EUR 850.00 For Business Accounts Only

Morningstar | Strong Pricing of Overseas Tobacco Lifted JT's Earnings; Domestic Volume Decline Lessening

Wide-moat Japan Tobacco's, or JT's, second-quarter profits came in below our expectations although the results seem in line with the company's internal target. Like-for-like adjusted operating profits saw a marginal 3% growth. Strong pricing of the overseas tobacco business contributed a 13% growth in adjusted operating profits, lifting the group's growth, while domestic volume decline narrowed. We believe that brand equity and cost advantages will sustain JT's competitive edge in combustible cigarettes although the secular volume decline in the domestic combustible cigarettes combined with a latecomer position to catch up in the fierce e-cig competition indicates a deteriorated moat trend. JT has lifted the full-year sales guidance to incorporate the Donskoy acquisition and better-than-expected domestic combustible sales, but revised down the operating profit target by 3.6% to reflect mainly an adverse foreign exchange movement in currencies of major markets including Russia, Iran, and Turkey. We have marginally adjusted our forecasts accordingly, but maintain our fair value estimate of JPY 3,750 as the increased time value of money largely offset the adjustment. We view JT's shares as undervalued with a 20% upside.

The overseas tobacco business posted a solid 10% like-for-like growth in sales (up 3.9% excluding volume impacts of acquisitions and negative inventory movement) and impressive 17.8% like-for-like growth in adjusted profits thanks to strong pricing in Russia, Iran, and Taiwan, although an unfavorable geographic mix and downtrading in the U.K. seems to have depressed gross margins. Pricing boosted the top line by more than 10% growth and adjusted operating profits by more than 30% during the quarter, offsetting the negative volume impacts and increased costs.

Japan Tobacco International, or JTI, will consolidate Donskoy from August and plans to gain shares by stepping up investment in the south regions where Donskoy has a strong presence. On the other hand, it has reduced its forecasts in Iran in preparation for potential procurement troubles caused by the U.S.'s sanctions although there has no notable impacts during the second quarter. While pricing will provide a strong support to JTI's profit growth, increased investment may slow the growth momentum in the second half.

In the domestic front, sales fell by 4.2% as increased reduced-risk products, or RRP, sales partially offset a 12.6% volume decline in combustibles. PloomTech achieved a 56% growth in sales quarter on quarter, lagging our expectation of doubled sales for the second quarter. It has acquired a more than 2% tobacco market share or 10% of RRP market share. While management has lowered its 2018 forecast of RRP market share by one percentage point to 22%, it has maintained its volume target for PloomTech capsules of 4 billion sticks (200 million packs), we think the target is fairly challenging and have cut our forecasts to 3 billion. It appears sales accelerated in July after the nationwide launch at the c-stores which represent an estimated 80% sales of cigarettes in Japan. Sales of its starter kit doubled to four million units by July 2018, up from the two million units achieved by April 2018 since the rollout of the product. We expect sales of capsules to accelerate but given that many PloomTech users seem not fully converted to RRPs, we expect growth of capsules to lag growth of devices.

On the other hand, the result of a 13.8% decline in combustibles (market down 14.5%) turned out to be better than expected given the recent growth deceleration in RRPs. JT has therefore lifted its volume guidance by 2 percentage points or 2 billion sticks but maintain its profit guidance for the domestic tobacco business as it plans to reinvest profits into RRPs in the second half. It appears that PloomTech's feature of odor free and benefits of low-temperature heating are not broadly recognized by its target customers. Given that the new smoking ban is likely to favor RPPs over combustibles, JT intends to take the opportunity to grow its presence by leveraging its sales capabilities. For example, JT has obtained approval of 2000 restaurants to allow customers using only PloomTech at their restaurants.