Philip Morris International - Q2 2023

Transcript

Operator (participant)

Good day, everyone, and welcome to the Philip Morris International second quarter 2023 earnings conference call. Today's call is scheduled to last about one hour, including remarks by Philip Morris International Management and a question-and-answer session. In order to ask a question, please press the star key followed by the number one on your touchtone phone at any time. Media representatives on the call will also be invited to ask questions at the conclusion of questions from the investment community. I would now like to 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 second quarter results. The press release is available on our website at 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 Exhibit 99.2 to the company's Form 8-K, dated July 20th, 2023, 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, our Chief Financial Officer. Over to you, Emmanuel.

Emmanuel Babeau (CFO)

Thank you, James, and welcome everyone. Our business delivered outstanding performance in the second quarter of 2023, exceeding our expectations to reach a record high quarterly adjusted diluted EPS of $1.60. This was driven by impressive ZYN and IQOS growth, coupled with strong combustible results. We delivered total cigarette and HTU shipment volume growth of +3.3%, putting us well on track for our third consecutive year of positive volumes. This excellent result underpinned double-digit organic top-line growth and high teens currency neutral adjusted diluted EPS growth. We also expanded our leadership in smoke-free product in the period. Firstly, IQOS strong momentum continued with adjusted in-market sales volume ahead by +16% and shipments up by +27%. This reflects very good user growth of +1.4 million in the quarter and continued strong traction across the world.

This is increasingly driven by IQOS ILUMA, which is now available in 23 markets, representing around 2/3 of our IQOS business by volume. Now 2 full quarters after the Swedish Match acquisition, ZYN is delivering an exceptional acceleration to our smoke-free business. U.S. volumes grew by over +50%, including a notable step-up in June. We are delighted with this performance. Our combustible business also delivered better-than-expected results, with over +7% organic net revenue growth after a very robust quarter for pricing and resilient volume. This was a key contributor to the strong +7% organic operating income growth, with a +200 basis points sequential improvement in our adjusted operating income margin.

Turning to the headline numbers, positive volumes supported very strong organic top-line growth of +10.5%, with continued excellent IQOS momentum and a further acceleration in combustible pricing. This does not include the remarkable +19% pro forma ex-currency top-line growth of Swedish Match, led by ZYN, with combined pro forma ex-currency net revenues increasing by +11.1%. Our total reported currency-neutral net revenues grew by +19%. Our organic net revenue per unit grew by +7%, driven by the increasing proportion of IQOS HTUs in our sales mix and combustible pricing. Due to these positive factors, adjusted operating income grew by a very robust +7% organically, despite continued inflationary headwinds. This excludes the tremendous growth of ZYN, and starting in Q4, our organic result will include Swedish Match.

Adjusted OI margins improved +210 basis points sequentially, and while still organically lower year-over-year by 140 basis point, this better-than-expected performance was notably supported by combustible strength and favorable timing of certain costs. We also increased our participation in the below Tier 1 segment in Indonesia, which now represents close to 40% of its industry volumes and is slightly dilutive to our margins. This organic delivery, including the favorable timing of cost, combined with exceptional June ZYN volume and a lower tax rate, allowed us to outperform our most recent Q2 forecast. We delivered adjusted diluted EPS of $1.60, representing +16.9% growth, excluding an unfavorable currency impact of certain cents, notably due to the Japanese yen.

While the first quarter of the year contained some exceptional headwinds and distortion due to timing and comparison effects, our business delivered a strong first half, including volume growth of +1.1%. Organic net revenues grew by +6.8%, with Swedish Match excellent ex-currency pro forma net revenue growth of +17% for H1, demonstrating its growth accretion to our business. Combined pro forma currency-neutral net revenue increased by around +7.5%. Following peak margin headwinds and a notable operating income decline in the first quarter, the strong improvement in Q2 narrowed the H1 organic decline to -2%. As in Q2, this excludes Swedish Match, which delivered an excellent profit performance and made a significant contribution to our adjusted OI margin. We expect continued strong reported and organic operating income growth in the second half.

Despite these headwinds, we delivered +5.9% growth in currency neutral adjusted diluted EPS to $2.98 in H1, providing a strong platform for the second half of 2023 and beyond. Let me now walk through the mechanic of our Q2 net revenues. While not included in our reported shipment volume growth of +3.3%, Swedish Match smoke-free volume grew by +15%, providing impressive accretion to our overall growth profile. Combustible and HTU pricing contributed +6 points of growth. This primarily reflect combustible strengths, partly benefiting from timing effect. As in Q1, HTU pricing was impacted in Japan and Germany by the annualization of 2022 excise tax increase, and in the case of Japan, the transition to ILUMA. These factors will have less impact in the second half as annualization recedes.

We also continue to expect greater visibility on the likely outcome of the court ruling related to the German tax surcharge towards the end of the year. The increasing proportion of HTUs in our business, again, contributed positively, reflecting higher net revenue per unit, partially offset by unfavorable geographic mix. The positive mix impact of HTUs overall volume growth and pricing are powerful drivers of our transformation and growth. Let's now turn to growth margins. While the year-on-year trajectory remained negative, we saw improvement versus the first quarter, driven by strong growth fundamentals. Indeed, we achieved sequential improvement of 1.2 percentage point despite increased inflationary pressures as top-line growth accelerated and supply chain disruption and ILUMA-related factors started to dissipate in the quarter. In addition, cost phasing and the geographic mix of inventory movement, notably for HTU in Europe, increasingly normalized after an adversely affected Q1.

Our IQOS business contributed positively to our growth margin in Q2, and we expect this to continue, partly mitigating combustible. We expect further improvement in our year-over-year growth margin trajectory in H2, as headwinds continue to subside, ZYN's outstanding growth continues, the underlying driver of our transformation accelerates. As expected, SG&A growth was much closer to net revenue growth in Q2 and at a more normalized growth rate with regard to our full year expectation. Indeed, with such a strong top line in Q2, SG&A costs were lower as a % of net revenues. While we continue to invest in IQOS and ZYN, our successful cost efficiency program continues to deliver, helping to finance growth investment and mitigate inflation, which remains a headwind.

With $1.9 billion of growth savings realized to date, including $820 million from SG&A, we are on track to achieve our 2021, 2023, $2 billion target ahead of plan. Turning now to the 2023 outlook, we are raising our currency neutral top and bottom-line growth forecast. We aim to be a growth company, starting with volumes. In 2023, we expect to grow total volume for the third year in a row, even before factoring in the excellent progress of Swedish Match portfolio. As part of this growth, we are reiterating our targeted HTU shipment range of 125 billion-132 billion, while we expect a cigarette volume decline of 1.5%-2.5%.

We are increasing our organic net revenue growth forecast to +7.5% to +8.5%, reflecting the continued momentum of IQOS, the resilience of our combustible business, and the ongoing excellent growth of ZYN, which we expect to contribute positively in Q4. We expect strong organic operating income growth in the remainder of the year to support H2 margin expansion, despite the headwinds previously mentioned and certain technical impact. These relate to the increased use of third-party manufacturing in a few markets, such as Indonesia and Ukraine, and the related growth of the below Tier 1 segment in Indonesia I already mentioned. The full year estimated impact of this factor is around 40 basis points on our adjusted OI margin, and without this impact, we would expect to be broadly in the middle of our forecast organic margin range.

On top of this organic evolution, we expect Swedish Match to add around 50 basis points of accretion. Our strong top line and OI outlook allows us to raise our forecast for currency-neutral adjusted diluted EPS growth to +8% to +9.5%. This translates to a revised range of $6.13 to $6.22, including $0.33 from unfavorable currency at prevailing exchange rate, notably due to the Japanese yen and Russian ruble. This forecast continues to assume around $150 million for incremental investment in the U.S. and our wellness and healthcare business. It also assumes around $1.2 billion in net finance costs, which includes higher interest on variable debt, partly offset by better returns on cash deposits. As previously mentioned, our forecast do not assume any contribution from a potential favorable ruling on the Germany tax surcharge.

Focusing on the second half in more detail, we expect strong performance on all key metrics as smoke-free product deliver an increasingly positive impact. In Q3, we forecast high single-digit organic top-line growth, with HTU shipments of 31 billion-33 billion units and adjusted diluted EPS of $1.60-$1.65, including $0.06 of unfavorable currency at prevailing exchange rate. Looking ahead to Q4, we expect notably strong reported and organic OI growth as certain inflationary impact are annualized, and we increasingly benefit from an optimized ILUMA supply chain and consumable. As I mentioned, Swedish Match will also be included in our organic figures during the quarter. The exceptional growth of ZYN is clearly margin accretive, as visible in our adjusted H1 figures.

Turning back to our results, our total shipment volume increased by +3.3% for Q2 and +1.1% year-to-date. HTU shipment volume grew by +26.6% in Q2, to reach 31.4 billion units, notably driven by continued strong performance in Europe and Japan. In addition to fundamental strength, HTU shipments to Japan were boosted in Q2 by around 2 billion units as we increased sea freight, with corresponding increase in inventory level. As I mentioned earlier, total PMI-adjusted IMS volume of HTUs increased by +16% in Q2, continuing the excellent trends in Q1. H1 shipment volume grew by +18.5%.

Notably, this does not include the excellent growth prospect of oral nicotine, for which shipment volume grew by +14% in Q2 and +12% in H1 on a pro forma basis. Cigarette volume declined by a modest 0.4% in Q2, with notable support from Turkey and Egypt, and by 1.7% for H1, reflecting a solid category share performance in a resilient category despite stepped-up pricing. Our smoke-free transformation continues to progress rapidly. Due to the continued impressive performance of IQOS, heated tobacco units comprise 16.4% of our total shipment volume in H1, as compared to 14% in the first half of 2022, despite a resilient cigarette category. Including all smoke-free product, this would be close to 18%.

Powered by IQOS and ZYN, smoke-free product made up 35% of our adjusted net revenue in H1, compared to 30.9% for the same period in 2022. IQOS devices accounted for approximately 4.5% of our H1 inhalable smoke-free net revenue. Focusing now on combustible. Our portfolio delivered strong organic net revenue growth of +7.4% in Q2 and +5.2% in H1. This reflects strong Q2 pricing, with a notable contribution from Indonesia and the Philippines. While we don't expect the exceptionally strong Q2 pricing, of 9.4%, which benefited from timing factors, to be fully replicated in H2, we now forecast a full-year increase of +7% to +8%.

Our cigarette category share grew by +0.7 points in Q2 on a year-over-year basis, including contribution from duty-free, Egypt and Turkey, and by +0.1 point in H1, resulting in only modest volume declines. Our leadership in combustible helps to maximize switching to smoke-free products, and we have fully achieved our ongoing objective of stable category share over the last 18 months, despite the impact of IQOS cannibalization. The combination of a stable share in combustible and the continued growth of our leading smoke-free brands position us to deliver total market share growth over time. We captured +1.1 points of international cigarette and HTU share in Q2, and +0.5 point in H1, with notable contribution from Turkey and Japan.

Impressively, despite increasing competition in many markets, our volume share of the growing heat-not-burn category remains stable at around 75%. This is supported by ongoing ILUMA market launches and increasing focus on our two-tier HTU portfolio, providing adult smokers with an expanding range of innovative and high-quality alternatives to cigarettes. PMI HTUs again strengthen their position as the second largest nicotine brand in markets where IQOS is present, with a sequential share gain in Q2 of +0.2 points to a record 9.2% share. We estimate there were 27.2 million IQOS user as of June the 30th. This reflects excellent growth of +1.4 million adult user in Q2, with notable progress in Japan and Europe, in addition to a broad range of other geographies.

While fundamentals remain very strong, I remind you that Q3 user growth can often be below the average for the year due to the seasonal factors evident in prior years. I will now turn to IQOS in the Europe region, where we are approaching a milestone of 12 million users. This reflect the further rollout of ILUMA, which is now available to around 70% of IQOS users in the region, and the expansion of our two-tier portfolio. As an illustration of its progress, TEREA is already close to 100% of our HTU in-market sales volume in the first launch market of Spain and Switzerland. Our second quarter HTU share increased by +1.6 points year-over-year to 9% of total cigarette and HTU industry volume.

While sequential share is, as usual, optically affected by the seasonality of the cigarette category, adjusted IMS volume continued to exhibit robust sequential growth and reached a record high on a four-quarter moving average. This reflects strong year-on-year growth of +20% in Q2, outstripping the +11 growth in HTU shipments, which were affected by some residual effect from the inventory dynamic seen in Q1. We expect robust growth in HTU shipments, adjusted IMS, and overall region organic revenue in the second half. We continue to be encouraged by the increasing number of European countries adopting multi-year excise tax plans with clear differentiation of smoke-free product. Over half of EU member states have now passed multi-year plans. Also in the EU, a number of member states are currently transposing the Delegated Directive, withdrawing the heated tobacco product exemption from the flavor ban into national legislation.

The ban is scheduled to come into effect on October 23rd. We will be adjusting our HTU portfolio as required in line with this transposition. While short-term volatility is possible, we do not expect a significant change in the structural growth of the category. To give some further color on our continued progress in the region, this slide shows a selection of the latest key city offtake shares. The success of IQOS continues across a diverse range of geographies from Western, Southern, Central, and Eastern Europe, including market with and without ILUMA. Despite the denominator effect of the combustible category I just mentioned, share results remain very strong. We are very pleased with trends in Rome, showing a sequential step up to 28% share following the ILUMA launch. Robust progress in London and Munich also bodes well for these two key markets.

While the Q2 2022 comparison for share in Vilnius was helped by the popularity of certain bundle offers, the share of over 40% remains impressive and underlying offtake continues to grow. In Japan, IQOS ILUMA continues to drive impressive growth momentum. Smoke-free products made up over 75% of our Japan net revenue in H1, clearly showing the path for the broader company. Adjusted total tobacco share for our HTU brands increased by +3.4 points in Q2 to 26.3%, further strengthening TEREA and SENTIA's position as a clear number 1 and 2 heat-not-burn brands despite intensified price competition from mid and low price offering. Importantly, adjusted IMS volume again grew sequentially, reaching a record high of 9.3 billion units on the fourth quarter moving average as IQOS outgrew the heat-not-burn category.

In addition to this excellent consumer trend, our Q2 shipment to Japan also benefited from progressively switching back to sea freight during the quarter. In addition to strong IQOS gains in developed countries, we continue to see very promising growth in low and middle-income markets. This slide highlights a selection of Q2 key city offtake shares across markets in Eastern Europe, Africa, Asia, and Latin America. Notable ongoing successes include Egypt, with scale offtake shares surpassing 8.5%, and Bulgaria, with offtake share in Sofia exceeding 15%, despite the usual impact of seasonality that I mentioned. We continue to see robust offtake volume growth across these important future markets. Moving to Swedish Match, which is meaningfully accelerating our smoke-free growth trajectory.

As covered earlier, the business delivered outstanding currency neutral net revenue growth of +19% in Q2 and +17% in H1. This means that in the first half of the year, Swedish Match has added 70 basis points of currency neutral growth to our pro forma top line and +60 basis points to our adjusted OI margin. In the U.S., ZYN delivered another exceptional quarter with volume growth of over 50%, reflecting positive momentum across the country. Elsewhere in smoke free, recent trends of share gain in U.S. smoke snuff, as well as category mix headwinds in Scandinavia, broadly continued. The cigar business performed well, with Q2 organic net revenue growth of +16%. This reflects ongoing share gains, despite being an early mover on category pricing.

I would like to again congratulate and thank all the Swedish Match employees for continuing to deliver terrific results as we thoughtfully integrate our activities, which is progressing very well. Looking at Zyn U.S. performance in more detail, exceptional year-over-year volume growth in can of +53% also reflect a +22% sequential increase versus Q1 2023. This accelerated growth reflects progressive increase in distribution and a broad nationwide step-up in store velocity as the category gains strong traction with adult nicotine user for its convenience and pleasurable experience. This includes California, which implemented a statewide flavor ban in December. While such elevated rates of growth may not continue indefinitely, the structural indicators remain very encouraging. Impressively, Zyn category volume share grew +2.2 points compared to prior year and +1 point sequentially, despite continued discounting from less premium offerings.

Retail value share also grew to 76.8%, highlighting its premium positioning and superior brand equity. Let me provide an update on our innovation and expansion plan as we further accelerate our smoke-free transformation. First and foremost, the global rollout of IQOS ILUMA continues to be a top priority. We launched ILUMA in 6 markets in Q2, and with HTU manufacturing constraint now normalized, we aim to be present in around 50 markets by the end of the year. The most significant opportunity to drive accelerated growth is in the U.S. We are investing behind ZYN and readying our organizational and commercial capabilities for the launch of IQOS in Q2 next year. As mentioned in today's release, we are also on track for IQOS ILUMA PMTA and supplemental MRTPA submission in Q4 2023. Our philosophy on the U.S. remains unchanged.

We will seek to accelerate our top line with IQOS and Zyn, supported by disciplined investment and leveraging both our extensive experience in smoke-free product and Swedish Match infrastructure and knowledge, while continuing to deliver strong bottom line growth for PMI. Our pilot city launches for Bond in the Philippines and Colombia continue to progress well. The learning from this market will be integrated as we roll out more broadly, starting next year. The international expansion of nicotine pouches remains a key medium-term opportunity, notably for Zyn, as the world's leading brand. We are now preparing for the relaunch of Zyn in several markets. In e-vapor, our refocused approach in select market is progressing with VEEV One, our newly designed pod-based system, introduced in 4 markets, and VEEV Now, our disposable product in 6 markets.

Let me discuss our wellness and healthcare segment, starting with its first clinical trial result for our inhalable aspirin product. While it was observed that the experimental product had a rapid onset of effect, which is a key medical advantage sought, there was significant variability in inhaled dose among subjects. The study was therefore deemed unsuccessful, and as a result, product design improvements are required. Our plan was to file this product with the FDA later this year. Additional time is now required, and the outcome is therefore less certain. The CDMO business has been facing slower than anticipated development, including cost-related challenges. We recorded a non-cash goodwill impairment from our annual assessment, as detailed in today's release.

While these elements will postpone the achievement of our 2025 aspiration to reach over $1 billion of net revenue from wellness and healthcare product, they will result in a corresponding decrease in the level of investment in 2024. Our ambition to build and monetize our product pipeline are unchanged. As in the early days of developing IQOS, certain headwinds are to be expected, and the 2021 acquisition in this segment has provided us with unique and enabling R&D capability. We remain committed to developing our wellness and healthcare business and continue to see attractive mid- and long-term growth potential on many fronts, such as inhalable drugs, NRC, and consumer wellness products, including non-recreational cannabinoid, in line with applicable regulatory requirements. We also aim to accelerate Vectura's growth and will be exploring potential partnerships to enhance its CDMO business.

We plan to discuss all these topics, including our plan for IQOS in the U.S. and a full update on our wellness and healthcare business at our Investor Day on the 28th of September in Lausanne, Switzerland. Moving now to sustainability. Addressing the product health impact of combustible product by switching adult smoker to smoke-free products, such as IQOS and VEEV, remains our most critical priority. This transformation is at the core of our strategy, driving accelerated growth and returns over time from a more sustainable business. In addition, we remain committed to delivering best-in-class progress in other key sustainability areas. With our extensive agricultural and manufacturing supply chain, human rights are very important responsibility for our company. We released our first dedicated report on the topic last month, detailing our strategy to promote, respect, and protect human rights and the progress to date in implementing our human rights commitments.

Our performance on human rights is included in the 19 KPIs of our Sustainability Index, which comprises 30% of executive long-term equity compensation, weighted towards our product transformation. Our goal is to conduct comprehensive human rights impact assessments in our 10 highest risk market by the end of 2025. This help us better understand and address our impacts, and we are making excellent progress, with seven completed to date. Addressing climate change is another priority for us, and I am pleased to share that PMI was included in the Forbes first-ever Net Zero Leaders List, ranking seventh overall for all U.S. public company, higher than any other consumer product or service company.

To conclude today's presentation, we delivered a very strong first half, despite a number of headwinds, putting us on track for the third consecutive year of positive volume and organic net revenue growth of over +7%. The powerful trajectory of our smoke-free business give us confidence in a strong full-year performance with excellent operating income growth. Outstanding momentum continues for IQOS and ZYN, the world-leading heat-not-burn and oral nicotine brands, and we have exciting plans to further grow oral nicotine pouches in the U.S. and internationally, along with the U.S. commercialization of IQOS next year. Importantly, we remain steadfast in our commitment to generously reward our shareholders, including through our progressive dividend policy. In short, our smoke-free transformation continues to deliver sustainable growth. We look forward to sharing more with you on the next phase of our transformation at our Investor Day on September the twenty-eighth.

Thank you very much. We are now delighted to answer your questions.

Operator (participant)

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 key followed by the 1 on your touchtone phone. In the interest of fairness and time, we ask that participants keep to a maximum of 2 questions each. If time allows, follow-up questions may be taken. You may rejoin the queue again by pressing star and 1 on your touchtone phone. Our first question comes from Pamela Kaufman from Morgan Stanley. Your line is now open.

Pamela Kaufman (Executive Director and Equity Analyst)

Hi, good morning.

Emmanuel Babeau (CFO)

Morning, Pam.

Pamela Kaufman (Executive Director and Equity Analyst)

I wanted to ask about your full year guidance. You exceeded your own Q2 guidance by at least $0.13. Did not flow through the EPS beat to the full year outlook, even when factoring the greater FX headwinds. What's tempering the flow through of Q2 upside, and how much does this reflect conservatism around the balance of the year versus a more cautious outlook on the second half or higher investments? Thanks.

Emmanuel Babeau (CFO)

Thank you, Pam. When we look at the driver for beating our initial expectation for Q2, I think we can probably make three buckets. One is the outperformance of ZYN versus our expectation, and that's something that we are of course, taking into account as we see a better trajectory for ZYN than initially anticipated. Remember, that will only contribute to our organic growth on revenue in Q4, but that is, of course, helping the adjusted EPS growth, excluding Forex. We also see some costs that have been moved to H2, and that is, if you want, costs that are we going to see in H2, so it's not a net addition for the year. Then there was, as we said, some better news on a financial cost, you know, cost on our debt.

There was also some element on tax. Of course, this one is more uncertain and more difficult to predict for the second part of the year. I think as always, you know, we are building scenario for the full year. We've been put including in a clear way what we see a real change in the trajectory and on which we have visibility for the second half. On things where we have postponement or things with good news, but of course, we still a lot of uncertainty on H2, of course, we have to be a bit more cautious when we take them in the scenarios.

Pamela Kaufman (Executive Director and Equity Analyst)

Okay, thanks. Just on operating margins, you pointed to operating margins closer to the lower end of your initial guidance range of down 50 to 150 basis points for the year. Can you discuss the puts and takes impacting your margin performance in the second half?

Emmanuel Babeau (CFO)

When you look at the margin, really things are happening as expected, I would say. After Q1, which was not coming as a surprise to us, we said from now on, we're gonna see an improvement of the margin trajectory. We knew that inflation would still be there, you know, for the rest of the year, although in the second part of the year, we're gonna be facing comparison where inflation was starting to kick in, so that's gonna have some impact. We knew that a number of other headwinds start to abate, and here I'm talking about the disruption on the supply chain and, you know, among other things connected with air freight.

The cost attached to the launch of IQOS ILUMA, and the fact that not everything was optimal, so we started to see improvement in Q2 as expected, and we're gonna continue to see improvement in the rest of the year. What we see playing in Q2 that we expect to see playing in the rest of the year, are the fundamental positive drivers that we have for our margin. The fact that IQOS growth is having a positive impact on our margin. We said it since the beginning, we expect a positive contribution on margin evolution for the year from the heat-not-burn business. Remember, we have a higher gross margin rate on our consumable for IQOS, so as we are growing IQOS, that is having a positive impact.

There is now, when it comes to our smoke-free business, another driver that is positing for our margin, which is ZYN and ZYN in the U.S., which is also accretive to the margin. You don't see it in the organic reporting so far, but it's gonna start to kick in in Q4, and we expect to have another nice positive. The third element that I think, you know, you see of course, nicely in Q2, is our pricing power. We see it today very clearly on combustible. We have some headwinds that are temporary coming from Germany and Japan on heat-not-burn, but we retain pricing power, which is positive for the long term. These are good elements.

Of course, in front of that, we will keep investing and making sure that we are maximizing the growth potential. That's really what is behind the margin development for the year. On top of it, and I think we've been trying that during this quarter, we have the development of businesses that are coming with lower margin because we are buying to sell parties, and that is a different margin dynamic. Also this business, which we call below T1, which is in fact with reduced excise duty in Indonesia, that is coming with lower margin. It's more a technical effect, I would say. As mentioned, without that, we would have been, in fact, in the middle of the bracket that we gave, the 50 to 150 negative.

Again, this is not reflecting the positive contribution for ZYN. I would say, as a summary, things are happening as expected. We start to see the fact that we have, on the long term, some fundamental positive driver for our margin that I summarized.

Pamela Kaufman (Executive Director and Equity Analyst)

Thank you. That's very helpful.

Emmanuel Babeau (CFO)

Thank you.

Operator (participant)

We will take our next question from Vivien Azer with TD Cowen. Your line is open.

Vivien Azer (Managing Director and Senior Research Analyst)

Hi, good morning.

Emmanuel Babeau (CFO)

Hi, Vivien.

Vivien Azer (Managing Director and Senior Research Analyst)

I wanted to follow up on the commentary on ZYN, certainly consistent with the very robust trends that we're seeing in the NielsenIQ scanner data, accelerating growth, strong market share gains. You've spoken in the past about the opportunity to offer some incremental investment to that business unit to expand the sales force, improve distribution and drive velocity. Can you just talk to us about where you are in that investment time horizon for ZYN, please? Thank you.

Emmanuel Babeau (CFO)

Sure, Vivien. Yeah, ZYN is, of course, I mean, we knew that the brand was great. I think we are seeing something that is above our initial expectation, to be very clear, for the time being, at the time of the acquisition of Swedish Match. There is a clearly a growing awareness of this category. We see a lot of dual use. You have a percentage that is fully converted, but a lot of dual use. We talk about people discovering that they can enjoy their nicotine in moment where they cannot enjoy, whether they're combustible cigarette or other inhalable product, that is certainly playing. I think there is a very positive lifestyle element around the development in the U.S. that is gathering momentum.

That is, I think, explaining the success of ZYN that is the icon of the category and of course, taking today the lion share of the growth of this nicotine pouch progression in the U.S. That is very good news, of course, because that mean that we have a very dynamic business in the U.S. To be very clear, it's not marginal at the group level, so you will see, and you already see in the performance, the impact of this ZYN U.S. performance. That's great to have another driver for our smoke-free performance and globally for the financial performance of the company. It's setting the scene very well for IQOS, because on top of what is successful, we're gonna be able to build a very efficient commercial engine. You said it, increased sales force.

We're in the making of that. It's happening progressively. It's of course, going to help both ZYN and IQOS, that also bodes very well for our capacity to develop IQOS successfully in the future in the U.S. We're gonna have a convergence of strengths between ZYN and IQOS. To be very clear, we haven't been, you know, suddenly increasing at that stage by several hundred people in the sales force. It's happening gradually as we build the capacity for IQOS, starting Q2 next year. There is other investment that we are doing in our digital capacity and the digital commercial engine. Again, just the beginning, I don't think it is really today behind the goal that we see behind ZYN, these are additional strengths and capacity.

Again, I think we are very excited about the amazing teams that IQOS and ZYN can be in the future in the U.S.

Vivien Azer (Managing Director and Senior Research Analyst)

That's really helpful. Thank you for that. Then just moving to.

Emmanuel Babeau (CFO)

Thank you.

Vivien Azer (Managing Director and Senior Research Analyst)

the wellness and healthcare segment for my second question, please. you know, understanding some of the challenges around, the clinical trial, I was wondering if you could just comment on your aspiration to delever the balance sheet, post the Swedish Match transaction, versus the potential need for incremental M&A as you think about, you know, an ultimate $1 billion revenue target, understanding that you pushed out the date for that. Thank you.

Emmanuel Babeau (CFO)

Yeah, I want to be very clear, I mean, the focus is on deleveraging the balance sheet. We are focusing on extracting the great potential that we have in our smoke-free business. I mentioned IQOS and ZYN together. We certainly want to grow VEEV as well, but I think there is so much potential on IQOS and ZYN that it's of course the key focus today. We are spending our time, energy on maximizing the potential there, and that's gonna generate deleveraging. The time today is not for us to think about, I would say, structural move on M&A in other spaces. We are very much focused on optimizing this great potential that we have in our smoke-free business today.

Vivien Azer (Managing Director and Senior Research Analyst)

Thank you.

Emmanuel Babeau (CFO)

Thank you.

Operator (participant)

We will take our next question from Gaurav Jain with Barclays. Your line is open.

Gaurav Jain (Consumer Analyst of Global Tobacco and Cannabis)

Hi, good morning.

Emmanuel Babeau (CFO)

Hi, Gaurav.

Gaurav Jain (Consumer Analyst of Global Tobacco and Cannabis)

Hi. I have a question on ZYN in the U.S. The volumes are coming in much ahead of where I think consensus is, where we were. We also know that U.S. cigarette volumes have persisted at very weak rates despite easy comps. What do you think is the cannibalization rate of ZYN on U.S. cigarettes today? You know, as you project out IQOS growth over the next 7 years, if ZYN's cannibalization is higher than what is thought of, does it mean that the cigarette universe is smaller, which implies that the IQOS opportunity is smaller?

Emmanuel Babeau (CFO)

It's Gaurav, an excellent question. I believe, first of all, I'm not going to be able to give a precise answer, as you can imagine. I believe that there is probably some cannibalization for the reason I mentioned. We see, you know, behaviors developing of people that probably are or were combustible user, and they discover that they can enjoy their nicotine in a different manner, with certainly positive perception on when they can do it and the impact, you know, on them. Now, I'm not able to tell you whether this is something very material. I don't have any data at that stage. I'm sure we'll try to elaborate on the ZYN driver on the 28th of September.

As I said, I'm not able to share with you know, any hard data on how it's materializing. Frankly, I don't think that this is gonna be really relevant for for IQOS, because maybe, you know, in a kind of super marginal manner. You know, we talk about with IQOS smokers who want to enjoy, when they are still enjoying today, combustible cigarette, a different product that is mimicking very closely their pleasure with clearly personal benefit on their health, but also on their lifestyle. I don't see the ZYN moment as something that is going to compete with IQOS in a meaningful manner. I think that that's not something that we see as a risk to undermine IQOS potential in the future.

Gaurav Jain (Consumer Analyst of Global Tobacco and Cannabis)

Sure. Thank you. The second question I have is on this EU heated tobacco flavor ban, and you know, you mentioned that there could be some volatility. The experience in California has been pretty bad for, you know, post the menthol cigarette ban, and that only 70% of the menthol smoker seem to have been retained in the cigarette market. Like, what is the precedence? Is there any precedence of a flavored heated tobacco ban anywhere, which helps you form the view that the impact will be?

Emmanuel Babeau (CFO)

Yes.

Gaurav Jain (Consumer Analyst of Global Tobacco and Cannabis)

quite minimal?

Emmanuel Babeau (CFO)

Yes, there is, Gaurav. I will take two example. One, in Europe, when there was the menthol ban, the flavor ban, in May 2020, where it had minimal impact on the combustible business, very, very small. That's one illustration. The other one is actually, because here we talk about, you know, growing product. The other one here is the ban on flavor in California, that impacted ZYN at the end of 2022. There was a few weeks with a blip on the volume, then the momentum came back, you know, on non-flavored product, actually with even more intensity, and blip has been swallowed, and you don't see today any impact of this ban.

I think here you have two element experiences that show that this is having minimum impact. Again, we're comparing in California with growing a category which, you know, maybe is more appropriate. But referring to combustible in Europe in May 2020, the impact was de minimis.

Gaurav Jain (Consumer Analyst of Global Tobacco and Cannabis)

Okay, sure. Thank you so much.

Emmanuel Babeau (CFO)

Thank you.

Operator (participant)

We will take our next question from Bonnie Herzog with Goldman Sachs. Your line is now open.

Bonnie Herzog (Managing Director and Senior Consumer Analyst)

All right, thank you. Hi, Emmanuel.

Emmanuel Babeau (CFO)

Good morning, Bonnie.

Bonnie Herzog (Managing Director and Senior Consumer Analyst)

I'd like to circle back to your guidance with just maybe a quick follow-on question. You know, your full year guidance implies, I guess, more riding on Q4. Just hoping you could help us understand, you know, maybe your level of conviction and/or visibility that your business really will strengthen so much later this year. I know it's early, and I don't expect you to guide next year, but is there anything we should think about that you're investing in this year that really could position you for even greater growth, you know, next year and beyond?

Emmanuel Babeau (CFO)

Bonnie, trying to be back on H2. I think you see it already in Q2. I mean, the momentum behind IQOS is there. We see it, 1.4, we estimate 1.4 million user growth in Q2. That's an excellent number. We see in-market sales going up. We know that there is seasonality, but it doesn't mean that the consumer offtake is going to decrease. There is more launch of ILUMA and some of them that happen in the end of H1, that is going to contribute as well in the second part of the year. We see very robust momentum there.

We see the work that we've been doing, and as we said, you know, the highest intensity of price increase has happened in Q2, is gonna be lower in H2, and we've been defending our market share well in a market that is resilient. You know, we may discuss why CC is so resilient, but the fact is that combustible is proving to be resilient in many geographies. There is a ZYN moment, clearly the ZYN momentum, which, you know, we're not saying we're gonna keep growing at 50%, of course, but clearly, we expect momentum to continue super nicely on ZYN, and starting Q4, that will also contribute to the organic growth.

In any case, it's gonna fully contribute to adjusted EPS growth, excluding Forex. All that, you know, give us the confidence that we are set for a very, very good and very strong H2 in term of performance. When we look towards 2024, we believe that the growth driver are gonna stay the same. IQOS with, of course, the launch in Q2 in the U.S., but let's be clear, it's gonna be the beginning, so it's not going to immediately have a huge impact. It's gonna be a ramp-up as we explain. There will be a number of country where ILUMA will be fully delivering. Look at Japan. That's quite interesting what happened in Japan.

In fact, we've seen a kind of another acceleration on market share and volume one year after the launch of ILUMA. It's not as if the whole positive impact was happening in the first, in the first weeks. I would say it takes some time to create the awareness, the understanding, and the positive appreciation. Then we're gonna have ZYN, and nicotine pouches. ZYN, first of all, starting in the U.S., but a number of exciting launch outside the U.S. as well. That is boding well for 2024. Of course, it's premature to talk about 2024, and we'll give guidance in due course.

Bonnie Herzog (Managing Director and Senior Consumer Analyst)

Okay, that all makes sense and helpful. I just, you know, for my second question, I was, you know, hoping for some more color on Japan, and, you know, it looks like your shipping volume was really strong in the quarter, your market shares increased nicely. Excuse me. Could you talk through key drivers of this? I believe BAT is cutting their prices on glo HYPER, starting in August. Could you talk through the current competitive environment and then maybe, you know, how you expect it might change in light of these actions, as well as how, you know, you may need to respond, if at all? Thank you.

Emmanuel Babeau (CFO)

Sure, Bonnie. Japan, of course, is a matter of great satisfaction. I was alluding to it, you know, the fact that 1 year after the launch of ILUMA, we see a further acceleration of our market share. We are now above 26%. As I said, that shows that the brand keeps doing inroads, converting more people, making a big difference versus competition. And we are actually, we've seen our capture share of the growth of the category that continues to grow, increasing. We have a 2-tier strategy between Terea and SENTIA that is proving to be very efficient. We have the premium range, Terea, with a lot of innovation, you know, great flavor experience.

We have SENTIA, which is, of course, at a lower level in term of positioning. You know, with these two, I would say, range, we managed to really reach the broadest possible member of IQOS ILUMA user, and that's clearly showing some great success. We are back in Japan to sea freight progressively, that was expected. Last year, the shipments were lower than the consumer offtake, this year, that is, of course, we're going back to the normal situation. That was absolutely planned. We see indeed, competition while trying to fight. They see the category that keeps having a lot of traction and gaining share.

They are fighting to keep growing when ILUMA is clearly doing well, and so far, they believe that their way forward is to come with cheaper consumable. That's, of course, their decision. I won't comment on that. It's clear that despite that, we managed to grow the share. It's good to see that there is a clear growing commitment from the whole industry behind the category in Japan.

Bonnie Herzog (Managing Director and Senior Consumer Analyst)

All right. Thank you again.

Emmanuel Babeau (CFO)

Thank you, Bonnie.

Operator (participant)

We will take our next question from Matt Smith with Stifel. Your line is open.

Matt Smith (Director and Senior Equity Research Analyst)

Hi, thank you for taking my question.

Emmanuel Babeau (CFO)

Hi, Matt.

Matt Smith (Director and Senior Equity Research Analyst)

I wanted to ask about the pacing of the rollout of ILUMA to 50 markets from the 23 markets where it's available today. Do you expect that to be fairly evenly spread across the second half? Could you talk about the rollout or the expansion, the impact on your operating margin in the second half, as well as your gross margin?

Emmanuel Babeau (CFO)

Matt. There will be a progressive, difficult for me, I mean, there will be events in Q3 and Q4 of launch of ILUMA in a number of countries. It's hard for me to tell you whether it's evenly spread, because I would have the ability to do that, depending on the size of each market, but it's gonna be relatively well spread. Let's be clear, we have already two-third of the IQOS volume that are exposed or benefit from ILUMA's presence. It's not marginal, but a big part of it has already been done. As we said, you know, at the beginning of ILUMA, we were not fully optimized on the product, on the productivity.

It doesn't mean that everything will be done at the end of the year, but we expect to certainly see an acceleration of productivity, reduction in the weight in the second part of the year, and that will have a positive impact on margin evolution. Absolutely in line with what I explained, a number of annualizations that are receding in line with expectation. That's really what you can expect for ILUMA in the second part of the year.

Matt Smith (Director and Senior Equity Research Analyst)

Thank you for that. If I could ask just a follow-up question on the combustible performance, it's been stronger in terms of both volume and organic revenue contribution. Then you've made a couple of comments about the demand environment holding up better than your expectation relative to the elevated pricing. Can you talk about the factors that are allowing the consumers to hold up elasticity better than your expectations? Do you expect that to continue now that you're going to lapse some pricing action?

Emmanuel Babeau (CFO)

Look, so far, I think that we've seen that pricing up doesn't mean that the consumer is going away. I'm not able to tell you how it's going to further evolve in the future. I think what we see globally on the combustible market is, first of all, a few markets where, because of the demographic, we see the consumption of combustible going up. I could certainly mention India, probably Egypt, Turkey, probably Vietnam, even if it's not a big market for us, where we see a combustible business going up. The resilience is also coming from a number of market where there is a ban on smoke-free products. Of course, that is to some extent protecting the combustible business. As you know, that's clearly not something that we like.

We think that it's a big mistake, but that is probably providing some resilience to the category, overall, though that would be my analysis on combustible.

Matt Smith (Director and Senior Equity Research Analyst)

Thank you for that, Emmanuel. I'll pass it on.

Bonnie Herzog (Managing Director and Senior Consumer Analyst)

Thank you, Matt.

Operator (participant)

We'll take our next question from Owen Bennett with Jefferies. Your line is now open.

Owen Bennett (Equity Research Analyst)

Afternoon, Emmanuel. Hope you are well.

Emmanuel Babeau (CFO)

Hi, Owen.

Owen Bennett (Equity Research Analyst)

Yeah.

Emmanuel Babeau (CFO)

Thank you, yeah.

Owen Bennett (Equity Research Analyst)

Related to heated competitive dynamics, so all three of your major tobacco peers now appear to be in a better spot, at least versus the past, with regard to product offerings, at least, and money they're investing. To this, I was just wondering if you could comment on IQOS trends in some of the more competitive heated markets, where all three of your major peers now have a presence, so like the Italy, for example. How is IQOS shareholding or is ILUMA having less traction in these markets than others? Are you seeing trial of other brands and consumers coming back to IQOS? Thank you.

Emmanuel Babeau (CFO)

Sure, Owen. Actually, you may have seen that our share of the category has remained stable in Q2 at around 75%. It shows that indeed there is increased competition, but the quality of IQOS and notably ILUMA, but not just ILUMA, the overall IQOS proposition is allowing us to, even if we are more premium, to maintain our share of the category, which is very good news. Here, I'm talking about volume. You can imagine in term of value, that is even higher. Now, let's be clear. Since the beginning, we knew, and I can say we were hoping for the whole industry to embrace heat-not-burn as the category of the future for inhalable nicotine product.

It's great to see a growing commitment from all the player behind that. No doubt that they will come with innovation. Ourself, as you can imagine, we're going to continue to innovate as well. We will see, certainly, innovation and, you know, new things coming in the future. Now, after six, seven, almost eight years of launch of IQOS, I think in term of franchise, in term of impact, in term of strength, in term of brand power, I think, you know, we are really second to none, and we made a clear gap and differential.

I think that this is exactly what we did with Marlboro in the past, which, you know, Marlboro was a superior product and recognized for the brand that was unique. On top of that, we managed to create a unique brand that was extremely appealing. I think with IQOS, that's what we are repeating today. IQOS products are clearly better, recognized as such. It's a different customer experience. The IQOS brand is also iconic, and people are seeing that as part of lifestyle and product they want to associate themselves with, which is a recipe for long-term success.

Owen Bennett (Equity Research Analyst)

Cool. Thank you, sir. I appreciate it.

Emmanuel Babeau (CFO)

Thank you, Owen.

Operator (participant)

We will take our final question from Jared Dinges with JP Morgan. Your line is open.

Jared Dinges (Equity Research Analyst)

Yeah, hi, guys. Like you talked about the ability to use sea freight finally to supply Japan, you know, as you progress throughout Q2. Would you be able to confirm that you're no longer capacity constrained on the TEREA sticks?

Emmanuel Babeau (CFO)

Yes. We can confirm that for the markets where we've been launching today, we have no constraint, and therefore, that's the reason why we've been able to move to sea freight. There is still a ramp-up for the remaining market that do not have ILUMA today, and this ramp-up is, of course, accompanying the growing capacity. It doesn't mean that today we could serve, you know, on the 1st of July, 100% of all the market, IQOS market, with ILUMA consumable, but we have no longer pressure or restriction and the fact that we are back to sea freight, and we have a plan to accompany the growth of the remaining markets in the coming months.

Jared Dinges (Equity Research Analyst)

Got it. Maybe, just to follow up on that, so you know, you guys did call out, Europe in with IQOS, saw some further negative inventory move in Q2. Should we expect that to reverse in H2? Because actually it's been, you know, on the whole in H1, it's been somewhat sizable, the negative, inventory.

Emmanuel Babeau (CFO)

Yes, in fact, Sure. In fact, that, you know, Japan was finishing with lower shipment volume than consumer offtake in 2022. That has been reversing in 2023, and Europe went the other way around. Remember, we had to load because of uncertainty on availability of product and energy supply in the manufacturing site. That was expected that the catch up has been happening mostly in Q1, but still a little bit in Q2. Now we expect to move to normal pattern of shipment versus consumer offtake or in-market sales. Therefore, we expect to have a strong H2 both in term of shipment progression and in-market sales in Europe. Back to normal.

Jared Dinges (Equity Research Analyst)

That's clear. If I can just follow up, just one last one. On Russia, you know, given the news, you know, last week or this week, just can you give an update on if that business is fully ring-fenced at this point?

Emmanuel Babeau (CFO)

Look, on Russia, we have nothing new to say. We've been explaining in the past communication that the situation was complex. There is no new element. I'm not going to comment on the situation of company that, you know, I know nothing about. We have nothing new to report on Russia at that stage.

Jared Dinges (Equity Research Analyst)

Okay. Maybe just in terms of supply, like, Russia's not supplying, you know, any neighboring markets at this point, right?

Emmanuel Babeau (CFO)

Well, we are, as you can imagine, complying with all regulation, restriction, sanction, today. We are obviously fully compliant.

Jared Dinges (Equity Research Analyst)

Perfect. Thank you.

Emmanuel Babeau (CFO)

Thank you.

Operator (participant)

It appears we have no further questions on the line at this time. I will turn the program back over to management for any additional or closing remarks.

James Bushnell (VP of Investor Relations and Financial Communications)

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

Emmanuel Babeau (CFO)

Talk to you soon. Thank you. Bye.

Operator (participant)

This does conclude today's program. Thank you for your participation. You may disconnect at any time, and have a wonderful day.