, 2023. Today's remarks contain forward-looking statements and projections of future results.

I direct your attention to the forward-looking and cautionary statements disclosure in today's presentation and press release for a review of the various factors that could cause actual results to differ materially from projections or forward-looking statements. It is now my pleasure to introduce Emmanuel Babeau, Chief Financial Officer. Over to you, Emmanuel.

Emmanuel Babeau (CFO)

Thank you, James, and welcome everyone. I am pleased to report that Q1 performance exceeded our expectations with strong underlying momentum from IQOS, ZYN, and our combustible business. As mentioned at our full-year earnings in February, we expected this quarter to be the weakest of the year due to a confluence of transitory factors impacting our top and bottom line. In this context, our business delivered robust results, and we look forward with confidence to the remainder of the year. Smoke-free net revenues made up almost 35% of total PMI, despite the impact of adverse timing factors on HTU shipments, with an increasing number of markets crossing the 50% threshold. IQOS continue to deliver strong share and user growth across its geographies, both with the blade version and ILUMA.

Where launched, ILUMA's excellent traction with both existing IQOS user and legal age smoker is boosting growth, demonstrating the dynamism and importance of our ongoing innovation. ILUMA's progress is especially notable in the first launch market of Japan, where share growth has accelerated in recent quarters. In combustibles, accelerated pricing across a range of markets helped to deliver robust organic net revenue growth. Swedish Match delivered impressive results with a standout performance from ZYN's +47% U.S. shipments volume growth compared to the first quarter of 2022. Following an encouraging start to the year, we are well set up to deliver strong performance in 2023, including excellent top and bottom line growth for the remainder of the year. Turning to the headline numbers.

Our Q1 organic net revenues saw robust growth of +3.2% against a very strong prior year quarter with organic growth of +9%. This reflect the continued strength of IQOS at a step-up in pricing, but was partially offset by expected HTU inventory movement, which I will come back to. This organic figure does not include the excellent +14% ex-currency top line growth of Swedish Match led by ZYN. Our total reported currency neutral net revenue grew by +9.6%, with combined pro forma adjusted net revenue increasing by around +4%, also excluding currency. Our total organic net revenue per unit grew by +4.4%, with strong combustible pricing of +7.4%, partially offset by HTU dynamic in Japan and Germany, which I will come back to momentarily.

We delivered Q1 adjusted diluted earnings per share of $1.38, well above our previous expectation. This reflect a strong underlying delivery from our existing operation, excellent Swedish Match performance, and favorable phasing on interest costs. Compared to a record high prior year quarter and with a number of one-off or accentuated margin headwind from inflation, supply chain efficiency, and timing factors as flagged previously, our adjusted diluted EPS contracted by -4.4%. Let me now walk through the mechanics of our Q1 net revenues. We delivered overall adjusted net revenue growth of +4.6% on an organic shipment volume decline of -1.1%. While included in this number, Swedish Match smoke-free volume grew by an extent +10%, adding impressive accretion to our overall growth profile.

Combustible and HTU pricing, excluding Germany and Japan HTUs, contributed +5.3 points of growth, including positive HTU pricing in a number of markets. This was partly offset by a -1.3-point HTU impact from Germany and Japan. The larger of the two was Germany, reflecting a full quarter of the 2022 excise tax increase, for which we await a court ruling later this year. Japan, the October 2022 excise tax increase and transition to ILUMA were also a drag on our top line, and we expect some of this impact to phase out in the second half. The increasing mix of HTUs in our business at higher net revenue per unit continues to positively impact our performance, lower shipments in Europe this quarter due to wholesaler and distributor inventory movements limited the benefit.

This was also the main driver for the difference between our smoke-free organic net revenue growth and HTU shipment volume growth. We expect this positive mix shift to accelerate as both smoke-free organic net revenue growth and HTU shipment growth align more closely with off-take trends for the year, as they also did in 2022. The positive mix impact of HTUs, overall volume growth, and pricing are powerful drivers of our transformation and growth. As expected, the first quarter was impacted by peak margin headwinds at both the gross margin and adjusted operating income level. Our gross margin contracted by 0.6 percentage points due to the net impact of COGS inflation, pricing, volume, mix, and productivity savings. We expect the positive elements of pricing, productivities, and favorable HTU category mix to increasingly compensate and ultimately outweigh inflation as we progress through the year.

Supply chain disruption and the accelerated transition of consumers and our business to ILUMA accounted for a further 0.6 percentage point impact. We anticipate this item to abate as we progress with ILUMA launches and gain efficiencies in our supply chain, including a return to sea freight. In addition, specific cost phasing and the geographic mix of inventory movement, notably for HTUs in Europe, impacted our gross margin by 1.8 percentage point in the quarter. Despite these exceptional Q1 dynamics, we continue to forecast the full year 2023 margin impact of our heat-not-burn business to be favorable as inventory movement and ILUMA-related factors dissipate. As explained previously, we expect a progressive improvement in our gross profit and OI margin, notably weighted towards H2 as headwinds subside and the underlying driver of our transformation accelerate.

At around 26% of adjusted net revenues, our Q1 SG&A costs are at a similar ratio to the full year 2022. However, as expected, there was a notable increase compared to Q1 2022, given lower commercial spend at the beginning of last year, the inflationary environment, cost phasing, and front-loaded commercial investment. Our successful cost efficiency programs continue to deliver, enabling ongoing investment and helping to mitigate inflation with $150 million of gross saving realized in Q1, of which almost $50 million were from SG&A. Importantly, we expect a significant slowdown in SG&A growth to a level below the rate of net revenue growth for the remainder of the year, which will support OI margin improvements. This brings me to the outlook for 2023. Our robust Q1 performance support visibility on strong full year growth.

We continue to expect +7% to +8.5% organic top-line progression, with a targeted acceleration in HTU shipment volume growth versus 2022. As detailed in this morning's press release, our other operating assumptions remain unchanged, and we remind you that our organic metrics do not include the contribution from Swedish Match for the large majority of the year. Our updated full year adjusted diluted EPS forecast of $6.10-$6.22 includes an estimated unfavorable currency impact of $0.30.

Positive estimated impact from the euro and a number of other currencies are outweighed mainly by the weakness of the Japanese yen, as well as the significant depreciation of the Russian ruble and the Egyptian pound. This range continue to reflect +7% to +9% currency neutral growth and does not include any contribution from a potential favorable excise tax ruling in Germany, which we would expect to add around 3 point to our adjusted diluted EPS related to 2023 tax payments. We continue to expect Swedish Match to be low single digit accretive to our 2023 adjusted diluted EPS after financing and for an increase of around $200 million in our non-acquisition related interest cost, despite a relatively modest increment in Q1. As discussed at full year earnings in February, this year's bottom line results are expected to be notably H2 weighted.

However, we expect our organic net revenue growth to already accelerate in the second quarter into the high single digit. We forecast second quarter HTU shipment volume of between $30 billion and $32 billion, with adjusted diluted EPS in the range of $1.42-$1.47, including an estimated unfavorable currency impact of $0.13. Looking ahead to the second half of the year, we expect close to double-digit organic top line growth and a return to margin expansion. Looking now at our full year forecast through a different lens, after the temporary headwinds in Q1, we expect very strong performance for the remainder of the year. Despite ongoing margin headwinds and investment, we expect organic top line growth of +8% to +10%, improving margin with expansion in H2, and currency neutral adjusted diluted EPS growth of +10% to +13%.

This reflect the strong underlying drivers of our transformation with IQOS and ZYN driving volume at a higher net revenue per unit, combined with stepped up pricing on combustible. Turning back to our results, our HTU adjusted in-market sales volume grew by an estimated +16%, demonstrating continued strong growth momentum. HTU shipment volume of 27.4 billion units were towards the higher end of our forecast range with growth of +10.4%, which was well below actual off-take trends as anticipated due to distributor and wholesaler inventory movement. As implied by our full year HTU shipment forecast, we expect the rate of shipment growth to accelerate for the rest of the year as shipments convert with consumer off-take and to grow at a faster pace in 2023 than in 2022.

Before detailing this inventory impact, it is important to note that in certain markets, such as Germany, IMS sales volumes are not measured at the point of distributor sales to the retail trade as the data is not available. In these cases, we instead use our shipment as the proxy. This means that shipment fluctuation can impact both IMS volume and reported market share and may not be representative of off-take dynamic. Given the volatility seen over this quarter and from now on, where there is a significant difference between estimated off-take performance and IMS data, we may choose to provide market share metrics based on adjusted IMS to better reflect off-take, where adjustments reflect the total estimated impact of distributor and wholesaler inventory movement. As you may note in the appendix to today's earnings release, this is the case for Germany this quarter, where we also provide historical figures.

Coming back now to Q1, HTU shipment volume in several European markets were below consumer off-take. This is explained by the reversal of some inventory buildup at the end of Q4, 2022 to meet the needs of ILUMA launch, as mentioned at our full year result in February, and also to create some safety stock to mitigate the risk of production and distribution constraint due to energy shortages. As anticipated, we were able to adjust this safety stock in Q1 as the risk receded. We also decreased the level of IQOS blade HTU inventory in several markets to reduce the risk of obsolete stock given the rapid transition to ILUMA. Notably impacted markets include Italy and Germany, where underlying market share and off-take trends remain strong.

Italian Q1 in-market sales volume grew by +21% compared to the prior year, with market share increasing from 15.4% in Q4 to 17.4% in Q1. In Germany, adjusted Q1 IMS volumes increased over 30% from the prior year, with adjusted market share up from 4.7% in Q4 to 5.3% in Q1. Turning back to the overall picture, while total Q1 cigarette and HTU shipment volume declined by -1.1%, our total IMS volumes were essentially stable and grew excluding total estimated inventory movement.

Our cigarette shipments declined by -3.1% with resilient trends in many markets. The decline includes a notable impact from a high prior year comparison in Japan and the introduction of an abrupt excise tax increase in Pakistan, resulting in an increase in illicit trade and an industry contraction of over 30%. Volumes also declined in the Philippines following industry pricing, with consumer purchasing power facing ongoing pressure. We continue to target stable to positive combined cigarette and HTU shipment volume for the year, following growth in 2021 and 2022. This notably does not include the excellent growth prospect of oral nicotine, for which shipment volume grew by +10% in Q1. Most importantly, the exciting growth combination of IQOS and ZYN presents an unrivaled platform for growth over the coming years.

Focusing now on combustible, our portfolio delivered robust Q1 organic net revenue growth of +3%. This reflects strong pricing of +7.4%, with a step-up across many markets, including Germany, Indonesia, and the Philippines. With over 80% of planned 2023 combustible pricing implemented or announced, we have good visibility on the full year delivery. Although some of the positive Q1 variance reflect earlier pricing compared to 2022. We now forecast a full year variance of +6% to +7%. Our cigarette category share declined by 0.3 percentage point in Q1, which was essentially all attributable to geographic mix as a total industry decline in large volume markets such as the Philippines and Pakistan.

The impact of share movements within market was neutral, with gains including Egypt, Poland, and Turkey, offset by decline in markets such as Ukraine, the Philippines, and Iraq. Importantly, we continue to target a stable category share in 2023 and over time, despite the impact of IQOS cannibalization. Moving now to our smoke-free product. We estimate there were 25.8 million IQOS user as of March 31st. This represents growth of close to one million adult users since December, with notable progress in Japan and Europe, in addition to a broad range of other geographies. IQOS ILUMA has been a positive catalyst for volume and share growth across a broad range of launch markets, both supporting our strong position in the heat-not-burn category with a superior user experience and fostering further category growth. For existing IQOS users, ILUMA drives an accelerated upgrade cycle.

This enhances retention and full conversion for the future, with a temporary margin impact from concentrated device sales. Indeed, we are now approaching an estimated 10 million ILUMA users, with ILUMA taking over 85% of HTU volume in the first launch market of Japan, Switzerland, and Spain. ILUMA is also enabling better acquisition and conversion of legal smokers, with market share acceleration visible in both earlier and more recently launched markets such as Italy and Korea. Since the introduction in these two markets in Q4, we are seeing encouraging trends in initial launch area and expect this to be increasingly visible at the national level over time, as it is in Japan and Greece after a seasonal inflection in the latter.

Our main focus in Q1 was on ensuring the success of ILUMA in the 16 markets launched by the end of 2022, which cover over half of our IQOS business by volumes. In addition, we launched ILUMA on a limited basis in Indonesia in February via our IQOS CLUB member program. This IQOS CLUB was introduced in 2019 and now has over 100,000 estimated user across 10 cities, with a notable boost from the launch of ILUMA. We expect to progressively launch ILUMA in more markets this year. With ILUMA accelerating IQOS growth where launched, PMI HTUs continue to strengthen their position as the second-largest nicotine brand in markets where IQOS is present, with a record high share of 9% in Q1.

Impressively, as of Q1, PMI HTUs are now the number one nicotine brand in 10 markets, with the addition of Italy and Greece during the quarter. Focusing now on Europe, which under our new regional structure include additional markets such as Ukraine. Our first quarter HTU share increased by +1.7 points to reach 9.2% of total cigarette and HTU industry volume, adjusted for estimated wholesaler and distributor inventory movement, such as those I mentioned earlier in Germany and Italy. On the same adjusted basis, IMS volume continued to grow sequentially and reach a record high of 11.1 billion unit on the four-quarter moving average. This reflects strong progress across the region.

We expect our Europe HTU volume to grow strongly in the remainder of the year, while as in the past, our quarterly HTU share of market can be impacted by seasonality of cigarette consumption during Q2 and Q3. To give some further color on our standing progress in the region, Slide 16 shows a selection of the latest key cities off-take shares. The success of IQOS continue across a diverse range of geographies from Western, Southern, Central and Eastern Europe, including markets with and without ILUMA. Notable standout include Budapest, with over 35% off-take share, as well as Rome and Athens, reaching the high 20s. To my earlier comments, we are very pleased with performance in Germany, where off-take share in Munich surpassed 10% for the first time.

We are also encouraged by recent positive regulatory development in Greece, where the Ministry of Health approved a differentiated health claim for heated tobacco product. Greece is the first country outside of the United States that permitted health-related statement following a robust scientific assessment. In Japan, the heat-not-burn category now represents over 35% of total tobacco, with IQOS driving category growth. The acceleration seen in recent quarters continued in Q1. Adjusted total tobacco share for our HTU brand increased by +3.4 points to 26.2%, with off-take share surpassing 32% in Tokyo and 30% in Sendai. Adjusted IMS volume again grew sequentially, reaching a record high of nine billion units on the four-quarter moving average. Strong performance in Japan further highlight the importance of continuous innovation and a broad consumable portfolio.

Our premium priced TEREA HTUs and mainstream priced SENTIA HTUs continue to grow through Q1, strengthening their position as the two largest heat-not-burn brands. We are delighted with the progress in Japan and as we look forward to further robust volume growth in the coming quarters, we would also like to remind you of the seasonality impact on quarterly share metrics. In addition to strong IQOS gains in developed country, we continue to see very promising growth in low and middle income markets, which are now approaching 30% of our total HTU volume. This slide highlights a selection of Q1 key city off-take shares across markets in Eastern Europe, the Middle East, Asia and Latin America. Notable successes include Bulgaria, with Sofia off-take share of over 16%, and Egypt, where off-take share in Cairo reached 7.5%.

We also continue to see robust off-take volume growth across these important future markets. Moving on to Swedish Match business, which deliver an excellent Q1 performance with currency neutral net revenue growth of +14% and smoke-free product comprising 77% of total net revenues. Most impressive was the continued outstanding performance of ZYN in the U.S., with +47% volume growth to 73 million cans. While volume growth benefited from inventory movement, including restocking in California following the December flavor ban, underlying growth in volumes was very strong, estimated well above +30%. We are also pleased with the Q1 performance in other U.S. smoke-free categories, including moist snuff, which gained +0.8 percentage point category share and deliver shipment volume growth of +3%.

The smoke-free category in Scandinavia continued to grow, driven by nicotine pouches, albeit at a slower rate following January's snus excise tax increase in Sweden and Norway, with destocking accentuating the volume decline for Swedish Match's premium skewed snus portfolio. In cigars, the business delivered positive pricing and robust shipment volume growth of +4% in a declining category driven by the strong development of natural leaf varieties. Finally, I would like to congratulate Swedish Match employees for continuing to deliver excellent results as we thoughtfully integrate our activities. The integration is progressing very well, and we look forward to sharing more on our combined growth plan later this year. Now, let's examine ZYN's recent U.S. performance in more detail. Superior progress continue with a record increase in 12-month rolling shipment volume of 23 million cans, which equates to +40% growth.

Category volume share remained essentially stable despite continued heavy competitive discounting from less premium offerings. Importantly, retail value share for ZYN also remained strong at 75.6%, highlighting its premium positioning and superior brand equity. There are two key engine driving the U.S. growth of ZYN as covered at CAGNY. First is a progressive increase in distribution with a number of stores +13% higher than Q1 2022 at around 140,000. There remains ample opportunity to further increase this over time. Second, our velocity or the number of cans sold per store per week. ZYN velocity is going to grow sequentially and by an impressive +21% compared to prior year as the brand continued to resonate with adult nicotine user. Let me update you on our exciting plans to further accelerate our smoke-free journey.

As previously mentioned, the full global rollout of IQOS ILUMA is a major priority. We are on track to make substantial progress this year as HTU manufacturing constraints continue to ease. We continue to work on our IQOS U.S. commercialization plan for launch in Q2 2024, in line with the principle outlined at the recent CAGNY conference. With the benefit of the expertise and commercial tools from launching IQOS successfully in over 70 international market and a U.S. market with a clear regulatory framework and the ability to communicate with adult smoker, we remain very positive about the opportunity. Importantly, we believe we can make the necessary investment in the U.S. business, generating additional top-line performance while continuing to deliver strong bottom-line growth for PMI during the investment period.

In addition to our premium offerings, we are continuing to focus on BONDS, our latest heat-not-burn innovation that is especially relevant for low and middle-income consumer. Pilot launches in the Philippines and Colombia are progressing well, and we intend to continue taking the learnings from this market before deploying on a wider scale. Another key midterm opportunity from the Swedish Match combination is the international expansion of nicotine pouches, notably within the world-leading brand. At CAGNY, I mentioned we are targeting up to 10 launches or relaunches this year as we look to develop the category with adult smoker who value the convenient, specific use occasion, taste, and satisfaction. We expect this to commence in a few markets this summer, including both developed and emerging countries.

While staying clearly focused on the heat-not-burn and nicotine pouch category, which present the largest and most accretive growth opportunities, we are adjusting our VEEV e-vapor portfolio approach. We intend to focus on commercializing in select markets and prioritizing profitability given the known category challenges. VEEV ONE is a new pod-based system providing an enhanced user experience with fully outsourced manufacturing of devices and consumable to optimize costs. VEEV ONE will replace the current VEEV product, and as a result, we no longer intend to file a PMTA for the former technology. Instead, we will focus our near-term FDA engagement on IQOS and VEEV. We will come back on future e-vapor FDA authorizations in due course. For disposables, the fastest-growing e-vapor segment, we are rebranding VEEBA to VEEV NOW. All of our e-vapor product will now be under the single recognizable brand, VEEV, for a seamless consumer experience.

We will introduce a new VEEV ONE platform in Canada later this month and will apply an agile and disciplined approach for further VEEV rollout later this year. Moving to sustainability, I want to first draw your attention to our 2022 Integrated Report published earlier this month, which outlines the progress we are making towards achieving our proposed and smoke-free future. The report provide a comprehensive run-through of all of our most material sustainability topic. This includes those in focus for investors such as post-consumer waste, youth access prevention, decarbonization, and our resource allocation towards advancing our smoke-free transformation. In conjunction with the Integrated Report, we also published an updated ESG KPI protocol, providing even more robust criteria on how we define success and measure ESG performance.

It focuses on the KPIs included in our sustainability index, which as outlined in our 2023 proxy statement, continue to represent 30% of our long-term performance-based equity executive compensation. I am also proud to announce that we released our first TCFD Report yesterday, which updates and compiles our previous disclosure on how we are implementing the recommendation of the task force on climate-related financial disclosures in one document. This will be an important topic for many companies as reporting regulations evolve. Lastly, we are also pleased that following CDP's AAA recognition, PMI was again included in CDP's Supplier Engagement Leaderboard, contributing towards achieving our Scope 3 ambitions. To conclude today's presentation, we are on for a strong performance in 2023 despite margin headwinds. Our underlying growth fundamentals remain strong, and we expect these headwinds to progressively ease through the year.

Indeed, we delivered higher than expected Q1 results, which put us on track for the third consecutive year of high single-digit organic net revenue growth. Continued excellent IQOS and ZYN performance further enhances our position as a global smoke-free champion with leadership position in the largest category of heat-not-burn and the fastest-growing category of oral nicotine. We are taking action through pricing in combustible and our cost-saving initiative to recover cost inflation as we progress rapidly toward our ambition to become a majority smoke-free business. Finally, we remain a highly cash generative business with an unwavering commitment to our progressive dividend policy. We look forward to further rewarding our shareholders as our transformation delivers sustainable growth. Thank you, and we are now extremely happy to answer your questions.

Operator (participant)

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 star key followed by the number one on your touchtone phone. In the interest of fairness of time, we ask that participants keep the maximum of two questions each. If time allows, follow-up questions may be taken. You may rejoin the queue by again pressing star then one on your touchtone phone. We'll take our first question from Bonnie Herzog with Goldman Sachs. Please go ahead.

Bonnie Herzog (Managing Director)

Thank you. Hi, everyone.

Emmanuel Babeau (CFO)

Morning, Bonnie.

Bonnie Herzog (Managing Director)

I guess, hi. I guess I have a question on your guidance as it relates to Q2. It does now seem to be a bit lighter, implying a lot more of the growth is now expected to be in the back half. Just, you know, trying to get a sense of how conservative your Q2 guide might be, and then really, Emmanuel, how much visibility, you know, and confidence you have that your business really can accelerate and outperform the second half? Maybe you could highlight for us, you know, some of the key puts and takes that give you this confidence, and you know, maybe where you see the greatest potential upside?

Emmanuel Babeau (CFO)

Sure.

Bonnie Herzog (Managing Director)

Also just color on outlook.

Emmanuel Babeau (CFO)

Okay. No, sure, Bonnie. Happy to do that. I guess, you know, thanks for the question because that helps me clarify certainly the phasing of the profit generation this year. I think when we're not coming with any different message from what we said back in February. We always said that we would be facing in the first half of the year a number of headwinds on profitability, that there would be some inventory movement playing. We highlighted that. We clearly said there will be margin improvement coming in the second part of the year. We are coming today exactly with the same message. We are pleased to have a Q1 that is above our initial expectation. We never gave a guidance until today on Q2.

I think what we are seeing today on Q2 is coming with a lot of positive. We are explaining that we do expect an acceleration of the top line. We are talking about high single-digit growth that we are targeting for the second quarter. And that's of course going to be a very nice contribution to the performance in the second quarter that is highlighting the momentum that we have on the business, that we see behind IQOS, that is not capturing the ZYN growth for the second quarter. ZYN is just coming in addition to this organic growth. I think it gives an idea of how nicely up and running and dynamic is our business.

In term of margin, it is true that again, in Q2, we're gonna have a number of headwinds and notably at the level of the gross margin. We're gonna continue to have a number of impact coming from inflation. This is going to be progressively corrected, but I think you should expect another quarter with a gross margin rate declining in a material manner versus 2022. Then the second part of the year will be showing improvement, again, in line with our initial thoughts. Where I guess you're gonna start seeing in term of margin evolution, some more positive impact, this is on the revenue, sorry, SG&A to revenue ratio, where we have seen a deterioration in Q1.

I think I'm not saying that we will have SG&A growing at a lower pace than revenue in Q2, but I expect the growth of SG&A in Q2 to be closer to the revenue and therefore that will weigh less on the operating income margin. That's really what you should expect in term of sequence for the year. Again, we expect a very nice acceleration for the top line, just confirming the nice momentum that we are experiencing in the business. We have this ramp-up on the margin that is coming progressively. It's gonna show up first at the level of the SG&A on revenue. In H2, we are expecting, as we said, a better evolution of the growth margin rate. So far we're just confirming initial expectation.

Bonnie Herzog (Managing Director)

No, that's super helpful. Just sounds like you've got some pretty good visibility. That's, yeah, definitely helpful. I guess just maybe a quick high-level question on, you know, the health of the consumer in sort of your key markets, if you could kind of touch on that for us, you know. In the context of that, you know, you've certainly been putting in, you know, stronger combustible cig pricing. Just love to hear a little more color on how the consumer's been responding to those actions and really how confident you are that you're going to be able to continue to push through that pricing for the remainder of the year. Thanks.

Emmanuel Babeau (CFO)

Yeah. Well, I'm not going to say that we don't see any pressure on the consumer in the world. It is quite obvious. Of course, you know, I'm not talking about the U.S., which maybe could deserve a separate comment. It is clear that in countries such as the Philippines, for instance, we see some impact on the business coming from purchasing power. I think we see some of that as well in Indonesia. There are markets where there was already some pressure on purchasing power, potentially leading to some down trading, and that continue to play as we progress through the beginning of 2023. I have to say that in many markets, we haven't seen clear signs so far.

We have to stay very cautious of course, of pressure on the consumer, or, you know, massive down trading. We don't see that. The Marlboro market share was a bit down, but, you know, I don't think that is clearly reflecting at that stage a pressure on the premium part of our portfolio. We've been increasing price, as you have seen, in a very significant manner. Of course, you know, competition not immediately or not totally responding to our price increase, that can have an impact on our market share.

I would say so far we have the feeling that in a highly inflationary environment, the consumer is taking as normal and is not seeing an issue to see also price increase on his tobacco product.

Bonnie Herzog (Managing Director)

All right. Thanks for that color, Emmanuel. Appreciate it.

Emmanuel Babeau (CFO)

Thank you. Thank you.

Operator (participant)

We'll take our next question from Gaurav Jain with Barclays. Please go ahead.

Gaurav Jain (Head of EU SMID, EU Packaging, and Global Tobacco and Cannabis)

Hi. Good morning, and thank you for taking my questions.

Emmanuel Babeau (CFO)

Good morning, Gaurav.

Gaurav Jain (Head of EU SMID, EU Packaging, and Global Tobacco and Cannabis)

The first question I have is on. Good morning. The first question I have is on FX. In Feb, you had guided for a $0.15 headwind, now it is $0.30. Egyptian pound had depreciated by Jan. You know, yes, yen has gone down a bit, but euro, which is a much bigger currency for you, is up also a bit more than that. Ruble can't be that big, right? Is it becoming bigger this year versus last year? Could you just help us explain the FX?

Emmanuel Babeau (CFO)

Yeah, Gaurav. I think you rightly pointed to the ruble. Actually, if you, I'm not going to disclose currency by currency, if you look at the ruble, just the ruble is more than the net impact of $0.30 that today we are anticipating for the year. I think it shows a very strong impact of the ruble. The Egyptian pound, you know, continued to devaluate after January, it's, I'm not sure we have the full impact of the Egyptian pound. If you cumulate ruble and the Egyptian pound, you have 80% of the net impact of $0.30.

It's a net impact, don't get me wrong, because you have also the yen that is quite negative, and then you have the euro and a number of other category that is positive. I think with the ruble and the Egyptian pound, you have a pretty good explanation of the net impact. I hope it's helpful.

Gaurav Jain (Head of EU SMID, EU Packaging, and Global Tobacco and Cannabis)

Okay, sure. Thank you. Second, you know, the U.S. cigarette volumes industry level are quite weak, you know, -9%. Looking at, you know, the European data that you shared, it is industry volumes are flat on what were already very strong comps. You know, the reasons what are being mentioned for the U.S. industry weakness, which is macro, weak consumer, you know, stimulus payments going off, disposable e-cigarette growth, I could apply the same logic to E.U. consumer, E.U. smoker, and still the volumes are so much better than trend. Is there, can you explain, like, why are the U.S. smoker and E.U. smoker, why are they behaving so differently?

Emmanuel Babeau (CFO)

Gaurav, I cannot, and I will have to confess that I'm not the greatest specialist of the U.S. consumer for combustible cigarettes. I, you know, I won't dare myself to give an analysis. I think it's in line with my previous comment on the fact that so far we've been a pretty good resistance from the consumer to, you know, seeing price increase and coping with inflation in Europe. I'm not able to tell you why there is a difference here. We know that the social model in Europe is different. You may have some more protection, some more safety nets, you know, that are playing and maybe limiting the impact of inflation.

There was maybe more compensation, you know, given from various government on trying to fight against energy price increase and sometime compensating of agricultural product inflation across a number of geographies. That can be one element to explain why the European consumer is resisting better. I'm not going to pretend that I have the perfect answers to your question.

Gaurav Jain (Head of EU SMID, EU Packaging, and Global Tobacco and Cannabis)

Okay, thank you so much.

Emmanuel Babeau (CFO)

Thank you.

Operator (participant)

We'll take our next question from Pamela Kaufman with Morgan Stanley. Please go ahead.

Pamela Kaufman (Executive Director and Equity Analyst for Packaged Food and Tobacco)

Hi. Good morning.

Emmanuel Babeau (CFO)

Morning, Pamela.

Pamela Kaufman (Executive Director and Equity Analyst for Packaged Food and Tobacco)

I was hoping that you could elaborate a bit more on your SG&A investment for this year. What are the key areas that you are investing behind and the step up investment in Q1? I guess how much of this reflects structural increases in inflation driving higher costs versus incremental investment that you're making behind, you know, ILUMA and your health and wellness and Swedish Match businesses?

Emmanuel Babeau (CFO)

I mean, I'm gonna try to go as far as I can. As you can imagine, you know, some of that is super sensitive, so we're not gonna share in detail, you know, what we are investing and where. First of all, trying to give you perspective for the full year, we believe we're gonna have our SG&A growing faster than revenue organically. Nevertheless, we expect a limited discrepancy between the two. That means that as we progress through 2023, you should expect the growth of our SG&A to converge with the top line growth. I'm speaking here organic. Q1 is really, I would say, impacted by a number of, one of both by the way, on the basis of comparison.

If you look at our Q1, Q2, Q3, Q4 numbers last year, you know, sequentially you will see that Q1 was very low, both because we did not invest at the same moment of the year, so there is a phasing in investment, and also because there was some one-off positive last year. So don't take Q1 as a reference. Having said that, we are facing inflation, of course, in our SG&A. It's a lot of people cost and of course, we are increasing salaries. We are also indeed generating some efficiency. That is giving us some leeway to invest on our priority. It's about, of course, commercial investment on our priority, as you can expect. It's everything on marketing, commercial to boost IQOS. That is of course a big, a big driver.

It is investment that we are making to prepare the U.S.. We talk about the investment that we are making in wellness and healthcare. We continue to innovate a lot. We have innovation in the pipe for all our smoke-free product and of course, that is also having some impact. That is really what is driving this growth. We continue to see as important, this capacity that we have to cope with inflation, to invest for the future and at the same time to have an SG&A evolution that thanks to the dynamism of the business, is allowing us to generate nice operating income and net profit growth. That's what I can share with you.

Pamela Kaufman (Executive Director and Equity Analyst for Packaged Food and Tobacco)

Okay, thank you. Can you talk about your change in your e-cig strategy? What prompted your strategy towards IQOS, VEEV? How are you thinking about the category over the long term and your participation in it?

Emmanuel Babeau (CFO)

Look, I think we've always been clear that, while we were clearly developing some offering on the vaping category, this was not our priority. We had IQOS. Now I would say we are even, you know, more taken by two priorities, which are IQOS and ZYN. You know, when you have such a fantastic team, and the potential that they have to deliver very strong top line growth, volume growth, revenue growth, in a very nicely profitable fashion, that's really the priority. I guess you listen to us at CAGNY, and we express the questioning that we have on the vaping category today, which are around the absence of clear regulation in many country.

The fact that that is giving way to inappropriate marketing activities, risk of underage consumption. Also the fact that this is a category where so far it's difficult. I'm not saying impossible, but difficult to see a lot of profitable model being developed. Therefore that is pushing us to look at that and continue to work on this category. The fact that we are coming with this evolution of the range, I think is just in line with the fact that the technology is evolving. We see the customer needs evolving as well. That's why we are developing VEEV NOW. We're gonna be focused. It's not gonna be across geography. It's gonna be where the vaping category is relevant.

It's gonna be where we have a differentiation, where we have the commercial strength to make an impact. I think it is a much better strategy to do that, develop a few successes instead of exhausting ourselves in trying to develop something global today when we don't see necessarily the ingredient or the driver for that to happen, in an interesting manner, both in term of growth top line and bottom line progression.

Pamela Kaufman (Executive Director and Equity Analyst for Packaged Food and Tobacco)

Thanks. That's very helpful.

Emmanuel Babeau (CFO)

Thank you.

Operator (participant)

We'll take our next question from Vivien Azer with TD Cowen. Please go ahead.

Vivien Azer (Managing Director)

Hi. Good morning.

Emmanuel Babeau (CFO)

Morning, Vivien.

Vivien Azer (Managing Director)

My first question is a follow-up to Gaurav's, please. In terms of your current FX outlook, does that contemplate another devaluation of the Egyptian pound? Because my understanding is that's pretty well expected at this point.

Emmanuel Babeau (CFO)

It does not, because of course, we don't have any idea of what it could be, when it could happen. These are really an average that we take on the spot, in the day before the announcement and not taking any kind of forward-looking or whatever consensus, you know, for currency evolution. You have a lot of people today that believe that the euro is set for a nice ride against the dollar in the coming months. Frankly, we're not, you know, betting on any kind of possible evolution, but really just working on the spot.

Vivien Azer (Managing Director)

Okay. That's fair. I understand you're not in the business of predicting currency. It just seems like this is tied to the IMF bailout, so it seems.

Emmanuel Babeau (CFO)

Yeah.

Vivien Azer (Managing Director)

Reasonable to expect. My follow-up question is on the Swedish Match margins, which came in quite nicely. I was just curious, given the incremental inventory benefits that you saw in California, like, how should we think about the 1Q margin in context of a normalized margin? Was there an incremental margin benefit that we should be backing out mentally as we think about what the appropriate level of profitability is for that business? Thank you.

Emmanuel Babeau (CFO)

Vivien, I think what I can share with you is that I believe Q1 is just the bright confirmation of what we said, i.e., Swedish Match is coming with a very nicely accretive impact to the PMI growth. It is true for the volume, it is true for the revenue, and it is true for the profitability. Indeed, ZYN growing in the U.S. very nicely, and I don't come back, you know, on this north of 30% growth without the impact of California. That is driving a business that is nicely profitable, that is itself, you know, accretive to the Swedish Match average business and therefore of course to PMI. It is just very good news to have this engine for growth, frankly.

I don't want to repeat myself. IQOS and ZYN together they're just a very exciting pair. ZYN is coming as a very nice top line and margin enhancement role. We expect that to continue.

Vivien Azer (Managing Director)

Understood. Thank you very much.

Emmanuel Babeau (CFO)

Thank you.

Operator (participant)

We'll take our next question from Andrei Condrea with UBS. Please go ahead.

Andrei Condrea (Beverages and Tobacco Equity Research Analyst and Associate Director)

Hi, Emmanuel. Thanks for taking my question.

Emmanuel Babeau (CFO)

Hi, Andrei.

Andrei Condrea (Beverages and Tobacco Equity Research Analyst and Associate Director)

I have two from me, please, if you don't mind. Firstly, on the input cost inflation side of things, obviously your ILUMA margins will have efficiencies coming online later this year. In terms of the other headwinds you flagged, leaf and acetate tow, is there any color what you can give on just how big these headwinds are?

Emmanuel Babeau (CFO)

They are very material, but we flagged that, and I think once again, you know, we explained that in Q1, and we expect that to continue in Q2. This big increase in energy price, leaf price, acetate tow, is gonna be the biggest driver for the pressure on the growth margin. As we enter the second half of the year, and notably towards the end of the year, we believe that this element will be, well, first of all, we'll be facing comps already with some of the bad news in H2. Of course, the period on period comparison will be of course, easier. We keep working on productivity. We may keep working on our COGS, you know, to see all optimization.

This negative pressure, I'm not saying is going to disappear, but it's going to ease versus what we are experiencing in H1. I would expect in Q2 the pressure to remain very strong at that level.

Andrei Condrea (Beverages and Tobacco Equity Research Analyst and Associate Director)

That's very clear. Thank you. My second question is a bit more long-term. Obviously, we saw one of your peers come out with a new product at the Investor Day for the nicotine pouch space for the U.S. And at the same time, your other peer is bringing their European product in. Is there scope for a similar innovation for ZYN, given the criticism? Well, rather the drawback it has, that it being a much drier product versus the.

Emmanuel Babeau (CFO)

Yeah.

Andrei Condrea (Beverages and Tobacco Equity Research Analyst and Associate Director)

European counterparts? Yeah.

Emmanuel Babeau (CFO)

I believe that with Swedish Match, we have the biggest specialist, super focused, knowledgeable player of the oral nicotine category. We've been adding to that amazing skill, the Fertin, you may remember that we bought this company that is specialized in formulation of product, some of them including nicotine, and that can also come with very nice innovation in the form factor. You should expect us, of course, don't expect me to come now with detail, but you should certainly expect us to come with nice innovation. There is certainly the appetite in some area from the consumer to try new things, new, you know, reduced-risk product to develop this oral nicotine category in other spaces. Probably the consumer doesn't know as well what can be done.

It's for us, it's our duty to come and make some proposal. I guess you can expect us, and I think we've demonstrated that, PMI and now, you know, PMI plus Swedish Match to be leading innovation in this category as well in the future.

Andrei Condrea (Beverages and Tobacco Equity Research Analyst and Associate Director)

Fantastic. Thank you very much.

Emmanuel Babeau (CFO)

Thank you.

Operator (participant)

We'll take our next question from Matt Smith with Stifel. Please go ahead.

Matt Smith (Director)

Hi. Thank you for the question.

Emmanuel Babeau (CFO)

Hi, Matt.

Matt Smith (Director)

The incremental number of IQOS users stepped up in the first quarter to about 900 million additional users on a sequential basis. Can you provide more details regarding the favorable conversion trends you've seen behind ILUMA? Should we expect IQOS user growth to accelerate in the second half as ILUMA capacity improves and you expand the geographical footprint of the product?

Emmanuel Babeau (CFO)

Thank you. Yes, we are close to a million additional IQOS user in Q1. It's a nice number. It's not something that we can beat. I think that there is a possibility to further accelerate as we continue in Q2 and beyond. First of all, I would like to have a few words of cautiousness. You know, it's not a scientific number. That's an estimate, and that can have some variation depending on the number of element. I think directionally it is correct, and I think it shows the very strong momentum of IQOS. It is confirmed, of course, by the consumer off-take that we've been describing. It is clear that ILUMA is helping this conversion.

What we see with ILUMA is a higher capacity to convince smokers because it is a more seamless experience. There is no cleaning. It is mimicking even closer the ritual of the combustible cigarette. The overall experience is more satisfying. The abandonment rate is lower. Of course, we talk about net user acquisition. That is also helping. We have very nice progression of the consumer satisfaction in all countries. That is, I guess, you know, probably supporting the lower abandonment. It is clear that the more we go for ILUMA, the more we are in the capacity to accelerate conversion. Japan, I think, I mean, we're coming with a number in Japan. You can build the historic.

I think Japan is providing a lot of interesting information because it took some time. I mean, the acceleration that we have since Q3 in Japan is quite spectacular, frankly, and probably goes beyond our expectation. It shows that ILUMA is probably gradually getting traction with, I don't know, it's word of mouth. The consumer is realizing that this is making a big impact. Frankly, the acceleration of the market share to north of 26%, and I'm not talking about here Tokyo, but average Japanese market share is a significant acceleration. It started in Q4, it accelerated, and it's one year after the launch. It shows that, you know, not everything is happening in the first quarter of the launch.

I think we're showing a number of charts here showing that. That bodes well for a nice ramp up, you know, in the coming quarters as not only do we have to start, you know, to launch ILUMA in a number of country, but we know that this positive effect will spread over the coming quarters. We take that as a nice driver for user acquisition growth in the coming quarters.

Matt Smith (Director)

Yes, thank you for that detail. A follow-up on a comment you mentioned on the call about maintaining profit growth in the U.S. as you launch IQOS. Can you talk about the investment needs in the U.S. to support commercialization and how the $75 million or so of investment here in 2023 begins to build out the infrastructure necessary for a broader IQOS launch?

Emmanuel Babeau (CFO)

Yeah. Well, that's the additional investment, we of course we are already starting with some investment in the U.S. We come at the time of the Investor Day in September with detailed plan on how we intend to grow IQOS in the U.S. And at that time, of course, we share much more color on the level of investment that we believe is gonna be necessary. I think the important message, because we have a lot of question here, is the fact that, yes, of course, you know, in order to express what we think is a great potential of IQOS in the U.S., investment will be needed. By the way, we've been investing, you know, to build this phenomenal business for IQOS in Japan and Europe. I mean, we've been investing. It didn't come by chance. We will invest in the U.S.

What we are seeing is that given the growth momentum that we have in the business, we think that investing in the U.S. behind IQOS will, first of all, provide even more momentum on the top line and that we can absorb this investment while continuing to grow the bottom line very nicely. We're not ready to compromise on bottom-line growth because of investment that we need to make in the U.S. If I want to repeat something that I said already, I think the question mark will be, what is the differential that we can generate between top-line growth and bottom-line growth? Remember, the last algorithm was 5% and 9%, you know, above 5%, above 9%.

Well, if we increase more than 5% the growth rate perspective, it doesn't mean that we're gonna keep 4 points of difference between top-line growth and bottom-line growth. That's the sense of the comment. I hope it's helpful.

Matt Smith (Director)

Very helpful. Thank you very much.

Emmanuel Babeau (CFO)

Thank you.

Operator (participant)

We'll take our next question from Jared Dinges with JPMorgan. Please go ahead.

Jared Dinges (European Staples Equity Research Analyst)

Yeah. Hi, guys. I wanna ask about ZYN growth in the U.S., which, you know, seemed to actually accelerate in the off-take data, despite the base continuing to grow, and it's actually pretty sizable now. Do you think there's any benefit there from the investments that you started to make as part of your IQOS preparations in terms of building out maybe a sales network? Are you also increasing SG&A investments in ZYN alone? You know, I'm just thinking of this in the context of, you know, the brand's getting bigger. We're seeing, you know, the cigarette data has clearly been very weak, yet, you know, the brand continues to do very well. Just trying to understand what's.

Emmanuel Babeau (CFO)

Yeah.

Jared Dinges (European Staples Equity Research Analyst)

What's maybe driving that.

Emmanuel Babeau (CFO)

Thanks, Jared, for the question. First of all, yeah, we are of course extremely pleased with the performance of ZYN in the U.S. I want to pay a tribute to the work that the team is doing there, which is absolutely fantastic. I don't think that there is yet a sizable impact coming from our investment in the U.S. I think it's being developed on the merit of the great commercial plan and action. The brand has amazing traction. I think that it's extremely highly regarded by the consumer, premium brand, a very nice franchise. They are building on these two drivers, as explained, one geography, the other one is consumption per store. We just show that two things.

One, of course, we haven't reached the full geographical coverage, and that's where probably in the coming quarters, you will see some acceleration as we're gonna put more feet in the street, and more capacity to visit retail stores. The other thing is that there is a growing knowledge, understanding and appetite for the category and for ZYN that epitomize the category, and that's what we are seeing. So far, no really increased investment beyond the natural increase. You know, when you have such a nice growth, of course, you increase investment year on year. We do increase investment in the U.S., but nothing kind of at that stage accelerated plan and not yet impact coming from investment on IQOS. That should come in the future.

Jared Dinges (European Staples Equity Research Analyst)

Perfect. Thank you.

Emmanuel Babeau (CFO)

Thank you.

Operator (participant)

We'll take our final question from Priya Ohri-Gupta with Barclays. Please go ahead.

Priya Ohri-Gupta (Managing Director)

Hello. Thanks for squeezing me in. Emmanuel, I was hoping that we could touch on your cash flow performance in the quarter a little bit. It sounds like the weakness was somewhat related to timing factors, because one, two is seasonally your weakest. If you could just walk us through sort of what the drivers for that negative cash flow from operations figure were, that would be helpful.

Emmanuel Babeau (CFO)

No. Yeah, absolutely. Indeed, Q1 has not been great in terms of cash flow performance, but that was, again, expected. That is linked with the timing of shipments, excise duty payment, and some of the working capital. There was nothing surprising. I mean, I would have preferred to see higher operating cash generation in Q1, but that was expected, and we are absolutely confirming the objective for the year of an operating cash flow between $10 billion-$11 billion.

Priya Ohri-Gupta (Managing Director)

Okay, thank you. Just a housekeeping item. Could you give us the pro forma leverage, including the benefit of Swedish Match for a full year versus the reported numbers that were in the release?

Emmanuel Babeau (CFO)

No, I don't think it was in the release. I don't know whether we'll communicate that, but I mean, you can come to us. I'm not sure to understand fully what your question, because we, I think you have the data to calculate things, but you can come back to us, and we'll see whether we can show where the information is available.

Priya Ohri-Gupta (Managing Director)

Sure. I think that the sequential increase in leverage, if you put in a full year's benefit of Swedish Match, is closer to about 0.2 of the turn versus just the higher figure that was reported. Is that directionally right?

Emmanuel Babeau (CFO)

Yeah. No, I think you are alluding to the fact that we concluded 2022 saying, well, we are around 2.9x, but of course, that would be lower and significantly lower, and maybe about what you are saying here, if you were to take the full year of Swedish Match.

Priya Ohri-Gupta (Managing Director)

Okay, perfect. Thank you so much.

Emmanuel Babeau (CFO)

You're most welcome.

Operator (participant)

All right. There are no further questions at this time. I'll turn the call back over to the management team for any closing remarks.

James Bushnell (VP of Investor Relations and Financial Communications)

Thank you all for joining today. That concludes our call. If you have any follow-up questions, please contact the investor relations team. Thank you again, and have a great day.

Emmanuel Babeau (CFO)

Thank you all. Talk to you soon. Thank you. Bye-bye.

Operator (participant)

Thank you. This does conclude today's program. Thank you for your participation. You may disconnect at any time.