JAPAN TOBACCO (2914 JP): EARNINGS GROWTH WILL COME FROM RUSSIA
Japan Tobacco is a cigarette manufacturing company, with some diversification in food and pharmaceutical businesses. The company traces its origins to 1898. Incorporated in 1949 as the Japan Tobacco and Salt Public Corporation, Japan Tobacco was a state monopoly until 1985, when it became a public company. It was two-thirds owned by the Japanese Ministry of Finance until June 2004, and the Japanese government share is presently 50%. JT has been very active in the M&A market over the past decade. JT acquired RJR Nabisco’s overseas tobacco operation in 1999, obtaining popular brands such as Camel and Winston. In 2007, it acquired UK-based Gallaher, extending its geographical reach into Russia and other emerging markets and greatly expanding its sales area.
For many years now, Japan Tobacco has been expanding outside of Japan to reach markets with higher growth and to reduce its dependence of the Japanese Market. The Japanese cigarette market has entered a difficult period with the ageing of the population. As you can see in the graph below the older the person the less likely it will continue to smoke. The health issue is the major reason for such decrease.
As a result Japan Tobacco needs to anticipate the future sales expectation in Japan and to diversify elsewhere. The recent acquisition of Gallaher opens up more opportunity especially in Russia where cigarette’s consumption is growing rapidly.
Over the past ten years the cigarette industry has encountered many changes. The numbers of players have been reduced greatly and now only a few major players remain. The most important are Philipp Morris, British American Tobacco, Japan Tobacco and Imperial Tobacco-Altadis (see chart below).
The piece of the pie shared by these four firms is expected to grow in the next few years as there have been rumours for months now that the Turkish government is planning the sale of its government owned cigarette manufacturing company. Players in this industry need to grow externally to survive has developed markets like Western Europe, US and Japan are facing aging population and increasing pressures from governments to reduce smoking habits by increasing taxes. Today, growth opportunities remains in the developing countries like China or Russia. There, governments don’t have the same restrictive regulations since they are in need of the tax revenues from cigarette’s sales to balance their budget.
Japan Tobacco’s sales break down is well diversified in term of volumes sales but the picture from the after tax sales revenues shows an important dependence to the Japanese Market.
Historically, JT has enjoyed a strong market share in Japan as most of the cigarettes are bought thru vending machine owned by Japan Tobacco. However, the new government regulation, meant to reduce under age smoking, pushes consumer to buy their cigarettes in convenient stores where there can choose other brand. There has been concerned about the result of another future increase in tax on cigarette, however, when looking at the first graph above, we can see that the previous tax hike did not change much of the Japanese consumption across all age groups.
As stated above, the aging the Japanese population is also a problem for JT and that is the reason why the company’s strategy the past ten years has been to expand its market shares worldwide. The acquisition of Nabisco in 1999 helped reach other developed markets but that too is starting to show sluggish growth. The recent acquisition of Gallaher has opened up new expectation for the company as JT reinforces its presence in the fast growing Russian market (going from 19% of market share to 35%). Gallaher and JT have great synergies in Russia as JT concentrates on the mid price brands while Gallaher focuses on the low price brands. The graph below shows that both categories as of 2007 represent more than 85% of the Russian demand for cigarette.
I expect Japan Tobacco to profit greatly from its new acquisition of Gallaher. There are important synergies the two companies should be able to realize especially as the two companies compensate each other weakness. However, the recent crisis has brought concerned from Russia. The sharp drop of commodities prices has put Russia under a lot of pressure. Russia resurgence as a very powerful country over the past decade has been the result of the strong demand worldwide for commodities. Russia’s power financial stability relies too much from oil and gas revenues. The recent burst of the commodity bubble shocked Russia and its financial stability. The fear of a new default on Russia’s debt, like in 1998, is growing among the financial community. Russia’s currency has been depreciated versus dollar and euro couple times since last September and some economists are raising more concerns about more depreciation ahead. Japan Tobacco recently expressed its concern too since 1% change in the rouble versus the dollar results in a change of $18 million in revenue.
I believe Japan Tobacco’s business strategy is very good. The economic crises around the world are putting pressure on the stability of the company’s revenue but it is just temporary. The European market is maturing and as a result I do not expect the company to grow too much there.
Gallaher had a strong market in Spain and is expected to keep it. Japan has somewhat the same story. The rapidly aging population is a concern for the future. However, it is evident the government will have to loosen its stand on immigration in the future for the Japanese to continue growing. As a result in the next 10-15 years Japanese market for cigarette should remain stable and I don’t expect competition to strengthen in the near future. The paradox in JT’s strategy comes from Russia. JT has a great strategy and should enjoy strong growth in volume of sales in the next few years. However, the depreciation of the Russian currency reduces considerably the revenue of the company when translated in yen. My optimism tells me Russia cannot experience another 1998, Putin is very much aware of that, or the country’s effort to regain credit on the international scene over the last decade would have meant nothing. So, given that oil is already trading at $33 a barrel, I don’t expect other bad news from Russia in the next coming months.
In term of valuation, I added the stock a couple days ago to my portfolio. The stock has underperformed the market by almost 20% in less than two months due to the concern of the strong yen and the difficulties in Russia. However the company just released positive T3 results. Revenues increased by 17% compare to last year with a strong growth coming from international sales revenues in local currency. It still remains unclear exactly what the impact the exchange rate will have on FY earnings, which is probably why the company decided not to revise upward its FY forecast. Goldman Sachs expects earnings growth of 14% in Russia in local currency and -25% in yen for FY03/2009 with an average of 36 rouble/$. Now the stock trades at 17x P/E for FY 03/2009. I would admit it is not cheap but still below the average 24x P/E of the stock over the past few years. (I did not pay attention to JT’s businesses outside the cigarette business because they only account for a little less than 9% of the total revenues).
In conclusion, the uncertainty of the revenues recognition coming from Russia raises important questions regarding the growth potential of the company in the future. However, I see it as temporary and if world economies stabilize over the next few months Japan Tobacco’s stock price would bounce back sharply. I believe the worst is behind for the stock and that Russia is not going to devaluate anymore its currency intentionally. As a result the company will beat its earning expectations for FY03/2009.
http://en.wikipedia.org/wiki/Smoking_in_Japan
http://en.wikipedia.org/wiki/Japan_Tobacco
http://en.wikipedia.org/wiki/Tobacco_industry
| mars-04 | mars-05 | mars-06 | mars-07 | mars-08 | |
| Income Statement | |||||
| Sales (¥bn) | 4625,2 | 4664,5 | 4637,7 | 4769,4 | 6409,7 |
| Operating profits | 234 | 273,4 | 306,9 | 332 | 430,6 |
| Recurring profits | 213,6 | 270,3 | 297,8 | 312 | 362,7 |
| Net profits | -7,6 | 62,6 | 201,5 | 210,8 | 238,7 |
| Gross margin | 20,3 | 20,4 | 19,5 | 19,4 | 18,4 |
| SG&A ratio | 15,3 | 14,5 | 12,9 | 12,4 | 11,7 |
| Operating margin | 5,1 | 5,9 | 6,6 | 7 | 6,7 |
| Recurring margin | 4,6 | 5,8 | 6,4 | 6,5 | 5,7 |
| Net margin | -0,2 | 1,3 | 4,3 | 4,4 | 3,7 |
| JAPAN TOBACCO [2914]: consolidated financial data | |||||
| mars-07 | mars-08 | mars-09 exp | |||
| Sales (¥bn) | |||||
| Tobacco Business | |||||
| Domestic tobacco business | 3416 | 3362 | 3169 | ||
| International tobacco business | 1000 | 2640 | 3155 | ||
| Subtotal | 4416 | 6002 | 6324 | ||
| Pharmaceuticals | 45 | 49 | 55 | ||
| Fodd | 287 | 336 | 478 | ||
| Other | 21 | 22 | 14 | ||
| Total | 4769 | 6410 | 6870 | ||