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Morningstar | Strong Overseas Pricing Lifts Profits for JT, but Downward Revision on Adverse Foreign Exchange Move. See Updated Analyst Note from 31 Oct 2018

Wide-moat Japan Tobacco’s, or JT's, third-quarter profits came in slightly below our expectations mainly due to lower earnings from the noncore businesses. The company has revised up its target of like-for-like, or LFL, adjusted operating profits by JPY 17 billion or 4.7% given healthy overseas growth thanks to strong pricing but have reduced the guidance of reported operating profits by JPY 9 billion given a JPY 28 billion impact of adverse foreign exchange movement.

We have reduced our profit forecasts accordingly and marginally lowered our fair value estimate to JPY 3,700, from JPY 3,750. JT’s continued share gains in the domestic combustible segment reinforces our thesis that brand equity and cost advantages will sustain JT’s competitive edge in combustible cigarettes. The slowing adoption of the reduced-risk products in Japan is also in JT’s favor, allowing it time to catch up the product development. We view JT’s shares as undervalued with an attractive 27% upside.

LFL adjusted operating profits saw a 20% growth. Apart from continued strong pricing of the overseas tobacco business contributing an estimated 20% growth in adjusted operating profits, a 1.3% growth in the domestic combustible volume caused by a surge in demand prior to tax and hike prices also boosted profits. The household stock, estimated to be equivalent to 0.4 months of consumption, will depress demand mainly in the fourth quarter.

The overseas tobacco business posted a robust 18% LFL growth in sales (up 7.6% excluding volume impacts of acquisitions and negative inventory movement) and 21% LFL growth in adjusted profits thanks to strong pricing in Iran, Philippines, Russia, and Taiwan. While JT has seen no impacts on sales volume and production, devaluation of the Iranian rial, Turkish lira, and Russia ruble, which combined account for 40% of its overseas sales, will further depress sales and profits into the fourth quarter and likely the first half of 2019.

The new U.S. sanction expected to take place in November may pose risks to its operation in Iran in 2019 as JT has managed to secure supply for the rest of 2018.

On the domestic front, JT has revised down its full-year sales target of reduced-risk product, or RRP, volume to 2.8 billion sticks, compared with its initial target of 4 billion and our forecast of 3 billion, as well as the forecast of RRP market share to 21% from 22% in 2018. The company cited a lack of salesforce to promote the features and benefits of low-temperature heated tobacco constrains its sales expansion. While it plans to expand the product lineup and add new favors under the Pianissimo brand, we think improving the technologies of devices to strengthen tobacco tastes will be a key to boost its share. JT plans to launch the new PloomTech + and PloomTech heated-not-burn products by March 2019. As PMI will also launch its IQOS 3 and IQOS Multi in mid-November, another round of new product introduction with refined devises and functionality may further drive RRPs’ penetration and potentially gives JT an opportunity to catch up.