Nicholas Rolli - Vice President, Investor Relations and Financial Communications Jacek Olczak - Chief Financial Officer

Patty Kanada - Wells Fargo Securities, LLC Judy Hong - Goldman Sachs & Company, Inc. Matthew Grainger - Morgan Stanley & Co. Inc. Michael Lavery - Piper Jaffray Companies Christopher Growe - Stifel, Nicolaus & Company, Inc. Vivien Azer - Cowen and Company Adam Spielman - Citigroup Jonathan Leinster - Berenberg Capital Markets LLC Thomas Russo - Gardner Russo & Gardner LLC

Good day, and welcome to the Philip Morris International Second Quarter 2017 Earnings Conference Call. Today's call is scheduled to last about one hour, including remarks by Philip Morris International management and the question-and-answer session. [Operator instructions] Media representatives on the call will also be invited to ask questions at the conclusion of questions from the investment community. I will now turn the call over to Mr. Nick Rolli, Vice President of Investor Relations and Financial Communications. Please go ahead, sir.

Welcome, and thank you for joining us. Earlier today, we issued a press release containing detailed information on our 2017 second quarter results and you may access the release on www.pmi.com, or the PMI Investor Relations app. During our call today, please note the following unless otherwise stated. First, we will be talking about results for the second quarter of 2017 and comparing them to the same period in 2016. Second, all references to total industry, PMI volume and PMI market share performance reflect cigarettes and PMI's heated tobacco units for those markets that have commercial sales of IQOS. A glossary of terms, adjustments, and other calculations, as well as reconciliations to the most directly comparable U.S. GAAP measures are at the end of today's webcast slides which are posted on our website. Reduced-Risk Products or 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 continued smoking. Today's remarks contain forward-looking statements and projections of future results, and 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 Jacek Olczak, our Chief Financial Officer. Jacek?

Thank you, Nick, and welcome ladies and gentlemen. We are pleased by our performance in the second quarter, notably reflecting strong currency neutral financial results, including growth in adjusted diluted EPS of 8.7%, sequential improvement in our total shipment volume declined compared to the first quarter, and market share growth for Marlboro across a broad range of geographies and continued positive momentum for IQOS, notably in Japan, but also across other launch markets. As announced this morning, we are revising for currency only our 2017 reported diluted EPS guidance at prevailing exchange rates to a range of $4.78 to $4.93. Our guidance now includes approximately $0.14 of unfavorable currency. Excluding currency and the favorable $0.04 tax item recorded in the first quarter, our guidance continues to represent the growth of approximately 9% to 12%, compared to our adjusted diluted EPS of $4.48 in 2016. As a reminder, we expect higher currency neutral growth in the second half of 2017, mainly reflecting increased heated tobacco unit shipment volume, partly offset by continued investment behind the commercialization of IQOS. The $0.06 increase in the unfavorable currency impacting on our guidance, as compared to our previous guidance on April 20, is due principally to the depreciation of the Japanese Yen and Russian Ruble versus the U.S. Dollar. Please note that the currency impact of the Yen depreciation relates to the unhedged portion of our 2017 forecast sales to Japan and is amplified by the strong performance of IQOS. Let me now take you through our second-quarter results in more detail, beginning with our total cigarette and heated tobacco unit shipment volume, which declined by 5.0%. The decline was due mainly to lower cigarette industry volume in the Asia and EEMA regions. In Asia, this notably reflected a challenging consumer-spending environment in Indonesia, as well as ongoing declines of low-margin volumes in Pakistan and the Philippines. In EEMA, this mainly reflected the impact of excise tax-driven price increases in Russia and an increase in illicit trade in Turkey. The decline was also due to lower volume in Saudi Arabia related to the introduction in June of an excise tax that resulted in the doubling of retail selling prices. In the case of Marlboro, the retail price increased by SAR 12 to reach SAR 24, or approximately $6.40 per pack. The cigarette volume decline was partly offset by the strong growth of our heated tobacco products principally in Japan, which increased by 5.2 billion units to reach 6.4 billion units in the quarter. As expected, we recorded a sequential improvement in our total volume decline during the second quarter, driven by favorable evolutions compared to the first quarter in three of our four Regions EU, EEMA, and Latin America & Canada. Excluding the negative impact on our volume performance of industry-wide trade inventory movements principally in Indonesia and Pakistan, the Asia Region would also have recorded a favorable evolution. For the full-year, we continue to anticipate a total shipment volume decline of 3% to 4%, broadly in line with last year. This reflects a further expected sequential improvement in the third and fourth quarters, notably driven by the Asia Region with higher RRP volume and improved cigarette volume in markets such as Indonesia, Pakistan, and the Philippines. In Pakistan specifically, we expect the recent fiscal restructuring, which introduced a new excise tax tier for lower-priced products, to ease the pressure on cigarette industry volume from illicit trade over the balance of the year. We recorded strong currency-neutral results in the second quarter. Net revenues increased by 7%, driven by higher heated tobacco unit and IQOS device sales, notably in Japan, as well as favorable pricing. Adjusted OCI increased by 5.9%, primarily reflecting the impact of higher net revenues, partly offset by increased investments supporting the commercialization of IQOS, notably in the EU Region. Adjusted diluted EPS increased by 8.7%. Net revenues for our RRP portfolio reached $615 million or 8.9% of total net revenues, in the second quarter, continuing the strong sequential growth trend. As we have noted previously, a portion of our RRP net revenues are from IQOS devices, which yield a negative margin due to introductory discounts offered in the initial commercialization phase to accelerate adult smoker switching. For reference, IQOS devices contributed approximately 22% of our RRP net revenues in 2016. Underpinned by the strong growth outlook for RRPs, we now anticipate total currency-neutral net revenue growth above 7% this year. We recorded a pricing variance of $367 million in the second quarter, supported by all Regions. Our year-to-date June pricing variance of $775 million represents 6.1% of first half 2016 net revenues, this is despite no net pricing in Russia, which I will discuss in more detail shortly. Turning to market share, we recorded strong sequential growth in the second quarter, with our total international share, excluding China and the U.S., up by 80 basis points to 27.6%. This growth was driven by both our cigarette and heated tobacco portfolios. Within the cigarette category, Marlboro's international share increased sequentially by 10 basis points to 9.6%. I will now discuss a few of our key geographies, beginning with the EU Region. Total industry volume in the second quarter declined by 1%, with sequential improvement compared to the first quarter that included a higher recovery from illicit trade in Poland and a lower impact from the 10s pack ban in Italy. June year-to-date industry volume declined by 1.8%, slightly better than our full-year decline forecast of 2% to 3%. Our Regional market share was down by 20 basis points in the quarter mainly due to Germany, Italy, and Spain, partly offset by France and Poland. In Germany, the lower share largely reflected the combined impact of price increases in March this year, which for reference saw the per pack price of Marlboro and L&M increased by €0.30 to €6.30 and €5.90, respectively, as well as the later timing of competitors' price increases. In Italy and Spain, the lower shares reflected a continuation of the pressures related to Marlboro price points discussed last quarter, though it is worth highlighting that our shares for Marlboro in these markets increased by 40 and 20 basis points respectively, versus the first quarter. Regional adjusted OCI in the quarter declined by 3.7%, excluding currency, primarily reflecting higher investments behind the commercialization of IQOS. These investments are supporting the encouraging market and off take share trends in our launch markets, which I will cover later in the presentation. Moving to Russia, total industry volume declined by 6.2% in the quarter due primarily to the impact of excise tax-driven price increases. For the full year, we continue to expect a decline in the range of 5% to 6%. Our May quarter-to-date cigarette share increased slightly versus the same period last year, and continued the fairly stable sequential share performance of the past four quarters. Recently launched Philip Morris continues to grow share, reflecting the successful morphing of Optima and Apollo Soyuz, as well as adult smoker down trading in the market. While the industry volume decline and market share trends have been in line with expectations, our price realization is lower than anticipated due to increased competitive pricing. This is putting pressure on our ability to grow profitability in the market. In the Philippines, higher pricing and favorable portfolio mix, reflecting the strong performance of Marlboro, drove another quarter of profitability growth. While our cigarette share declined in the quarter, Marlboro's share increased by 3.8 points, driven by in-switching from lower-priced brands. Importantly, we are beginning to see a stabilization in our cigarette share, which increased by 20 basis points sequentially versus the first quarter. The cigarette industry volume decline rate moderated sequentially with a decline of 5.7% in the second quarter following a 15.3% decline in the prior quarter. As we look toward the balance of the year, we are encouraged by the combination of recent competitor price increases and lower competitor discounting at the bottom of the market. This has led to a reduction in the price gaps between our portfolio, notably Fortune, and lower-priced competitor brands, enhancing the overall competitiveness of our portfolio particularly in the low and super-low price segments. In Indonesia, cigarette industry volume in the second quarter was adversely impacted by three main factors: a challenging comparison, due largely to inventory movements mainly associated with the timing of Ramadan; above inflation tax-driven retail price increases; and the effect of higher utility prices on consumer spending. We now anticipate a decline of around 3% this year. Our cigarette market share declined by 60 basis points in the quarter, due mainly to the soft performance of our hand-rolled kretek portfolio. The decline was partly offset by Marlboro, reflecting the growth of Marlboro Filter Black in the full-flavor machine-made kretek segment, and the strong early performance of Dji Sam Soe Magnum Mild, a lighter-tasting machine-made kretek product that we launched in May. These two offerings are driving our growth in the overall machine-made kretek segment, the largest and fastest-growing product segment industry-wide. In Japan, the spectacular growth of HeatSticks continues to drive our results. The brand's shipments in the second quarter increased by 37% on a sequential basis to reach 5.7 billion units, accounting for over 40% of our total shipments in Japan. Total market share increased by 4.5 points to 32%, with HeatSticks up by 7.8 points to 10.0%. On a sequential basis, HeatSticks grew by an impressive 2.9 points versus last quarter. During the second quarter, we expanded the availability of two new HeatSticks variants, in the smooth taste and differentiated menthol taste segments respectively, and both are performing very well. Total industry volume declined by 3.2% excluding inventory movements, consistent with the secular decline rate for cigarettes prior to the introduction of IQOS. The strong performance of IQOS in Japan is further evidenced by our retail offtake shares, as seen on the slide. HeatSticks closed the quarter with a weekly offtake share of 12.7% nationally, up by 3.1 points versus the last week of the first quarter. This growth was achieved despite a continued cap on the number of IQOS devices supplied to the market, as well as the increasing presence of competitors' products in select geographies. Turning to the commercialization of IQOS more broadly, we have now launched IQOS in key cities in 27 markets globally, following city launches in Korea in May and the Czech Republic earlier this month. We are particularly pleased with the early performance in Korea, and last week announced increased distribution within Seoul, as well as further expansion into four additional cities. We remain on track to be in key cities or nationwide in a total of 30 to 35 markets by yearend, subject to capacity. Importantly, we continue to grow the national share of our heated tobacco portfolio sequentially in many of our early launch markets beyond Japan. For example, in Italy, Portugal and Romania, our national share increased to 0.6% or above in the second quarter. While we have expanded the weighted retail distribution of our heated tobacco portfolio across these markets, Japan remains, for the time being, the only market with national coverage, due to capacity constraints. In many of our more recent launch markets, we are recording positive sequential quarterly offtake share trends within the current focus areas, as seen on this slide. Our performance in Greece for example, has been particularly strong, reaching 2% share in the Athens region less than one year after launch. To conclude, our second-quarter results were robust, reflecting sequential improvements in total volume and market share compared to the first quarter. Our currency-neutral net revenue growth in the quarter was strong, driven by the continued momentum of IQOS and favorable pricing. We now expect full-year currency-neutral net revenue growth of over 7% in 2017. Our 2017 EPS guidance, revised today for currency only, continues to reflect a growth rate of approximately 9% to 12%, excluding currency and the favorable tax item, this compares to adjusted diluted EPS of $4.48 in 2016. Finally, we remain focused on generously rewarding our shareholders with our robust cash flow. For the year, we continue to target operating cash flow of approximately $8.5 billion and capital expenditures of $1.6 billion. Thank you. And I'll be happy now to answer your questions.

Thank you. We will now conduct a question-and-answer portion of the conference. [Operator Instructions] Our first question comes from the name Vivien Azer with Cowen and Company.

Hello, Vivien.

Hello, Vivien.

Our next question comes from Bonnie Herzog with Wells Fargo.

Hi, good morning. This is Patty…

Hi, good morning, Bonnie.

Hi, this is Patty Kanada calling in for Bonnie. Just a quick question on South Korea, is there - could you give us a sense of what you've learnt so far with IQOS there in terms of conversation rates, cannibalization, any big surprises you could share? Are you feeling incrementally more or less optimistic about the replicability of the Japan model there?

It's very early stages, but for reasons we are not talking about the market share et cetera. But I think first reaction of Korean smokers are much better than what we experienced at the same period when we entered Japan, largely much better. I guess, obviously, Korea benefits from the somehow cross-border growing awareness coming from Japan. So the grant at the consumer level really was a better prepared. But, I think Korea might equally or better surprise us in terms of the results in Japan. This would be my reading at this stage.

Okay. Just one quick follow-up on Japan pricing. Could you confirm that you applied to rise prices in September, and if so, would that be absent of any sort of tax increase, which I think is more typically the time that we see pricing?

Finally, we have applied for the price increase of Marlboro and a conventional - the conventional cigarettes. And timing for the implementation is September this year. I'm not aware at this stage of any other competitor price changes in Japan.

Okay. Thank you.

Thank you.

Our next question comes from Judy Hong with Goldman Sachs.

Thank you. Good morning. Hi.

Hi, Judy.

So, Jacek, a couple of questions first on your guidance. First, just in terms of thinking about your revenue growth guidance FX neutral, now you're expecting over 7%, but you haven't changed the earnings guidance FX neutral; so I just wanted to get a sense of why not higher in terms of earnings, even with higher revenue. And then, even the 7% revenue growth guidance seems somewhat conservative in the context of IQOS likely to really build much more contribution in the back half with the capacity ramping up. So just trying to get a sense of - I know you said over 7%, but kind of what sort of contribution from IQOS in the back half should we expect in terms of the revenue?

Look, Judy, it all boils down to the available capacity, okay? I think we observe as we speak a better productivity from the installed machines. So we might be able to go beyond the 32 billion, which we had initially announced available capacity for this year. If this would happen, I mean, it clearly will be able to sell or to ship more. But I can say, look, if we have that product available and then we can actually do the revenue better than 7%. But at this stage, we'll just say that we will be about 7%. More precisely that number will be - I think we'll update it that outlook in Q3, as we will know so much really the productions we had capacity with them. When it comes to the one point lift in our revenue guidance if you like, and they're not lifting the guidance. I mean, we have a range, 9% to 12%, so this is pretty - or relatively broad territory. I have highlighted in my remarks that we actually have a pretty challenging situation from a pricing perspective in Russia, so we have to be relatively cautious on this one. Although, very recently it comes from good news from the fiscal authorities with regards on the view on the potential excise increase in 2018, which will not really or at all change the 2017, but gives us a better outlook for 2018. And we still have to see what is the total impact from this very high tax price increase in Saudi. Okay, and that's very much the Q2 - sorry, Q3, Q4 type of event, which we have in front of us. We'll see what we'll have. We're continuously investing behind the IQOS. As you could see, the growth rate in all geographies are very solid, very good, very encouraging. We opened recently Korea. We have a few other markets which we will have - very likely - we'll have to very likely put up the investment to support that revenue level, which these markets are generating now. We will see how we close. But I think it's a nice problem to have as long as we see the good quality of a top-line growth and you presumably notice that for the first time we're not only driving the revenue by pricing variance, but there is a pretty good contribution at the revenue level from a volume mix actually or product mix. So I think the quality very nicely comes to the top line. And I think it will one day also flow very nicely to the bottom line.

Okay. And then, just - my second question is just in terms of thinking about IQOS and seeing particularly in the markets where obviously some of the competitive products have launched. So in Sendai in Japan, you obviously had a little bit more of a lead time in IQOS being in those markets before glo came in. In Korea, it sounds like you're going to have glo going in more quickly. Korea Tobacco talking about a competitive launch there too. So I'm just wondering from your perspective, just not having that much of a lead-time in those markets, do you think that that's going to curtail IQOS' performance? Or if you kind of look at markets in Japan, just the broader category expansion could be accelerated and so for IQOS could continue to grow. So how do you sort of think about the timing of some of these competitive launches now in some of the markets that could be sooner than what you saw in Japan?

Look, I think that - we actually welcome the competitors entering the Heat-not-Burn category, because from a consumer awareness perspective, et cetera, it's actually going to be helpful other than us riding the - building the awareness of the category, the product, the brand in our own. We have been coexisting at least at the city-type basis, with competitors' product, the [GET product and the BET] [ph] product. You see the trajectory of - the growth trajectory of IQOS in these places, I mean, it's still pretty comfortable. But overall, I think it's actually not that bad, but the competitors also coming to the market and the general awareness of the product is - of the product categories - sorry - is growth. I mean, IQOS, it is early days. I mean, we'll have to look at the national expansion like here announced by the competitors in Japan. I mean, how it is going to change the dynamics in terms of the growth rates of IQOS. But at this stage, I think we feel pretty confident that consumer will - we will continue having a high conversion rate and very importantly higher stickiness rate to our proposition.

Got it, okay. And then just finally quickly on the hedging on the Yen, because it sounds like second quarter, the FX was a lot worse than many people had anticipated, so can you just give a sense of what happened in 2Q from a hedge perspective and where we are at this point?

Well, at the beginning of the year, if I remember, we said that we will cover to the Yen for about 40%. We obviously brought up the hedge ratio higher to about 50%. But in the meantime, the cash flows and revenue from Japan start shooting higher also than we initially thought. So it's a little bit now of a moving target. So therefore, we have the exposure - we have this exposure, still uncovered exposure on Yen. But the Yen in Q2, just Q2, if I take the actual, right, the $0.11 which we had in the quarter, the Yen actually contributed to the negative only by $0.01. I think it's more what we think will be the cash flows and our hedge ratios going forward and it will value this at the spot rate. So this obviously changes the outlook, i.e., the guidance over $0.14. So, two currencies which moved us in this quarter were Euro by $0.04 and Egyptian pound over $0.04. And Egyptian pound is something which we need to pay attention, because we had the - last quarter of 2016 we had a quite big negative currency variance, despite the fact that the majority of the currencies were actually improving versus dollar. And these were the transactional losses, which we incurred on Egyptian pound. Now, Egyptian pound is relatively are pretty stable since then, after this massive devaluation. So at the current spot rate we should have a complete reversal of the negative variance on a currency line in Q4, which may lead to the - or it should lead the current spot rate to the situations that we will have some negative currency in Q3. And we should flip completely to the positive currency in Q4 and this blended will give us this $0.14, which we have announced today in the guidance.

Okay. Thank you.

Thank you.

Our next question comes from Matthew Grainger with Morgan Stanley.

Hi, good morning. Thanks, Jacek.

Good morning, Matthew.

Thanks. I wanted to come back to the Russia pricing dynamic and sounds like this may continue for at least a few more months. Is that going to have any impact on your expectations for 6% combustible pricing for the year or any impacts on your ability to reach potentially the higher end of the EPS guidance range? And when we think about potential offsets in the P&L to help compensate for lower pricing there, do you have sufficient flexibility in other markets to compensate for that without having to make any changes in your RRP investment plans?

Matthew, without going into specifically the pricing variance for the full year, which obviously Russia will wait, because now for the six months, two quarters, we essentially have no net pricing despite the fact that for the first two quarters PMI had about 6% pricing variance, but it's going to wait for the year. I'd rather focus that the pricing situation in Russia is, in fact, well factored in our net revenue outlook for the year by above 7%, this is probably trying to manage the situations, clearly it always have had not allow the pricing opportunity to take extra pricing in Russia, I mean, net revenue and pricing volumes correspondingly would be high. This is the situations in Russia today. To remember usually as of Q2, us, I guess, industry where even net positive start of a pricing situation in Russia, right, to generate tax increases pass on a little bit ahead was that back end of the year, the previous year, and the current year, and now we aimed in June, and my estimates are correct, industry and us are presumably few rubles maybe up to 5 rubles below the pass-on as of January this year. So actually the only pricing which we have in Russia today, is the fading out annualization of the past year, and you have no net pricing due to current year. But as I said, this is factored in at 7% higher revenue growth for us. That's the situation.

Okay. Thanks. And just in terms of the impact on the EPS outlook and where you might found that range, obviously you don't want pullback it all on standing behind IQOS in the broader RRP platforms. Are there - are you confidence that there is enough additional offsets in the combustible business maybe stronger profit performance in other combustible markets that could help compensate for that or its pricing doesn't come through, does that limit your ability to maybe get to the higher end of the 9% to 12% range?

Well, I mean, the few factors which we have for the Q3 and Q4 ahead us. First, I think, we expect the correction of volumes in Indonesia due to the timing, right, because Indonesia along due to the timing of this inventory movements around Ramadan and et cetera, I guess our estimate is about 2 billion units in Indonesia, which we should see the payback of that in Q3. There is a bit lower growth in Indonesia compared to the last year, but pricing goes through the consumer is a bit softer than in past years. Philippines are going where we wanted Philippines to go. So that's - I wouldn't expect any surprises price gap's getting close. Marlboro performance well. I think we might also improve our competitive situation and profitability situations at the bottom end of the market, I think, Philippines should nicely be continue contributing. Indonesia, I said, should have a better second half of the year than the first half of the year. Pakistan a little help on the volumes, the Pakistan is not really the driver of the financial performance, but it's good to solve this problem. Russia, I don't think - I wouldn't count on any surprises on a pricing there on both sides. And the question mark is how consumers going to take this 100% of doubling the prices in Saudi, and they are still a few other GCC states, which as we understand also planned to increase the taxes between now and the year-end, so we'll have to see how this unfolds. The EU has a good strength both on the underlying volumes. Share is in a good shape is more the questions how much, we will report in terms of the investment behind than IQOS, which we may reach the sacrifice the profitability within EU for the sake of building the right revenue opportunity, which lies in front of IQOS in EU. This is how I will do. The range is 9% to 12%, how we - there was the reasons why we expanded that range, I think we will deliver in the range. That's clearly the report today we have to have. We have not revised the range, both the target EPS range probably 5% in currency. We will reach the high-end of the range. Look, I mean, the speculations we'll have to see.

Okay. Hopefully, Russia improves. And then can I just ask about plain packaging in France and the UK, UK is pretty recent, but France since beginning of the year. Can you just give us whatever observation you have at this point on consumer behavior and reaction what the impact has been on mix dynamics volumes? Has there been any shift in pricing dynamics in the super-low segment in the UK since May?

I think, you guys, a little bit still early to talk about this. France is a few months longer with plain packaging. And I don't want to sound sarcastic, okay. But I remember when we had these discussions in Australia, a couple of years ago, the early quarters of implementation, there was the market share erosions and down trading, and people were trying to connect the dots between plain packaging, and what is happening in the market, which we were arguing that this is correlation of quotation at the best place. In France actually Marlboro grew share in the quarter by 60 basis points. This is the quarter post plain packaging implementation. And I am not implying discussed through of the plain packaging, I think this is the never argument for each the market dynamics at this in a short-term is nothing so there was the plain packaging implementation. We always - we are using this argument that the two things are somehow thought to relate. And actually my total share, if I recall the number correctly in a release. I think, we grew the share total PMI by almost one full 90 basis points, while doesn't seem there is a down trading in a market, doesn't seem that the premium brands or premium segments at this stage is impacted by plain packaging, but I won't to be surprised frankly speaking, that it would be.

Okay. Great. Thanks, Jacek.

Thank you.

Our next question comes from Michael Lavery with Piper Jaffray.

Thank you.

Hi, Michael.

Thanks. With the question earlier, you touched a little bit on some of the awareness boost that you get from having Japan right next door and some interaction there. Can you just talk a little bit about in other markets, how you're expanding for this year compares to what you had expected or thought that it would be. And related to that how much does national distribution really help in terms of just getting in front of many more people and helping the word of mouth or sort of network effect, and are you spending and need to offset not having national distribution in some markets in Europe, for example?

Thank you. It's a very good question actually, because, yes, the national distribution would help in the building the momentum and growing the awareness on behalf of our international distribution requires the full availability of full capacity, okay, to meet very lightly searching demand. So reasons why we holding many of our markets essentially, all of our markets outside Japan for the city-type of territories, it's for the reasons that we'll create essentially on a manageable constraint on the supply chain. We are barely still until the end of this quarter. We are coping with Japan. The capacity should start this in Q3, Q4. But again, as we have highlighted through before over the - I mean the priorities to stabilize Japan from a supply chain perspective, okay. And we need to leave the quota for the devices, we also working on developing the second device suppliers. We will have a full flexibility on devices hopefully full flexibility of the HeatSticks volume for Japan. And then we can start leveraging the expanded distribution as the factor of increasing the awareness in our market. But you're absolutely spot on I your question. There is some correlations between broader availability of the product and the awareness. It's a little bit opportunity. But in territories, surely focused at the stages even this restricted part of the territories as much as obviously, one can restrict territory in a given market. In these restricted territories, the growth trajectory, acceptance, conversations are very positive. I mean, you see this on the chart which regularly update this performance on every market. There are differences between the markets. But they have one common denominator, they all have good offer, that's very encouraging for us. And with regards to spending, we will maintain high level of spending in Japan that's pretty obvious, but we are now serving, Japan summer this year will close by past 3 million consumers. So that's an obviously entails, so requires some support, which we have a link to do. And obviously building up, or preparing the rest of the market mainly, EU. You will see by the spending year-on-year in comparison behind IQOS in particular in the EU Region. Obviously, Korea will come in Asia. This is on the early stages so there will be investment, mainly at Korea.

Okay, yes. Thank you. And then just on Indonesia, certainly the machine-made kreteks have been gaining a lot of momentum, and you have typically been underrepresented there. How significant you think this Dji Sam Soe Magnum Mild launch can be? And how do you see the portfolio evolving as far as where the consumer demand has been making shifts?

It can be very significant. I mean, where we trying to compete on a full flavor pipe part of the machine-made and the lighter - or lighters, smoother part of that segment. It is a growing segment. I mean, this largely - fastest growing segment. We obviously - it's important segment for us, it's a building block of our continuous leadership in the market. So we will be very focused there. We also very pleased with the Marlboro trends to the kreteks segment, if you like. Very good results despite that there were some sort of cannibalization between Marlboro Whites and Marlboro - to Marlboro kretek combined Marlboro Fresh nicely grew this year. I think there is still a distribution expansion ahead of this brand. So despite that they are not in international wide availability, they're very nicely both the proposition already contributing to the overall share of the Indonesian market. So we are very pleased with this, and we'll continue focus on this. There will be some happening from time to time, which is very much around the pricing. There are some brands, which are sitting at around per pack price points. But we had it in the past. So this is sort of a cyclical type of a thing, and - but we'll focus to conclude the answering your questions, we'll focus on the machine-made segment going forward.

I think the Marlboro kretek launched about eight or nine months ago. And you said, it still has some distribution upside. How do you expect the distribution trajectory for Dji Sam Soe Magnum Mild with that move a little more quickly or something similar?

Yes. I mean, we're building this distribution, will it go faster than Marlboro. It's hard to - for me to say now, but clearly, we have that expansion. The classical launch planned in Indonesia, with you start with x number of territories. You build that brand there, and then, you start going to a number of territories, pretty large market, right. So we don't have despite the fact that we think we have a pretty strong capability to deploy - deployment capability in Indonesia. We have the capability to have our Indonesia in one month or two months in terms of a national distribution.

Okay, great. Thank you very much.

Thank you.

Our next question comes from Chris Growe with Stifel.

Hi, good morning.

Good morning, Chris.

Good morning. I just had a question for you, if I could first on the volume performance in the quarter, particularly also around the combustible volumes. Was this quarter in line with your expectations from like a - so the sequential progress you made in volume. There were some puts and takes this quarter, no doubt, but does this put you on track towards your progress towards that negative 3 to negative 4 for the year?

No. It was IQOS could, I guess, by not better than we initially would have thought, but this is more the function of how much product we have available. So we just - which has essentially sold those [indiscernible] what we could. And on the combustible business, on the conventional business not much actually surprises. I mean, we knew that, we have that [indiscernible] but the timing in Indonesia. I have quantified this is roughly about $2 billion for us, but this what should see in Q3. So the Q3 should come stronger versus the Q3 last year. Pakistan, I think, authorities addressing this problem with illicit trade. They're trying to help addressing this problem with creation of this extra tax tier, it's very helpful. I mean, that come as a surprise, but the results volume-wise, I think should start growing Q3 and Q4. And we know that we expecting that tax increase in GCC. Okay, Saudi started - okay, it's a little bit of impact on Q2 volume. But we sometime - we've somehow been factoring this in our projection. So remember that during the first quarter earnings call, I said, that we expect the total combined volume for the year to be 2% to 3%. I think, I came that we might actually come - 3% to 4% and that we may come closer to the 3%, actually pretty sure we're going to come closer to the 3% based on what we have achieved in Q2, how we've seen our situations level for the Q3 and Q4.

Okay. Thank you. That's helpful. When I think about - sorry, go ahead.

Go on. Go on.

Just a question relation to your IQOS capacity, we know generally, which you have available for the year. How big of a step forward do you make in Q3, is this the quarter we are going to see a marked improvement in your capacity availability in the quarter?

Well, Q4 is higher than Q2. But…

Thank you. Yes.

And then Q4 will be higher than Q3.

Okay. Got you.

But, look, it's - we're gaining - we're taking the benefits now of a better productivity. We can run the machine faster and we can install machine faster. So it's not necessary that we can accelerate the CapEx as such. But once the machine arrives at the factory, we can put them in a production much faster than the first groups of machines. So it's obvious gain on the timing of implementation. And clearly we have a gain that the factory people are doing the spectacular job with how well they start running this machines, and this is becoming material. So I have said as answer to the one of the previous questions, we will end up with the higher volume than a 32 billion. That's very clear to me. But at this stage, I wouldn't like to commit to this, because this is a productivity gains. So the calculation is a little bit more complicated. But for sure, we are going to end up with higher volume than 32 billion guaranteed.

Okay. Just to be clear, are there any markets where you'd have a national - you want to be national by the end of the year. Or it just a matter of the incremental capacity being used for incremental markets to get to those 30 to 35 markets?

I think, we'll try to build the full - we'll have to unblock the supply chain for Japan first, which includes proper lifting hopefully the caps on the devices. We have on hand in Japan, onshore, the right inventory. So we can have smooth operations from the supply chain perspective in Japan. That's our objective number one. So most of the capacity will be - our priority on the capacity allocations would be for Japan. So I don't think we might be in a situation to push any market outside Japan for the national distribution. I don't think we'll be in the positions to do so. But then obviously is Korea, as I hinted, Korea started better than Japan, and we have to start factoring Korea in this calculations as well. So I think - so we will now go national outside Japan this year, like, 99% guarantee.

Okay. Thanks so much for you time and your color. Thank you.

Thank you.

Our next question comes from Vivien Azer with Cowen and Company.

Hi, can you hear me out?

Yes. Hi, Vivien.

Hi, guys. Sorry about that. So I did want to follow-up on IQOS, please. So my first question on Japan. We noticed some e-commerce activity on Amazon Prime is that something that you guys are pushing as an initiative? Because it creates a little bit of a disconnect for me when I hear that you guys are still capacity constraint?

Look, this unavailability or not the full availability of the devices has created a lot of opportunities for our people, completely not related to Philip Morris, and I guess, this is from what you're referring to. So we have a number of e-commerce sites in a various number of places, not only in Japan, but outside Japan, with our devices somehow are being sold. And you know, Vivien, very well, we have a listed of $100 plus-minus the currency in different countries. And we ended up with devices being sold on this various e-commerce site at the prices of $600, $800 or even $1000. So that's the situation, until the moment when we completely lift the caps on the devices. And we will be in the - in ability to supply fully the market, we'll have all of these things. We have our online sales, our own online PMI sales in the different countries. You can go to the iqos.com, korea.com, et cetera. But we are not pushing this for the third party channel.

Great. Thanks for the clarification. My second question on IQOS development recognizing the bulk of the business is still coming out of Japan. But as you look beyond Japan, in some of these other markets, considering that you have made some adjustments to the product packaging and branding. Have you noticed any differences in terms of initial cannibalization now that you've deemphasized or in some cases, totally eliminated the Marlboro aspect of the HEETS branding?

No, there is no correlation. Actually, where we're selling the product, there's a Marlboro and the Marlboro trademark in Japan or as HeatSticks from Marlboro in other places, which is the [Park, Dresden and other] [ph] places, there is no differences in cannibalization between the two geography.

Great. Thank you very much.

Thank you.

And you next question comes from Adam Spielman with Citi.

Thank you. So my first question is about IQOS is Europe. You said a couple of times that you're increasing the marketing there. But when I look at Slide 20 and Slide 21, I see sequentially the growth is slower. So it slowed a bit in Italy, in Switzerland, throughout the same in Portugal, but faster, I think in Romania, slowed in Germany, slowed in Greece in second quarter, slowed in Russia. But I just wondering, what I should make of that, particularly in light of the fact that you said that when you get to sort of 1% or 2%, or 3% market share we should expected to accelerate? So that would be my first question. Thank you.

Good afternoon, Adam. Look, the territories which we are listing on the slide, okay, you have to look that we still very much focus depends on the country, on the cities, right, not even on the entire territories. If I give example of Switzerland, right, because presumably, might for some, look like a slowdown in the penetration of the growth of a market share. I mean, you have to really zoom what is happening in Geneva, Lausanne, Neuchatel and Zurich, I mean, a few places where we're really focused, okay. Some of these places, iQOS is already above 3% or 4%, some of the place, I think, is even closer to the 6%. Obviously, in this territory, altogether, including the villages, you have to look at the urbanization, non-urbanization of Switzerland, I mean, this turns to 0.9%. We're not worried about this at all. In every zooming territory in which we are, we have a good trajectory, and therefore, the investment is behind these markets to have a right base going forward, but also remember that we expanding our territories, which are not even in Europe, which are not even in this chart. That is obviously entails the additional spend. We don't read the chart in a way that - Greece, in my opinion, have a very spectacular growth rate, and we know that the Greece could have gone higher if we would allow Greece to expand broader. We're just focusing on what we focus. It's good that is relatively faster or slower, the famous 2%, 3% that which we think is the point from which the word of mouth et cetera, start to help.

So as I just to be clear, what you said about Switzerland, just zooming on that. But in Zurich and Geneva, we're accelerating up to, I don't know 3% or 4%. But nonetheless the rest of Switzerland is going backwards so fast that overall the market share has only gone up 10 bps on a nationwide basis?

No. I am talking that the 42% weighted distribution on our Switzerland, but the real focus is on few cities. And obviously for the distributions, when you have a HeatSticks available in the stores, et cetera, there is not much of the IQOS sales shop - support, okay. The focus is in the big cities of relative to the size of Switzerland. And there, if I look at the readings, as I said, in the places like Lausanne, Geneva, few others, I mean, they pretty impressive. That is what I mean.

Okay. Thank you. So moving onto the conventional business. In the past, you used to have a target of 46% top line growth. That's growth constant currency. This half, you've done minus 2%. You obviously said that it will accelerate a bit in the second half, helped by Indonesia, in particular, but also Philippines, for example. The question is, do you - are you happy enough with the way the combustible business is going? Do you feel that you are just happy to let it go, the current run-rate, so do you think you need a total increased investments there?

No, we're happy with the progress we're making on the conventional business. I mean, you have to - there is a reason why we're talking about the total revenue line and the combined volumes, et cetera, because you'll have to now factor back to the combustible business, the volumes and the margins and the revenues which we are cannibalizing on the way, okay? So that's the job. Am I happy with the development of pricing in Russia? Clearly, not, okay. So it's - and am I happy that the consumer - are we happy that the consumer in Indonesia is a bit softer? I mean, obviously not. Am I happy that Mighty was not really playing fairly or faring the market? No. So we always will have the [indiscernible] the situation. But the way we love to handle that thing is actually we can grow the revenue or deliver the pricing value, for the six months of 6%, despite the fact that we had this clearer headwind that we can deliver the good quality, in my opinion, very good quality, in my opinion top-line growth of 7% or above for the full year, which is a nice mixing of the pricing and the volume rather than just the pricing with just the past [indiscernible]. I'm very pleased with this development. I mean, we're very much looking at the quality of the top-line growth. And you see this quarter, and revenue level at least, I mean, for the first time we're turning into positive volume type of a territory in terms of the contribution from IQOS.

And then very quickly, any comments on the Platform 4 test in Birmingham and do you have anything sort of new or specific you should say about the - I think it's going to be in 4Q that Platform 2 test that you're thinking about.

The old platform as we said before, sorry the two and three before the year-end should go to the test market.

City test, yeah.

Yeah, city test market and platform for the product growth is now hearing the comments of the feedback which we get from the consumers in Birmingham. And this is incorporating or incorporating this feedback into the next version of the product. This was the purpose of the test market. I think the MESH, we delivered on what we wanted to deliver. But also that has also to see what else we should add to the product in terms of the performance of that, try to address what are the consumer needs. But that's the part of our - you will see more of the things that the test market is for the purpose of really verifying in real-life what we need to do and then go back quickly to the drawing board and follow up shortly with the new product release. We somehow went for this very quickly in Japan. But people may not remember that their version of the IQOS device, which we have sold initially during the test market in Nagoya is a different product version which we have nationally expanded. And it is a different product version what we are shipping to Japan right now. So Japan is already at the third generation or release if you like of the devices and you incorporate the feedback from the consumers. And I guess, other platforms will follow the same sort of a pattern.

Thank you. I have more questions, but I think I should give somebody else a go. Thank you.

Thank you.

Our next question comes from Jonathan Leinster with Berenberg.

Hi, Jonathan. Yeah, now a few questions, if I may. First of all, with regard to Japan, what sort of inventory levels, trade inventory levels are there in terms of IQOS? And given you just talked about still being sort of capacity-constrained and wanting to build out a supply chain and such, what level of inventory in a perfect world would you be looking at in that sort of environment?

Well, usually we target inventory in terms of the duration, right? So if I would compare the duration of inventory there for IQOS compared to what we strategically or normally maintain for the conventional IQOS would be below conventional, so that's clearly the level of inventories which is not sufficient to maintain the current level of operation. Now, obviously on a conventional business in Japan even before the opening of a new product category, the market is in a secular decline rate, et cetera. So from time to time, your inventories automatically have a longer duration if you don't adjust the volume. IQOS is a reverse situation. I mean, as result - on a projected volume, what we think is the duration. And if I don't ship the product next week the inventory is going to grow dramatically, because I'm on the increasing shipments to the retailer. So I would - our thinking is that we should end up in Japan with the inventories at minimum duration-wise with the level of conventional cigarettes. And actually if we could, we would like to build that inventory higher, because let us remember that we still today have one operation - one manufacturing center supplying the market. So our dependence from the risk perspective is - risk management perspective is extremely hard, completely different than what we have on the conventional cigarettes. But we have said it already with the Q1 that if we can build inventory in Japan, which will allow us to operate more freely the supply chain, we will do it this year.

Sorry, I missed the last one, did you say, 10 billion?

No, I didn't say 10 billion.

Sorry, okay, and what…

I was referring to the duration of inventories, okay. So without…

And what duration normally would there be on the FMC [ph] side then?

You're talking somewhere between up to about three months. But you need to take into consideration that the shipments to Japan are literally taking - are going by water. So your inventory is essentially on the water. So two-thirds of that duration is not accessible for sales in Japan, because it's in the pipeline to Japan. It's the [indiscernible].

Okay, okay. And in terms of capacity constraints, I mean, when we were into Q3, I mean, I think you were suggesting that you were still capacity constrained in terms of Japan, so does that mean the leaning come off now in Q4?

Well, we'll have increased sales and shipments to Japan, because that capacity - we're producing more week-by-week and month-by-month. But what we say that, hopefully, around the Q4 we should be in that situation that we can ship to the shops what is required and somehow in parallel get the inventory right, which would absorb any sales. We can leave the surge in demand or we can leave the quarter on the devices and Japan will not be putting further constraints on the supply chain. You'll have gradual expansion…

All right, and in terms of the - okay, gradual expansion, okay. I was going to say, in Japan, in terms of the Marlboro price rise, I mean, clearly, there was some there that one of your competitors increased prices of one of its major brands last year and then there was not much of the response from anybody. And conversely, in France, there has been a tax rise, but there has been no increase in prices including obviously Marlboro which is the largest brand. I mean, can you explain, first of all, what's the theory behind moving the prices for Marlboro in Japan? And secondly, with regards to France, why has the industry decided to simply absorb the tax?

Not, I mean, the pricing decisions are made to - are in our case country-by-country basis. So I wouldn't link the price development on our side in France to what we have done in Japan. We just think that taking into considerations the market dynamics, the projected elasticity, et cetera that we could increase the prices in Japan. As you might have heard, the initial attempt was to increase for more brands than just Marlboro. We ended up with Marlboro increase. So this is what it is. And I have no clue whatsoever why the industry, as you phrase it, have decided not to pass on the tax in France. I can speak for Philip Morris. Again, it's the case in Italy very often, we look at tax structure, we look at brand elasticity, and we're just running the numbers whether this makes sense or not in the current configuration, the increased prices from the view of growing the profitability and we just moving the pricing variance with the volume variance and vice versa, that's the situation. Having said that, and as you noticed, despite the fact that - we didn't have the pricing in France where there is no pricing still in Japan et cetera, we still had the 6% pricing variance for the six months of the year. So somehow, they have this factored in 12 months.

But just following up on that, in Japan you'd be quite happy if Marlboro is the only price that went up?

Well, we're always happy, if you like, if the prices are going up.

Yeah, okay. And very lastly, what do you think that the total sort of conventional cigarette volumes globally are likely to decline this year?

I guess, somewhere this 2% to 3%. And I don't think we would - if the Pakistan - we will have to now start factoring in this. Russia, I think this 5% to 6% about right. Euro, volume view, which we have to forecast, should be around what we have said. I think Indonesia should now have a bit of better volumes. The question is what's going to continue to happen in Philippines. But we observe some relatively moderations in the decline rates relative. Pakistan, which is a big market thinking the international volumes. I think the 2% to 3% of the industry seems like a right number for the year.

Okay. Thank you very much.

Thank you.

Our next question comes from Thomas Russo with Gardner Russo.

Yes, hi, good morning.

Tom, thank you for calling.

Yes, right, good morning. Couple of quick questions. The first, I read the - maybe your General Counsels appearing before the FDA in light of the submissions. I would love to have an update on the submissions, their progress, and then what the steps might be for Altria under your agreement with them, what opportunities do they have to start to roll out IQOS, first question.

I guess you're referring to that Marc Firestone recent address with regards to illicit trade.

Yes.

Yes, well, I mean, look, I mean, there is a number of countries which we see a pretty good improvement on illicit trade. But I think also Marc was trying to show in our experiences, one can help in collaborations industry and collaborations with the government, continuing probing this trend, so…

Yes.

And, as I said, I mean, we follow up for a while. You see that over the last two, three years, we've made a pretty, I would argue, significant improvement with regards to illicit trade. There are still some pockets which have to be addressed. But globally I think it is getting better. And with regards to Altria, I think Altria waits, as we are waiting for FDA, premarket approval authorization with the FDA.

Yes.

And counting just my calendar days, somewhere before the year-end it should happen. So Altria would be - should be good to go to launch the product in the U.S. And I know from our collaborations with Altria that Altria is working on the plans to - for this to happen. We're just waiting for FDA.

Great. Also, I read, Jacek, at some place, reference to a new IQOS Heat cigarette manufacturing facility authorized to get built in Germany. What is the timing of that and what's the capacity of that?

Production of Germany will lead to the capacity beyond January 2019.

Oh, I see.

Our numbers for today are, as we said, 50 year-end installed this year, plus minus now the productivity gains which I highlighted in answer to the previous questions.

Yes.

That we actually may leave the 100 year-end installed capacity 2018 and Dresden facilities to start contributing beyond. So this is our second, if you like, greenfield operations of Cologne. In the meantime, we talk about Greece, we talk about Romania, et cetera, which are the retrofitting or converting the conventional capacity into the RRP capacity, so we got…

Great. And then, what happens in the capacity at launch for Dresden, how large would that start and how will it grow over time?

Well, we will build it to the appropriate level of capacity.

Well, that's a good answer, thank you. And then who will supply the actual products to the U.S. market?

Initially, PMI.

Okay.

And then we'll have to see.

Thanks for the update. Bye.

Thank you.

And with that, I'll hand the program back over to you, Mr. Nick Rolli, for any additional or closing remarks.

Well, that concludes our call for today. Thank you very much for joining us. And if you have any follow-up questions, you can contact the Investor Relations team here in Switzerland. Thanks again and have a nice day. Thank you.

Ladies and gentlemen, that does conclude today's conference call. You may now disconnect your lines.