Should Venture worry about a third IQOS manufacturer for Philip Morris?

It could struggle for more market share as the second manufacturer, FLEX, has already hit supplier limit.

A third manufacturer to enter the fray for Philip Morris&rsquo IQOS products could spell heightened difficulty for Venture Corporation to carve its space in the production of the tobacco company&rsquo s devices, UOB Kay Hian said.

The brokerage shared in a research note how it found out that the second manufacturer for Philip Morris&rsquo IQOS products, FLEX, has reached supplier concentration limit. The team was not able to find out if this has also affected Venture&rsquo s production status.

A third manufacturer will be introduced and will likely create IQOS 2.4+ to prepare for the product&rsquo s US launch. UOBKH analyst Foo Zhi Wei cited a CNBC report that said a US launch will entail the sale of only the older IQOS models.

&ldquo We believe that this third manufacturer will largely manufacture the IQOS 2.4+. It may be possible for some small-scale production of the next-generation products,&rdquo Foo said.

The expected effect on Venture is that a third manufacturer entering the fray will likely try to do so at a price competitive to the current incumbents. &ldquo Between the current two, FLEX remains more cost-effective than Venture. Logically, Philip Morris will want to shift some of its higher cost production to this new manufacturer to improve economics on its IQOS devices,&rdquo the analyst added.

Venture makes IQOS 2.4+ and IQOS 3, whilst IQOS produces the IQOS 2.4+ and IQOS 3 Multi. &ldquo Venture is at greater risk of having production share taken away (again), given its higher cost base,&rdquo Foo said.

Macroeconomic factors come into play as well. Nikkei Malaysia&rsquo s Manufacturing Purchasing Managers Index (PMI) worsened from 49.2 in October to 48.2 in November, extending a deterioration since May. Notably, Venture has a significant capacity in Malaysia.

Whilst manufacturers are optimistic for 2019, their outlook is tempered on concerns of the wider economy which may dent the order outlook. &ldquo This is corroborated by  reductions in revenue estimates in Venture&rsquo s listed clientele,&rdquo Foo said, citing revenue estimates of 4% to -17% (for Honeywell) with the average revision a negative 1.4%.

&ldquo To be fair, the current situation for Venture points to the 12-month forecast volume for IQOS being better relative to 2018&rsquo s,&rdquo the analyst said. This is nearly similar to the situation in December 2017, when the outlook for next year was higher. However, it tapered off due to  weaker-than-expected sales in Japan.

There could be two outcomes for Venture to this development. The first scenario sees them lose some production to the third player. The second scenario sees Venture sacrifice margins on the IQOS and lose less volume. &ldquo Either way, profitability in 2019 may be impacted, given IQOS&rsquo contribution to Venture&rsquo s earnings,&rdquo Foo said.

On the contrary, IQOS 3 may see a better-than-expected demand, which could result in a production ramp-up across all manufacturers. According to Foo, it is difficult to gauge the sales performance of the new IQOS models, though there is a greater incidence of IQOS 3 on social media.

&ldquo Analysis of various Japanese sites point to familiarity with the IQOS 3 design as the main reason,&rdquo the analyst added. UOBKH said to look out for fourth quarter 2018 results that will give a better indication.

Venture could also raise its final dividend payout, thanks to its net cash balance of $697.9m, and battle negative share price sentiment or other weaker-than-expected earnings.