2018 Guidance Reduction Sets an Achievable Bar

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1 July 19, :28 PM GMT Philip Morris International Inc 2018 Guidance Reduction Sets an Achievable Bar Stock Rating Overweight Industry View In-Line Price Target $ Q2 results reflected improved cigarette fundamentals while iqos again fell short of expectations and contributed to PM's 2018 guidance reduction. However, we believe updated 2018 guidance sets an achievable bar. We remain OW, $102 PT. iqos slowdown tempers 2018 guidance: PM shares ended the day -1.5% despite the company's sizable guidance reduction for heated tobacco ("HTU") volumes (~48-50 bn to bn) and organic revenue growth (from +8% to +3-4%), suggesting, in our view, that investors' iqos expectations were already low ahead of the quarter and that better than expected combustible results assuaged concerns about stability in the core. Combustibles volumes improved meaningfully (-1.5% vs. -5.3% in 1Q18) and net pricing remained strong (+7.5% YTD). Heated tobacco was again a source of disappointment due to softer sales in Japan, contributing to the company s reduced 2018, as lower device/htu sales are expected to be a -2.5% and -2% headwind to topline growth. Updated HTU guidance reflects a sizable net ~3 bn unit inventory drawdown in Q3 (~4 bn in Japan offset by other markets). Within Korea, iqos growth stalled due to confusion among smokers about the health impact from heated tobacco vs. cigarettes while positive momentum continued in Italy and Greece (share up 40/50 bps sequentially). PM is taking a number of steps to address slowing iqos growth: PM is committed to its plan to spend an incremental $600 MM behind iqos investment in 2018 (although the company reduced its iqos capex plans by $200 MM partly due to lower demand). PM is taking multiple steps to accelerate iqos growth in Japan, including: i) the introduction of a nextgen iqos device with enhanced features such as multiple consecutive uses; ii) launching stronger tasting HeatSticks to facilitate full-flavor smoker conversion; and iii) a mainstream priced product, which is intended to attract price sensitive smokers reluctant to switch to iqos, but could also result in downtrading among existing users. We believe it will take longer and likely be more costly to reach incremental customers in Japan as smokers who have not switched to HNB are older, are more price sensitive given they have a lower average income, and live in suburban/rural areas. Lowered 2018 EPS sets an achievable bar: We are reducing our 2018e EPS from $5.14 to $5.06 (guidance $ % constant-f/x plus a $0.07 currency headwind), taking into account lower HTU shipments (MSe 41.0 bn) and adverse MORGAN STANLEY & CO. LLC Pamela Kaufman, CFA EQUITY ANALYST Pamela.Kaufman@morganstanley.com Philip Morris International Inc ( PM.N, PM US ) Tobacco / United States of America Stock Rating Overweight Industry View In-Line Price target $ Shr price, close (Jul 19, 2018) $80.90 Mkt cap, curr (mm) $125, Week Range $ Fiscal Year Ending 12/17 12/18e 12/19e 12/20e EPS ($)** Prior EPS ($)** Consensus EPS ($) ModelWare EPS ($) P/E Div yld (%) Unless otherwise noted, all metrics are based on Morgan Stanley ModelWare framework ** = Based on consensus methodology = Consensus data is provided by Thomson Reuters Estimates e = Morgan Stanley Research estimates QUARTERLY EPS ($) 2018e 2018e 2019e 2019e Quarter 2017 Prior Current Prior Current Q a - - Q a - - Q Q e = Morgan Stanley Research estimates, a = Actual Company reported data Morgan Stanley does and seeks to do business with companies covered in Morgan Stanley Research. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of Morgan Stanley Research. Investors should consider Morgan Stanley Research as only a single factor in making their investment decision. For analyst certification and other important disclosures, refer to the Disclosure Section, located at the end of this report. 1

2 F/X. With respect to phasing, PM pointed to ~1% organic revenue growth in 3Q and an ~4% decline in Q4 due to challenging prior year comparisons. We expect PM to deliver on its undemanding iqos shipment forecast in 2H18, and combustible fundamentals to remain stable sequentially. We believe PM set an achievable bar for 2H18 with its reduced organic revenue/underlying EPS growth guidance and retains EPS flexibility given the ability to adjust elevated iqos investment plans. 2

3 Philip Morris International (PM) Risk-Reward Underlying Fundamentals Remain Best In Class $ $ (+26%) Price Target Price Target $102 Based on a blend of DCF and SOTP valuation. Our SOTP reflects 16x C2019e tobacco EPS plus $20 per share for iqos, representing a 20x combined P/E, or a 10% discount to US Staples given PM's advantaged prospects for sustained double-digit EPS growth. Bull $137 29x Bull Case 2019e P/E (19x bull tobacco EPS plus $47/share for iqos) and supported by our Bull Case DCF. Paradigm shift with China entry and reduced risk. LSD volume growth as EM markets improve further and iqos consumer adoption accelerates. Pricing is slightly above historical $1.8 Bn contribution (HSD) due to solid underlying cigarette demand. USD weakens from current levels and leads to moderate F/X headwinds. Solid cigarette fundamentals, better than expected iqos adoption, and China entry lead to further re-rating. However, greater success of iqos also means moderation of growth for PM's tobacco business due to cannibalization, resulting in only a moderate re-rating for the underlying tobacco business. Base $102 20x Base Case 2019e P/E (16x tobacco EPS plus $20/share for iqos) and supported by our DCF. Delivering on plan. PM's delivers on current 2018 growth objectives, with a 2% overall volume decline, 7% cigarette price/mix, and EPS toward the high end of the company's 8-11% outlook. iqos continues to gain share sequentially, including in Japan (albeit at a slower pace than that observed in 2017). US Dollar & Euro remain relatively unchanged from current levels, with F/X a ~$0.07 heading. Solid ongoing fundamentals and continued momentum for iqos result in peer leading valuation. Bear $64 15x Bear Case 2019e P/E (13x bear tobacco EPS plus $9/share for iqos) and supported by our Bear Case DCF. FX and economic headwinds worsen. Local-currency operating income growth slows to up LSD-MSD in FY18 as EM markets slow, EU profits decline, the USD rallies further, regulation intensifies, and iqos disappoints, all resulting in PM's combustibles business trading closer to historical levels excluding iqos $80.90 $ (+69%) $64.00 (-21%) 0 Jul-16 Jan-17 Jul-17 Jan-18 Jul-18 Jan-19 Jul-19 Price Target (Jul-19) Historical Stock Performance Current Stock Price Source: Thomson Reuters, Morgan Stanley Research WARNINGDONOTEDIT_RRS4RL~PM.N~ Investment Thesis Philip Morris operates in an inherently attractive industry, with high profit margins & substantial free cash flow. The company benefits from significant geographic diversification, with good exposure to EMs (growth) and Developed Markets (high margins). We anticipate continued long-term improvement in PM s local-currency operating results, driven by a general absence of excise tax shocks and good industry pricing. iqos provides an incremental source of volume and profit that should contribute to long-term underlying OCI growth at the high end of PMI's 6-8% algorithm. Valuation looks attractive vs. premium Staples peers (e.g., KO/CL/Nestle). Key Value Drivers Emerging markets. While up-trading has slowed in certain markets, there is no evidence of widespread consumer tradedown. The effectiveness of product innovation, particularly around Marlboro and L&M. The presence or absence of excise tax shocks and/or price skirmishes. Reduced prevalence of illicit trade. Ongoing consumer adoption of iqos. Potential Catalysts Short term: Stronger-than-expected EPS and operating profit growth; Relative value of the US dollar. Medium term: Stronger than expected improvement in price-mix; Dividend growth and share repos. Long-term: The prospect to develop a scaled business in China, and potential expansion of reduced-risk tobacco products. Risks to Achieving Price Target Additional strength of US dollar. Large-scale excise tax increase. Shortfall in iqos expectations 3

4 Key Charts Exhibit 1: PM's combustible volumes decreased 1.5% in Q2 Exhibit 2: HNB cigarette volumes increased 73% YoY in Q2 Combustible Volumes - YoY % Change 6% 4% 2% 0% (2%) (4%) (6%) (8%) (10%) 1Q15 2Q15 3Q15 4Q15 1Q16 2Q16 3Q16 4Q16 1Q17 2Q17 3Q17 4Q17 1Q18 2Q18 3Q18E 4Q18E HNB Cigarette Volumes (Units) Q15 3Q15 4Q15 1Q16 2Q16 3Q16 4Q16 1Q17 2Q17 3Q17 4Q17 1Q18 2Q18 3Q18E 4Q18E Exhibit 3: Price of 6.2% in Q2 Exhibit 4: Organic revenue grew +8.3% in Q2 $700 Pricing Impact Pricing benefit 12% PM Organic Sales Growth Mix Price Volume Revenue 25% $600 $500 $400 $300 $200 $ % 5.9% 7.3% 6.4% 4.1% 5.0% 6.4% 8.8% 6.7% 5.5% 4.4% 4.4% 5.5% 6.2% 10% 8% 6% 4% 2% 20% 15% 10% 5% 0% (5%) 18.8% 10.5% 9.2% 4.6% 5.9% 7.0% 8.9% 8.2% 8.3% 4.0% 3.6% 2.4% 1.3% 1.6% 0.7% (3.9%) $0 1Q15 2Q15 3Q15 4Q15 1Q16 2Q16 3Q16 4Q16 1Q17 2Q17 3Q17 4Q17 1Q18 2Q18 0% (10%) (15%) 1Q15 2Q15 3Q15 4Q15 1Q16 2Q16 3Q16 4Q16 1Q17 2Q17 3Q17 4Q17 1Q18 2Q18 3Q18E 4Q18E Exhibit 5: PM expects FX to be a $0.07 tailwind to EPS in FY18 Cumulative PMI FX Impact on EPS $0.40 $0.20 $0.00 ($0.20) ($0.40) ($0.60) ($0.80) ($1.00) ($1.20) ($1.40) $0.19 $0.12 ($0.07) ($0.07) ($0.23) ($0.22) ($0.34) ($0.46) ($0.53) ($0.79) ($1.19) E 2019E Annual F/X EPS Impact - Left Axis Cumulative (from 2008) - Right Axis $0.00 ($0.50) ($1.00) ($1.50) ($2.00) ($2.50) ($3.00) ($3.50) ($4.00) Exhibit 6: We see ~2.1x Net Debt/EBITDA in 2018 PM Leverage Gross Debt / EBITDA Net Debt / EBITDA 3.0x 2.5x 2.0x 1.5x 1.0x 0.5x 0.0x 2.8x 2.8x 2.7x 2.5x 2.5x 2.2x 1.9x 1.5x 1.3x 1.4x 2.1x 2.2x 2.1x 2.1x 2.1x 1.9x 1.7x 1.2x 1.3x 1.1x E 2019E 4

5 Financials Exhibit 7: PM Income Statement $ millions, except per share E 2019E 2020E Total Gross Sales 80,106 73,908 74,953 78,097 79,271 81,276 82,246 Excise Taxes 50,339 47,114 48,268 49,350 49,623 49,487 48,507 Net Sales 29,767 26,794 26,685 28,747 29,340 31,789 33,739 Cost of Goods Sold 10,436 9,365 9,391 10,432 11,021 11,575 12,053 Gross Profit 19,331 17,429 17,294 18,315 18,318 20,214 21,687 margin % 64.9% 65.0% 64.8% 63.7% 63.6% 63.6% 64.3% SG&A 6,731 6,616 6,391 6,734 6,713 7,610 8,095 % of sales 22.6% 24.7% 23.9% 23.4% 22.9% 23.9% 24.0% Operating Companies Income 12,600 10,813 10,903 11,581 11,605 12,604 13,592 margin % 42.3% 40.4% 40.9% 40.3% 39.6% 39.6% 40.3% Interest & other debt expense, net 1,052 1, ,016 1,032 Pension & other employee benefit cost Earnings before Min. Int./Taxes 11,548 9,683 9,924 10,589 10,740 11,517 12,490 Taxes 3,224 2,752 2,773 3,008 2,578 2,735 2,935 Effective Tax Rate % 27.9% 28.4% 27.9% 28.4% 24.0% 23.8% 23.5% Equity (income)/loss (105) (105) (94) (59) (54) (59) (64) Minority Interest Earnings attributable to stock options Net Income 8,229 6,853 6,942 7,318 7,865 8,472 9,232 EPS $5.25 $4.42 $4.48 $4.71 $5.06 $5.47 $6.03 Average Basic Shares 1,566 1,549 1,551 1,552 1,553 1,547 1,531 Average Diluted Shares 1,566 1,549 1,551 1,553 1,554 1,548 1,532 Basic Shares 1,566 1,549 1,551 1,552 1,553 1,547 1,531 Constant Currency EPS 8.7% 6.8% 11.5% 10.2% 9.0% 9.5% FX Impact ($0.79) ($1.19) ($0.46) ($0.22) ($0.07) ($0.07) EBIT 12,342 10,569 10,668 11,329 11,605 12,604 13,592 EBITDA 13,231 11,458 11,557 12,218 12,494 13,578 14,639 NOPAT 8,022 6,870 6,934 7,364 7,543 8,192 8,835 Dividend $3.88 $4.04 $4.12 $ Payout 73.8% 91.3% 92.1% 89.5% 88.7% 84.9% % Growth Gross Sales 0.1% -7.7% 1.4% 4.2% 1.5% 2.5% 1.2% Excise Taxes 3.1% -6.4% 2.4% 2.2% 0.6% -0.3% -2.0% Net Sales -4.6% -10.0% -0.4% 7.7% 2.1% 8.3% 6.1% COGS 0.2% -10.3% 0.3% 11.1% 5.6% 5.0% 4.1% Gross Profit -7.1% -9.8% -0.8% 5.9% 0.0% 10.3% 7.3% SG&A 0.1% -1.7% -3.4% 5.4% -0.3% 13.4% 6.4% Operating Companies Income -10.5% -14.2% 0.8% 6.2% 0.2% 8.6% 7.8% EBIT -11.5% -14.5% 1.1% 6.6% 2.5% 8.6% 7.8% Pretax Income -11.9% -16.1% 2.5% 6.7% 1.4% 7.2% 8.4% Net Income -8.8% -16.7% 1.3% 5.4% 7.5% 7.7% 9.0% EPS - Adjusted -5.5% -15.8% 1.2% 5.3% 7.4% 8.1% 10.1% 5

6 Exhibit 8: PM Balance Sheet $ millions, except per share E 2019E 2020E Consumer Products Assets: Cash & Cash Equivalents 1,682 3,417 4,239 8,447 9,820 11,290 12,338 Accounts Receivable 4,004 2,778 3,499 3,738 3,582 3,700 3,753 Inventories: 8,592 8,473 9,017 8,806 8,926 8,940 8,896 Other Current Assets 1,206 1, Total Current Assets 15,484 15,804 17,608 21,594 22,931 24,533 25,590 Net Fixed Assets 6,071 5,721 6,064 7,271 7,876 8,109 8,344 Intangible Assets 2,985 2,623 2,470 2,432 2,432 2,432 2,432 Goodwill 8,388 7,415 7,324 7,666 7,666 7,666 7,666 Other 2,259 2,393 3,385 4,005 4,005 4,005 4,005 Total Assets 35,187 33,956 36,851 42,968 44,909 46,746 48,037 Current Liabilities Accounts Payable 1,242 1,289 1,666 2,242 2,368 2,487 2,590 Accrued liabilities 11,344 10,867 11,585 10,715 10,715 10,715 10,715 Short Term Debt Plus Current Maturities of LT Debt 2,526 3,230 3,216 3,005 3,005 3,005 3,005 Total Current Liabilities 15,112 15,386 16,467 15,962 16,088 16,207 16,310 Long Term Debt 26,929 25,250 25,851 31,334 32,334 33,834 35,334 Deferred Income Taxes 1,549 1,543 1, Postretirement Benefits 2,202 2,566 2,800 2,271 2,271 2,271 2,271 Other Liabilities ,832 2,832 2,832 2,832 Total Liabilities 46,390 45,432 47,751 53,198 54,324 55,943 57,546 Stockholders' Equity Common Stock Paid in capital 710 1,929 1,964 1,972 1,972 1,972 1,972 Earnings Reinvested in business 29,249 29,842 30,397 29,859 30,689 31,906 33,595 Accumulated other comprehensive losses (6,826) (9,402) (9,559) (8,535) (8,535) (8,535) (8,535) Treasury Stock (35,762) (35,613) (35,490) (35,382) (35,397) (36,397) (38,397) Total Shareholders' Equity (12,629) (13,244) (12,688) (12,086) (11,271) (11,054) (11,365) Noncontrolling Interests 1,426 1,768 1,788 1,856 1,856 1,856 1,856 Total Liabilities and Shareholders' Equity 35,187 33,956 36,851 42,968 44,909 46,746 48,037 Leverage Total Debt 29,455 28,480 29,067 34,339 35,339 36,839 38,339 Debt/EBITDA 2.2x 2.5x 2.5x 2.8x 2.8x 2.7x 2.6x Total Debt / Equity % % % % % % % Total Capitalization 16,826 15,236 16,379 22,253 24,068 25,785 26,974 Total Debt / Cap 1.8x 1.9x 1.8x 1.5x 1.5x 1.4x 1.4x Net Debt 27,773 25,063 24,828 25,892 25,519 25,549 26,001 Net Debt/EBITDA 2.1x 2.2x 2.1x 2.1x 2.1x 1.9x 1.8x Net Debt / Equity (219.9%) (189.2%) (195.7%) (214.2%) (226.4%) (231.1%) (228.8%) Net Total Capitalization 15,144 11,819 12,140 13,806 14,248 14,495 14,636 Net Debt / Net Total Cap 1.8x 2.1x 2.0x 1.9x 1.8x 1.8x 1.8x Quick Ratio Current Ratio EBIT/Interest Expense Unfunded pension/postretirement liability Net Debt (incl. OPEB) 27,773 25,063 24,828 25,892 25,519 25,549 26,001 6

7 Exhibit 9: PM Cash Flow Statement $ millions, except per share E 2019E 2020E Operating Activities: Net Income 7,658 7,032 7,250 6,341 7,804 8,408 9,161 Depreciation ,047 Amortization Total Depreciation and Amortization ,047 Deferred Income Taxes (62) (18) 182 (501) Receivables (463) 647 (1,009) (92) 156 (118) (52) Total Inventory 105 (841) (695) 730 (120) (14) 43 Other Current Assets (230) (42) (209) 1, Accounts Payable Change in Other and Accrued Liabilities (507) (8) 1,477 (554) Total Changes in Working Capital: (918) 66 (63) 1, (13) 94 Other Operating Activities (35) Cash from Operating Activities 7,739 7,865 8,077 8,912 8,861 9,369 10,302 Investing Activities: Capital Expenditures (1,153) (960) (1,172) (1,548) (1,500) (1,208) (1,282) Acquisitions and Investments (110) Divestitures Other Investing Activities (1,466) Cash from Investing Activities (996) (708) (968) (3,014) (1,500) (1,208) (1,282) Financing Activities: Cash dividends (6,035) (6,250) (6,378) (6,520) (6,974) (7,191) (7,472) Change in current debt (1,080) (266) (12) (127) Change in long term debt 4, ,143 4,299 1,000 1,500 1,500 Issuance of common stock (3,833) (48) - - (15) (1,000) (2,000) Other financing activity (242) 1,518 (166) (421) Cash from Financing Activities: (6,839) (4,736) (5,413) (2,769) (5,989) (6,691) (7,972) Effect of Exchange Rate (376) (686) (874) 1, Cash and equivalents, Beginning 2,154 1,682 3,417 4,239 8,447 9,820 11,290 Change in cash and equivalents (472) 1, ,208 1,373 1,470 1,048 Cash and equivalents, Ending 1,682 3,417 4,239 8,447 9,820 11,290 12,338 Net Issuances / (Repurchases) (3,833) (48) - - (15) (1,000) (2,000) Free Cash Flow Levered FCF 6,586 6,905 6,905 7,364 7,361 8,161 9,020 Unlevered Free Cash Flow 7,429 7,698 7,675 8,144 8,209 9,180 10,084 Discretionary Cash Flow (Levered FCF - Dividends) ,548 Levered FCF per Share $4.21 $4.46 $4.45 $4.74 $4.74 $5.27 $5.89 Unlevered FCF per Share $4.74 $4.97 $4.95 $5.25 $5.29 $5.93 $6.59 Levered FCF Yield 5.0% 5.4% 4.9% 4.6% 5.9% 6.0% 6.1% Unlevered FCF Yield 5.6% 6.0% 5.4% 5.1% 6.6% 6.7% 6.8% Average Share Price $84.05 $82.69 $91.49 $ $80.00 $88.00 $

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9 STOCK RATING CATEGORY COVERAGE UNIVERSE INVESTMENT BANKING CLIENTS (IBC) OTHER MATERIAL INVESTMENT SERVICES CLIENTS (MISC) COUNT % OF TOTAL COUNT % OF TOTAL IBC % OF RATING CATEGORY COUNT % OF TOTAL OTHER MISC Overweight/Buy % % 25% % Equal-weight/Hold % % 27% % Not-Rated/Hold 50 2% 5 1% 10% 7 0% Underweight/Sell % 81 11% 15% % TOTAL 3, Data include common stock and ADRs currently assigned ratings. Investment Banking Clients are companies from whom Morgan Stanley received investment banking compensation in the last 12 months. Due to rounding off of decimals, the percentages provided in the "% of total" column may not add up to exactly 100 percent. Analyst Stock Ratings Overweight (O). The stock's total return is expected to exceed the average total return of the analyst's industry (or industry team's) coverage universe, on a risk-adjusted basis, over the next months. Equal-weight (E). The stock's total return is expected to be in line with the average total return of the analyst's industry (or industry team's) coverage universe, on a risk-adjusted basis, over the next months. Not-Rated (NR). Currently the analyst does not have adequate conviction about the stock's total return relative to the average total return of the analyst's industry (or industry team's) coverage universe, on a risk-adjusted basis, over the next months. Underweight (U). The stock's total return is expected to be below the average total return of the analyst's industry (or industry team's) coverage universe, on a risk-adjusted basis, over the next months. Unless otherwise specified, the time frame for price targets included in Morgan Stanley Research is 12 to 18 months. Analyst Industry Views Attractive (A): The analyst expects the performance of his or her industry coverage universe over the next months to be attractive vs. the relevant broad market benchmark, as indicated below. In-Line (I): The analyst expects the performance of his or her industry coverage universe over the next months to be in line with the relevant broad market benchmark, as indicated below. Cautious (C): The analyst views the performance of his or her industry coverage universe over the next months with caution vs. the relevant broad market benchmark, as indicated below. Benchmarks for each region are as follows: North America - S&P 500; Latin America - relevant MSCI country index or MSCI Latin America Index; Europe - MSCI Europe; Japan - TOPIX; Asia - relevant MSCI country index or MSCI sub-regional index or MSCI AC Asia Pacific ex Japan Index. Stock Price, Price Target and Rating History (See Rating Definitions) 9

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12 The trademarks and service marks contained in Morgan Stanley Research are the property of their respective owners. Third-party data providers make no warranties or representations relating to the accuracy, completeness, or timeliness of the data they provide and shall not have liability for any damages relating to such data. The Global Industry Classification Standard (GICS) was developed by and is the exclusive property of MSCI and S&P. Morgan Stanley Research, or any portion thereof may not be reprinted, sold or redistributed without the written consent of Morgan Stanley. INDUSTRY COVERAGE: Tobacco COMPANY (TICKER) RATING (AS OF) PRICE* (07/19/2018) Pamela Kaufman, CFA Altria Group, Inc. (MO.N) Philip Morris International Inc (PM.N) E (11/29/2016) O (03/31/2008) $56.94 $80.90 Stock Ratings are subject to change. Please see latest research for each company. * Historical prices are not split adjusted Morgan Stanley 12