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Morningstar | JT's Bangladesh Deal Seems Pricey but the Upside to Gain Shares Might Justify Expensive Valuations

Japan Tobacco, or JT, announced the acquisition of Bangladesh's United Dhaka Tobacco Company, or UDTC, formerly owned by local conglomerate Akij Group, for JPY 164.5 billion or $1,476 million including JPY 43 billion or $386 million in trademarks and design rights. The deal, following the recent acquisitions in Philippines and Indonesia, is part of JTI's strategic efforts to expand its footprint in the under-represented emerging markets. JT is expecting to leverage UDTC's distribution and sales capabilities to gain shares in the world's eighth largest tobacco market while hoping to grow its global flagship brands over the long run when smokers trade up along with the rising disposable income. The deal, representing less than 1% of the group’s profits, has marginal impacts on our fair value estimate of JPY 3,750. We maintain our wide moat and negative moat trend ratings. JT plans to finance the deal through borrowings and cash on hand.

UDTC (Akij’s tobacco business) is the second-largest player in Bangladesh with a 20% market share, mainly in two value brands Sheikh and Navy. It appears UDTC has lost a sizable chunk of market share, down to 20% from 26% in 2016 and 38% in 2012, after the leader British American Tobacco heavily invested in the market. BAT raised its market share to 63%, up from 35% of 2012. JT’s Winston currently has a mere 0.1% share. It appears Akij’s management found it difficult to compete with the global tobacco companies with limited marketing and operational know-how and therefore decided to divest the business. The deal, priced at 20 times EV/EBITDA or 7.9 times sales on 2018, looks pricey compared with JT’s recent deals at 4.6-6.6 times sales. While JT thinks the relatively high operating margin at about 30% (given low pricing points), along with steady volume growth and consistent price increases justify expensive valuations, we think the deal would seem sensible if JT could regain the lost ground and lift the share to more than 30%.

Cigarette value sales in Bangladesh has seen a nearly double-digit growth per year including a 2% growth in volume and above GDP growth or 6% increase in pricing along with a 1%-2% excise tax hike over the past four years. The value segment represents about 90% of Bangladesh’s cigarette market. JT will be introducing its operational and marketing expertise to UDTC to enhance sales efficiency and regain shares. It appears that Akij has underinvested in marketing and sales in order to maintain the profitability. In addition to investment in brand building, JT will reallocate human capital and introduce technology tools to drive sales. While the required investment may have some negative impacts on profits, JT expects profit contribution from UDTC shortly after the deal is complete. On the other hand, there will be limited investment in UDTC’s manufacturing facilities. Indeed, UDTC has been JT’s outsourcing partner manufacturing Winston and thus its production lines will be able to support expansion when JT plans to introduce more global flagship brands to the market. There will be little cost synergy as JT does not own production facilities in the country.

The key risks lie in currency movement and regulatory changes. Given that Bangladesh Taka is in its 10-year low and has depreciated about 4% against the U.S. dollar over the past 12 months, a downside risk seems limited. Likewise, while the Bangladesh government has drafted a policy to curb the use of tobacco products and turn the country smoke-free by 2040, there are no details in the implementation plan yet. We expect that most developing countries will introduce similar policies to reduce tobacco use over the long term and thus Bangladesh is not an exception.