Japan Tobacco Inc

TSE:2914

Earnings Call Transcript 2020-Q1

[Naohiro Minami, executive]

Thank you for joining this call today. I'm Naohiro Minami, Chief Financial Officer of the JT Group. I will take you through the first quarter earnings results. I will start by covering the impact of COVID-19 on our business and financials. Please take a look at Slide 3.

As you can see, there are no business continuity concerns in any of our businesses as of now. Each business continues operations by meeting and, whenever possible, exceeding the local directives and instructions of the governments of each country. Please refer to the earnings report for more details.

Let me now provide you the status update of each business operation. First of all, in the tobacco business, manufacturing facilities, including those in Japan are operational, while taking stringent personal care and sanitation measures. Most distribution networks are also operational in these markets with approximately an average of 2 months' worth of finished goods inventory. There are no significant impacts on the supply of products to our consumers.

On the other hand, in some markets, we have adjusted or temporarily suspended our sales and promotion activities to fully comply with the directives from the local governmental authorities. Although the distribution or sales channels activities are very different across markets, we did not recognize any significant impact on consumer demand as of the first quarter, other than the inventory buildup in several markets.

Having said this, we did recognize a significant drop in the Duty-Free sales in our first quarter results. In 2019, the Duty-Free sales represented less than 3% of the group's net revenue. In order to minimize such impacts that have already been recognized and to mitigate those as potential risks, it is necessary for us to closely monitor how the situation evolves. In the pharmaceutical business, while almost all sections of the supply chain are operational, we are experiencing a slight delay in some clinical researches due to the temporary closure of medical facilities. Because of the nature of pharmaceutical products, there are no significant impact to sales and demand as well.

Lastly, in the processed food business, we have not recognized any impact to our supply as all the factories in Japan are operational, taking stringent personal care and sanitation measures. Although our manufacturing plant in China had to temporarily suspend its operation in accordance with government directives, it is now operating normally. In regards to the sales and demand implications, following the local prefectural government's request to avoid nonessential outings, demand for household commodities has increased in frozen and ambient food business. This, in turn, has resulted in a lower demand for food service products in the frozen and ambient foods and the seasonings businesses as well as the decline in consumer footfall at our bakeries. The impact in the first quarter will be covered later.

In Slide 4, we have provided the precautionary and countermeasures that we have taken across the group. As a global responsible company, the JT Group gives utmost priority to the safety of its employees, their families and stakeholders involved in our business activity, and we'll continue this approach as long as it's necessary. We are ensuring the safety of our employees by, for instance, adopting work from home for all positions that are not critical to business continuity and prohibiting business trips and other nonessential activities. In addition, when a person is confirmed to be infected at any of the business sites, such as the manufacturing or sales site, the employees who are in close contact with the affected person are asked to go home, and the site is disinfected according to the instructions of those authorities before any business operations are resumed. The business continuity plan has been designed to address contingencies across the group and is already being implemented. In addition, we are extending all necessary support to our third-party supply chain partners by, for instance, relaxing credit terms to limit disruption as much as possible.

From a funding and cash situation perspective, the JT Group has enough resources available to satisfy the requirements from its business activities. While we have ample unused commitment lines, we are increasing cash on hand by implementing measures such as the issuance of commercial paper to ensure a full state of readiness for any possible contingencies. We will continue to implement all necessary countermeasures to address the volatile COVID-19 situation that is evolving rapidly.

From a business and financial perspective, as I mentioned earlier, there are no business continuity concerns in any of our businesses as of the first quarter. COVID-19 had limited business impact to our financial results in the first quarter. Going forward, while we cannot predict the potential risks or impacts from COVID-19, we cannot ignore the impact of the Duty-Free business, which has been confirmed in the first quarter. We will keep monitoring closely how the situation from April evolves to analyze the potential impact to our business and financials. The COVID-19 pandemic is impacting the world in an unprecedented scale with significant consequences globally. We will continue to give utmost priority to the safety of our stakeholders involved in our business activities, including our people and continue to take every possible measure to mitigate its business and financial impact to the group.

Moving on to Slide 5 for our first quarter financial results. Adjusted operating profit at constant currency, our main KPI, increased by 14% year-on-year, driven by the growth of the total tobacco, the pharmaceuticals and the processed food businesses. This growth was primarily attributed to the international tobacco business, which had a significantly high-growth rate, driven by very favorable pricing gains year-on-year.

I will now move on to the reported figures, starting from revenue. Revenue increased by 2.8% year-on-year, essentially driven by the international tobacco business, exceeding the decline in the Japanese domestic tobacco and pharmaceutical businesses as well as negative currency movements. Adjusted operating profit on a reported basis also increased by 5.8% year-on-year, despite currency headwinds. Operating profit, on the other hand, decreased by 29.4% year-on-year, due to the nonrecurring onetime gain of approximately JPY 60 billion in the pharmaceutical business in 2019, despite the growth in the adjusted operating profit. Profit attributable to the owners of the parent company also decreased by 28.5%, essentially due to the decline in the operating profit and higher financing costs, partly offset by lower income taxes attributed to lower profit base.

Moving on to the results by business segment. Let me start with the Japanese domestic tobacco business on Slide 6. The total tobacco industry volume was resilient, and its volume was almost flat year-on-year. This was attributed to the favorable price revision impact to the volume. The impact of the tobacco excise tax increase in October 2018 was higher in comparison to that of the consumption tax increase in October 2019. RMC industry's volume for the first quarter declined by 2.2% year-on-year, and the RRP market share of the total tobacco market expanded in comparison to that of the fourth quarter of 2019, reaching approximately 24%. COVID-19 had limited impact to the industry volume in the first quarter.

Turning to our volume performance. The RMC shipment volumes declined by 4.2%, driven by RMC industry contraction and market share loss in the RMC category where the loss is due to competition in the value segment. To address this competition that has continued, we launched the slim menthol little cigar SKUs in March and are also launching 3 new SKUs tomorrow on May 1, which offers light tobacco taste. These SKUs are branded by Camel. Supported by these initiatives, our RMC category share remains resilient compared to the 59.3% share for the fourth quarter 2019. RRP shipment volume increased by 0.3 billion to 0.9 billion units, and the RRP category share reached approximately 10%.

Now let me provide you our financial performance. For the first quarter, there were several negative factors as shown on the slide, such as the RMC volume variance and tax absorption for some brands in October 2019. In addition, due to the COVID-19 outbreak, sales in the duty-free business declined significantly. RRP-related revenue increased year-on-year. However, it did not offset the negative factors mentioned earlier. As a result, core revenue decreased by 5.7% year-on-year. Adjusted operating profit declined by 15.3% year-on-year, essentially due to the revenue decline and increased marketing costs related to RRP and little cigar SKUs. COVID-19 did not impact the bottom line this quarter, as the sales decline in the Duty-Free business was offset by the decrease in the related costs, including marketing and SG&A expenses. At the bottom right section of this slide, we provide the trends in which we have recently observed, although its duration and extent cannot be predicted.

In particular, the sales decline in the Duty-Free business is becoming more prevalent. We have seen beyond our expectations, a weaker industry volume in the Japanese duty-paid market and increasing RRP category share. This has been true since the local prefectural government's requests to avoid nonessential outings and the Japanese government's declaration of a state of emergency. In addition, the revision of the Health Promotion Act, a regulation to restrict indoor smoking, has been fully implemented in April, which now has certain impacts on our business. We will closely monitor how, for how long and to what extent of which these factors will affect the tobacco market, mainly the consumer trends in RRP category, especially as the impact will become prevalent from April. Moreover, we will focus our efforts to address any impacts with an agile mindset, reviewing our initiatives and carrying out the revised plans swiftly.

Turning to the international tobacco business on Slide 7. Robust share performance of our brands, notably GFB, continued for the first quarter. Also, favorable inventory movements were seen with the stock buildup following the COVID-19 outbreak in key markets, notably in Europe. Consequently, GFB shipment volume increased by 4.8% to 67.5 billion units. The total shipment volume was 104.1 billion units, a minimal decline year-on-year as a result of those positive factors, almost offsetting the volume declines due to the industry contraction in several markets. The Duty-Free sales in the international tobacco business declined year-on-year due to the COVID-19 outbreak. Other than this, no material impact affected the sales volume. The robust core revenue growth was driven by strong pricing gains. These gains are benefited from price increases that have been made since March 2019, mainly in the Philippines, Russia and the U.K. as well as favorable comparisons to the previous year, largely attributed to the timing of tax increases in Russia and Turkey. In addition, volume contribution was positive, driven by the solid volume performance in European markets with a higher unit price, where it was also impacted by favorable inventory movements.

These factors resulted in a 14.1% year-on-year core revenue growth at constant currency or a 8.8% growth on a reported yen basis, including currency headwinds. Adjusted operating profit at constant currency grew 29.4% year-on-year or 16.7% on a yen basis, including unfavorable currency movement, essentially driven by significantly strong top line growth for the first quarter. In the bottom right section, we have provided the trends to date in the international tobacco business. As I mentioned earlier, we have observed more prevailing impact to the Duty-Free business, although we do not see any other material changes on consumer demand at this moment. However, we cannot ignore the disruption of our supply chain caused by lockdown and travel restrictions. While factors such as a higher unemployment rate due to the slowdown of the global economy may impact consumer behavior, these sequential impacts are difficult to assess or predict. Therefore, it is currently too early to assess full year implication of these factors as how these factors evolve are still highly uncertain.

In addition to the COVID-19 impacts, local currencies in our key markets are depreciating against the U.S. dollar. We will continue to monitor these situations closely.

Now I would like to briefly talk about the Iran market. As you may be aware, in January, the U.S. announced an additional set of sanctions coming into effect in April. We have been closely monitoring and thoroughly analyzing implications of sanctions, and we believe we can continue our operations. However, there are still high levels of uncertainties due to the potential impacts of these sanctions, along with the outbreak of COVID-19. In any case, we will focus our efforts on monitoring the impact to our consumers to the best of our capabilities.

Moving on to Slide 8 for the results of the pharmaceutical and the processed food businesses. In the pharmaceutical business, revenue decreased by JPY 2.1 billion year-on-year to JPY 20.7 billion mainly due to lower overseas royalty income. Meanwhile, adjusted operating profit grew by JPY 2.1 billion year-on-year to JPY 6.6 billion. This was essentially driven by lower R&D expenses according to the progress of research and development as well as top and bottom line growth in our subsidiary Torii Pharmaceutical. In regards to the progress of our clinical development, JT received manufacturing and marketing approval for CORECTIM Ointment, a new drug for atopic dermatitis, in January 2020. On April 22, CORECTIM Ointment, was listed on the Japanese National Health Insurance Drug Price List. Torri plans to launch this drug in Japan in June 2020.

In the processed food business, revenue increased year-on-year by JPY 0.8 billion to JPY 36.7 billion, and adjusted operating profit also increased year-on-year by JPY 0.1 billion to JPY 0.4 billion, mainly driven by increased demand for household products in the frozen and ambient food business. This was partly offset by lower demand in the food service products for frozen and ambient foods as well as the seasonings businesses. In addition, sales in the bakery business also declined. Moreover, we have observed lower demand in the food service industry since the Japanese government declared a state of emergency in April.

Finally, please take a look at Slide 9. To summarize the first quarter results, despite currency headwinds, consolidated financial performance was solid. This was driven by the strong top and bottom line growth in the international tobacco business, which benefited from the very favorable pricing gains year-on-year. Also, there were no material impacts to the bottom line from COVID-19 this quarter.

I would like to mention a word about the full year forecast. The full year forecast is not revised as we continue to closely monitor how the COVID-19 situation evolves from April in order to determine the business and financial impact going forward. We plan to provide an updated guidance on the forecast during the Q2 financial disclosure or other appropriate opportunity. As I mentioned earlier, there are no business continuity concerns following the execution of the business continuity plan. At the same time, however, we must further assess the overall impact to our business and financials as the factors involved in affecting our business are in decline. Such factors include the implications to the consumer behavior underlying evolving environment as well as the unknown timing of Duty-Free sales recovery.

We continue to observe additional currency headwinds under the current circumstances. The Russian ruble, for instance, has already depreciated approximately 20% against our initial assumptions. Although it is difficult to foresee how these local currencies move, given that each key local currency remains stable at this current rate from April to December, we estimate that there will be further negative currency impact to adjusted operating profit by USD 500 million compared to our initial outlook.

Last but not least, I would like to comment on our shareholders return. Our shareholder return policy and DPS guidance for 2020 remain unchanged. The JT Group is committed to fulfilling our role as a global corporate citizen and contributing to support the resilience of communities where we operate, while we take all possible measures to carry out our responsibilities in minimizing the impact on our business. Thank you for your attention.

[Statements in English on this transcript were spoken by an interpreter present on the live call.]