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September, 2006


Sun Rising on Japan Tobacco Inc.

By Joseph Finora

New brand distribution arrangement and sharp management decisions bear fruit.

Building on the strength of its in-depth portfolio of brands, Japan Tobacco Inc. (JT) has become the world’s third-largest tobacco company, with the international operation in over 120 different countries through 40 different regional centers. Today it also has thriving foods and pharmaceuticals businesses and has taken stands on such issues as child labor and global environmental protection. It has some 31,500 employees around the world and is one of the most admired companies, not only in Asia but across the globe as its well-recognized brands continue to bring in cash as it expands into new business lines and geographic markets.

JT International (JTI) headquartered in Geneva, Switzerland, is the operating division of parent Japan Tobacco Inc. (JT) and handles the international production, marketing and sales of the group’s cigarette brands. JT International manufactures such sturdy brands as Camel, Mild Seven, Salem, Winston, as well as Winchester, Gold Coast, Genghis Khan and Peace. Mild Seven alone occupies five of the top ten best-selling cigarette products in Japan and the company is expanding globally as demographics in its home country point towards lower consumption. But for a company that can trace its origins to 1898 (it was incorporated in 1949 as the Japan Tobacco and Salt Public Corporation and did not become a public company until 1985), meeting challenges is standard operating procedure.

JT sells eight of the top ten cigarettes in Japan, with the top three styles each belonging to the Mild Seven brand. Across Asia Mild Seven is also a dominant brand and the major one in JT’s pan-Asian portfolio. In the global market, three of the best-selling international cigarette brands: Camel, Mild Seven and Winston, are in JT’s product portfolio, along with Salem, one of the world’s leading international menthol brands.

Consider that in May, 1999, JT acquired the non-US tobacco operating business of RJR Nabisco, and a company experienced a significant metamorphosis over the last several years. When JT purchased RJRI, the international operations of RJ Reynolds, acquired company was renamed as JT International to better reflect its new scope and ambitions. In the Japan market, in August of 2003 the parent company JT and Philip Morris International agreed not to renew its Marlboro’s license agreement, which expired at the end of April, 2005. It has also made strategic acquisitions in the foods business during this same period as it positions itself for a rapidly changing global marketplace that offers unprecedented opportunities, demands that companies utilize foresight and efficiency when making their future plans. Today the foods business accounts for about 13.8% of the company’s consolidated net sales and pharmaceuticals about 2.4%. The pharmaceutical division’s task is to deliver “world-class drugs” to the global marketplace. While its food business achieved profitability one year ahead of schedule, its goal is to provide more substantial profits to the company via three main areas: beverages, processed foods and seasonings products. About 7,700 people are employed in its non-tobacco operations. The company also has a small interest in real estate leasing.

Since 1985, JT has strategically diversified into pharmaceuticals and foods. Today its pharmaceutical division has partnerships with such international firms as Hoffman-LaRoche and Gilead Sciences. Earlier this year JT signed a licensing agreement with GlaxoSmithKline (GSK) for a “candidate compound” developed by JT. GlaxoSmithKline will exclusively distribute it worldwide while JT retains co-promotion rights in Japan. In addition, JT received an upfront payment for development and royalties on future sales from GSK.

“It looks as if Japan Tobacco, the third-largest tobacco company in the world is getting a real handle on how to make big money and is becoming a force the industry once only controlled by the big MO (Altria Group) and RJR (Reynolds American),” notes Mark Hall, Smithfield, NC-based Market Street Advisers, an independent financial advisory firm in the heart of US tobacco country.

The JT PLAN-V was created to help JT navigate the more substantial challenges it’s been facing. Its objective has been to consolidate the company and position it for the future although president and CEO Hirosi Kimora described some of the steps taken as “painful” in his most recent Letter to Shareholders. The JT PLAN-V concluded in March 2006 amid record profits. The Plan was described as “an important step” in JT becoming a “global growth company.” It’s now been replaced by JT2008, which aims to take the company to a “higher level” as the international tobacco business will strive to be the “driving force” for profit growth as the domestic side’s goal is to “mitigate the effects of declining consumption.”

Japan Tobacco Inc. reported group net profit for the last fiscal first quarter climbed 60%, as consumers rushed to buy cigarettes ahead of a July 1 price increase in Japan. The company said net income for the quarter ended in June rose to 76.25 billion yen ($664.4 million) from 47.52 billion yen a year earlier. Group revenue climbed 12% to 1.29 trillion yen from 1.151 trillion yen, while group operating profit rose 19% to 102.07 billion yen from 85.54 billion yen a year earlier. The company said its domestic market share stood at 65.5% during the quarter, down 4.1 percentage points from a year earlier.

During the fiscal year ended March 2006, the company recorded revenues of JPY 4,637,657 million (approximately $39,447.9 million), a decrease of 0.6% from 2005. The operating profit of the company was JPY 306,946 million (approximately $2,610.9 million) during fiscal year 2006, an increase of 12.3% over 2005. The net profit was JPY 201,542 million (approximately $1,714.3 million) in fiscal year 2006 compared to net profit of JPY 62,583 million (approximately $532.3 million) in 2005.

Nevertheless, it aims to cut the number of cigarette products it sells domestically by about 30% to 80, as it aims to run a tighter ship in the face of a more challenging climate. JTI’s brand-portfolio strategy is focusing on continuing to provide improved profitability through a greater emphasis on its premium brands which have the highest growth potential and steadiest customer base, each of which is supported by some 3,000 sales representatives and some 240,000 vending machines geared for adult operation.

Winning in a Tough Market
While Japan is fourth in global cigarette consumption, growth there began slowing in the mid-1970’s. And as in other parts of the world, the number of domestic smokers is declining as awareness of the health risks combined with tougher government regulations and an aging population continue to grow. In 2005, 46% of men in Japan described themselves as smokers. That number was 61% in 1990, according to that country’s ministry of health. However, the trend may have a twist as among Japanese in their twenties, some 52% of men and 21% of women classified themselves as smokers in 2005, the last year for which data was available.

JT maintains consistent, year-over-year cash flow, a testament to its popular brands, reliable distribution, active marketing and efficient management. JT continues to reduce debt but its non-core businesses have still not become significant contributors to the company’s profits, putting further pressure on the tobacco arm.

“We take a positive view of JT,” notes NikkoCitigroup analyst Nobuyoshi Miura. “We believe it is a company that is set for stable, longer-term earnings growth. We forecast double-digit (EBITDA) growth over the next three years in the overseas cigarette segment, driven by Winston in Russia, Mild Seven in Taiwan and Camel in the European Union.” Miura also notes that Japan’s cigarette prices are “low relative to other developed countries.” Analysts believe this gives the company the ability to raise prices independent of any tax increases, something it did earlier this year without much customer backlash. Last July Philip Morris Japan and British American Tobacco Japan raised prices by 30 yen on key brands Marlboro, Lark and some Kent varieties. Japan Tobacco put a price hike of the same amount into effect the same month. On July 1, a 20 yen tax increase took effect in Japan. This may be a sign of consistently rising cigarette prices for the Japanese consumer — a scenario which has already begun in Western markets with reasonable success.

JT sees the possibility to raise production in Russia by more than 40% while demand in its home market shrinks, Kimura said. Russia’s “economy is in full swing, and political conditions are stable,” Kimura told Bloomberg Television. “It’s not unrealistic to envision producing 100 billion cigarettes a year, and it’s time to seriously consider capital spending in Russia.”

In May, JT agreed to purchase Serbia’s biggest state-owned raw tobacco producer Senta Tobacco Industry for 27.5 million euros. Prior to the acquisition, JTI had to pay ten times more tax on tobacco sales in Serbia than domestic producers, said Japan Tobacco spokesman Kazunori Hayashi in Tokyo. “We wanted a local production site there,” he said. “By signing the contract, we can also sell our products there at the same tax rate as the domestic cigarettes for one year.” JTI plans to start producing cigarettes in Serbia by 2007. JTI’s Serbian acquisition is emblematic of a larger consolidation trend gripping the entire global tobacco industry. Nearly every global cigarette company has been seeking ways in which it can galvanize geographic markets. As foreign governments continue to adopt more free-market principles and open their economies accordingly, multi-nationals will continue to creatively seek out joint-venture opportunities. Considering its heritage, distribution, powerful brands and cash flow, JTI should be active in this area.

Like other multi-nationals, JTI faces potential storm clouds on its horizon, which could significantly derail its growth plans. Most notably economic and/or political turmoil in Eastern Europe could be disastrous for the inroads it’s making there. A similar case could be made for its businesses in several Asian countries. Currency fluctuation is another risk – a serious drop in a major foreign currency, such as the euro, would diminish overseas revenue. Tax increases and an erratic level of consumption at home and in significant foreign markets could hamper any traction the company had been gaining in those areas with the price of expensive class-action type lawsuits. JT’s challenge is to remain committed to developing new business while building on its large foundation of brands which should be able to deliver revenue in nearly any climate. Its ability to overcome and circumvent a wide variety of risks will play a role in determining its future.

JTI is a founding member of the Eliminate Child Labor in Tobacco (ECLT) Foundation, officially launched in Geneva in April 2002. The entire tobacco community is involved and committed, from trade union representatives, to tobacco growers, to the corporate sector.

“Child labor in agriculture is a complex and sensitive issue as it is often part of a cultural tradition,” said Solveig Holy, JTI representative on the Foundation’s Board. “There’s often a fine line between children helping their parents and hard labor. One of the initial aims is to sensitize children and families to the need for a balance between work and education.”

The ECLT Foundation’s overall objective is to contribute to the elimination of the use of child labor in the tobacco-growing sector in order to provide children with a positive and healthy upbringing. The Foundation will support and fund local and community based projects that combat child labor in tobacco-growing, and share best practices and lessons learned in this area. The Foundation is concentrating its efforts in tobacco-growing countries of Eastern and Southern Africa in the first phase and will work with local partners such as NGO’s, governments and communities. Malawi is an urgent concern. Some 60% of the country depends on tobacco. Entire families including children are now employed in its harvest. The Foundation is currently reviewing a pilot project proposal submitted by a local group that focuses on improving health, water, alternative income sources, and education.

Tobacco International - September, 2006

U.S. Tobacco Cooperative

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