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Philip Morris takes cigarette alternative to South Korea

IQOS device embraced in Japan may challenge KT&G

Philip Morris’ IQOS stores in Japan bear resemblance to those of Apple.

LONDON - IQOS, the high-tech alternative to cigarettes produced by U.S. tobacco company Philip Morris International, has been embraced most warmly by Japan among the 25 global markets where it is sold. Now the company will see whether smokers in neighboring South Korea are just as adventurous.

PMI announced Wednesday that it will start selling iQOS devices, which heat rather than burn tobacco which is packed into what resemble mini cigarettes, at two company stores in Seoul on May 27. The rollout will expand to CU convenience stores and other outlets beginning June 5.

IQOS is critical for PMI as it tries to counter tightening anti-smoking legislation and falling smoking rates around the world. By 2020, PMI hopes to generate up to $1.2 billion a year in earnings from smoke-free products such as IQOS though many Asian governments have been moving to restrict sales of new-generation devices.

The iQOS tobacco-heating-system from Philip Morris

Japan, the only Asian market where iQOS has been put on sale, accounted for 93.5% of company shipments of the HeatStick tobacco rolls that go into the device during the January-March quarter. HeatSticks in turn now have an 8.8% share of the Japanese market for tobacco products. IQOS had its global debut in Nagoya in 2014.

South Korea accounts for about 2% of PMI's global sales and shares many characteristics with the Japanese market. "We believe iQOS has the potential to be as successful in Korea as it's been in Japan," said Ilwoo Chong, head of PMI's South Korean arm.

Financial analysts are more cautious. UBS analyst Jennifer Han noted that South Korea's legal classification of iQOS will restrict public usage to in designated smoking areas. Regulations in Japan are far looser, allowing iQOS use in restaurants and on the street.

In a survey of 1,100 Japanese iQOS users by UBS, most respondents said the main reason they had switched away from cigarettes was to stop tobacco smoke and smells from bothering other people. Han concluded this is "a cultural orientation [that]... may not necessarily pertain to Korea."

Challenging incumbents

Morgan Stanley analysts however suggest that iQOS could pose the same challenge to local tobacco market leader KT&G that it has to Japan Tobacco. In 2016, cigarette sales volume fell 4.7% in Japan, according to estimates by Berenberg, a bank.

Morgan Stanley noted that constraints on the supply of HeatSticks, to be branded as HEETS in South Korea, which have limited sales in Japan "will have been resolved before the Korean launch, while awareness should be higher." PMI officials say they are on track to raise annual HeatStick production capacity this year from 15 billion sticks to 50 billion.

KT&G and Japan Tobacco are both former state monopolies that still dominate their local markets, with PMI in second place in both cases. At the end of 2016, KT&G had a market share of 59% versus 20% for PMI.

KT&G and Japan Tobacco have been slow to respond to the challenge of next-generation tobacco products. Japan Tobacco plans to launch Ploom Tech, its own tobacco-heating device, in June. KT&G recently said it would observe consumers' reaction to iQOS before launching its own product.

KT&G posted a 0.6% rise in operating profits on an 8% improvement in revenues during the first quarter. Its shares have underperformed the local Kospi benchmark stock index, rising only 2.5% this year against a 13.3% gain for the Kospi.

KT&G management said in an earnings call that they expected iQOS to take off more slowly in South Korea than in Japan because consumers already have access to e-cigarettes, devices that produce vapor from nicotine-laced fluids. According to the South Korean Ministry of Health and Welfare, about 7% of adult males are "vapers." Such devices are effectively banned in Japan where they are classified as pharmaceutical products.

Japan and South Korea both have very high smoking rates and a preference for low-tar brands, which may accelerate the shift to potentially less harmful alternatives. Morgan Stanley estimates that ultra-low tar cigarettes have a penetration rate of more than 50% in South Korea and 39% in Japan.

South Korea has a high proportion of males who smoke, at 42%, which has been partly attributed to the country's compulsory two-year military service. The government has stepped up its anti-smoking campaign with a target of reducing the overall smoking rate by 2020 from 39.3% to the average 29% of members of the Organization for Economic Cooperation and Development.

In 2015, South Korea imposed a 120% tax increase on cigarettes, helping push up the average price of a cigarette pack to 4,500 won ($4.02) from 2,500 won and driving many smokers to try e-cigarettes, which were not affected by the tax change. The county also introduced graphic warnings on cigarette packaging at the end of last year.

Packs of HEETS will need to display labels that highlight nicotine addiction risks too. PMI said it will sell HEETS for 4,300 won per pack, about 200 won less than a pack of the company's Marlboro cigarettes. "We're confident many will make the switch to iQOS," Chong said.

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