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September, 2007

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Japan Tobacco Inc., Positions Itself for the Future

By Joseph Finora

World’s third-largest cigarette maker continues taking bold steps.

In a challenging international tobacco environment, Japan Tobacco (JT), the world’s third-largest cigarette maker, is planning on its 2008–10 earnings growth to surpass 10%. While this figure comes before interest, taxes, depreciation, and amortization (EBITDA) it points to a corporate-wide confidence in a shifting industry fighting uneven international consumption trends, excessive taxation, political turmoil, smuggling, and declining usage in its home market—a traditional stronghold. Nevertheless, Japan Tobacco along with its foreign arm JT International (JTI) is largely banking on over $300 mn in cost-savings synergies to help it meet its financial targets. Much of this is expected as a consequence of the newly acquired Gallaher Group, which brings with it a stable of steady brands, as well as cost savings and anticipated synergies resulting from the $17.9 bn (¥2 tn) takeover last April.

Japan Tobacco is expecting growth from its acquisition of Britain’s Gallaher Group which adds such dependable brands as Benson & Hedges, Mayfair, Ronson, and Silk Cut to an already strong JT lineup that includes Camel, Mild Seven, Salem, Winston, Winchester, Gold Coast, Genghis Khan, and Peace. The company noted that international business was driving growth while sales and profits in Japan have been sliding as more people there stop smoking—reflecting a trend that is regularly taking hold in greater numbers across the more developed world due to public smoking bans, high taxation, and a growing awareness of health concerns. United with Gallaher, however JT controls 10.8% of the global market behind Altria which has 18.2% and British American Tobacco Plc (BAT) which weighs in with 12.3%.

JT’s Chief Executive Hiroshi Kimura noted that currently the company intends to focus on integrating Gallaher into its worldwide operations. Kimura expects the integration to be completed within two to three years and has hinted that additional merger-and-acquisition activity could be on JT’s agenda. High on the target list are governments that may wish to privatize their tobacco interests. JT International recently signed a Memorandum of Understanding with the Macedonian Customs Administration—as it has in nearly a dozen countries so far—to promote joint cooperation in such activities as smuggling prevention, counterfeiting, and tax evasion. Last year, JTI agreed to purchase neighboring Serbia’s biggest state-owned raw tobacco producer Senta Tobacco Industry for e27.5 mn. Its overture with Macedonia may be a move to shore up a position in the—an area with large tobacco consumption rates.

“In short, we’re not planning anything in the near future, but beyond that, (M&A) is one of the things we’ll be thinking about,” he said at a news conference after the Gallaher acquisition.

Japan Tobacco, has said that its Gallaher acquisition would generate some $400 mn in cost savings and other synergies by 2010, while helping it make greater inroads in the overseas cigarette business—a vital step as it keeps pace with such rivals as Philip Morris International (Altria) and British American Tobacco and wrestles with dropping smoking levels at home.

When JT’s offer to buy Gallaher first came in, Nigel Northridge, then CEO, reflected on a decade of accomplishments: “…we have built a significant position in the global tobacco market, nearly quadrupled volumes, almost doubled Group EBITA and delivered total shareholder return of some 600%. Our employees have been the cornerstone of this success” Mr. Northridge referred to JT’s acquisition as “a justifiably proud, highly efficient, and extremely effective organization.”

Wall Street so far likes what it sees although JT watchers admit there are risks to the strategy behind the acquisition. Standard & Poor’s Tokyo-based analyst Machiko Amano rates the post-Gallaher JT an “A+” for the long term, basing this decision on expectations that the “investment burden of this acquisition” will not have a significant impact on the combined group’s financial profile. Similarly, Moody’s Investors Service gave JT an enviable “Aa3” rating.

JT expects to pay for the Gallaher acquisition with its own cash as well as issuing debt. This announcement has slightly weakened JT’s otherwise enviable fiscal status as historically it’s been a financially conservative company. JT will likely issue some ¥150 bn worth of bonds in several installments with maturities of three to five years to help cover the Gallaher debt. JT is expected to maintain strong, stable cash flow mostly generated from its domestic tobacco business where it enjoys a leading position in a declining market notes Amano. This share dominance should “mitigate heightened exposure to the highly competitive overseas tobacco business and the increased debt from the acquisition.” He does however, indicate that JT should “refrain from further M&A activity” until the Gallaher deal is fully integrated into its operations.

A Complementary Acquisition
The Gallaher acquisition by JT is nothing if not complementary on several levels. Geographically, the newly formed group will become a market leader in 10 important areas, including Western and Eastern Europe, as well as Russia and Japan. The company has recently reported sales growth in Russia, Spain, and Iran. Recent efforts to promote the Mild Seven brand in Japan have also produced positive results. But the newly expanded JT will now be able to offer a deeper menu of brands covering both premium and discount segments. As attractive as this sounds it’s one area in which Amano sees potential risk.

“In our view the combination presents some integration risks in retaining and sharing Gallaher’s marketing expertise in geographies and product segments so far unfamiliar to JT,” he says. It’s also taking on potential political risk in some emerging markets as well as possibly new litigation and currency risks as it’s always enjoyed a virtual monopoly in its home territory. Under the Japan Tobacco Inc. Law, the Japanese government holds approximately 50% of the company’s outstanding shares. The law also places a number of restrictions on JT, including requirements to buy domestically grown tobacco leaves and seek the approval of the Finance Minister on retail pricing. JT only entered the world scene on a big scale when it purchased the overseas business of U.S.-based RJR Nabisco Holdings Corp. (RJR) in 1999. JT can come under pressure if it fails to achieve gradual, but measurable improvement in its balance sheet as its native landscape is changing.

Greater numbers of Japanese men are quitting smoking. The percentage of male smokers in Japan today is under 40% and JT dominates over 70% of the country’s cigarette market. The Gallaher acquisition, the largest Japanese takeover of a foreign company, should help JT to further grow its international cigarette trade which has become its main profit and growth source, counterbalancing a shrinking home market. “Previous Gallaher management was more interested in short-term profit, and didn’t necessarily invest in brand equity,” Yasushi Shingai, Executive Vice president of JT International, said at a news conference. “We’re going to be investing in improving quality.” Annual cigarette output is expected to reach 600 bn cigarettes, according to the company.

Profits for the second quarter of 2007 fell 15.2% to ¥64.6 bn yen (US$540.1 mn) from ¥76.2 bn a year earlier, according to the Tokyo-based company. Performance in Japan also dropped when compared with the same period a year earlier as smokers had stocked up on cigarettes in anticipation of a tax increase. Historically, Japan has enjoyed one of the highest smoking-per-capita rates in the industrialized world.

Analysts however are calling for a 33% rise in its operating profit for the fiscal year ending in March 2008, boosted by earnings from Gallaher Group. Japan Tobacco previously forecast a 6% decline in operating profit—its first fall in seven years—but the outlook excluded any Gallaher contribution. The revised 2008 full-year forecast has been updated by the company to net sales of ¥6,410 mn on operating income of ¥419 mn resulting in net income of ¥256 mn. The previous forecast had called for net sales of ¥1,520 bn with operating income of ¥107 mn and net income at ¥70 mn. Year-over-year, JT’s net sales were ¥4,769,387 bn, up 2.8% from the prior year. Profit rose 4.8% and net income was up 4.6%.

Thanks to expected synergies with Gallaher in its international units, cost savings are expected to be over $300 mn by 2010. International earnings before interest, taxes, depreciation and amortization (EBITDA) should grow by at least $100 mn after taking into account promotional expenses, the company said in a statement.

“We’ve been increasing share and profits in Western Europe and are going to keep doing that. We’re also going to be pursuing growth in areas like the Commonwealth of Independent States (CIS) and Asia where consumers are now looking to buy more expensive cigarettes,” said Shingai. The company expects to make 70% of its sales outside Japan this year, compared with just under 60% before the acquisition.

In a move to improve public sentiment before it reaches uncontrollable proportions, Japan Tobacco is covering Japanese subways, newspapers, and billboards with public-service style ads. Known as the “Smoking Manners” campaign, it encourages smokers to refrain from participating in anti-social-behavior, such as cigarette-butt littering to blowing smoke in other’s faces. Public reaction has been mixed.

“Don’t smoke in a crowd, coats are expensive,” reads one of 40 different print and outdoor advertisements that hang in Tokyo’s subway and other public areas. The ad is illustrated with a stick-figure man holding a giant cigarette next to a woman wearing a coat with a hole in it. The series also urge smokers to use portable ashtrays—small, reusable pouches to extinguish their cigarettes and discard the butts.

Japan Tobacco is aiming to help smoking remain acceptable and allow smokers and non-smokers to peacefully co-exist. “Our customers are beginning to feel marginalized,” says Toshimasa Kurita, head of the Smoking Manners campaign. “Tobacco is a legal product, and our customers are adults who made an adult decision. We want them to enjoy their decision. It’s our responsibility as a manufacturer to protect them.” Japanese antismoking activists disagree and counter that JT is actually advertising in areas that are off-limits for cigarettes and trying to recruit new smokers.

On the environmental front, the company began its fourth reforestation project in the Chizu area in Tottori Prefecture. JT, the Tottori prefectural government and the town of Chizu have formed a joint partnership for forest conservation. JT is the sixth company to support the program and will contribute to 23 hectares of forest conservation. It led similar projects in Tanabe City in Wakayama Prefecture, Kosuge-mura in Yamanashi Prefecture, and Nahari-cho in Kochi Prefecture. JT plans to implement its five-year plan of thinning and cultivating trees in an effort to recover the forest in the Chizu area. The forest plays an important role in providing a secure source of water for the surrounding ecosystem, and as such, the initiative contributes not only to forest’s sustainable growth, but also to the area’s natural beauty. JTI is also a founding member of the Eliminate Child Labor in Tobacco (ECLT) Foundation.

In its non-tobacco businesses, JT reports that its foods business is showing solid progress. The company’s beverage business showed a steady expansion in vending machine sales channels. The processed foods business saw growth in its overall business scale, including the enhancement of its frozen-processed foods and chilled-processed foods. As a result, mid-year net sales increased 5.2% compared to the same period in the previous year but operating income for the period decreased 26.8% due in part to an increase in expenses.

Its pharmaceutical business currently has seven drugs in the clinical pipeline, including joint ventures with US-based Pfizer Inc., GlaxoSmithKline, and MedImmune. JT’s Torri Pharmaceutical showed a decrease in net sales from the prior year due to sales decreases in its primary products. Net pharmaceutical sales were down 7.7% at ¥45.4 bn.

The last time Japan Tobacco made international headlines was its dramatic and sudden purchase of Reynolds overseas business. This was matched by its acquisition of Gallaher. Each moved brought top-notch brands into JT’s portfolio. What remains to be seen is if JT is successful in marketing the sprawling brand lineup in a growing list of international markets amid a backdrop of changing business conditions.

Tobacco International - September, 2007

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