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Morningstar | Strong Pricing Lifts Japan Tobacco's Profits While New Products Shed Light on Reduced-Risk Growth

Wide-moat Japan Tobacco's first-quarter results came in above our expectations thanks to greater-than-expected pricing variance in the domestic and overseas tobacco businesses, although management considered the results in line with its internal target. Like-for-like adjusted operating profits saw 7% growth. Reported operating profits, up 24%, were lifted by Gilead’s one-off payment of JPY 62 billion for buying back the distribution rights of six HIV drugs. We reiterate our view that brand equity and cost advantages will sustain JT’s competitive edge in combustible cigarettes, although the secular volume decline in combustible cigarettes combined with the company's weak position in the reduced-risk product segment indicates a deteriorating moat trend. We maintain our forecasts and fair value estimate of JPY 3,600. We view the shares as undervalued with an attractive 38% upside.

The unsatisfying performance of Ploom Tech, combined with the accelerating volume contraction of combustibles in Japan, continues to overshadow JT’s share performance. Ploom Tech’s share in the reduced-risk market fell to 8% during the first quarter compared with 10% in the previous quarter because of rivals’ new product rollouts and a cut in marketing investment for acquiring new customers before the launch of Ploom Tech+. Indeed, volume increased by only 300 million sticks (equivalent to combustibles) to 600 million during the quarter compared with our expectation of 800 million. However, we expect growth to accelerate along with expanded distribution of the new products.

Comments from influential bloggers online and the feedback JT has received indicate that the new products have been well received. Many smokers said the taste of new products has greatly improved, resembling the taste of combustibles more than the previous product. Our survey and retailers’ feedback both point out that taste resembling combustibles is the most critical attribute to convert combustible smokers to reduced-risk products. JT’s reduced-risk market share has recovered to 10% in the areas where Ploom Tech+ was launched in April. Given the positive response, JT will bring the nationwide launch schedule forward to mid-June from July and plans to accelerate the rollout schedule of its heat-not-burn Ploom S.

On the other hand, there are more combustible smokers switching to cheaper brands in the markets post tax hikes. We have heard from retailers that there is an increasing number of smokers switching to cheaper brands post excise tax hikes as brands with retail prices around JPY 400 saw sales rise more than 50% while sales of premium brands fell 12%-15%. This echoes the results of growth in Camel and declines in Mevius and Natural American Spirit.

Overseas, volume was flat excluding acquisition impacts. Strong pricing in Iran, the United Kingdom, Canada, and the Philippines lifted profits with 13% growth in like-for-like adjusted operating profits. Due to a tough comparison hurdle resulting from two tax hikes within a six-month period, JT’s share in Russia appears to be affected by smokers’ downtrading. While Donskoy’s exposure to value brands should benefit from the trend, the volume didn’t seem to grow much as JT has been holding back shipment to rightsize Donskoy’s channel inventory and improve its cash flow. It appears the market has been concerned about the impacts of Juul and IQOS expansion on JT’s share. The launch of Logic Compact in February appears to have gotten off to a solid start. However, with the device priced at RUB 1,300 and refill with two pods at RUB 300, management suggests it is too early to reach a conclusion until the products are distributed to broader areas.