The downward revision in the bottom-line was primarily driven by an increase in finance costs and corporate tax, coupled with costs related to VGR acquisition. Additionally, the company has also revised its free cash flow forecasts, decreasing it by JPY220bn to JPY156bn owing to payments related to the VGR acquisition. This has not been well-received by investors, as the stock dropped around 4% the next day and has declined approximately 8% since announcement.

Japan Tobacco, based out of Tokyo, Japan, and established in 1985, is a prominent player in the global tobacco industry, which manufactures and sells some reputed brands including Winston, Camel, MEVIUS, and LD. The company markets its heated tobacco products under its Ploom brand and various e-cigarette products under its Logic brand. In addition, the Group, with over 53,000 employees, also operates pharmaceutical and processed food businesses. In FY23, the Tobacco business contributed 91.2% of the sales mix, followed by the Processed food business (5.4%), Pharmaceutical business (3.3%), and Others (0.1%).

One of the leading tobacco players

The tobacco industry can be bifurcated into two product categories - combustible products and Reduced-Risk Products (RRP). The global combustibles industry volume, comprising of products like cigarettes, pipe, and cigars, totaled around 5tn stick equivalent units in 2023, representing a value of JPY101tn. The RRP market consists of products like heated tobacco, E-Vapor, and oral products, where nicotine is delivered without consumption, thereby reducing potential health hazards. The global RRP industry stood at JPY11tn in 2023, with Japan being the largest market for HTP, and the US for -Vapor and oral products. The segment has demonstrated steady growth over the last few years, and the growth is expected to sustain going forward. Overall, the company’s tobacco business, with a strong presence in both segments, ranks third in the world (excluding China) by volume. The business is expected to nudge ahead driven by the pricing of the combustibles segment, and the value and volume of RRP.

Pricing and volume of tobacco driving sales

The Group delivered a revenue CAGR of 5.5% over the period FY19-23 to reach JPY2,841bn. The operating income grew at a much better pace, clocking a CAGR of 9% to register JPY645bn in FY23. The rise has been aided by a notable increase in efficiency leading to over 335 bps improvement in operating margin performance to 22.7% in FY23. Japan Tobacco also registered strong operating cash flow performance over the same period, generating consistent cash inflows in the range of JPY470-570bn. This impacted the cash position positively, demonstrating a rise of 2.9x to reach JPY1,040bn as of FY23 end.

Japan Tobacco delivered a strong performance in 3QFY24, growing its revenue 7.7% YoY to JPY 823.4bn, while the core revenue also grew at 7.7% (constant FX) to JPY791.6bn. The growth was achieved on the back of strong pricing performance in the tobacco business, whose core revenue grew 8.4% to JPY730.5bn. The total volume from the segment increased 2.4% YoY, driven by market demand in key markets along with substantial growth in Ploom volume. The expansion of Ploom has gained pace, aligning with the management’s investment priority, and has now reached 23 markets. The brand continued to demonstrate dominance in Japan and gained market share in the HTS (heated tobacco sticks) segment to reach 11.8% quarter-to-date. Overall, the RRP revenue increased 9.8% to reach JPY24.9bn, during the period. However, the Group’s operating profit and net income declined 6.6% and 11.5% YoY to JPY204bn and JPY137.2bn, respectively. The decline in profitability was primarily owing to muted top-line performance in the pharmaceutical business, coupled with an increase in R&D expenditures.

The company has maintained its dividend per share guidance for FY24 at JPY194, reflecting an estimated payout ratio of 74%, and a yield of 4.7%, based on the current price level.

Optimistic view on the stock by analysts

The company is currently valued at a P/E of 14.3x, based on the estimated FY24 EPS of JPY283, at par with the global peer average of 14.3x. Historically, over the past 10 years, Japan Tobacco’s average P/E stood at 13.9x. However, valuation through the EV/EBITDA approach yields a lower multiple of 7.6x, compared to a global peer average of 11.9x. The company’s stock has delivered modest returns of over 5% in the past 12 months. A total of 9 analysts have covered the stock, with 3 of them giving a ‘Buy’ rating and 1 suggesting “Outperform’ for an average target price of JPY4,600 for an upside of over 15% from the current levels. The analysts have consistently revised the FY24/25 revenue and EPS estimates upward, implying bullish sentiments and encouraging outlook.

Overall, the company’s long-term fundamentals look strong, driven by sustained pricing growth in the tobacco business, volume growth for Ploom, dominance in the HTS segment, and strength in cash profile. Moreover, the recent acquisition of VGR would enable the company to raise its market share from 2.4% to 8.2% in the US and become the 4th largest tobacco player in the region. However, it is to be noted that the tobacco industry is subject to high regulations, which may make the sales very volatile and impact the top-line growth of the company. Moreover, tobacco products are subject to additional taxes in addition to sales tax or VAT, with some countries mulling to increase tax further from a public health standpoint. Notwithstanding the risks, the company continues to move ahead, aided by organic as well as inorganic growth.