JT International - The Eagle Struggles to Take Off

JTI shed more light on its performance during its analysts’ briefing yesterday. The absence  of  trade  speculation  before  the  Budget  softened  3Q  volume  and consequently, volume should rebound swiftly in 4Q. The company’s performance trailed its peers’ this year due to poor VFM sales as price-sensitive smokers opted for  illicit whites.  Higher marketing  expenses  expected  next  year arising  from  therebranding  of  Mild  Seven  to  Mevius  may  lead  to  some  margin  compression. Maintain  NEUTRAL,  with  an  unchanged  RM7.02  FV,  given  the  rising  regulatory 
risks in the tobacco industry. 

Tepid trade speculation softens sales. JTI sold 713m sticks of cigarettes in 3QFY12 (-8.1% y-o-y, +0.1% q-o-q), as the near absence of trade speculation prior to the Budget announcement  on  28  Sept  kept  volume  muted.  While  the  absence  of  tobacco  excise hike last year caught many off guard, this year’s no-hike was mostly anticipated in view of the looming general election, hence resulting in less trade speculation.

PMI  on  fire.  JTI’s sales  decline  was  steeper  than  its  peers’. BAT’s shipping volume during the quarter was 2.2bn sticks (-4.9% y-o-y, +1.8% q-o-q), implying a strong 522m sticks  for  the  non-listed  PMI  (+8.7%  y-o-y,  +2.8%  q-o-q).  For  the  9-month  period,  JTI and BAT’s sales volumes edged  down  1.3%  and  0.7%  y-o-y  respectively,  while  PMI’s sales  surged  18.1%  following  the  highly  successful  introduction  of  the  Marlboro  Ice Blast.  JTI  subsequently  shed  0.6ppt  market  share  to  21.0%.  PMI,  in  contrast,  gained 2.1ppt to chalk up 15.2% of the legal market (excluding sub-VFM).

VFM  underperforms;  Premium  shines.  Winston  was  again  the  company’s major disappointment, with its Value-for-Money (VFM) segment continued to suffer from down-trading to illicit cigarettes. A key task management has on its hands is figuring out a way to  “premium-ize”  the  brand  by  building  enough  brand  equity  to  stem  the  switch. Winston’s  sales  volume  declined  to  1.1bn  so  far  this  year  (-6.0%  y-o-y), while JTI’s flagship  Premium  brand  Mild  Seven  continued  to  be  the  sole  bright  spot  for  the Japanese company (9MFY12 volume: 563m, +15.0% y-o-y).

Government  gets  greater  leeway.  Following the Government’s mandatory ex-factory price  increase  in  late-October,  JTI  on  25  Oct  raised  its  selling  prices  by  RM0.20  per pack  to  cover  the  higher  ad-valorem  taxes.  We  understand  that  the  Government  now uses  an  “open  market  value”  to  determine  the  transfer  pricing  between  the manufacturing  and  trading  arms, thus  leaving  it much discretion  in  adjusting  taxes  and pricing.  Nonetheless,  JTI’s  RM0.20/pack  price  hike,  which  more  than  covers  the additional taxes, should help shore up margins for the company, all else being equal.

Higher marketing costs. In tandem with Japan Tobacco’s initiative to rebrand Mild Seven to Mevius starting February  2013,  FY13  marketing  expenses  are  expected  to  increase  by  ~10%.  Margins  next  year  are  thus likely  to  be  squeezed  if  the  name  change  does  not  immediately  translate  into  higher  sales  volumes.  Pack designs for Mevius will continue to utilize Mild Seven’s recently-revamped packaging. FY13 and FY14 capital expenditures  should also be higher than FY12’s on the back of  several  anticipated  new  launches  and  new machinery purchases.

Maintain  NEUTRAL.  We  are  keeping  our  earnings  forecasts  unchanged  following  our  downward  revision yesterday. We see intensifying regulatory risks and an excise hike for the tobacco industry after the general election as the Government looks to promote a healthier population  while increasing tax revenues. Maintain NEUTRAL with FV of RM7.02, based on our FCFF model (WACC: 7.5%, terminal growth: 1.0%).

 Source: OSK