FOUNDATION
`
`MORGAN STANLEY & CO.LLS
`
`Pamela Kaufman, CFA
`EQUITY ANALYST
`Pamela.Kaufman@morganstanley.com
`
`4+17:2172 761-7151
`
`
`
`Equal-weight
`Stock Rating
`In-Line
`Industry View
`$63.00
`Price target
`$57.07
`Shr price, close (Jun 25, 2018)
`$159,801
`Mkt cap, curr (mm)
`$77.00-53.91
`52-Week Range
`12/17 12/18e 12/19e 12/20e
`Fiscal Year Ending
`3.42
`3.97
`4.27
`4.50
`EPS ($)**
`-
`3.98
`4.33
`4.71
`Prior EPS ($)**
`3.28
`4.01
`434
`4.78
`Consensus EPS($)§
`3.42
`4.14
`4.27
`4.50
`ModelWare EPS($)
`20.9
`13.8
`13.4
`12.7
`P/E
`3.5
`5.2
`5.8
`6.1
`Div yld (%)
`Unless oterwise noted, all rnatrics are based on Morgan Stanley ModelWare
`framework
`* = Based on consensus methodology
`§ = Consensus data is srovided by Thornson Reuters Estimates
`e~ Morgen Stanley Research eatinetes
`
`2018e
`Prior
`
`
`
`2018e
`
`Current
`2017
`Quarter
`0.95a
`Qit”*~é‘iCODT
`0.97
`0.97
`Q2
`0.85
`1.09
`1.10
`Q3
`0.90
`0.99
`1.00
`Q4
`0.91
`@ = Morgan Stanley Research estimates, a = Actual Cornpany reported data
`
`2019e
`Prior
`
`2019e
`Current
`*
`
`Morgan Stanley |
`
`researcs
`
`June 26, 2078 04:01 AM GMT
`
`Altria Group,Inc.
`Is JUUL Hype Overblown?
`
`
`
`l¥ Stock Rating
`Equal-weight
`
`@ Industry View
`In-Line
`
`®Price Target
`$63.00
`
`JUUL's success underscores the potential for disruptive
`technology to undermine US Tobacco's reliable business
`algorithm. We estimate JUUL e-cigs could be a ~100 bps
`annual heacdwind to cigarette volumes in our Base Case and
`
`see MO moving towards MSD EPS growthin 2020. EW.
`
`JUUL's success is having a growing impact on UScigarette volumes. US cigarette
`volume declines accelerated from -4% in 20°17 to -5.5% in 1Q18, coinciding with
`rapid JUUL growth. JUUL accounted for 3.5% of total cigarette equivalent
`volumesin May (vs. just 0.5% in 2017) and we estimate was a ~50 bps headwind
`to cigarette volumes in the LI2W (vs. 10-30 bps in 2017). We estimate JUUL is
`sourcing ~20%ofits volumes from cigarettes but expect growth to increasingly
`source from cigarette volumes as JUUL's distribution and awareness grows.
`
`In our new Base Case, we estimate a ~100 bps annual headwind to 2018-22 US
`cigarette industry volumes: Since JUUL is a nascent product, we assess a range of
`scenarios for its long-term impact to cigarette volumes and provide a framework
`for quantifying its impact. In our Base Case, we see a ~100 bps annual headwind
`to 2018-22 cigarette volumes, assuming 15% JUUL volume share of cigarettes by
`2022 with ~40%ofits sales sourcing from cigarettes. In our Bull and Bear Cases,
`we see a 20 bps and 300 bps annual headwind, respectively, to cigarette
`volumes. We believe the FDA's near-term options for constraining JUUL growth
`are limited. We see an equal impact across MO/RJR's brands, as RJR skews toward
`a younger demographic but MO has higher overall share.
`
`MO's growth outlook to slow to MSD post 2019: The combination of smokers’
`desire to switch to Lower risk alternatives, the FDA's agenda to shift smokers
`down the continuum ofrisk to reduced-risk products CRRPs") and e-cig
`technological improvements create a strong force for accelerating the pace of
`change in the tobacco industry. We believe it will become increasingly difficult
`for MO to retain its degree of category leadership as the tobacco industry shifts
`to become more fragmented, complex, and technology-dependent. This shift
`enhances risk to both MO's volume trajectory and cigarette pricing elasticity, and
`may require increased reinvestment. We are reducing our 2019-22 volume
`forecasts by ~100 bps, to -4.5% annually and see 5-6% annual EPS growth
`beginning in 2020 as more achievable.
`
`We are EW given greater long-term concerns and a widening risk-reward: MO's
`shares have meaningfully de-rated over the last year (from 22x NTM P/Ein June
`2017 to 13.1x today), and the stock is now trading at ~25% discount to Staples (at
`17,.0x 2019e P/E), below its 5-year 10% discount. However, we remain EW as we
`
`
`
`Morgan Stanley does and seeks to do business with
`companies covered in Morgan Stanley Research. As a
`result, investors should be awarethat the firm may have a
`conflict of interest that could affect the objectivity of
`Morgan Stanley Research. Investors should consider
`Morgan Stanley Research és only a single factor in making
`their investment decision.
`
`For analyst certification and other importantdisclosures,
`refer to the Disclosure Section, located at the end ofthis
`report.
`
`JLI Ex. 2038, Page 1 of 30
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`JLI-NJOY-ITC1368-01332225
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`JLI Ex. 2038, Page 1 of 30
`
`

`

`Morgan Stanley |
`
`researcs
`
`have long-term concerns about the sustainability of MO's HSD growth algorithm
`and anticipate MSD EPS growth beyond 2019. We see a widening risk reward
`given the range of potential JUUL outcomes and resulting impact to MO's
`fundamental growth outlook. We are reducing our PT to $63 (vs. $65 prior)
`based on 15.0x our updated 2019e EPS and reflecting a 10% discount to Staples
`peers, in-line with its 5-year average. We see a widening risk-reward with ~33%
`upside/downside to our Bull and Bear Cases.
`
`Exhibit 1: Average annual headwind to cigarette volumes from JUUL market share
`and cannibalization rate scenarios from 2018-2022
`
`FOUNDATION
`
`Cannibalization Rate
`
`JUUL
`
`
`
` Ce
`
`eeee
`20
`og
`oe
`oe
`10%
`~68 bps
`~48 bps
`"8 bps
`-49 bos
`~29 bos
`-39 bps
`20%
`-449 bps
`~49 bps
`Be bos |
`_-fBbps
`88 bos
`e6 bos |
`30%
`~180 bos
`~29 bos
`“86 bos
`58 bos
`“119 bos
`|
`1a bps
`40%
`~243 bps
`~39 bps
`Age bes
`Theos
`118 bps
`9201 bos
`50%
`-307 bps
`-49 bos
`SG bos
`2071 bps
`264 bps
`_ 149 bps
`60%
`~373 bos
`~243 bps.
`-68 bos
`-180 bps
`-118 bos
`-307 bps
`70%
`441 bps
`~139 bps
`-B8 bos
`“211 bps
`~286 bps.
`“362 bps
`80%
`510 bps
`-159 bos
`-78 bos
`~243 bps
`“329 bps
`~418 bps
`30%
`75 bps
`-581 bos
`«180 bos
`«88 bos
`-275 bps
`~373 bos
`-98 bps -654 bps -201 bas -307 bps +418 bps -534 bps
`
`100%
`
`
`
`
`Source: Nielsen xAOC+C, Morgan Stanley Research
`
`JLI Ex. 2038, Page 2 of 30
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`JLI Ex. 2038, Page 2 of 30
`
`

`

`Morgan Stanley |
`
`researcn
`
`FOUNDATION
`
`Risk-Reward: Altria Group (MO,Equal-weight, Price Target $63)
`Risk-Reward View: Balanced risk-reward as high visibility to near-term EPS growth is
`offset by greater long-term concerns
`$90
`ao
`70
`
`'
`
`=
`
`60)
`0
`40
`wo |
`
`
`SaG.00 [3Sp"
`
`a
`
`10
`a
`stun16
`Geo18
`dunt?
`Dect?
`dun-18
`Dec-18
`® Curved Boek Prog
`waitbeiprical Slack Pariormance
`i Beee Cage luni
`Source: Thomsen Reuters, Morgan Stanley Research
`
`Jat38
`
`|
`
`|
`
`Investment Thesis
`“2 MO is facing increasing cigarette volume
`headwinds from reduced-risk products such
`as JUUL, which should accelerate volume
`declines and could increase pricing elasticity.
`mw MO has multiple Levers, including
`consistent cigarette pricing power, tax reform
`savings and the contribution from ABI equity
`income to support its 7-9% EPS growth
`algorithm in the near term but we see MSD
`EPS growth beyond 2019.
`@ We see potential for upside from possible
`iOS commercia lization in the us in early
`2019.
`
`$63
`Price Target
`Based on 15x C2019e P/E, at a 10% discount to US Staples, consistent
`with the stock's 5-year historical average discount and supported by
`our DCF analysis.
`Bull
`$76
`18x 2019e P/E
`Limited disruption to the status quo. JUUL only captures 5% of the market by
`2022, with a 20% cannibalization rate and resulting in a 20 bps headwind to
`annual cigarette volumes. Volumes decline ~3.5% annually and net pricing
`remains at 4% annually. Margins expand by 570 bps 2025. Minimal FDA
`movementon nicotine reduction agenda.
`
`$63
`
`Base
`15x 2019e P/E
`Volume declines accelerate below low end of historical range; increased
`investment needs drives MSD EPS growth beyond 2019. JUUL captures 15%
`market share of baseline cigarette volumes by 2022 and assuming 40% of JUUL
`volumes are sourcing from cigarettes by 2022, volume declines accelerate to
`45% annually. Net pricing remains solid at ~3.5% EBIT margins expand by 150
`bps by 2025 due to cost cutting and improved All Other profitability. MSD EPS
`growth beyond 2019.
`
`$38
`
`Bear
`10x 2019e P/E
`Elevated volume declines and limited net pricing. JUUL captures 30% market
`share of baseline cigarette volumes and assuming 50% of JUUL's growth comes
`a the expense of cigarettes, volume declines accelerate to ~7% annually. No
`Long-term net pricing growth. Margins contract by 1,100 bps by 2025 due to
`operating deleverage. FDA aggressively pursues its nicotine reduction agenda.
`
`
`
`|
`_
`
`§@ MOis facing a more challenging regulatory
`backdrop due to the FDA pursuingits nicotine
`reduction agenda.
`
`| Key Value Drivers
`i Aggressiveness of management with
`respect to net pricing, further cost reductions,
`share repurchases, and monetization of
`noncore assets.
`
`|
`
`W Cigarette pricing realization and pace of US
`cigarette industry unit volume decline.
`
`i@ MO's success in reduced-risk products.
`
`..
`hiev;
`i k
`| Risks to Ac leViNg Price Target
`im Upside risks: Stronger net pricing and
`margin expansion in cigarettes; Increased
`shareholder returns via share repurchases;
`
`| Lower than expected headwinds from JUUL
`| growth.
`@ Downside risks: Promotional spending,
`taxes & FDA, higher than expected JUUL
`market share and cigarette cannibalization
`rates.
`
`JLI Ex. 2038, Page 3 of 30
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`JLI-NJOY-ITC1368-01332227
`
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`
`

`

`Morgan Stanley |
`
`researc
`
`
`
`FOUNDATION
`
`Is US Tobacco Facing an Existential Threat?
`
`Our View
`
`Webelieve JUUL has becomea growing a headwind to UScigarette volumes.
`Our analysis suggests that ~20% of JUUL volurnes are comingat the
`expense ofcigarettes ancthat it can presenta ~100 bps annual headwindto
`
`volumes in 2018-22. Given that JUUL is a nascent product anc itis unclear if
`it will have enduring success, we provide a frarmework for assessing its
`
`potential impactto cigarette volumes.
`
`With respect to MO,weare reducing our long-term volume andEPS growth
`forecasts towards a MSD EPSgrowthalgorithm (o take into account greater
`
`topline and cost headwinds associated with growth in alternative products
`
`such as JUUL We see a range of RRP outcomes contributing toa widening
`risk-reward.
`
`coe
`
`Exhibit 2: E-cig growth is driven by JUUL's success,with e-cigs
`holding 4.5% $ market share
`es
`v%
`ina
`US. E-CigS as % of Total E-cig + Cigarettes Seles
`5.0%
`a ene
`. eee
`40%
`3.5%
`ROG wees
`2.5%
`2.0%
`1.5%
`1.0%
`0.556
`0.08%
`
`:
`cosines BE
`
`
`
`:
`
`_
`
`
`| fen Mo:'sshare price performance YTD,investors:are clearly concerned
`
`L abouttheimpactofcompetitive products such as JUULonMO$ ability to.
`
`_Sustain itsoe anc EPSgrowth algonthn
`a
`However,wiwedonotoeconsensussestimatesreflectthe potentialfor
`
`:
`acceleratingJUUL adoption. Consensus foreoastsreflect 2Ua5% volume
`| declines |in 2019-20, at the fuch end ofthe industrys histoncal annual volume|
`
`|cecliac.Moreover,consensus forecastsreflect sustcinedceliverycn MOS 2.
`O% EPS ge algorithm,
`
`
`:
`
`:
`
`'
`
`:
`
`:
`
`
`
`JUUL disruption underscores the tobacco industry's complex
`.
`oa.
`challenge as e-cig technological improvements and product
`proliferation are likely to reshape the tobacco landscape.Selling
`cigarettes has been a long-standing,reliable and profitable
`business given limited viable alternatives and the industry's strong
`pricing power. However, the combination of smokers' desire to
`switch to lower risk alternatives, improving RRP technology, and
`the FDA's regulatory agenda to move smokers down the
`continuum of risk creates a strong force for accelerating the
`industry's pace of change. We expect the tobacco industry to
`
`move towards a more fragmented range of products that will address varying consumer preferences and usage occasions. The
`
`Source: Nielsen 1AOC#, Morgan Stanley Research
`
`fact that a San Francisco-based start-up founded by two Stanford
`design students is emerging as a formidable competitor to the
`large, deep-pocketed industry incumbents with abundant R&D and marketing resources
`as well as brand building and regulatory expertise, highlights that it wil! likely be
`challenging for the tobacco manufacturers to retain their market leadership as the
`category becomes increasingly fragmented, complex, and technology-dependent.
`
`JUUL's rapid growthis coinciding with decelerating US cigarette volumes. Cigarette
`volumes declined -4% in 2017 following two years of unusually strong performance ¢
`0.5%/-2.5% in 2015/16) and remained soft in 1Q18 5.5%). This softness is coinciding with
`an acceleration in e-cigarette category growth due to JUUL's success, raising concerns
`about it's threat to the cigarette category. Over the Last year, e-cig sales grew by 85% to
`$1.8 bn in measured channels ($3.0 bn total in 2017) driven predominantly by JUUL, a
`new e-cigarette, which launched in 2015 and expanded capacity as the company raised
`external capital. Within measured channels, which understate JUUL sales as they do not
`
`JLI Ex. 2038, Page 4 of 30
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`JLI-NJOY-ITC1368-01332228
`
`JLI Ex. 2038, Page 4 of 30
`
`

`

`Morgan Stanley |
`
`FOUNDATION
`researcn
`capture online or vape shops, JUUL had $785 MM in sales over the last 52 weeks and
`sales grew 950% YoY in May. JUUL holds 64% market share of e-cigs after less than a
`year and a half in conventional distribution channels. It also accounts for 3% of total
`spend on cigarettes and e-cigs combined and sold units equivalent to 3.5% of cigarette
`volumes in May.
`
`JUUL captured 3.5% share ofcigarette industry volumes with relatively limited
`distribution. Over the last 52 weeks, JUUL was sold at stores accounting for only 2.7%
`ACV (all-commodity volume), a measure of their share of total US retail sales but is
`growing rapidly, accounting for 6.0% ACV in LAW. Within measured channels, JUUL is
`sold at convenience stores and was available at 62,000 convenience stores in May
`compared to only 29,000 at the end of 2017. Among conveniences stores, JUUL is sold
`at stores representing holds 54% ACV.Traffic challenged convenience stores have a
`strong incentive to sell the product as its sales per store are growing over 200% YoY.
`JUUL still has a meaningful distribution opportunity in the US relative to ~155,000
`convenience stores in the US.
`
`Exhibit 4: JUUL is now sold at 60K conveniencestoresvs. 29K in
`December
`
`Number of Convenience Stores Selling JJUL
`70,000
`
`60,000
`eh
`
`BWLeRED BWPeeo SLL2iso SLELAD ALSELO LIeEEO AGLLO
`SLISOEL
`SLIGOFL
`ZLALOMOL
`LLIOEIEL
`
`
`
`
`
`
`
`Source: Nielsen xAOC+C, Morgan Stanley Researcn
`
`JUUL's successcan attract more competition. From a practical standpoint, the tobacco
`industry has high barriers to entry given the FDA's oversight. In 2016, the FDA extended
`its authority to e-cigarettes through the Deeming Regulations, which allows any e-
`cigarette on the market prior to August 8, 2016, to remain on the market, but
`manufacturers are required to file a Pre-Market Tobacco Application (PMTA) with the
`FDA by 2022. A product developed after August 8, 2016, can not be commercialized
`without submitting a PMTA and receiving approval from the FDA.Despite this
`regulation, new e-cigs are still coming to market Gncluding from MO and BAT) as long
`they had some commercial presence in 2016 and we would not be surprised to see new
`competitors emerge based on a technology that was in limited distribution over the last
`several years. In addition, there is nothing stopping new competitors from developing
`their own technology and filing a PMTA with the FDAat any point prior to 2022. While
`this is a costly process, JUUL has been successful in raising capital, including a $150 MM
`in a round late last year, and recent press reports indicate a $10 bn valuation, so the
`financial burden is likely not a prohibitive factor.
`
`JUUL is uniquein the extent to whichit is disrupting the category. in the past multiple
`e-cigs (such as NJOY, blu) experienced initial rapid growth but ultimately disappointed in
`
`JLI Ex. 2038, Page 5 of 30
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`JLI-NJOY-ITC1368-01332229
`
`2
`2
`tS
`a
`S
`m
`
`=n
`
`40,000
`30,000
`
`20,000
`
`2iog2t
`
`BL/Fe/EO
`
`Exhibit 3: JUUL Gaining ACV
`
`JuulACV %
`6%
`5%
`4%
`3%
`2%
`1%
`
`Source: Nielsen xAQC+C, Morgan Stanley Research
`
`
`10,000 2LiGLZ0‘ Lb/20/01-
`0%
`m
`ad
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`LURZIPO-
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`
`JLI Ex. 2038, Page 5 of 30
`
`

`

`Morgan Stanley |
`
`researcn
`
`FOUNDATION
`
`their ability to fully satisfy smoker needs. We believe JUUL is different because of its
`enhanced technology which is based on a nicotine salt that more closely mimics the
`nicotine delivery of smoking a cigarette. Moreover, no other e-cig has been able to
`capture such a meaningful share of the overall cigarette category. Whileit is unclear if
`JUUL will demonstrate enduring success, its results so far suggest that consumers are
`both eager to try alternative products and that e-cig technological improvementsare
`increasingly satisfying smokers. The impending introduction of competitive products
`such as myblu (mperial Tobacco) may impact JUUL's ultimate success but nonetheless
`pose a similar headwind to conventional cigarettes.
`
`In our view, JUUL's growthis partly coming at the expense of cigarette sales. Our
`discussions with JUUL users indicate that the product appeals to smokers who viewit as
`a means of quitting/reducing their cigarette consumption. In addition, our analysis of US
`scanner data by region suggests cigarette volume declines are worsening in regions
`where JUUL's market share momentum is growing. Anecdotal evidence suggests JUUL
`appeals to youth, and if this is the case, JUUL is also likely "stealing" future smokers as
`the average age of smoking initiation is 19.5 years old. Given that smokers’ consumption
`increases as they age, this dynamic could contribute to accelerating cigarette volume
`declines long-term as the current JUUL user base ages.
`
`We estimate that JUUL can have a ~100 bps impactto annual cigarette industry
`volumes overthe next five years. Given that JUUL is still a nascent product,it is difficult
`to gauge the sustainability of its current success and/or category impact. In particular,its
`growth rate may be constrained by regulatory measures to combat its alleged youth
`appeal (though we believe the FDA's options are limited) or its success may be a
`temporary fad. It is prudent to evaluate a range of potential outcomes for its impact to
`cigarette volumes based on different market share and cigarette cannibalization rate
`scenarios. As a baseline, we estimate US cigarette industry volumes decline 3.5%
`annually. In our base case, we estimate a ~100 bps incremental headwind to cigarette
`volumes annually reflecting ~15% JUUL market share of baseline cigarette volumes by
`2022 (versus 3.5% today) and that ~40% ofits volumes will come at the expense of
`cigarettes (versus ~20% today).
`
`Exhibit 5: Annual headwind to industry volumes from JUUL market share and cannibalization rate scenarios
`
`Oe ue JUUL Volume % Baseline Cigarette Volumes (pre-JUUL impact)
`
`Assumptions a
`
`30.9%
`Ad7%
`5.2%
`3.5%
`50.0%
`800% =
`22.0%
`22.0%
`JUUL % Volumes Sourcing from Cigs
`
`Average Annual Headwind to Cigarette Volumes (2018-22E) |LObps] 21 bps 116 bps -217 bps|
`Source: Nielsen xAOC+C, Morgan Stanley Research
`
`JLI Ex. 2038, Page 6 of 30
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`JLI Ex. 2038, Page 6 of 30
`
`

`

`Morgan Stanley |
`
`researcn
`
`FOUNDATION
`
`Exhibit 6: Average annual headwind to cigarette volumes from JUUL market share and
`cannibalization rate scenarios from 2018-2022
`
`JUULShare of Caarete Volumes by 2027
`oC
`oo
`a
`ao
`-68 bos
`-19 bps
`-9 bps
`10%
`a 39 bps ge. es ea +119 bps
`-19 bps
`205%
`58 bos
`|
`}
`:
`|
`|bpes
`-180 bps
`~29 bps
`30%
`39 bps a bose p eee
`Nibps
`243 bps
`40%
`-49bps 88 bos 149 bps= bps 2 _
`-307 bos
`50%
`5Bbps
`—--118 bps
`-243 bps
`-373 bos
`60%
`“68 bps.
`~139 bes
`-286 bps
`“441 bos
`70%
`~78 bps
`~159 bps
`~329 bps
`10 bps
`80%
`-88 bps.
`-180 bos
`~373 bps
`-581 bos
`90%
`~98 bos
`-2071 bos
`418 bps
`-654 bps
`100%
`Source: Nielsen xAGC+C, Morgan Stanley Research
`
`
`
`-362 bps
`~418 bps
`~475 bos
`-534 bps
`
`<
`g
`a8 ®
`3 é s
`ed
`&
`
`“275 bps
`~307 bps
`
`We see MO moving toward a MSD EPSgrowth algorithm beyond 2019. Growing JUUL
`adoption enhances risk to MO's volume trajectory and could result in elevated
`investment needs behind innovation in reduced-risk products (RRPs) and to defend
`cigarette sales. While we believe the cigarette industry has a long runway for pricing
`growth, the proliferation of viable Lower risk substitutes such as JUUL, which are
`cheaper than cigarettes due to their excise tax advantage, could elevate cigarettes’
`historical 30% pricing elasticity. Given these increased risks, we are reducing our outlook
`for 2019-22 volume declines by ~100 bps, to -4.5% but still see solid 3.5% net pricing.
`We expect it to become increasingly difficult for MO to sustain its 7-9% EPS growth
`algorithm as volumes continue to decline and further cost reduction becomes
`challenging. Beyond 2019, we see 5-6% EPS grawth as more achievable.
`
`MOcould acquire JUUL to eliminate it as a threat but several considerations that
`reduce this possibility. Specifically,in its latest funding round, JUUL was valued at $10
`bn and MO would likely have to pay a premium to this amount. JUUL could see MO's
`interest as an affirmation of its negotiating leverage and would probably want to be
`compensated for its international expansion opportunity as it plans to expand in Europe
`this year. In December 2017, JUUL appointed a new CEO who was previously Chobani's
`COO, an indication the company may not view a sale as imminent. Lastly, we do not
`believe MO would acquire the company right before new competition (myblu) enters
`the market as it would probably wait to see how the competitive dynamics play out.
`Note that Altria has acquired market leaders in other tobacco categories such as UST
`(smokeless tobacco) and Middleton (cigars).
`
`We remain EW as we havelong-term concerns aboutthe sustainability of MO's 7-9%
`growthalgorithm. While we believe the company should deliver on its outlook in 2018
`and sustain HSD EPS growth in 2019 as it will be lapping elevated 2018 investment, we
`believe EPS growth will moderate towards mid-single digits beyond 2019 due to
`accelerating volume declines (MSe -4.5%), higher investment needs, and more elusive
`cast savings. As a result, we are ~2.0% and ~5.5% below 2019 and 2020 consensus EPS
`forecasts. However, we recognize that the stock has already significantly de-rated over
`the last year From 22x NTM P/Ein June 2017 to 13.1 today) with the stock now trading
`at ~25% discount to Staples (at 17.0x 2019e P/E), approximately 1-standard deviation
`below its 10-year 15% discount to Staples. Our $63 PT is based on 15.0x 2019e EPS a
`10% discount to Staples, in-line with the stock's 5-year average discount versus Staples
`peers. We remain Equal-weight as we see a widening risk-reward.
`
`JLI Ex. 2038, Page 7 of 30
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`JLI-NJOY-ITC1368-01332231
`
`JLI Ex. 2038, Page 7 of 30
`
`

`

`Morgan Stanley |
`
`researcn
`
`
`
`FOUNDATION
`
`Exhibit 7: MS vs. Consensus EPS 2018-20
`MS vs. Consensus EPS
`
`Exhibit 8: We believe increased fundamental risks are already reflected
`in MO's valuation
`MO NTM PIE vs. Consumer Staples
`<M
`
`“6.0%
` 00% ~
`
`AO
`
`-2.0%
`
`-3.0%
`
`8.0%
`
`6.0%
`
`Dax
`
`4
`
`fax
`“
`
`oye
`
`OSx
`
`Source: Thomson Reuters, Morgan Stanley Research
`
`Source: Thomson Reuters, Morgan Stanley Research
`
`JLI Ex. 2038, Page 8 of 30
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`JLI-NJOY-ITC1368-01332232
`
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`
`

`

`Morgan Stanley |
`
`researc
`
`FOUNDATION
`
`_ Whatis JUUL? JUUL is an e-cigarette that contains a device, pod, and a charger. The
`_ e-liguid ina JUUL contains 5% nicotine concentration by weight, which is more than _
`_ double the amountin most other e-cigarette products on the market. Instead of
`the freebase’liquid nicotine used in many e-cigs,JUUL contains benzoic acid, which
`_ creates a nicotine salt when heated that gives the vapor a smoother, less harsh
`taste relative to other e-cigs and allows users to inhale the product more strongly
`Tor a longer period of time. Nicotine saltsalso allow nicotineto travel deeperinto
`the body with the nicotine absorption occurring in the lungs rather than in the
`throat and more closely mimics cigarettes’ nicotine delivery. Other products
`containing a nicotine salt include RJR's Vuse Solo and MO's MarkTenBolde-cigs.
`
`JUUL is available in eight flavors; Mango, Cool Cucumber, Virginia Tobacco, Classic
`Menthol, Fruit Medley, Creme Brulee, and Classic Tobacco.
`|
`
`_ JUUL's appeal likely stems from its design, nicotine content, flavors, social media
`presence, and cost. Aside from its high nicotine content and flavor options, JUUL
`has a sleek design,is discrete, and it can be recharged in a USB drive JUUL has a
`large social media presence as users share photos and videos using the product.
`From acost perspective, a JUUL starter kit sells for $49.99 and includes a JUUL
`device, USB charger, four JUUL pods. A device kit alone is $34.99 and a pack of four
`pods cost $22.99. Assuming onepodis equivalent to one pack of cigarette (based
`on 200 puffs/pod), the cost on the company’s websiteis $5.75 per pack equivalent.
`However, based on US scanner data, |UUL refills cost $4.18 (vs. $6.15 per pack of
`_ cigarettes).
`
`Exhibit 9: JUUL device and podrefills
`
`
`
`
`
`
`
`
`
`
`
`
`
`
`
`Source: Juulcom
`
`JLI Ex. 2038, Page 9 of 30
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`
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`
`

`

`Morgan Stanley |
`
`researcn
`
`FOUNDATION
`
`A Framework for Quantifying JUUL's Impact to Cigarette Volumes
`
`JUUL's successis driving a revival in the US e-cig market, which had tepid sales growth
`in 2014-16 due to existing technologies’ shortcomings in broadly satisfying smoker
`preferences. However, JUUL has proven to be a formidable competitor, contributing to a
`meaningful acceleration in e-cig category sales growth to +49% in 2017 and +100% in
`2018 YTD within measured channels. Specifically, JUUL accounted for almost the entire
`incremental increase in US e-cig sales as a percent of total cigarette and e-cigarette sales
`in the last year (Exhibit 9). Within measures channels, which only capture a portion of
`JUUL's sales, it held 3.5% share cigarette volumes in the LaW compared to only 50 bps in
`2077.
`
`Exhibit 10: E-cig sales growth accelerated throughout 2017 and
`remained strong in 2018
`
`Exhibit 11: E-cig growth is driven by JUUL's success,with e-cigs
`holding 4.1% $ market share
`
`U.S. E-Cigarette Retail Sales Growth
`200%
`
`20%
`
`15%
`40%.
`
`U8. E-Cig 5 as % of Total E-cig + Cigarettes Sales
`a5
`
`4.0%
`3.5%
`
`0%
`2.8%
`2.015%
`1 o%
`ueDSM
`OM.
`
`on
`
`
`|ii +
`
`165%
`
`100%.
`
`50%
`
`(80%)
`
`ot domeeuewree csLTE
`
`eh
`o%
`(5%)
`(10%)
`ree
`8 8 (8%)
`hm
`mh
`mM
`BD mm mh
`DB
`GB
`OO
`GQ 0 & © GC 8 G@
`S55 5558 682 BSS AERE & S
`a 2-2 & 2
`@ © fo oOo 8 &@
`fe fee e&
`eR 8 =f
`BSSSESRESESHSERSRSSE BS
`i a
`
`i
`Ae
`Source: Nielsen xAOC+C, Morgan Stanley Research
`
`Source: Nielsen xAOC+C, Morgan Stanley Research
`
`Webelieve that JUUL contributed 10-20 bps to decelerating cigarette volumes in 20T/.
`We estimate that the industry's volume declines worsened in 2017 due to several
`headwinds including a ~75-100 bps impact from California's outsized excise tax increases
`in ($2.00/pack) as the state accounts for ~7% of the smoker population and retail prices
`rose 40% and a potential 10-20 bps impact from JUUL given it grewrapidly off of a low
`base in 2017. 1Q18 industry volumes remained elevated (5.5%) due to lapping inventory
`Loading ahead of California's price increase last April and we believe 2018 industry
`volumes should begin to normalize toward 3-4% annual declines but will remain at the
`Low end of the industry's volume declines.
`
`In our view, JUUL will be an ~100 bps annual headwindto UScigarette volumesin
`2018-22.In particular: ) we believe that JUUL is sourcing a portion ofits user base from
`existing smokers: 2) there is a correlation between regions where JUUL market share
`momentum is accelerating and US cigarette volume declines are accelerating; and 3)
`JUUL captured a 3.5% share equivalent of US cigarette volumes with limited, but growing
`distribution. Below, we provide a framework to quantify its potential impact if these
`growth rates continue and in our base case, see a ~100 bps headwind to annual
`cigarette volumes.
`
`JLI Ex. 2038, Page 10 of 30
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`JLI-NJOY-ITC1368-01332234
`
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`
`

`

`Morgan Stanley |
`
`FOUNDATION
`researcn
`1) JUUL growthis partly sourcing from cigarette sales
`
`JUUL refills grew from 0.5% of cigarette volumes in 207? to 3.5% in the last month.
`Based on JUUL's sales within US scanner data in 2017, the company sold 55 MM refills,
`which have ~200 puffs each and equate to one pack of cigarettes according to the
`company’s website, These volumes are not completely comparable to cigarettes given
`the way in which they are used differs, as e-cig smokers draw strength varies and users
`can take a few puffs at a time. Applying the company's conversion rate, JUUL volumesin
`2017 equate to 0.5% of total cigarette volumes within measured channels and have
`grown meaningfully to 3.5% of total cigarette volumes in May. JUUL’s sales in measured
`channels also understate their sales given e-cigs are also sold online (~30% total sales)
`and at vape shops, which are not included in scanner data.
`
`Exhibit 12: Accelerating cigarette volume declines coincided with increasing JUUL growth
`
`Cigarette Volumes - YoY vs. JUUL Penetration (L4W)
`4.0%
`3.0%
`2.0%
`1.0%
`
`
`
`0.0% Pre
`“1.0%
`2.0%
`-3,0%
`4.0%
`6.0%
`6.0%
`
`B
`@ 888 8 88 22288 8
`8B
`8S
`s
`@
`8
`8
`¢
`&
`8
`8
`&
`§ Bs
`—
`=
`on
`=
`=
`=
`=
`=
`=
`aa
`=
`=
`=
`ed
`
`ao —0ooa oG & © 8 @ BD A ~ ON ~d
`
`
`
`
`
`
`
`
`
`
`
`
`
`» Cigarettes -~ YoY
`
`ww vie Cigs - 2-Yoar Avg.
`
`ooo Juul Y Packs + Juul
`
`Exhibit 13: MRI survey data suggests 61% of e-cig users also smoke
`cigarettes
`incidence Past 12 Months (% Population)
`
`60.05%
`
`50.0% -
`
`40.0%
`
`30.0%
`
`Webelieve JUUL also appeals to existing smokers. Press reports
`scrutinizing JUUL’s growing popularity focus on its youth appeal,
`including to students in high school and college. We believe that
`JUUL also appeals to smokers given its high nicotine concentration
`(5% by volume), discrete design, and range of flavors. Our
`discussions with adult JUUL users suggest that smokers are using
`JUUL for a variety of reasons, including as means of smoking
`cessation, and are dual using the product in order to cut down on
`their cigarettes consumption and in situations where smoking is
`prohibited. These smokers believe that JUUL is contributing to a
`reduction in the number of cigarettes they consume. In addition,
`our analysis of MRI survey data indicates that 61% of e-cig users
`also smoke cigarettes, suggesting prevalent dual usage among e-
`cig users.
`
`Cigarette volume declines are worsening in regions where JUUL's
`share momentum is accelerating. {UU L's impact on cigarette
`
`20.0% es
`
`10.0% 0.0%
`
`3
`Cigarette
`Smoker
`
`
`
`:
`at
`E-Cigarette
`Smoker
`
`
`
`
`
`Overlap (Cig & :
`E-cig Smokers
`|
`E-¢ig}
`2 Who Smoke
`' Cigarettes
`
`Prnsiniansosesia
`en
`
`Smokers who
`Use E-cigs
`
`Source: MRI, Morgan Stanley Researcn
`
`JLI Ex. 2038, Page 11 of 30
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`
`

`

`Morgan Stanley |
`
`researcs
`
`FOUNDATION
`
`volumes is apparent in regional scanner data, which indicates that cigarette volume
`declines are increasing in regions were JUUL's market share is momentum is accelerating.
`For example, JUUL's YoY share momentum accelerated the most (+240 bps YoY in L4W
`ended 4/21/18 vs. L52W) in the West South Central census division, where cigarette
`volume decelerated by 260 bps. While there may be a number of factors contributing to
`accelerating declines in these regions, JUUL appears to be an incremental headwind.
`
`Exhibit 14: JUUL's market share momentum is accelerating
`throughout the country
`-duul § Market Share Momentum (LAW - Lo2Wy
`S60
`
`wha Lavi ve. LS
`
`Exhibit 15: Accelerating JUUL share momentum has coincided with
`accelerating cigarette volume declines
`
`
`
`
`
` B
`
`i) Paice
`
`f
`
`%
`
`
`
`Cig volumes YoY (L4W minus Laz)
`6.0%4
`|
`4.0%4a|i
`oe
`Oe, a
`2.0% : Nos
`New Eraland
`ay
`OLY eepip egg :
`East Novih ha
`iy Bast South Central
`OH |
`> Tota us
`1
`lileftle Atiantic
`South East South
`LS West
`Total
`North
`West
`mh
`E
`ba
`|
`South Atlantic
`ms
`>. West South Central
`oe
`
`
`
` antral Atlantic: Gantrat Division:RAO Inct=Central
`Attentia
`Cental
`England
`Dhaision
`Divigion
`Division
`Tibvigions
`Givision
`Division
`Corw
`Eivigion
`Divigion
`ii
`me 0% :
`> West North Central
`“0%
`2
`
`Source: Nielsen rAOC+C, Morgan Stanley Research
`
`oO
`
`100
`
`150
`
`200
`
`2nd
`
`B00
`
`Exhibit 16: We estim