# Philip Morris International Inc. (PM) FY 2021 MD&A

Verbatim Item 7 Management's Discussion and Analysis from Philip Morris International Inc.'s 10-K for fiscal year 2021.

SEC filing source: https://www.sec.gov/Archives/edgar/data/1413329/000141332922000011/pm-20211231.htm
Accession: 0001413329-22-000011
Filing date: 2022-02-11
Report date: 2021-12-31
Extracted structurally from real Item 7 body heading to real Item 7A/8 boundary.
Confidence: high

Company profile: /company/PM/
All MD&A years: /company/PM/mda/
Next year: /company/PM/mda/fy2022/ (FY 2022)

Item 7.Management’s Discussion and Analysis of Financial Condition and Results of Operations.

The following discussion should be read in conjunction with the other sections of this Annual Report on Form 10-K, including the consolidated financial statements and related notes contained in Item 8, and the discussion of risks and cautionary factors that may affect future results in Item 1A. Risk Factors.

Description of Our Company

We are a leading international tobacco company working to deliver a smoke-free future and evolving our portfolio for the long-term to include products outside of the tobacco and nicotine sector. Our current product portfolio primarily consists of cigarettes and reduced-risk products, including heat-not-burn, vapor and oral nicotine products, which are sold in markets outside the United States. Since 2008, we have invested more than $9 billion to develop, scientifically substantiate and commercialize innovative smoke-free products for adults who would otherwise continue to smoke, with the goal of completely ending the sale of cigarettes. This includes the building of world-class scientific assessment capabilities, notably in the areas of pre-clinical systems toxicology, clinical and behavioral research, as well as post-market studies. The U.S. Food and Drug Administration ("FDA") has authorized the marketing of a version of PMI’s IQOS Platform 1 device and consumables as a Modified Risk Tobacco Product (MRTP), finding that an exposure modification order for these products is appropriate to promote the public health. We describe the MRTP order in more detail in the "Business Environment" section of this Item 7. With a strong foundation and significant expertise in life sciences, in February 2021, we announced our ambition to expand into wellness and healthcare areas and deliver innovative products and solutions that aim to address unmet patient and consumer needs.

In the third quarter of 2021, our former Latin America & Canada segment was renamed as the Americas segment.

We currently manage our business in six geographical segments and an Other category:

•European Union ("EU");

•Eastern Europe ("EE");

•Middle East & Africa ("ME&A"), which includes our international duty free business;

•South & Southeast Asia ("S&SA");

•East Asia & Australia ("EA&A");

•Americas ("AMCS"); and

•Other, which includes our third quarter 2021 acquisitions of Fertin Pharma A/S, Vectura Group plc. (also known as Vectura Group Ltd.) and OtiTopic, Inc. For further details, see Item 8, Note 6. Acquisitions, and Item 8, Note 12. Segment Reporting.

Our cigarettes are sold in approximately 180 markets, and in many of these markets they hold the number one or number two market share position. We have a wide range of premium, mid-price and low-price brands. Our portfolio comprises both international and local brands.

In addition to the manufacture and sale of cigarettes, we are engaged in the development and commercialization of reduced-risk products ("RRPs"). RRPs is the term we use to refer to products that present, are likely to present, or have the potential to present less risk of harm to smokers who switch to these products versus continuing smoking.  IQOS is the leading brand in our smoke-free product portfolio. As of December 31, 2021, our smoke-free products are available for sale in 71 markets in key cities or nationwide.

During 2021, we laid the foundation for our long-term growth ambitions beyond nicotine in wellness and healthcare, including the milestone acquisitions of Vectura Group plc and Fertin Pharma A/S which provide essential capabilities for future product development.

We use the term net revenues to refer to our operating revenues from the sale of our products, including shipping and handling charges billed to customers, net of sales and promotion incentives, and excise taxes. Our net revenues and operating income are

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affected by various factors, including the volume of products we sell, the price of our products, changes in currency exchange rates and the mix of products we sell. Mix is a term used to refer to the proportionate value of premium-price brands to mid-price or low-price brands in any given market (product mix). Mix can also refer to the proportion of shipment volume in more profitable markets versus shipment volume in less profitable markets (geographic mix).

Our cost of sales consists principally of: tobacco leaf, non-tobacco raw materials, labor and manufacturing costs; shipping and handling costs; and the cost of devices produced by third-party electronics manufacturing service providers. Estimated costs associated with device warranty programs are generally provided for in cost of sales in the period the related revenues are recognized.

Our marketing, administration and research costs include the costs of marketing and selling our products, other costs generally not related to the manufacture of our products (including general corporate expenses), and costs incurred to develop new products. The most significant components of our marketing, administration and research costs are marketing and sales expenses and general and administrative expenses.

Philip Morris International Inc. is a legal entity separate and distinct from its direct and indirect subsidiaries. Accordingly, our right, and thus the right of our creditors and stockholders, to participate in any distribution of the assets or earnings of any subsidiary is subject to the prior rights of creditors of such subsidiary, except to the extent that claims of our company itself as a creditor may be recognized. As a holding company, our principal sources of funds, including funds to make payment on our debt securities, are from the receipt of dividends and repayment of debt from our subsidiaries. Our principal wholly owned and majority-owned subsidiaries currently are not limited by long-term debt or other agreements in their ability to pay cash dividends or to make other distributions that are otherwise compliant with law.

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Executive Summary

The following executive summary provides the business update and significant highlights from the Discussion and Analysis that follows.

Consolidated Operating Results

•Net Revenues – Net revenues of $31.4 billion for the year ended December 31, 2021, increased by $2.7 billion, or 9.4%, from the comparable 2020 amount, and were impacted by the effects of the COVID-19 pandemic, particular in 2020. The change in our net revenues from the comparable 2020 amount was driven by the following (variances not to scale):

Net revenues, excluding currency and acquisitions, increased by 6.7%, mainly reflecting: favorable volume/mix, primarily driven by higher heated tobacco unit volume (notably in the EU, particularly Germany, Hungary, Italy and Poland, as well as Japan, Russia and Ukraine), and higher device volume (notably in the EU, primarily Italy, and Japan, partly offset by South Korea), partially offset by lower cigarette volume (mainly in the EU Region, notably the Czech Republic, France and Germany, as well as the GCC, North Africa, the Philippines, Russia and Ukraine, partly offset by India, Indonesia, PMI Duty Free and Turkey) and unfavorable cigarette mix (primarily in Germany, Japan and Russia, partially offset by Indonesia and PMI Duty Free); and a favorable pricing variance (notably driven by the Czech Republic, Germany, Japan, Kazakhstan, the Philippines, Russia and Turkey, partly offset by Australia, Indonesia, Poland and Ukraine); partially offset by the unfavorable impact of the Saudi Arabia customs assessments of $246 million, included in "Other" and further described in the following "Diluted Earnings Per Share" discussion.

This net revenue growth reflects the continued strength of IQOS, and the recovery of the combustible business in many markets from the low base in 2020 due to the impact of COVID-19.

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Net revenues by product category for the years ended December 31, 2021 and 2020, are shown below:

Net revenues in the Other category primarily consist of operating revenues generated from the sale of inhaled therapeutics, and oral and intra-oral delivery systems resulting from the third quarter 2021 acquisitions of Fertin Pharma A/S, Vectura Group plc. and OtiTopic, Inc.

•Diluted Earnings Per Share – The changes in our reported diluted earnings per share (“diluted EPS”) for the year ended December 31, 2021, from the comparable 2020 amounts, were as follows:

[[GREPCENT_TABLE]]
[["","Diluted EPS","% Growth"],["For the year ended December 31, 2020","$","5.16"],["2020 Asset impairment and exit costs","0.08"],["2020 Brazil indirect tax credit","(0.05)"],["2020 Fair value adjustment for equity security investments","0.04"],["2020 Tax items","(0.06)"],["Subtotal of 2020 items","0.01"],["2021 Asset impairment and exit costs","(0.12)"],["2021 Saudi Arabia customs assessments","(0.14)"],["2021 Asset acquisition cost","(0.03)"],["2021 Equity investee ownership dilution","0.04"],["2021 Tax items","\u2014"],["Subtotal of 2021 items","(0.25)"],["Currency","0.12"],["Interest","\u2014"],["Change in tax rate","0.08"],["Operations","0.71"],["For the year ended December 31, 2021","$","5.83","","13.0","%"]]
[[/GREPCENT_TABLE]]

Asset impairment and exit costs – During 2020, we recorded pre-tax asset impairment and exit costs of $149 million, representing $124 million net of income tax and a diluted EPS charge of $0.08 per share, related to the organizational design optimization plan,

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primarily in Switzerland. During 2021, we recorded pre-tax asset impairment and exit costs of $216 million, representing $181 million net of income tax and a diluted EPS charge of $0.12 per share, related to the organizational design optimization plan, primarily in Switzerland, and the product distribution restructuring in South Korea. The total pre-tax charges in 2020 and 2021 were included in marketing, administration and research costs on the consolidated statements of earnings. For further details, see Item 8, Note 19. Asset Impairment and Exit Costs.

Brazil indirect tax credit - Following a final and enforceable decision by the highest court in Brazil in October 2020, we recorded a gain of $119 million for tax credits in 2020 ($79 million net of income tax and $0.05 per share increase in diluted EPS) representing overpayments of indirect taxes for the period from March 2012 through December 2019; these tax credits were applied to tax liabilities in Brazil during 2021. This amount was included as a reduction in marketing, administration and research costs in the consolidated statements of earnings for the year ended December 31, 2020, and was included in the operating income of the Americas segment. An additional amount of overpaid indirect taxes of approximately $90 million is dependent on a potential tax authority challenge.

Fair Value adjustment for equity security investments – During 2020, we recorded an unfavorable fair value adjustment for our equity security investments of $60 million after tax (or $0.04 per share decrease in diluted EPS).  The fair value adjustment for our equity security investments was included in equity investments and securities (income)/loss, net ($76 million loss) and provision for income taxes ($16 million benefit) on the consolidated statements of earnings in 2020. For further details, see Item 8, Note 4. Related Parties - Equity Investments and Other.

Income taxes – The 2020 Tax items that increased our 2020 diluted EPS by $0.06 per share in the table above were due to final U.S. tax regulations under the Global Intangible Low-Taxed Income ("GILTI") provisions of the Internal Revenue Code for years 2018 and 2019 ($93 million).

The change in the tax rate that increased our diluted EPS by $0.08 per share in the table above was primarily due to the corporate income tax rate reduction in the Philippines (enacted in the first quarter of 2021), as well as changes in earnings mix by taxing jurisdiction. For further details, see Item 8, Note 11. Income Taxes.

Saudi Arabia customs assessments – In June 2021, the Customs Appeal Committee in Riyadh notified our distributors in Saudi Arabia of its decisions to largely reject their challenges of the Saudi Arabia Customs General Authority assessments as described in Item 8, Note 17. Contingencies. On the basis of these decisions and in line with arrangements with the distributors, we recorded a pre-tax charge of $246 million in the second quarter of 2021 (representing $215 million net of income tax and a diluted EPS charge of $0.14 per share). The pre-tax charge was recorded as a reduction of net revenues on the consolidated statement of earnings for the year ended December 31, 2021, and was included in the Middle East & Africa segment results.

Asset acquisition cost – In August 2021, we acquired 100% of OtiTopic, Inc., a U.S. respiratory drug development company with a late-stage dry powder inhalation aspirin treatment for acute myocardial infarction. We accounted for this transaction as an asset acquisition since the acquired in-process research and development ("IPR&D") of the dry powder inhalation aspirin treatment represented substantially all of the fair value of the gross assets acquired. At the date of acquisition, we determined that the acquired IPR&D had no alternative future use. As a result, we recorded a pre-tax charge of $51 million (representing a $0.03 per share charge to diluted EPS) to research and development costs within marketing, administration and research costs in the consolidated statements of earnings for the year ended December 31, 2021. For further details, see Item 8, Note 6. Acquisitions.

Equity investee ownership dilution – In 2021, our equity method investee, Medicago Inc, initiated additional rounds of equity funding in which we did not participate. As a result, our share of holdings in Medicago Inc. was reduced from approximately 32% to approximately 23% as of December 31, 2021. The ownership dilution resulted in a $0.04 per share favorable impact to diluted EPS and income of $55 million to Equity investments and securities (income)/loss, net in the consolidated statements of earnings for the year ended December 31, 2021. For further details, see Item 8, Note 17. Contingencies - Third Party Guarantees.

Currency – The favorable impact of $0.12 per share during the reporting period primarily results from the fluctuations of the U.S. dollar, especially against the Euro. This favorable currency movement has impacted our profitability across our primary revenue markets and local currency cost bases.

Operations – The increase in diluted EPS of $0.71 per share from our operations in the table above was due primarily to the following segments:

•European Union: Favorable volume/mix, lower manufacturing costs and favorable pricing, partially offset by higher marketing, administration and research costs;

•Middle East & Africa: Favorable pricing, favorable volume/mix and lower manufacturing costs, partially offset by lower

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fees for certain distribution rights and higher marketing, administration and research costs;

•Eastern Europe: Favorable volume/mix, lower manufacturing costs, favorable pricing and lower marketing, administration and research costs;

•East Asia & Australia: Favorable pricing and lower manufacturing costs, partially offset by higher marketing, administration and research costs; and

•Americas: Favorable pricing and lower marketing, administration and research costs, partially offset by higher manufacturing costs;

partially offset by

•South & Southeast Asia: Unfavorable pricing, unfavorable volume/mix and higher marketing, administration and research costs.

For further details, see the Consolidated Operating Results and Operating Results by Business Segment sections of the following Discussion and Analysis.

IQOS Device Supply

The current global semiconductor shortage has resulted in a tightness in IQOS device supply in the second half of 2021. In the fourth quarter of 2021, the IQOS device supply situation eased, resulting in an improved IQOS user growth versus the third quarter. We expect an improving IQOS device supply situation, with a gradual return to an unconstrained IQOS user quarterly growth progression. However, we still do not have full visibility over the full year 2022.

IQOS in the United States

On November 29, 2021, an importation ban and cease-and-desist orders imposed by the U.S. International Trade Commission ("ITC") relating to IQOS Platform 1 products (including consumables and infringing components) went into effect. As a result, IQOS is not currently available for sale in the U.S. We have appealed the patent and statutory issues related to the ITC's Final Determination, and also have contingency plans underway, including domestic production. We hope to be able to resume U.S. supply in the first half of 2023. For more details on the ITC case and related legal matters, please refer to Item 8, Note 17. Contingencies.

The ITC decision has no bearing outside the U.S.; competitor lawsuits based on the same patent families have repeatedly and universally failed in European courts and the European Patent Office.

Acquisitions

During 2021, PMI acquired the following companies:

•Vectura Group plc, an inhaled therapeutics company based in the United Kingdom;

•Fertin Pharma A/S, a Danish company that is a leading developer and manufacturer of innovative pharmaceutical and well-being products based on oral and intra-oral delivery systems;

•OtiTopic, Inc., a U.S. respiratory drug development company with a late-stage dry powder inhalation aspirin treatment for acute myocardial infarction; and

•AG Snus Aktieselskab, a Danish company, and its Swedish subsidiary, Tobacco House of Sweden AB, fully owned by AG Snus, which operates in the oral tobacco and modern oral product categories.

For further details on these acquisitions, see Item 8, Note 6. Acquisitions.

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Discussion and Analysis

Critical Accounting Estimates