EUR 850.00 For Business Accounts Only

Morningstar | Trimming Japan Tobacco Earnings but Negatives Priced In; Shares Still Undervalued With 25% Upside

We have lowered our fair value estimate for Japan Tobacco to JPY 3,600 from JPY 3,700 to reflect our reduced forecasts for reduced-risk products in Japan, reduced forecasts for the pharmaceutical business, lowered gains from asset restructuring, and adverse foreign exchange impacts, specifically regarding the Iranian rial, on JTI. Despite a secular volume decline in domestic combustible cigarettes and thus far uninspiring performance against the fierce reduced-risk product competition, we consider the stock undervalued with an attractive 25% upside and a more than 5% dividend yield. We see limited downside risk at the current price level as JT is trading close to our bear-case scenario, which indicates a slight decline in earnings over the next five years. Our estimates over the next three years are toward the lower end of the consensus range.

It appears that the nationwide launch of new PloomTech Plus (low-temperature heating) and Ploom S (high-temperature) is unlikely to take place until the second half of 2019, given constrains on manufacturing capacity of the new devices. The vendors are most likely to add new capacity after JT gains visibility on sales performance of the new products. On the other hand, it has built plenty capacity for capsules. PloomTech + will adapt the same capsule technology as PloomTech while the Ploom S will employ a similar manufacturing process to combustibles.

Management is convinced that the nearly odor-free trait, a key benefit of low-temperature heating, meets Japanese smokers’ demand most but meanwhile is struggling to communicate the benefit with potential users. It appears that JT’s reach to smokers through marketing activities is limited to a small group of end users, which may explain its less successful attempt to communicate the benefits of PloomTech. We suspect that it is caused by concerns about appealing to nonsmokers or increasing underage smoking or JT is less experienced in marketing to consumers as it has been relying on entrenched relationships with retailers to secure its presence.

As low-temperature heating will remain the key feature to differentiate JT’s RRPs from rivals’ products, efforts and resources will be channeled to PloomTech and PloomTech Plus. JT may reconsider its strategies if PloomTech Plus, designed to make up for the weak tobacco tastes of the existing PloomTech, is better received by smokers. Given a constrained supply of new products in 2019 and the recent slowdown in RRP penetration, we have lowered our forecast for JT’s RRP volume by 10% for the explicit forecast period, expecting the company to achieve 8.5% of total domestic volume share by 2021 compared with the previous estimate of 11% share and JT’s target of 12% by 2020. Nevertheless, we consider the currently slowing RRP penetration is in JT’s favor as the slow development allows JT time to catch up in product offerings and to convey the benefits of low-temperature heating to end users.

We have also cut the pharmaceutical sales and profit forecasts on the announcement that Gilead and JT’s pharmaceutical arm will end a license agreement in Japan in the beginning of 2019. Gilead will pay $559 million (about JPY 63 billion) to JT to buy back rights to develop and distribute the six HIV drugs including Genvoya and Descovy in Japan. Meanwhile, JT will pay JPY 43.2 billion to Torii Pharma, a subsidiary in which JT owns a 53.4% stake, for cancelling the exclusive distribution agreement of the same six drugs. Torii has been selling and distributing Gilead’s HIV drugs in Japan and sales of the six drugs account for one third of Torii’s sales. While the cancellation of the agreement has a limited impact on our fair value estimate, we expect a decline in royalty revenue generated from sales of Gilead’s HIV drugs employing the compound developed by JT to depress earnings.

Gilead expects Biktarvy, a new HIV drug approved by the U.S. Food and Drug Administration in early 2018 and available in the United States and European Union, to replace Genvoya and Stribild, which employ JT’s compound. As Biktarvy does not employ JT’s compound, the royalties paid by Gilead to JT for using the compound will decrease along with expanded sales of Biktarvy globally. JT’s pharmaceutical business was in the red over most of the past decade before 2016. It appears that the royalties received from Gilead significantly boosted JT's pharmaceutical profitability. With no major launch in the pipeline, we expect a sizable drop in profits and the business to return to the red as JT increases spending to accelerate new drug research and development.

Historically, Japanese food companies were keen to gain pharmaceutical exposure as the business used to earn high margins and helps extend a brand image of quality products. However, as the pressure of price cuts is likely to continue squeeze pharmaceutical margins and profitability, JT might be forced to review the need to retain the pharmaceutical exposure if the business struggles to make profits.