It’s been a long time since we’ve updated our readers on tobacco companies, but we’ve never stopped following them. In order of size, we currently hold: Philip Morris International (PM) which goes well according to our thesis, Altria (MO) pending IQOS development, and also British American Tobacco (BTI) (OTCPK: BTAFF).
If you had time to read it, it was one of our best Seeking Alpha articles we’ve ever written. At that time, no one had yet done any analysis showing this path for Philip Morris leading to a 50% upside margin-driven expansion from IQOS mix growth.
Today we wanted to focus on Japan Tobacco Inc. (OTCPK: JAPAF) [2914:JP]. The Japanese cigarette manufacturer markets tobacco products, but also medicines and processed foods in Japan and around the world. One important thing to note is that the Japanese Ministry of Finance owns 33.35% of the outstanding shares.
The first question that came to my mind was why does a tobacco company own a pharmaceutical company and a processed food company? At first glance, we thought this was due to historical reasons, but then we saw that there had been mergers and acquisitions activities that had been carried out by Japan Tobacco to strengthen these operations in the past. The reality is that the two divisions represent a smaller percentage of Japan Tobacco’s total revenue, and looking deeper into the details, the underlying profitability doesn’t perform well either. We see this as a downside, but we don’t count any conglomerate discounts.
Commentary on the results of the 2021 results report
Year-on-year, sales increased 11.1% to JPY 2.325 billion. This was attributed to the price mix in the international tobacco segment as well as in the domestic division, the results were partially offset by a decline in the processed food business. At the EBIT level, we see a disproportionate increase (compared to the revenue trajectory) which is explained by higher SG&A expenses for “strengthen the competitiveness of the Japanese tobacco industry“.
Source: Japan Tobacco 2021 Earnings Report
What are we looking at? Our analysis is based on the Reduced Risk Product (RRP) category and we note the following:
- Ploom Tech, the Japanese brand RRP, is out of play in its own market. Thanks to Google trends and looking at the stats in Japan, we see no sign of Ploom Tech and also Ploom.
Source: Google Trends
- According to the latest presentation of the PMIQOS ILUMA recently showed very promising signs in Japan and it is progressing to gain more and more market share. Quoting the PM’s statement: “these newly designed sticks should only be used with IQOS ILUMA, which has an auto-start feature that detects when the TREATM stick is inserted and automatically turns on the device. These bladeless devices provide a cleaner way to heat tobacco from the core, without burning it, to deliver a more consistent experience, with no tobacco residue and no need to clean the device.”
Source: Q4 PMI report
- We weren’t impressed with comments from CEO Masamichi Terabatake, who on the last call said “By 2027, our ambition is to achieve RRP balance category by securing share of the mid-teen heated tobacco segment in our core HTS markets. To achieve this objective, we are accelerating the necessary commercial investments and expect an average annual growth rate in constant currency adjusted operating profit of mid-single digits during the period of the 2022 business plan. In addition, we plan to increase earnings, which will increase shareholder returns, in line with our shareholder return policy.“.
Conclusion, assessment and main risks
Japan Tobacco lags behind Philip Morris and also follows British American Tobacco. The Company has exposure in countries where the rate of decline in cigarettes is more pronounced. Profits decline and are not offset by higher cigarette prices. Japan Tobacco looks like a value trap considering that the dividend was cut recently (from 154 JPY to 140) and is now set at a payout rate of 75%, one can expect a additional volatility on DPS.
Source: JT Annual Report 2020
We value the company with a neutral rating with a P/E of 10x based on 2022 internal results at a discount to its relative peers.
Source: 2020 JT Annual Report
Besides the usual secular downward trend in the cigarette industry, other risks for Japan Tobacco are: