# Philip Morris International Inc. (PM) FY 2022 MD&A

Verbatim Item 7 Management's Discussion and Analysis from Philip Morris International Inc.'s 10-K for fiscal year 2022.

SEC filing source: https://www.sec.gov/Archives/edgar/data/1413329/000141332923000025/pm-20221231.htm
Accession: 0001413329-23-000025
Filing date: 2023-02-10
Report date: 2022-12-31
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/
Previous year: /company/PM/mda/fy2021/ (FY 2021)
Next year: /company/PM/mda/fy2023/ (FY 2023)

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 to evolve 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 smoke-free products, which include heat-not-burn, vapor, and oral nicotine products. Since 2008, we have invested more than $10.5 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 investment 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. In November 2022, we acquired Swedish Match AB ("Swedish Match") – a leader in oral nicotine delivery – creating a global smoke-free combination led by the companies’ IQOS and ZYN brands. The U.S. Food and Drug Administration ("FDA") has authorized versions of our IQOS Platform 1 devices and consumables, and Swedish Match's General snus, as Modified Risk Tobacco Products (MRTPs). We describe the MRTP orders in more detail in the "Business Environment" section of this Item 7.

As of December 31, 2022, we managed our business in six geographical segments, a Swedish Match segment and a Wellness and Healthcare segment:

•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");

•Swedish Match, which reflects our fourth quarter 2022 acquisition of the company; and

•Wellness and Healthcare ("W&H"), which includes the operating results of our new Wellness and Healthcare business, Vectura Fertin Pharma. In the third quarter of 2021, we acquired Fertin Pharma A/S, Vectura Group plc. (also known as Vectura Group Ltd.) and OtiTopic, Inc. On March 31, 2022, we launched a new Wellness and Healthcare business consolidating these entities, Vectura Fertin Pharma. The operating results of this new business are reported in the Wellness and Healthcare segment.

To further support the growth of our smoke-free business, reinforce consumer centricity, and increase the speed of innovation and deployment, in January 2023, we rearranged our operations in four geographical segments, down from the current six and as follows:

•Europe Region is headquartered in Lausanne, Switzerland, and covers all the European Union countries, Switzerland, the United Kingdom, and also Ukraine, Moldova and Southeast Europe;

•South and Southeast Asia, Commonwealth of Independent States, Middle East and Africa Region is headquartered in Dubai, United Arab Emirates. It covers South and Southeast Asia, the African continent, the Middle East, Turkey, as well as Israel, Central Asia, Caucasus and Russia;

•East Asia, Australia, and PMI Duty Free Region is headquartered in Hong Kong, and includes the consolidation of our international duty free business with East Asia & Australia; and

•Americas Region is headquartered in Stamford, Connecticut, and covers the United States, Canada and Latin America.

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The operations of Swedish Match and our Wellness and Healthcare segment remained unchanged. We will report our financial results based on the new geographical segments as of the first quarter of 2023.

In November 2022, we completed the relocation of our corporate headquarters, including our AMCS headquarters, from New York, New York, to Stamford, Connecticut.

Our cigarettes are sold in approximately 175 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.

Smoke-free products ("SFPs") is the term we primarily use to refer to all of our products that are not combustible tobacco products, such as heat-not-burn, e-vapor, and oral nicotine. In addition, SFPs include wellness and healthcare products, as well as consumer accessories such as lighters and matches.

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. We have a range of RRPs in various stages of development, scientific assessment and commercialization. Our RRPs are SFPs that contain and/or generate far lower quantities of harmful and potentially harmful constituents than found in cigarette smoke. IQOS is the leading brand in our SFP portfolio. As of December 31, 2022, our smoke-free products were available for sale in 73 markets.

In 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, as noted above, which provide essential capabilities for future product development. Now, through our Vectura Fertin Pharma subsidiary, with a strong foundation and significant expertise in life sciences, we aim to expand into wellness and healthcare areas.

In 2022, we acquired Swedish Match AB, a market leader in oral nicotine delivery with a significant presence in the United States market. The Swedish Match acquisition is a key milestone in PMI’s transformation to becoming a smoke-free company. Swedish Match already has a leading nicotine pouch franchise in the U.S. under the ZYN brand name. The Swedish Match product portfolio is complementary to our existing portfolio, permitting us to bring together a leading oral nicotine product with the leading heat-not-burn product. By joining forces with Swedish Match, we expect to accelerate the achievement of our joint smoke-free ambitions, switching more adults who would otherwise continue to smoke to better alternatives faster than either company could achieve separately.

For further details of our 2021 and 2022 acquisitions, see Item 8, Note 3. Acquisitions and Note 13. Segment Reporting

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 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.

War in Ukraine

Since the onset of the war in Ukraine, our main priority has been the safety and security of our more than 1,300 employees and their families in the country. PMI has helped to evacuate more than 1,000 people from Ukraine and relocate over 2,700 others from conflict zones to locations in the country away from the heaviest fighting; provided critical aid to employees who cannot leave or who decide to remain in Ukraine; and provided those who have left the country with a range of support in neighboring countries. We are continuing to pay salaries to all our Ukrainian employees and are also providing substantial in-kind support to them and their families. In addition, we have contributed approximately $10 million in funds and donated essential items across the country.

On February 25, 2022, in order to preserve the safety of our employees, we announced the temporary suspension of our commercial and manufacturing operations in Ukraine, including at our factory in Kharkiv. We subsequently resumed some retail activities where safety allowed, in order to provide product availability and service to adult consumers, and began to supply the market from production centers outside Ukraine, as well as through a contract manufacturing arrangement. Production at our factory in Kharkiv remains suspended.

In 2022, Ukraine accounted for around 2% of our total cigarette and heated tobacco unit shipment volume and around 1% of our total net revenues. As of December 31, 2022, our Ukrainian operations had approximately $0.4 billion in total assets, excluding intercompany balances.

We employ more than 3,200 people in Russia and will continue to support our employees there, including paying their salaries, while continuing to fulfill our legal obligations. We will continue to make decisions with employee safety and security as a priority.

On March 24, 2022, we announced the concrete steps we had taken to suspend planned investments and scale down our manufacturing operations in Russia, including: the discontinuation of a number of cigarette products; the suspension of our marketing activities; the cancellation of all product launches planned for 2022, including ILUMA; and the cancellation of our plans to manufacture heated tobacco units for ILUMA in Russia.

We are continuously assessing the evolving situation in Russia, including: recent regulatory constraints in the market that entail very complex terms and conditions that must be met for any divestment transaction to be granted approval by the authorities; and restrictions resulting from international regulations.

In 2022, Russia accounted for approximately 9% of total shipment volumes and around 7% of our total net revenues. As of December 31, 2022, our Russian operations had approximately $2.5 billion in total assets, excluding intercompany balances, of which approximately $0.6 billion consisted of cash and equivalents held mostly in local currency (Russian rubles).

We recorded pre-tax charges related to the war in Ukraine of approximately $151 million in 2022 (including humanitarian efforts). This includes charges in Russia related to the cancellation of the planned launch of ILUMA and the planned production of related heated tobacco units.

These developments above have and will continue to have a material adverse impact on our business, results of operations, cash flows and financial position, and may result in impairment charges.

For further details, see Item 8, Note 4. War in Ukraine to our consolidated financial statements as well as Item 1A. Risk Factors and the "Trade Policy" section of this MD&A.

Agreement with Altria Group, Inc. regarding Commercialization of IQOS in the U.S.

On October 20, 2022, PMI announced that it had reached an agreement with Altria Group, Inc. to end the companies' relationship regarding the IQOS commercialization rights in the U.S. as of April 30, 2024. As a result of PMI reacquiring these rights, effective May 1, 2024, PMI will have the full rights to commercialize IQOS in the U.S. As part of the agreement, PMI agreed to pay a total cash consideration of $2.7 billion, with $1.0 billion paid at the inception of the agreement and the remaining $1.7 billion (plus interest, at a per annum rate equal to six percent (6%)), to be paid by July 2023 at the latest.

For further details, see Item 8, Note 3. Acquisitions.

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Swedish Match Acquisition

On November 11, 2022, Philip Morris Holland Holdings B.V. (“PMHH”), a wholly owned subsidiary of PMI, acquired a controlling interest of 85.87% of the total issued and outstanding shares in Swedish Match. Swedish Match's operating results beginning on November 11, 2022 through December 31, 2022, are included in PMI's consolidated statement of earnings and disclosed as a separate segment.

On November 28, 2022, PMHH announced that it had acquired 93.11% of the shares in Swedish Match and intended to: (i) initiate compulsory redemption under the Swedish Companies Act to acquire all remaining shares in Swedish Match; and (ii) request delisting of Swedish Match’s shares from Nasdaq Stockholm.

On December 16, 2022, Swedish Match announced that the compulsory redemption process had been initiated. On December 30, 2022, the shares of Swedish Match were delisted from Nasdaq Stockholm, by which time PMHH had become the owner of 94.81% of Swedish Match's shares.

For further details, see Item 8, Note 3. Acquisitions.

KT&G

On January 30, 2023, PMI announced a long-term collaboration with KT&G, South Korea’s leading tobacco and nicotine manufacturer, to continue to commercialize KT&G’s innovative smoke-free devices and consumables on an exclusive, worldwide basis (excluding South Korea).

The agreement covers fifteen years, to January 29, 2038, with performance-review cycles and associated commitments, based on volume, to be confirmed for each three-year period, to allow flexibility for evolving market conditions.

For further details, see "Acquisitions and Other Business Arrangements" section of this MD&A.

Consolidated Operating Results

•Net Revenues – Net revenues of $31.8 billion for the year ended December 31, 2022, increased by $0.4 billion, or 1.1%, from the comparable 2021 amount. The change in our net revenues from the comparable 2021 amount was driven by the following (variances not to scale):

Net revenues, excluding currency and acquisitions, increased by 8.0%, mainly reflecting: favorable volume/mix, primarily driven by higher heated tobacco units ("HTU") volume and device volume, partly offset by lower cigarette volume and unfavorable device mix, cigarette mix and HTU mix; a favorable pricing variance, driven by higher combustible tobacco pricing, partly offset by lower device pricing and lower HTU (net) pricing; and a favorable comparison related to the Saudi Arabia customs assessments of $246 million in 2021, shown in "Other" and further described in the following "Diluted Earnings Per Share" discussion.

In 2022, Russia and Ukraine accounted for around 8% of PMI's total net revenues.

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Net revenues by product category for the years ended December 31, 2022 and 2021, are shown below:

Following the Swedish Match acquisition and a review of PMI and Swedish Match’s combined product portfolio, PMI reclassified certain of its own products previously reported under its combustible tobacco product category to the newly created smoke-free product category to better reflect the characteristics of these products. This reclassification did not impact PMI’s segment reporting, consolidated financial position, results of operations or cash flows in any of the periods presented. For further details, see Item 8, Note 13. Segment Reporting.

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•Diluted Earnings Per Share – The changes in our reported diluted earnings per share (“diluted EPS”) for the year ended December 31, 2022, from the comparable 2021 amounts, were as follows:

[[GREPCENT_TABLE]]
[["","Diluted EPS","% Change"],["For the year ended December 31, 2021","$","5.83"],["2021 Asset impairment and exit costs","0.12"],["2021 Saudi Arabia customs assessments","0.14"],["2021 Asset acquisition cost","0.03"],["2021 Equity investee ownership dilution","(0.04)"],["2021 Amortization and impairment of intangibles","0.05"],["2021 Tax items","\u2014"],["Subtotal of 2021 items","0.30"],["2022 Charges related to the war in Ukraine","(0.08)"],["2022 Fair value adjustment for equity security investments","0.02"],["2022 Amortization and impairment of intangibles","(0.15)"],["2022 Costs associated with Swedish Match AB offer","(0.06)"],["2022 Swedish Match AB acquisition accounting related item","(0.06)"],["2022 Tax benefit associated with Swedish Match AB financing","0.13"],["2022 Tax items","0.03"],["Subtotal of 2022 items","(0.17)"],["Currency","(0.77)"],["Interest","0.02"],["Change in tax rate","0.03"],["Operations","0.57"],["For the year ended December 31, 2022","$","5.81","","(0.3)","%"]]
[[/GREPCENT_TABLE]]

Asset impairment and exit costs – 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 pre-tax charge was recorded in 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 20. Asset Impairment and Exit Costs.

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 18. 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 3. 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% at December 31, 2020, to approximately 23% as of December 31, 2021. The ownership dilution resulted in a $0.04 per share

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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 18. Contingencies - Third Party Guarantees.

Amortization and impairment of intangibles – During 2022 and 2021, we recorded amortization and impairment of intangibles of $271 million (representing $227 million net of income tax or $0.15 per share decrease in diluted EPS) and $96 million (representing $78 million net of income tax or $0.05 per share decrease in diluted EPS), respectively. The pre-tax amortization and impairment of intangibles amount in 2022 consisted of amortization expense of $159 million primarily due to increased acquired intangible assets recorded as a result of our acquisitions in the third quarter of 2021, and an impairment charge of $112 million reflecting the impact of general economic and market conditions resulting in a reduction in future estimated cash flows on certain products within the Wellness and Healthcare segment. For further details, see Item 8, Note 3. Acquisitions and Note 5. Goodwill and Other Intangible Assets, net.

Charges related to the war in Ukraine – During 2022, we recorded a pre-tax charge of $151 million, representing $128 million net of income tax and a diluted EPS charge of $0.08 per share, related to circumstances driven by the war, including machinery and inventory write-downs, additional allowances for receivables and the cost of PMI’s humanitarian efforts. For further details, see Item 8, Note 4. War in Ukraine.

Fair Value adjustment for equity security investments – During 2022, we recorded a favorable fair value adjustment for our equity security investments in India and Sri Lanka ($0.02 per share increase in diluted EPS). For further details, see Item 8, Note 6. Related Parties - Equity Investments and Other.

Costs associated with Swedish Match AB offer – During 2022, we incurred pre-tax costs associated with the Swedish Match acquisition of $116 million (representing $99 million net of income tax and a diluted EPS charge of $0.06 per share) primarily related to financing costs, derivative financials instruments and certain transaction related costs. These pre-tax costs of $116 million were recorded in marketing, administration and research costs ($115 million expense) and interest expense, net ($1 million expense) on our consolidated statement of earnings for the year ended December 31, 2022.

Swedish Match AB acquisition accounting related item – Following the Swedish Match acquisition, we recorded pre-tax purchase accounting adjustments of $125 million related to the sale of acquired inventories stepped up to fair value (representing $94 million net of income tax and a diluted EPS charge of $0.06 per share). These pre-tax adjustments were recorded in cost of sales in the consolidated statements of earnings for the year ended December 31, 2022. For further details, see Item 8, Note 3. Acquisitions.

Income taxes – The 2022 Tax benefit associated with Swedish Match AB financing that increased our 2022 diluted EPS by $0.13 per share in the table above was due to a deferred tax benefit for unrealized foreign currency losses on intercompany loans related to the Swedish Match acquisition financing reflected in the consolidated statements of earnings, while the underlying pre-tax foreign currency movements fully offset in the consolidated statements of earnings and were reflected as currency translation adjustments in the consolidated statements of stockholders' (deficit) equity at December 31, 2022. The 2022 Tax items that increased our 2022 diluted EPS by $0.03 per share in the table above were due to a reduction in deferred tax liabilities related to pension plan assets of $40 million. The change in the tax rate that increased our diluted EPS by $0.03 per share in the table above was primarily due to changes in income tax reserves.

Currency – The unfavorable impact of $0.77 per share during the reporting period primarily results from the fluctuations of the U.S. dollar, especially against the Egyptian pound, Euro, Hungarian forint, Japanese yen and Polish zloty, partially offset by the Russian ruble and Swiss franc. This unfavorable currency movement has impacted our profitability across our primary revenue markets and local currency cost bases.

Interest – The favorable impact of $0.02 per share from interest in the table above was primarily driven by the repayment of long-term debt maturing in 2021 and 2022, and higher net interest income driven by higher interest rates, partially offset by higher interest expense in connection with the Swedish Match acquisition.

Operations – The increase in diluted EPS of $0.57 per share from our operations in the table above was due primarily to the following segments:

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

•Middle East & Africa: Favorable volume/mix, favorable pricing and lower marketing, administration and research costs, partly offset by higher manufacturing costs; and

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•South & Southeast Asia: Lower marketing, administration and research costs and favorable pricing, partly offset by unfavorable volume/mix;

partially offset by

•East Asia & Australia: Unfavorable volume/mix and higher manufacturing costs, partly offset by lower marketing, administration and research costs;

•Wellness and Healthcare: Primarily reflecting investments in research and development, as well as expenses related to employee retention programs;

•Americas: Higher marketing, administration and research costs and higher manufacturing costs, partly offset by favorable pricing; and

•Eastern Europe: Unfavorable volume/mix, higher manufacturing costs and higher marketing, administration and research costs, partly offset by favorable pricing.

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

Discussion and Analysis

Critical Accounting Estimates