EUR 850.00 For Business Accounts Only

Morningstar | JT Beating Full-Year Targets but Guiding a Conservative Outlook; Share Buyback a Positive Surprise

Wide-moat Japan Tobacco’s fourth-quarter profits came above our expectations and its guidance mainly because of additional profits from property divestiture, better-than-expected volume sales in domestic combustible and Iran, on top of contribution of UDTC (Bangladesh) acquisition. We have lowered our forecasts specifically for 2019, which combined with the increased time value of money, has marginal impacts on our JPY 3,600 fair value estimate. It seems that Japan Tobacco's assumptions are somewhat conservative, and our 2019 profit forecast is 9% above the company’s guidance. The announcement of a JPY 50 billion share buyback is a positive surprise although the management has curtailed the pace of dividend hike to reflect the amplifying adverse foreign exchange impact on profits. The slowing adoption of the reduced-risk products, or RRPs, in Japan is in Japan Tobacco’s favor given its 60%-plus share in combustible cigarettes. We view Japan Tobacco's shares as undervalued with an attractive 32% upside.

Management guides a slight decline (0.7%) in revenue but an 8.8% drop in adjusted operating profits as the adverse foreign exchange movement of emerging-market currencies, is expected to wipe out JPY 60 billion of profits. In particular, the Iranian rial, the Turkish lira, and the Russian ruble combined represent more than 40% of Japan Tobacco's profits. Pricing, a key driver behind Japan Tobacco's growth in 2018, will fade in 2019 after the benefits of price hikes in several core markets' cycles.

Sales volume and supply seem to remain stable in Iran although there is a delay in customs clearance for raw materials. On the other hand, a sizable tax hike (3.6 lira tax hike per pack versus the retail price of 11 lira for a pack of Winstons) that took place in January in Turkey poses risks to Japan Tobacco's margins as the government allows a maximum of 0.5 lira price hike. Japan Tobacco is waiting for the leader PMI’s action although the tobacco companies will continue their lobbying activities. The January 10% tax hike in Russia will continue to depress volume sales, offsetting some pricing benefits.

On the domestic front, management guides a 7+% volume decline in combustibles while projecting sales volume equivalent to 5 billion sticks of RRPs with the RRP market share advancing only 1-2 percentage points to 22%-23% in 2019. It will launch the new PloomTech + (low-temperature heating) and Ploom S (high-temperature heating) nationwide in July and September, respectively. We consider the volume guidance of 5 billion sticks conservative and project annual sales volume of 6 billion for 2019 as the existing product achieves 1 billion sticks per quarter. We should be able to gain better visibility to smokers’ response to the new products once they are available at the C-stores in six prefectures, including Tokyo, in April and July.

To our surprise, management announced a JPY 50 billion share repurchase program. Apart from the JPY 63 billion payment from Gilead for canceling the licensing agreement, management appears to think Japan Tobacco’s shares are undervalued. On the other hand, it has reduced the pace of dividend hikes, lifting dividends by JPY 4 per share to JPY 154 for 2019, compared with a JPY 10 hike in 2018 and 2017, respectively. Given the enlarging impacts of currency depreciation in many of its core markets, management has revised its dividend policy, which takes into consideration not only growth in adjusted profits at constant foreign exchange, but also foreign exchange impacts.