BTAFF - Japan Tobacco: Accelerating Growth Justifies A Higher Valuation

2023-10-09 11:41:53 ET

Summary

• Japan Tobacco faces challenges due to regulations and growing awareness of health risks, but the tobacco market continues to grow.
• New Zealand plans to implement a lifetime ban on tobacco purchasing for young people, but it is unlikely to have a significant effect on global tobacco revenue.
• Japan Tobacco is undervalued compared to some of its peers, and its growth initiatives and potential share buybacks could boost earnings and dividends.
• The stock has a valuation upside of at least 30%.

1. Introduction

Japan Tobacco Inc. (JAPAF) is one of the 5 biggest tobacco companies and faces several challenges due to regulations, proposed bans for some of its products and continuously growing awareness of the health risks of smoking. However, the tobacco markets has been growing for years and is expected to grow till 2030 by 2.1% annually . Furthermore, it is considered an oligopoly which has many advantages for the producers like pricing power and limited competition. As a consequence, political interference seems to be the biggest threat to companies like Japan Tobacco while the number of potential customers will slightly decrease but will remain above 1.25 bn smokers. So customer demand will be robust for years which is a good environment to increase prices and revenues. But first of all, let's have a look at the major risk for tobacco companies: a lifetime ban on purchasing tobacco products.

2. Lifetime tobacco purchasing ban

The first country to implement such a lifetime ban is New Zealand. The government has banned tobacco purchasing for all young people born on or after January 1st, 2009 . A similar plan was proposed in the UK by PM Sunak and by members of the European Parliament. It is unlikely that these rules will be implemented in the near future because opponents of this ban argue that it will increase illicit tobacco trade as the ban does only prohibit buying tobacco products but not its consumption. Young people desperately willing to smoke will find a way to do so. There are currently no other countries that plan a lifetime ban on purchasing tobacco. While New Zealand is just a tiny country with little effect on global tobacco consumption, banning plans in the UK or Europe won't have a significant effect on tobacco revenue in the near future. Hence, the proposed annual growth rate of 2.1% is a valid assumption.

3. Valuation and peer comparison

Japan Tobacco has 1.775 billion shares outstanding, a share price of $22.15 and a resulting market cap of 39.3 . In traditional valuation categories, it is overvalued compared to British American Tobacco but undervalued to Altria (MO) and Philip Morris International Inc. (PM):

Japan Tobacco has the second lowest yield but the best payout ratio which gives the management more room for dividend increases. The growth rate was just beaten by British American Tobacco (BTI) for the last six years. Current growth initiatives seem to be successful as shown in the next section. Compared to its major peers, especially for the price/EBIT ratio, Japan Tobacco is undervalued. Another advantage for Japan Tobacco is the stock‘s positive momentum while peers currently underperform.

4. Growth initiatives and share buybacks

Heat not burn products are supposed to outpace growth of traditional tobacco products with an expected CAGR of 3.8% . Japan Tobacco has already launched a new product in this category with Ploom X in 2021 which is, according to the company, its fastest growing segment among risk-reduced products. According to the latest half year numbers, new products and stable customer demand helped JTI to report high revenue growth of 9.9% YoY even though the management's guidance is significantly lower with an expected 3.8% growth rate (which would match the average growth rate for the last six years). It is highly likely that growth will accelerate over the next years which will boost earnings and dividends. Competitors like BTI (+4.4%), Imperial Brands (+0.3%), Altria (-0.5%) and Philip Morris (+10.5%) show lower growth rates in the first half of 2023 apart from PM which integrated Swedish Match, a company that showed high growth rates prior to the acquisition. Comparing the fundamental valuation and growth rates, Japan Tobacco seems to offer greater value than Philip Morris.

One important aspect for shareholder returns are share buybacks. While Philip Morris has suspended share buybacks, Altria spent $1.8 bn in 2022 and another $1 bn this year (=3.7% buyback yield). BTI spent $2.4 bn last year (=3.6% buyback yield) but has no plans for further buybacks yet. Imperial Brands returns more than $2.5 bn in two years which is 14% of its current market capitalization. JTI has stated in the 2022 annual report that it is considering future share buybacks "mainly taking into account the Company’s financial outlook of the respective year and mid-term capital needs" . Due to the non-cyclical business and the oligopoly tobacco market, Japan Tobacco has many opportunities to grow revenues and cashflows near-term. Furthermore, JTI's advantage is a healthy balance sheet (55% equity ratio vs. negative equity of Altria and Philip Morris). Therefore, a share buyback launch is possible in the next few years and would help the company to unlock shareholder value. Imperial Brands has already been very generous towards shareholders and offers a higher shareholder yield (buybacks and dividend combined) than BTI and JTI. However, a combination of higher revenue and dividend growth rates and the implementation of share buybacks justify a higher valuation for Japan Tobacco's share. A similar price/EBIT multiple of 5-6 would justify a valuation upside of +30% to+50%.

5. Conclusion

Japan Tobacco offers a strong market position in a single-digit growing tobacco market that faces a risk of lifetime tobacco purchasing ban. The implementation of such a ban in many countries is highly unlikely and many years away from realization. A stable customer base will generate stable or growing cashflows which the company can pass on to its shareholders. Financial stability, above-average growth rates (due to investments in faster growing segments) and a possible share buyback plan can justify a higher valuation of at least 30%.

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