Japan Tobacco Inks Billion-Dollar Deals in Southeast Asia to Keep the Fire Alive

 | Aug 23, 2017 | 9:00 AM EDT
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Japan Tobacco (JAPAY) has agreed to buy Mighty Corp., the second-biggest cigarette maker in the Philippines, as it looks for salvation in Southeast Asia, with its own market dying at home.

It is the company's second major deal in the region this month alone. On Aug. 4, it agreed to buy Karyadibya Mahardhika in Indonesia, which makes the kretek clove cigarettes that dominate the Indonesian market, as well as the company's distributor.

"JT" is spending 46.8 billion pesos ($910 million) on Mighty. The acquisition helps Japan Tobacco International, its overseas wing, expand nationwide through a broad sales network. It currently has a small presence in only the largest cities in the Philippines.

The purchase price for the Indonesian cigarette maker and the distributor, Surya Mustika Nusantara, is $677 million but rises to $1.0 billion when you consider the debt Japan Tobacco is taking on. It is similar, then, in size to the deal in Manila.

The Philippines is the 10th-largest cigarette market in the world, worth 80 billion cigarettes a year. Almost half (43%) of the men over the age of 15 smoke. I don't think they're too careful about checking IDs at the cash register, either.

Indonesia, with the fourth-largest population in the world, is even bigger as a cigarette market. It ranks only behind China, with sales of 285 billion cigarettes last year. Cigarette sales are actually growing, too, up a compound 5.3% per year in Indonesia since 2012. And it is the world leader in terms of the share of the population that smokes -- 76.1% of adult men do, according to the World Health Organization.

In the Philippines, a joint venture between Fortune Tobacco and Philip Morris International (PM) dominates the market, with a 71% share, followed by Mighty and its 23%. Japan Tobacco, which sells Camel, Winston and Mevius brand cigarettes in the Philippines, already had 4% of the market and now becomes the only serious competitor to the market leader. 

It also sells Mevius in Indonesia, but has a paltry 0.1% of the market. Its Indonesian acquisition is only the sixth-largest cigarette company, itself with just 2.2% of the market, but it gives JT a better distribution network and an operating base of nine plants across the country.

Sales of cigarettes inside Japan have dropped 11.3% for Japan Tobacco so far this year, through July. It has shifted 54.7 billion cancer sticks, down from 61.7 billion from January through July last year. Sales fell 9.5% to ¥325.3 billion ($3.0 billion).

So to diversify in the rest of Asia, where incomes aren't as high, education about smoking isn't as intense, and life expectancies are short enough that many men simply don't seem to care about the risks, is essential. The company says it is also looking for acquisitions in Africa and Latin America. 

This may work in the short- or even medium-term. Building out a pan-Asian cigarette network makes sense. But it's not a long-term strategy. Japan Tobacco should be investing its capital in the e-cigarette companies that it has already bought to ensure their competitiveness and success.

Consider that Japan Tobacco closed its Malaysian cigarette plant when it opted to then open a factory in the Philippines in April this year.

Exactly the same 43% of adult men smoke in Malaysia as in the Philippines. But incomes in Malaysia are higher, with average monthly salaries at $810, the highest alongside China in emerging Asia. They are well above the $319 in the Philippines. Those trends tend ultimately to sharpen the steepness of the decline in smokes sales.

Governments also start to care a whole load more about their citizens' health when their people are making enough money that the state coffers no longer require cigarette cash.

British American Tobacco (BTI) is the market leader in Malaysia, followed by JT International and then Philip Morris. Malaysia has been a manufacturing center of choice for Southeast Asia. But the Malaysian government hiked the sales tax on cigarettes by a drastic 40% in 2015, which has driven out some smokers and driven others underground, to black-market cigarettes.

BAT is also closing its iconic cigarette plant at Petaling Jaya in Malaysia. Smuggled or illegally made cigarettes now make up around 50% of the market, according to the Malaysian government

Japan Tobacco cannot allow its rivals to steal a lead on e-cigarettes internationally. It has already been incredibly slow at introducing "cigarette alternatives" in Japan.

The Japanese giant bought the British e-liquid brand E-Lites in 2014 and the U.S. maker Logic in 2015. It markets its products in Britain under the brand Logic LQD. Those companies produce vaping devices, turning nicotine-laced liquid into water-based vapor, that aren't legal in Japan. 

"Heat-not-burn" devices are, however, allowed in Japan Tobacco's home market. Those heat tobacco sticks to the point where they emit vapor but do not combust. Although they seem less healthy to me than vaping products, "heets" have passed muster with the Japanese government -- which owns one-third of Japan Tobacco.

JT bought the technology of the San Francisco-based producer Ploom in 2015 and has toyed around with its devices and sticks, sold under the Ploom Tech brand. But it only started introducing the products in Tokyo at the end of June.

That allowed Philip Morris, with its iQos device, and British American Tobacco, with glo, to steal an advance on its home turf. The Ploom Tech device costs only ¥4,000 ($37) compared with ¥8,000 ($73) for a glo burner and ¥9,980 ($91) for the iQos ("I quit ordinary smoking"). But smokers are of course creatures of habit. Converting the converted may be hard.

JT is also plagued by production constraints that have meant it is struggling to supply Ploom Tech devices, even after customers have reserved them online. Its first stores in Tokyo were forced to open without being able to sell the actual devices themselves. The Ploom tobacco capsules have required new manufacturing lines, and Japan Tobacco wasn't ready for demand.

It took initial orders for 120,000 devices. It is now waiting for feedback on initial sales before planning how to proceed in 2018. It better not wait too long. Philip Morris has already sold three million iQos devices in Japan by the end of last year, and is selling them in 25 different nations. 

Ploom Tech does have its advantages -- it is a hybrid product that heats vapor and passes it over tobacco, meaning it is virtually odor-free, melding "heat-not-burn" and vaping. The Philip Morris competitor still smells, although much less than a cigarette. Vaping products using nicotine-laced liquids are illegal in Japan, as they are here in Hong Kong, although I can't for the life of me figure out why, when cigarettes that kill for sure are legal.

It has been a good strategy to go long shares of Philip Morris, up 27% so far this year, while BAT has at least gained 8.1%. Japan Tobacco shares, on the other hand, have gained 4.8% in 2017 and are trading essentially flat since the start of 2016. They're there to short or avoid until they get the e-future figured out.

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