# Philip Morris International Inc. (PM) FY 2023 MD&A

Verbatim Item 7 Management's Discussion and Analysis from Philip Morris International Inc.'s 10-K for fiscal year 2023.

SEC filing source: https://www.sec.gov/Archives/edgar/data/1413329/000141332924000013/pm-20231231.htm
Accession: 0001413329-24-000013
Filing date: 2024-02-08
Report date: 2023-12-31
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/fy2022/ (FY 2022)
Next year: /company/PM/mda/fy2024/ (FY 2024)

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, actively delivering a smoke-free future. We are 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 smoke-free products. Since 2008, we have invested $12.5 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 (the "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.

In January 2023, we began managing our business in four geographical segments, down from six previously, in addition to our continuing Swedish Match and Wellness and Healthcare segments: As of December 31, 2023, our operating segments were as follows:

•Europe Region;

•South and Southeast Asia, Commonwealth of Independent States, Middle East and Africa Region ("SSEA, CIS & MEA");

•East Asia, Australia, and PMI Duty Free Region ("EA, AU & PMI DF");

•Americas Region;

•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 Vectura Fertin Pharma business.

Following the combination and the progress in 2023 toward integrating the Swedish Match business into the existing PMI regional segment structure, we will update our segment reporting by including Swedish Match results in the four existing geographical segments. As of the first quarter of 2024, we will report on this basis.

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 (also referred to herein as "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 SFPs portfolio. As of December 31, 2023, our smoke-free products were available for sale in 84 markets.

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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 ("Vectura") and Fertin Pharma A/S ("Fertin Pharma"), which provide essential capabilities for future product development. Now, through our Vectura Fertin Pharma business, 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 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 cigarettes to better alternatives faster than either company could achieve separately.

In 2022, we also completed an agreement with Altria Group, Inc. to end our commercial relationship in the U.S. covering IQOS as of April 30, 2024. Thereafter, PMI will hold the full rights to commercialize IQOS in the U.S. On July, 14, 2023, we made the final payment to Altria under the terms of the agreement.

For further details of our 2021 and 2022 acquisitions, as well as the agreement with Altria Group, Inc., see Item 8, Note 3. Acquisitions and the "Business Environment" section of this Item 7

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.

Executive Summary

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

Global Patent Settlement

On February 1, 2024, we entered into a global settlement agreement with British American Tobacco p.l.c. ("BAT") that resolves all ongoing patent infringement litigation between the parties related to heated tobacco and vapor products. The settlement includes non-monetary provisions between PMI and BAT that resolve all ongoing global patent infringement litigation, encompassing all related injunctions and exclusion orders, and prevents patent infringement and certain other future claims against current heated tobacco and vapor products. Under the settlement PMI and BAT also agreed to request rescission of the Limited Exclusion Order and Cease and Desist Order issued by the International Trade Commission prohibiting the importation of certain heat-not-burn products by PMI and

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its affiliates into the U.S. The settlement also allows each party to innovate and introduce product iterations. For further details, see Item 8, Note 18. Contingencies.

War in Ukraine

In Ukraine, our main priority remains the safety and security of our employees and their families in the country. We continue commercial activities in select locations where safety allows, in order to provide product availability and service to adult consumers, and supply the market from production centers outside Ukraine, as well as through a contract manufacturing arrangement. Production at our factory in Kharkiv remains suspended. On June 20, 2023, we announced the investment of $30 million in a new production facility in the Lviv region, in Western Ukraine. Preparatory work for the facility began in July 2023 and production is expected to commence in the first quarter of 2024. As of December 31, 2023, our Ukrainian operations had approximately $0.4 billion in total assets, excluding intercompany balances.

In Russia, we are continuously assessing the evolving situation in the country. This includes regulatory constraints in the market entailing 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 the event of a divestment, our ability to fully realize the value of the business would likely be subject to material impairment. As of December 31, 2023, our Russian operations had approximately $2.7 billion in total assets, excluding intercompany balances, of which approximately $0.8 billion consisted of cash and equivalents held mostly in local currency (Russian rubles).

Additionally, we hold a 23% equity interest in Megapolis Distribution BV, the holding company of CJSC TK Megapolis, PMI's distributor in Russia. For further details, see Item 8, Note 6. Related Parties – Equity Investments and Other.

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 Item 7.

Consolidated Operating Results

•Net Revenues – Net revenues of $35.2 billion for the year ended December 31, 2023, increased by $3.4 billion, or 10.7%, from the comparable 2022 amount. The change in our net revenues from the comparable 2022 amount was driven by the following (variances not to scale):

Net revenues increased by 10.7%, including the impact of the Swedish Match acquisition and currency. Net revenues, excluding currency and acquisitions, increased by 7.6%, mainly reflecting: a favorable pricing variance, primarily driven by higher combustible tobacco pricing, and favorable volume/mix, mainly driven by higher HTU volume, partially offset by lower cigarette volume. The increase was partly offset by lower fees for certain distribution rights billed to customers in certain markets and a charge to net revenues in 2023 of $80 million following the termination of a distribution arrangement in the Middle East, both shown in "Other." The termination of a distribution arrangement in the Middle East is further described in the following "Diluted Earnings Per Share" discussion.

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Net revenues by product category for the years ended December 31, 2023 and 2022, are shown below:

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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, 2023, from the comparable 2022 amounts, were as follows:

[[GREPCENT_TABLE]]
[["","Diluted EPS","% Change"],["For the year ended December 31, 2022","$","5.81"],["2022 Charges related to the war in Ukraine","0.08"],["2022 Fair value adjustment for equity security investments","(0.02)"],["2022 Amortization of intangibles","0.09"],["2022 Impairment of goodwill and other intangibles","0.06"],["2022 Costs associated with Swedish Match AB offer","0.06"],["2022 Swedish Match AB acquisition accounting related item","0.06"],["2022 Income tax impact associated with Swedish Match AB financing","(0.13)"],["2022 Tax items","(0.03)"],["Subtotal of 2022 items","0.17"],["2023 Charges related to the war in Ukraine","(0.03)"],["2023 Asset impairment and exit costs","(0.06)"],["2023 South Korea indirect tax charge","(0.11)"],["2023 Termination of agreement with Foundation for a Smoke-Free World","(0.07)"],["2023 Fair value adjustment for equity security investments","0.02"],["2023 Amortization of intangibles","(0.25)"],["2023 Impairment of goodwill and other intangibles","(0.44)"],["2023 Termination of distribution arrangement in the Middle East","(0.04)"],["2023 Swedish Match AB acquisition accounting related item","(0.01)"],["2023 Income tax impact associated with Swedish Match AB financing","0.11"],["2023 Tax items","(0.11)"],["Subtotal of 2023 items","(0.99)"],["Currency","(0.63)"],["Interest","(0.21)"],["Change in tax rate","0.03"],["Operations","0.84"],["For the year ended December 31, 2023","$","5.02","","(13.6)","%"]]
[[/GREPCENT_TABLE]]

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. During 2023, we recorded a pre-tax charge of $53 million (representing $43 million net of income tax and a diluted EPS charge of $0.03 per share), related to circumstances driven by the war, including the cost of PMI’s humanitarian efforts, severance payments, as well as an impairment of certain long-lived assets. 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). During 2023, 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.

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Amortization of intangibles – During 2022, we recorded amortization of intangibles expense of $159 million (representing $129 million net of income tax or $0.09 per share decrease in diluted EPS). During 2023, we recorded amortization of intangibles expense of $497 million (representing $389 million net of income tax or $0.25 per share decrease in diluted EPS). The higher amortization expense in 2023 was primarily due to increased acquired intangible assets recorded as a result of our acquisitions in 2022. For further details, see Item 8, Note 5. Goodwill and Other Intangible Assets, net.

Impairment of goodwill and other intangibles – During 2022, we recorded an impairment charge related to definite-lived intangible assets of $112 million (representing $98 million net of income tax and a diluted EPS charge of $0.06 per share) 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. This impairment charge was recorded within cost of sales in the consolidated statements of earnings for the year ended December 31, 2022.

During the second quarter of 2023, we completed our annual review of goodwill and non-amortizable intangible assets for potential impairment. Based on this review, it was determined that the estimated fair value of the Wellness and Healthcare reporting unit was lower than its carrying value. Consequently, we recorded a total non-cash impairment charge of $680 million (representing a $0.44 per share decrease in diluted EPS) consisting of a goodwill impairment charge of $665 million and a non-amortizable intangible asset pre-tax impairment charge of $15 million for an in-process research and development project related to one of our 2021 acquisitions. The impairment charge was recorded in impairment of goodwill ($665 million) and marketing, administration and research costs ($15 million) within the consolidated statements of earnings during the year ended December 31, 2023, and was included in the Wellness and Healthcare segment results.

For further details, see Item 8, Note 5. Goodwill and Other Intangible Assets, net.

Costs associated with Swedish Match AB offer – During 2022, we incurred pre-tax costs associated with the Swedish Match offer 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 financial 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 in 2022 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). During 2023, we recorded pre-tax purchase accounting adjustments of $18 million related to the sale of acquired inventories stepped up to fair value (representing $13 million net of income tax and a diluted EPS charge of $0.01 per share). These pre-tax adjustments were recorded in cost of sales in the consolidated statements of earnings for the years ended December 31, 2023 and 2022. For further details, see Item 8, Note 3. Acquisitions.

Asset impairment and exit costs – During 2023, we recorded pre-tax asset impairment and exit costs of $109 million, representing $96 million net of income tax and a diluted EPS charge of $0.06 per share, related to a project to fully outsource and restructure the manufacturing of e-vapor devices and consumables. For further details, see Item 8, Note 20. Asset Impairment and Exit Costs.

South Korea indirect tax charge – On July 13, 2023, our South Korean subsidiary, PM Korea, received an adverse ruling from the Supreme Court of South Korea related to cases alleging underpayment of excise taxes in connection with a 2015 excise tax increase and subsequent audit by the South Korean Board of Audit and Inspection. The Supreme Court ruling reversed previous decisions that were in PM Korea’s favor at the trial and appellate levels. As a result of the ruling, we concluded that an adverse outcome is probable. Consequently, we recorded a non-cash pre-tax charge of $204 million (representing $174 million net of income tax or $0.11 per share decrease in diluted EPS) in the second quarter results of 2023, reflecting the full amount previously paid by PM Korea. For further details, see Item 8, Note 18. Contingencies.

Termination of agreement with Foundation for a Smoke-Free World – On September 29, 2023, PMI and the Foundation for a Smoke-Free World (the "Foundation") entered into the Final Grant Agreement and Termination of the Second Amended and Restated Pledge Agreement ("Agreement"). Under the terms of the Agreement, PMI paid $140 million in the third quarter of 2023 in return for the termination of the pledge agreement between the parties. As a result, in the third quarter of 2023, PMI recorded a pre-tax charge of $140 million (representing $111 million net of income tax or $0.07 per share decrease in diluted EPS) commensurate with the early termination of the pledge agreement. The pre-tax charge was recorded in marketing, administration and research costs in the consolidated statements of earnings during the year ended December 31, 2023. For further details, see "Other Developments" within the Business Environment section of this Item 7.

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Termination of distribution arrangement in the Middle East – Following the termination of a distribution arrangement in the Middle East, we recorded a pre-tax charge of $80 million in the first quarter of 2023 (representing $70 million net of income tax and a diluted EPS charge of $0.04 per share). The pre-tax charge was recorded as a reduction of net revenues in the consolidated statements of earnings and was included in the SSEA, CIS & MEA segment results.

Income taxes – The Income tax impact associated with Swedish Match AB financing that increased our 2022 diluted EPS by $0.13 per share and increased our 2023 diluted EPS by $0.11 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.

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 2023 tax items that decreased our 2023 diluted EPS by $0.11 per share in the table above were due to an increase in deferred tax liabilities related to the unremitted earnings of PMI's Russian subsidiaries due to the unilateral suspension of certain Russian double tax treaties by the Russian authorities on August 8, 2023, with respect to certain payments including dividends. 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 earnings mix by taxing jurisdiction.

Currency – The unfavorable impact of $0.63 per share during the reporting period primarily results from the fluctuations of the U.S. dollar, especially against the Argentine peso, Egyptian pound, Japanese yen, Russian ruble and Swiss franc, partly offset by the Euro. This unfavorable currency movement has impacted our profitability across our primary revenue markets and local currency cost bases.

Interest – The unfavorable impact of $0.21 per share from interest in the table above was due primarily to higher interest expense in connection with the Swedish Match acquisition, partially offset by higher net interest income driven by higher interest rates.

Operations – The increase in diluted EPS of $0.84 per share from our operations in the table above was due primarily to the following segments:

•Swedish Match: Reflecting the 2023 impact following the fourth quarter 2022 acquisition; and

•EA, AU & PMI DF: Favorable volume/mix, favorable pricing and lower supply chain costs;

partially offset by

•Americas: Unfavorable volume/mix and higher marketing, administration and research costs, partly offset by favorable pricing;

•SSEA, CIS & MEA: Higher marketing, administration and research costs, higher manufacturing costs, unfavorable volume/mix and the impact of lower fees for certain distribution rights billed to customers in certain markets, partly offset by favorable pricing;

•Wellness and Healthcare: Primarily reflecting commercial investments and higher administration costs; and

•Europe: Higher marketing, administration and research costs, higher manufacturing costs and unfavorable volume/mix, 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