Earnings Call Transcript - PM Q2 2022

Operator, Operator

Good day, and welcome to the Philip Morris International Second Quarter 2022 Earnings Conference Call. Today's call is scheduled to last about one hour, including remarks by Philip Morris International management sessions, and the question and answer session. Media representatives on the call will also be invited to ask questions at the conclusion of the question-and-answer from the investment community. I would now like to turn the call over to Mr. James Bushnell, Vice President of Investor Relations and Financial Communications. Please go ahead, sir.

James Bushnell, Vice President of Investor Relations and Financial Communications

Welcome. Thank you for joining us. Earlier today, we issued a press release containing detailed information on our 2022 second quarter results. You may access the release on pmi.com. A glossary of terms, including the definition for reduced risk products or RRPs as well as adjustments, other calculations and reconciliations to the most directly comparable U.S. GAAP measures and additional heated tobacco unit market data are at the end of today's webcast slides, which are posted on our website. Unless otherwise stated, all references to IQOS are to our IQOS heat-not-burn products and all references to smoke-free products are to our RRPs. Growth rates presented on an organic basis reflect currency-neutral adjusted results, excluding acquisitions and disposals. Consistent with last quarter, figures and comparisons presented on a pro forma basis entirely exclude PMI’s operations in Russia and Ukraine. As mentioned previously, starting in the second quarter of 2022, and on a comparative basis, PMI will exclude amortization and impairment of acquired intangibles from its adjusted results. Today’s remarks contain forward-looking statements and projections of future results. I direct your attention to the Forward-Looking and Cautionary Statements disclosure in today’s presentation and press release for a review of the various factors that could cause actual results to differ materially from projections or forward-looking statements. It’s now my pleasure to introduce Emmanuel Babeau, Chief Financial Officer. Over to you, Emmanuel.

Emmanuel Babeau, Chief Financial Officer

Thank you, James. Welcome to you in your new role, and welcome, everyone. Before I begin, I want to reiterate our focus on supporting our employees and their families affected by the war in Ukraine and above all on the safety of our people. We continue to deploy humanitarian support and additional benefits for our Ukraine employees. As previously announced, we intend to exit the Russian market in an orderly manner, as the complexities of continuing to operate in Russia increase such as supply chain challenges and financial and banking sector restrictions. We continue to actively work on options for doing so in the context of an increasingly complex and rapidly changing regulatory and operating environment, including the requirement to obtain certain governmental approval for any transaction. Turning to our business. We demonstrated strong underlying momentum in the second quarter of 2022 with another quarter of positive volume supporting better-than-expected top and bottom-line growth. Most impressive was the continued excellent IQOS performance and strong Q2 pro forma user growth of more than 1.1 million, demonstrating further sequential acceleration compared to Q1 as device limitation and COVID restrictions continue to ease. This reflects strong momentum in the EU region, Japan, and developing markets. Q2 RRP pro forma net revenues grew by 11% despite the adverse shipment timing impact due to supply chain constraints highlighted last quarter, while HTU IMS volumes grew by 20%. IQOS ILUMA delivered further impressive results in its first three markets of Japan, Switzerland, and Spain. The acceleration in category growth in these diverse geographies highlights the exciting future growth opportunity across the world, including in the latest launch market of Greece. In combustibles, robust Q2 pro forma volume growth of 2.4% and organic net revenue growth of 4.2% were driven by Marlboro share gains, stronger pricing, and the continued recovery of the market. Maintaining leadership of the cigarette category allows us to maximize the switching of adult smokers to smoke-free alternatives and accelerate our transformation into a predominantly smoke-free business by 2025. We expect the strong underlying momentum of our business in H1 to continue, and we are optimistic about the organic growth outlook for the year. We are now well on track to deliver two consecutive years of volume growth, confirming our status as a growth company in terms of volumes, organic net revenues, and margins. Despite a substantial currency headwind in 2022, we expect to deliver full year adjusted diluted EPS of around $6, including Russia and Ukraine. The proposed addition of Swedish Match would further boost our future financial profile. This is a value-creating offer for both sets of shareholders with a compelling strategic and cultural fit, providing an additional opportunity to accelerate our smoke-free future. Turning to the headline numbers. Our Q2 volumes grew by 3% on a pro forma basis and by 1.1% in total, including Russia and Ukraine. Pro forma net revenues grew organically by 6.2% and by 5.3% for total PMI, reflecting both the continued strong growth of IQOS and the ongoing recovery of the combustible business in many markets against a pandemic-affected comparison. As we anticipated and indicated previously, less unfavorable timing of cigarette shipments also played a role, notably due to replenishment of duty-free inventories. Our total organic net revenue per unit grew by 3% on a pro forma basis and by 4.1% in total despite the expected delay of HTU shipments to Japan as we manage through global supply chain disruptions. This incorporates combustible pricing of 3.5% on a pro forma basis or almost 5% excluding Indonesia. Our Q2 adjusted operating income margin declined organically by 190 basis points on a pro forma basis and by 150 basis points in total. As expected and communicated in our Q1 quarterly results, this reflects four main factors: first, investment to further expand and match the speed of growth in our smoke-free portfolio. This includes the initial higher cost of ILUMA devices and HTUs and the transitory dilutive margin impact of higher device sales as we roll out ILUMA and replenish distribution channels as device constraints ease to support reaccelerating IQOS user growth. Second, the impact of supply chain disruptions, notably due to the war in Ukraine, including around $80 million in additional air freight expenses. Third, inflation of around 4% in our cost of goods driven by the global pandemic recovery and exacerbated by the war, notably for certain direct materials, wages, energy, and transportation costs. And last, a challenging prior year margin comparison, which included substantial cost of goods sold productivity savings. Despite these typical margin challenges, our robust top-line growth and ongoing cost efficiency enable us to deliver 5.6% growth in pro forma currency-neutral adjusted diluted EPS ahead of expectation to $1.32 and 3.8% growth for total PMI to $1.48, including Russia and Ukraine. Looking at the first half of the year now, our volumes grew by 4% on a pro forma basis and by 2.2% for total PMI. Pro forma revenues grew by 8.1% and by 7.1% in total, also driven by strong IQOS performance and the recovery of the cigarette category. We delivered organic net revenue per unit growth of 4% on a pro forma basis and 4.7% in total, again, reflecting the positive impact of growing HT volumes and pricing. Our H1 adjusted operating income margin contracted organically by 110 basis points on a pro forma basis and 90 basis points in total, driven by the factors mentioned previously. We expect better margin performance in H2, a topic I will review shortly. Currency-neutral adjusted diluted EPS grew by 10.4% to $2.79 on a pro forma basis and 9.2% in total to $3.06, an excellent performance given the circumstances. Reflecting this strong momentum, we are raising our guidance for 2022. With strong IQOS growth and robust trends in combustibles, we foresee an acceleration in our currency-neutral growth expectation relative to our previous forecast. First, we now expect to grow our total pro forma shipment volume by 1.5% to 2.5% for 2022, achieving another year of volume growth. For pro forma net revenue, we expect to deliver between 6% and 8% organic growth as compared to the 4.5% to 6.5% announced previously, despite a greater-than-anticipated drag from hyperinflationary accounting in Turkey. With a strong recovery in device volume, the increasing contribution of ILUMA with initially higher unit costs and ongoing global inflation, we are narrowing our forecast for pro forma adjusted organic OI margin expansion to between zero and 50 basis points. We are also raising our growth outlook for pro forma currency-neutral adjusted diluted EPS to between 10% and 12%. This reflects a range of $5.23 to $5.34, including an estimated unfavorable currency impact of $0.80 at prevailing rates notably due to the euro and Japanese yen. We'll include a slide in the appendix with further detail on this estimated impact. For total PMI, which assumes a full-year contribution from Russia and Ukraine, we expect adjusted diluted EPS of $5.90 to $6.05, reflecting a similar dynamic to the pro forma basis and including an estimated $0.69 unfavorable currency impact. Please note our 2022 forecast assumes no contribution from the proposed combination with Swedish Match, which is expected to close in the fourth quarter of this year, subject to Swedish Match shareholder acceptance and the necessary regulatory approvals. The outlook for IQOS growth is excellent, and we now expect to deliver full-year pro forma HTU shipment volumes of 90 billion to 92 billion units, representing the upper half of our previous forecast range. With growth momentum very strong, the main constraint for not further raising our HTU volume target is our production capacity, notably for ILUMA HTUs due to their outstanding initial success and the cancellation of production in Russia as we convert existing production lines for induction consumption. We continue to expect excellent HTU growth in the coming quarters with a progressive improvement in ILUMA HTU capacity through the first half of 2023. We are prioritizing ILUMA launch markets accordingly with further launches planned in Q4 as communicated previously. A notable further update to our outlook is an increase in our operating cash flow forecast to around $10.5 billion as compared to around $10 billion previously despite notable currency headwinds. This includes our accelerated pro forma earnings growth forecast and an assumed full-year contribution from Russia and Ukraine. We delivered robust operating cash flow growth in H1 of 14%. And as shown through the challenges of recent years, the cash generation capacity of our business remains exceptional. While flattened somewhat in 2021 by favorable timing and one-off impacts, our revised full-year forecast demonstrates underlying growth against this exceptional year after also accounting for higher inflation-driven working capital requirements and currency. This underlines our ability to maintain a strong balance sheet, pay down debt and invest in the growth of our business. Our net debt of $23 billion at June 30, 2022, decreased compared to both June and December 2021, despite H1 capital expenditure of $0.5 billion and ongoing dividend payments. Our commitment to our progressive dividend policy is unwavering, and we look forward to the additional cash flow the proposed combination with Swedish Match would bring. We also continue to expect around $1 billion in full-year capital expenditure. Moving now to the pro forma outlook for the second half. We expect to deliver strong top-line growth, organic adjusted OI margin expansion, and further acceleration in bottom-line growth. For Q3, we expect mid-single-digit organic top-line growth driven by IQOS with around $22 billion in pro forma HTU shipment volumes. While there is a tougher comparison for cigarettes and a modest negative impact expected from shipment timing, we expect combustible volume trends to remain resilient by historical standards. Net revenue growth will also continue to be impacted in both Q3 and Q4 by the shift to hyperinflationary accounting in Turkey. While the temporary cost headwinds in Q2 are expected to ease somewhat in the third quarter, we expect this to be broadly offset by a step-up in smoke-free commercial and R&D investment as compared to a device constraint in Q3 2021. This results in an expected Q3 pro forma adjusted diluted EPS range of $1.23 to $1.28, including an estimated adverse currency impact of $0.24 at prevailing rates. We expect a strong Q4 with a rebound in HTU shipment volume due to phasing, the most pronounced as HT capacity constraints improve. The H2 recovery in our pro forma adjusted OI margin is also expected to be Q4 weighted. Turning back to our results. Pro forma HTU in-market sales volume grew strongly by 20% for both the second quarter and the first half, notably driven by strong performance in the EU region. As expected, Q2 IMS pro forma growth was significantly ahead of shipment volume growth reflecting the later timing of shipments I mentioned earlier. Our total pro forma shipment volume increased by 3% for Q2 and 4% for H1. As I touched on earlier, this puts us well on track to deliver total volume growth for the second consecutive year on both a pro forma and total PMI basis. With the impressive performance of IQOS, heated tobacco units comprised 12.6% of our pro forma shipment volume in H1 or 14% in total despite the anticipated HTU shipment timing impact in Q2. Our sales mix is also changing rapidly as we aim to become a majority smoke-free company by 2025. Smoke-free net revenues made up almost 30% of our pro forma total and exceeded 30% for total PMI in the first half of the year. IQOS devices accounted for approximately 5% of the $4.2 billion of pro forma H1 RRP net revenues. This reflects higher device volume at a lower average price than last year as we expand our device portfolio with VEEV and ILUMA and price ladder our blade device portfolio in preparation for the launch of a premium position in ILUMA. The positive momentum of IQOS continues and is further accelerating in many geographies, providing a powerful driver of revenue and margin growth. We delivered organic growth of 8.1% in H1 pro forma net revenues and shipment growth of 4%. This reflects the twin engines driving our top line in addition to volume. The first is pricing led by combustibles. The second is the increasing mix of RRPs in our business at higher net revenue per unit, which continue to deliver substantial growth. This is an increasingly powerful driver as our transformation accelerates. Let's now turn to the drivers of our H1 pro forma adjusted OI margin which contracted organically by 110 basis points. Pro forma gross margin decreased by 280 basis points organically, reflecting the factors I mentioned previously, as we invest in our smoke-free business and manage temporary supply chain disruption and cost inflation. This margin headwind was partially offset by better pro forma adjusted marketing administration and reserve costs, which improved by 160 basis points organically. This was driven by the positive operating leverage of RRP growth and our successful cost efficiency program where we generated around $420 million in gross cost savings, of which approximately $170 million came from COGS productivity and over $250 million from SG&A. With more than $1.2 billion of savings realized by this halfway point, we are well on track to deliver cost savings of $2 billion for 2021 to 2023. This allows us to reinvest in top-line growth and mitigate inflationary pressures while continuing to deliver margin expansion. We continue to accelerate investment in our commercial programs, digital engine, and R&D for long-term growth as well as a number of growth opportunities across categories and geographies. As reflected in our full-year outlook, we expect our operating margin trajectory to improve in the second half of the year as temporary headwinds ease. Focusing now on combustibles, our portfolio again delivered growth in pro forma volume and organic net revenue in Q2. Our pro forma shipment volume grew by 2.4% against a pandemic-affected comparison notably driven by Indonesia, Poland, and Turkey. In addition, we saw a continued recovery in international duty-free outside Asia as passenger traffic increases. Pro forma combustible pricing of 3.5% was slightly ahead of our expectations. And while we remain cautious on the economic outlook, the pricing environment has been gradually improving. We expect to deliver a similar level of pricing for the full year. Our leadership in combustibles helps to maximize switching to smoke-free products and both the positive Q2 and H1 segment share demonstrate the strength of our portfolio. We continue to target a stable category share over time despite the impact of IQOS cannibalization. This year marks the 50th anniversary of Marlboro becoming the world's leading cigarette brand. With the return of social consumption occasions, Marlboro volumes grew 7% year-over-year in H1, with category share again surpassing 10% on a pro forma 12-month rolling basis. Our long-standing success in building Marlboro's brand equity is the strength we now have with smoke-free products as we make excellent progress with IQOS as the undisputed global smoke-free leader. The positive combination of a stable share in combustibles and the continued growth of IQOS position us to deliver total market share growth over time. We captured 40 basis points of pro forma share gain in Q2 including gains in duty-free, Italy, Japan, and Turkey. Moreover, PMI HTU strengthened their position as the second largest nicotine brand in markets where IQOS is present with a 7.5% share, excluding Russia and Ukraine. Moving now to IQOS performance. We estimate there were approximately 19 million IQOS users as of June 30 on a pro forma basis. This reflects very strong growth of over 1.1 million users in Q2 and 2.2 million in H1, a record first half high on this basis. The acceleration of IQOS user growth compared to both Q1 and last year was driven by the reactivation of acquisition and retention programs in many markets as device supply constraints receded as well as the impressive start of IQOS ILUMA. While device supply constraints have eased in recent quarters, this is largely due to the success of our own proactive efforts. The global supply of semiconductors remains tight, and we continue to closely monitor and manage the situation. In the EU region, we are now approaching the milestone of 9 million IQOS users, reflecting stepped-up commercial activities to drive acquisition and retention, along with the launch of ILUMA in Switzerland and Spain. Our second quarter HTU share increased by 1.6 points to 7.1% of total cigarette and HTU industry volume. As noted in prior years, sequential share compared to Q1 was affected by the usual seasonality of the combustible market with the additional element of a strong year-over-year combustible recovery this quarter. Most importantly, IMS volume continued to exhibit robust sequential growth, and we expect this to continue in the second half. The strong performance includes excellent user and volume growth across the region with notable contributions from Italy and Poland. Now to give some further color on our progress in the region. This slide shows a selection of the latest key city of Texas in Q2. Despite the denominator effect of the combustible category I just mentioned, share results remain very strong. Most impressive is Venus, the first city in the world to surpass 40% share while Athens, Budapest, and Rome are in the mid- to high 20s. Elsewhere, we are especially pleased by the results in London, Vienna, and Zurich. In Japan, IQOS ILUMA is driving significant growth, and our share of the market continues to increase in key cities such as Tokyo. Most importantly, our IMS volume trends remained strong with continued sequential growth. As indicated last quarter, Q2 shipments were lower due to timing factors and should recover in the second half with a weighting towards Q4. The adjusted share for our H2 brands increased by 1.9 points to a record 22.9% in Q2 despite seasonality. While we are very pleased with these results, our share performance could have accelerated even further. The combustible category was notably resilient in the quarter, and our rollout of mainline price entire HTUs for use with ILUMA was slightly slower than initially planned. However, early results were encouraging in catering to consumers switching to ILUMA and more price-conscious legal-age smokers. We also observed an increase in legal-age users switching from low price competitive products. We estimate users of competitive offerings to have lower average daily consumption due to lower full conversion, which we believe ILUMA should improve over time. The heat-not-burn category now represents around one-third of total tobacco in Japan, with IQOS increasingly driving this year's growth. In addition to strong progress in developed countries, we continue to see very promising IQOS growth in low and medium income markets. The pro forma share of our HTU brands in the 28 such markets launched by December 31, 2021, continued to grow and reach 2.9% in Q2, reflecting sustained growth in IMS volumes. Given the large size of this market, the premium positioning of the existing IQOS portfolio, and the relatively early stage of commercialization, this represents outstanding progress. A prime example of this is Lebanon, where Q2 off-take share in Beirut increased by 8.1 points to 17.4%, and Egypt, where off-take share in Cairo reached around 5% after launching less than a year ago. Other notable successes include the recently launched markets of Morocco and Tunisia, as well as Georgia, Jordan, North Macedonia, and the Philippines despite pandemic restrictions in Manila. Moving now to IQOS ILUMA, which continued to drive increased conversion and retention rates across initial launch markets. In Japan, ILUMA continued to exhibit strong growth with premium-priced TEREA HTUs growing rapidly to become the second largest tobacco brand, reaching an off-take share of 14.6% within nine months of national launch. Encouragingly, SENTIA's off-take share has already surpassed the level of prefectures covering around 45% of industry volume. The expansion of our device portfolio with ILUMA 1 in Q1 has also seen robust traction with legal smokers. We exited Q2 with a record high of tech share and continue to see a long runway of growth in Japan for ILUMA over the coming quarters. ILUMA and TEREA HTUs also continue their strong start in Spain and Switzerland. We launched ILUMA in Spain in March 2022 with very positive initial results, notably in key cities such as Barcelona and Madrid. Sequential IMS volumes grew by 27% in Q2. TEREA exited the quarter, making up over 50% of HTU sales only four months after commercialization, and our national HTU share has grown to over 1.7%. This is especially encouraging as Spain has been a market where regulatory restrictions had limited the speed of IQOS growth. In Switzerland, the demand for ILUMA remains very strong. IMS volume continued to grow sequentially, increasing by 13% in the second quarter. A significant proportion of existing users have upgraded to ILUMA, and the off-take exit volume of TEREA now exceeds 70% of our HTU sales. We continue to expand our global smoke-free portfolio through our rich pipeline of innovation. We launched ILUMA in Greece in late June with further market launches planned for Q4. With regard to our new heat-not-burn device tailored to low and middle income markets, we continue to plan pilot launches in the fourth quarter, further expanding our portfolio to serve different consumer needs and segment the market. In e-vapor, IQOS VEEV continued to deliver encouraging results, and for example, is now the established number two closed-pod brand in Italy with off-take share growing sequentially to around 20%. This is a premium proposition with an average price premium to competitive devices of 20% to 30% as we pursue a differentiated and profitable category leadership position over time. In Q2, we expanded into three additional geographies, including France, and are now present in 10 markets. The latest addition to our e-vapor portfolio is the VEEBA disposable device. Responsibly marketed disposable e-vapor products can play an important role as a convenient hassle-free entry into the smoke-free category for legal-age smokers. VEEBA was recently launched in Canada with nine varieties. Our geographic expansion of smoke-free products also continued in Q2 with the launch of IQOS in Bahrain. Of course, the biggest potential near-term addition to our smoke-free portfolio is the proposed combination with Swedish Match. This would deliver a major acceleration in our transformation to becoming a smoke-free company. The visions of our two companies are aligned in working towards a smoke-free future without cigarettes and would create a global smoke-free champion. If completed, we would have a comprehensive global smoke-free portfolio with a leadership position in heat-not-burn and the fastest growing category of oral nicotine with potential for accelerated international expansion. Another compelling rationale for this deal is the large, attractive, and growing U.S. smoke-free market. Swedish Match leads the nicotine pouch franchise with ZYN and has a substantial U.S. operational platform, which would help us unlock significant opportunities across other categories over the coming years. This would be a strong strategic and cultural fit, offering significant shareholder value creation over the medium and long term. As stated in the offer document published on June 28, the waiting period for the transaction under the U.S. antitrust process has expired, meaning that we have satisfied our requirement in the U.S. to proceed with the transaction. We expect the transaction to close in the fourth quarter of this year, subject to Swedish Match shareholder acceptance and the necessary regulatory approvals. Moving to sustainability, I want to first draw your attention to our 2021 integrated report published in May, which outlines our new sustainability strategy and ESG performance in detail as we continue to transform for good. Included in the report is our new sustainability index comprised of 19 KPIs across our most material sustainability issues. The index is weighted towards product transformation and now represents 30% of our long-term performance-based equity executive compensation. The definitions, methodology, and scope of each of these KPIs are included in our recently published ESG KPI Protocol, providing further transparency on how we define success and major ESG performance. With regard to tackling climate change, I am delighted to report that the science-based target initiative has validated our 2040 net-zero target. The initiative also revalidated our near-term 2030 target for reducing greenhouse gas emissions and our new 2025 target for 15% of our suppliers by spend to have their own Science-Based Target by 2025, a very positive development, given that Scope 3 remains the most challenging aspect of any company's decarbonization strategy. To support the achievement of these targets, we are accelerating progress to decarbonize our chain, and we have made eight more factories carbon neutral this year, more than doubling from last year and placing us on track to meet our goal of all factories by 2025. Finally, product health impact remains one of our most critical ESG priorities. There is a growing body of scientific and real-world evidence of the substantial risk reduction potential of smoke-free products compared to smoking. We continue to support policy and fiscal frameworks that recognize the positive impact tobacco harm reduction policies can have on public health. Recent examples include a further multiyear tax plan with differentiated treatment for smoke-free products in Romania and a statement from the Belgian Superior Health Council on the role e-vapor products can play in switching adult smokers away from cigarettes. To conclude today's presentation, we have delivered a strong first half despite some challenging headwinds, placing us well on track to deliver robust volume growth and an accelerated currency-neutral pro forma financial performance in 2022. We remain excited by the promising results of IQOS ILUMA. Increased consumer satisfaction is driving higher retention and conversion, and we look forward to further market launches later this year. Our combustible business continues to perform well with pro forma volume and organic net revenue growth, maintaining our share of the market over time despite the impact of IQOS cannibalization that allows us to accelerate further switching of smokers to better alternatives and to invest for long-term growth in the development of innovative wellness and health care products that seek to deliver a net positive impact on society. We continue to enrich our pipeline of smoke-free innovations, such as ILUMA and VEEBA to expand and grow across new and existing categories and geographies. We are raising our pro forma growth guidance for the full year and expect to deliver around $6 in total adjusted diluted EPS, including Russia and Ukraine despite currency headwinds. Importantly, with an excellent 2021 performance and our strong 2022 outlook, we now expect to comfortably exceed our 2021-2023 minimum CAGR target on a pro forma basis of more than 5% in organic net revenue growth and more than 5% in currency-neutral adjusted diluted EPS growth. Our ambition to become a majority smoke-free business by net revenue in 2025 also remains fully intact. We are confident in the rapid pace of our transformation. Finally, we continue to be steadfastly committed to returning cash to shareholders. Our top priority for capital allocation remains reinvestment in the business and our progressive dividend policy, underpinned by strong cash flow generation. Thank you and we are now more than happy to answer your questions.

Operator, Operator

Our first question comes from Pamela Kaufman from Morgan Stanley. Your line is now open.

Pamela Kaufman, Analyst

I wanted to get a sense for what's contributing to the strong IQOS new user momentum that you've experienced in the last two quarters. Is there anything that you're doing differently? And where are you adding these users geographically? How much is driven by ILUMA versus prior IQOS devices? And then, related to that, what do you estimate new user growth would be if you were not constrained by production capacity?

Emmanuel Babeau, Chief Financial Officer

Thank you, Pamela. We are very pleased with the performance of IQOS, which is reflected in the strong user growth of over 1.1 million in the second quarter. We noted that this represents record growth for the first half of the year. It’s encouraging that we are experiencing growth across various regions. Countries like Italy, Poland, and Japan have contributed significantly this quarter due to their larger size. However, we are also seeing impressive growth trends in smaller countries such as Romania, Portugal, and Hungary. This highlights that IQOS is meeting customer expectations, and people are recognizing the benefits of transitioning from combustible cigarettes to IQOS products. ILUMA is certainly contributing to our performance, although our rollout is currently limited to Japan, Switzerland, and Spain, with a launch also taking place in Greece. This is positively impacting performance in those areas. Importantly, our success is not solely reliant on ILUMA, as we are seeing improvement in all markets, including those where ILUMA has not yet launched. We are enhancing our customer experience, including digital interactions and outreach to smokers, guiding them on the benefits of IQOS and helping them move away from combustible products. We are also improving our commercial strategies, which is effective. As awareness increases, markets with higher market share see more visibility for IQOS, leading to organic growth as people independently discover the product. Additionally, we are pushing innovation by introducing new devices and references, making IQOS even more appealing. These are significant factors driving the success of IQOS. Regarding ILUMA, we are observing its impact in the three markets where it has launched, effectively addressing the challenges of the previous version. This new offering enhances customer experience, driving conversion, loyalty, and daily usage while reducing issues. We have seen an improvement in customer satisfaction scores in those regions, creating momentum for markets where ILUMA is introduced. This can be viewed as a new phase in our strategy to elevate IQOS sales in upcoming markets.

Pamela Kaufman, Analyst

That's very helpful. I also wanted to get a sense for how you would characterize your current appetite for additional acquisitions in the near-term in light of the Swedish Match transaction. There are additional assets for sale in the U.S. market. Are you in a position to consider more acquisitions?

Emmanuel Babeau, Chief Financial Officer

Today, we are focusing on Swedish Match. The timeline is the same as we were expecting at the beginning. We continue to expect the closing of the transaction in Q4, of course, subject to Swedish Match shareholder acceptance. Nothing has changed. We are focusing on that. Am I closing the door on the future acquisition opportunities that would further accelerate our journey to become a leading smoke-free company? No. But clearly, the priority and focus today is on Swedish Match.

Operator, Operator

We will take our next question from Bonnie Herzog with Goldman Sachs. Your line is open.

Bonnie Herzog, Analyst

I have a question on your pro forma adjusted OP margin in Q2. It declined on an organic basis. You did highlight that the drag on your margins, at least partly, was from the higher cost of ILUMA devices and HTUs. You also lowered your full-year OP margin guidance. So just hoping you could give us a sense of how long margins could be negatively impacted, I guess, from the rollout of ILUMA. And just based on your FY '22 guidance, which does imply lower year-over-year EPS growth in the second half, I assume the drag on margins could be a key driver of this in the second half, but I just wanted to verify that? And just thinking out into 2023, should the drag possibly ease? Or will that continue as you keep pushing on ILUMA?

Emmanuel Babeau, Chief Financial Officer

Yes, thanks, Bonnie for the question. That's true that in H1, we’ve seen a number of headwinds on the margin. Needless to say, inflation is one of them, and we said that we are seeing around 4% inflation on our input costs. That's probably lower than inflation that we see in many countries, but still significant. We have costs arising from disruption in the supply chain, notably influenced by the war in Ukraine. We have a dramatic increase in air freight that is temporary. We're not going to keep air shipping in the long term, but during this period, we needed to do that and it's very costly at a time when freight costs are going up globally. There are also costs connected to the launch of ILUMA, with significant investment made at the beginning, particularly in Japan. We had very strong investment on the device, and we now have three devices available in Japan, and the strong device volumes are impacting margins. Also, we’ve been clear that we didn’t start ILUMA's launch with optimized cost and weight on TEREA and SENITA. That initial period leads to a negative margin impact, but it's something we expect to be temporary. We anticipate gradually improving margins through 2023 as these headwinds lessen. However, inflation is not temporary. For the rest, many of the headwinds we are facing in H1 are temporary, and we will see a recovery over time. I’m unable to pinpoint exact timing, but that’s certainly our expectation. For H2, we are expecting margin improvement—skewed more towards Q4. The margin deterioration in Q3 would be lower, but it'll come with additional investments; we need to ensure we keep pace with growth. Q4 should see a better improvement with a more favorable mix. Let’s not forget that some volumes that were supposed to be shipped and should be in the P&L to Japan did not make it due to circumstances, but we will see compensation in H2. While Q1 was a difficult beginning, it doesn’t mean that everything will be back to normal in H2. We'll still face some headwinds, but certainly, most of what we encounter is temporary, and we expect a margin recovery.

Bonnie Herzog, Analyst

Okay. That all makes sense. And yes, definitely a lot of moving parts. So that was helpful. My second question is on your proposed acquisition of Swedish Match, I guess. Could you give us a little more color on where things are? And perhaps, what you see as potential risks of this transaction not happening? I guess I'm asking in light of the activist involvement; I'd like to hear how committed you are to this transaction and how much flexibility you have in terms of your leverage. I don't believe you have a target leverage ratio, but you’ve stated in the past that you want to maintain your investment-grade ratings. So, I just wanted to get a sense of what the rough threshold for that leverage would be to maintain that.

Emmanuel Babeau, Chief Financial Officer

Thank you, Bonnie. On Swedish Match, I want to reiterate that we have cleared the U.S. requisite for regulatory approval, which is behind us. The processes are still ongoing in several jurisdictions according to plan, and we confirm that we expect to close the transaction in Q4, subject to Swedish Match shareholder acceptance. I’d like to emphasize that we believe this is a very compelling offer for Swedish Match shareholders. I would remind everyone that we offered a 40% premium at the time of the announcement in May. Since then, the markets have been quite volatile, with many declining, and that this offer has been approved by the Swedish Match Board, confirming that they viewed it as compelling for their shareholders. That's what I have to say on Swedish Match, and I don't have any additional comments to make.

Operator, Operator

We will take our next question from Chris Growe with Stifel. Your line is now open.

Chris Growe, Analyst

I just had a question for you first on the timing of shipments across the second half. You've talked about just over 2 billion sticks that shifted to the second half of the year. Does that shift mostly to the fourth quarter as we're thinking about your guidance for IQOS shipments in 3Q versus what's implied for the fourth quarter?

Emmanuel Babeau, Chief Financial Officer

Yes, Chris. If I can try to help you manage expectations, what we expect in Q3 is that shipments will be much more in line with the underlying growth we saw in IMS in H1, which was around 20%. That’s what we expect for shipments. However, we don’t expect the recovery of shipments that missed in H1 and that recovery will happen in Q4, where we also expect very strong dynamism of IQOS consumables. In Q4, the shipment will be above IMS to broadly align with the year. That’s the phasing we expect.

Chris Growe, Analyst

Okay. And just one other question on relation to device sales. They've been a little elevated here as you had more availability. Does that remain elevated even in, say, the first half of '23 as you continue to build your availability of devices? Is that the right timeline to think about fully available devices in the first half of '23 based on the chip shortage?

Emmanuel Babeau, Chief Financial Officer

I think you have two elements here, Chris. The first is that, we faced constraints on device availability that began in Q2, with an impact in Q3 and last year. So, of course, there is an increase in device levels this year based on low comparisons. It's really important to make sure that smokers have access to IQOS devices to drive conversion. We are doing well in commercial efforts here, and our device performance is clearly leading to better conversion. The second element is the wave of replacement brought about by ILUMA. In the markets where we launched ILUMA, there is rapid replacement of existing IQOS blade devices with IQOS ILUMA. This wave of replacement creates a strong one-off acceleration in device levels. When consumers are equipped, the surge of demand will subside, but we must get through that period, which is affecting margins temporarily.

Operator, Operator

We will take our next question from Vivien Azer with Cowen. Your line is now open.

Vivien Azer, Analyst

So my first question pertains to the proposed elimination of menthol variants in the EU for heat-not-burn products. Could you please provide some color on your menthol mix in that geography and then, secondly, an outlook on the timing of that proposal? Thank you.

Emmanuel Babeau, Chief Financial Officer

Look, I'm not sure we disclosed the component of menthol. Of course, that's a minority of our business. What I can say about that is that this is a move in application from the TPD in Europe. So, it's not a decision. It's an application based on the TPD of 2014, which in certain circumstances was planning for a kind of automatic ban to be implemented. This still needs to be approved by the parliament and by the European Council that will come in front of these two bodies later on in 2022, and we'll see what the final decision is. To be very clear, this occurred in our combustible business with almost no impact or very limited impact. Consumers reorganize their taste and switch to other products, but it would likely have a minimal effect. Therefore, we believe that if we are left with tobacco taste only, our product will maintain its appeal compared to the competition, appealing to people who may switch to new products if flavors are removed. So, we are, of course, waiting to see the developments, but we have limited concerns on that matter.

Vivien Azer, Analyst

Certainly. And my follow-up question is on IQOS in the U.S. If we can revisit the timing of reintroducing that product into the marketplace, please? Thank you.

Emmanuel Babeau, Chief Financial Officer

We expect to be in a position to introduce IQOS in H1 of 2023. I cannot provide a more exact timeline at this stage. We continue to work on the plan to make that happen, and we'll keep you posted when we have more clarity and a precise reintroduction date.

Operator, Operator

And we will take our last question from Gaurav Jain with Barclays. Your line is open.

Gaurav Jain, Analyst

So a couple of questions from me. One is on Russia. So, the way you’re now guiding, you are including Russia for the full year, while earlier, you had included Russia just for Q1. So can you still export devices into Russia, IQOS devices, because you still have IQOS shipments there? And also, can you take cash out of Russia to pay the dividends, which you are paying in USD?

Emmanuel Babeau, Chief Financial Officer

Thank you, Gaurav. Yes, I confirm that we can still export our devices, which are not covered by sanctions. Therefore, there are many parts of the business that are disrupted in the supply chain, but for now, our ability to export devices remains unaffected. Regarding dividend payments, I can't provide an answer because we have not attempted to pay a dividend yet. What I can tell you is that we have been making the usual payments between our subsidiaries in terms of procurement and intercompany royalties or any normal procedures.

Gaurav Jain, Analyst

Okay. And my second question is on the Canadian market. Clearly, you do not consolidate Canada, but you provide the volume numbers. The market is down 16% in H1 '22 and 19% in Q2. The retail pricing is I think 6% to 7%, which is not out of the ordinary. It’s mentioned you faced e-cigarette cannibalization. You launched VEEBA, the disposable device in Canada. So what's happening exactly in Canada? Is it that e-cigarettes are now growing very fast and cannibalizing the market? Could you help us understand that?

Emmanuel Babeau, Chief Financial Officer

Yes. I think that is a market where you may have some basis for comparison and some one-off elements, but the trend is clearly not to take the minus 16% as a reference for the market. But clearly, the trend is for combustible business to decrease while smoke-free products, including vaping, are developing nicely. Our ambition is also to see heat-not-burn grow as a substitute to combustibles. That market is moving rapidly.

Operator, Operator

I would now like to turn the program back over to management for any additional or closing remarks.

Emmanuel Babeau, Chief Financial Officer

Well, thank you very much for participating in this call today. We were delighted to share the very good progress that we are making on IQOS and on becoming a smoke-free company despite the challenges that you all know. We look forward to talking to you soon. Thank you very much.

James Bushnell, Vice President of Investor Relations and Financial Communications

That concludes our call today. Thank you again for joining us. If you have any follow-up questions, please contact the Investor Relations team. Thank you again, and have a nice day.

Operator, Operator

This does conclude today's program. Thank you for your participation. You may disconnect at any time, and have a wonderful day.