Japan Tobacco Inc

TSE:2914

Earnings Call Transcript 2020-Q2

[Naohiro Minami, executive]

Good evening, and thank you for joining today's call. I'm Naohiro Minami, Chief Financial Officer of the JT Group. I will take you through the second quarter earnings results.

I will start with our consolidated financial results for the first half of 2020. Please look at Slide 4. Overall, the JT Group's business performance was resilient in the first half. Let me take you through the details, starting with revenue. Despite the strong performance in the international tobacco business, revenue decreased by 2.7% to JPY 1,030.2 billion due to the decline in the other businesses. The international tobacco business had a strong business momentum due to significant pricing gains, which was partially offset by currency headwinds. As mentioned on this slide, COVID-19 mainly affected the tobacco and processed food business by an estimated negative impact of approximately JPY 35 billion to date. Despite of this, adjusted operating profit at constant currency increased by 7.5% year-on-year as the pricing gains in the international tobacco business were significantly favorable in the first half.

On a reported basis, adjusted operating profit was almost flat year-on-year as a result of positive performance in the international tobacco business, offsetting the negative impact of foreign currencies. On the other hand, operating profit and profit attributable to the owners of the parent company declined due to the reasons mentioned on the slide.

Let me now review the performance highlights of each business. Please turn to Slide 5 for the Japanese domestic tobacco business' volume performance. RMC industry volume decreased 6.9% year-on-year. Significant decline was confirmed in April and May when the Japanese government declared a state of emergency due to the pandemic. As shown on the bottom right graph, monthly RMC volume trends in June have recovered to March levels after significantly being impacted in April and May. On the other hand, RRP industry volume increased year-on-year, and the category continues to expand. With more people staying at home, this provided a tailwind for the RRP category growth. I will further cover this topic in a later slide.

As a result of these trends, total tobacco industry volume, RMC and RRP together, declined approximately 3.5% in the first half. On a separate note, as you already know, the revised Health Promotion Act, which restricts indoor smoking, went into effect in April, coinciding with the state of emergency. Therefore, it is difficult to isolate the impacts of the act from those of COVID.

Now I will cover our volume performance. RMC shipment volume decreased due to industry contraction and lower market share year-on-year due to the competition in the value segment. Quarterly RMC segment share remained firm, recovering to 60% in the second quarter. RRP shipment volume was in line with our business plan, increasing by 400 million units year-on-year to 1.8 billion units. With more opportunities to use tobacco products at home and in an environment in which people are required to avoid nonessential outings, consumers reaffirm the benefits of low-temperature heating products. And we are pleased to inform you that Ploom S Plus is performing well. Further, we launched Ploom S 2.0 this month as scheduled. And we'll continue to strengthen our presence in the high-temperature heating category.

Slide 6 shows the financial results for the Japanese domestic tobacco business. The top line was impacted by lower volume and negative price variance of RMC. In addition, RRP-related revenue also declined year-on-year. This was mainly due to lower sales of devices and accessories as well as the tax hike absorption in October 2019 when the tax structure for RRP was revised. COVID-19 negatively impacted the top line and is estimated to have had an impact of over JPY 10 billion. Half of this impact is attributable to the Japanese duty-free and China businesses. The other half is primarily due to the onetime impact in the Japanese domestic market, following the declaration of the state of emergency in April and May. Resulting core revenue is as shown in the slide. However, I would like to note that we have not seen acceleration of down-trading due to COVID-19. Adjusted operating profit decreased by 25.1% to JPY 81.8 billion as a result of negative top line performance, along with marketing investments strengthened as planned.

Please turn to Slide #7, where I'll cover our performance in the international tobacco business. Despite increasing market shares in key markets, total shipment volume decreased 4.8% year-on-year due to COVID-19 impact as well as lower volume in Bangladesh, Russia and Turkey. Further, the net impact of COVID-19 on volume was negative due to the volume impact of duty-free business and some emerging markets, which more than offset the positive impact of inventory pilot by distributors and retailers led by the COVID-19 uncertainty.

On the other hand, share was solid in markets listed on the slide. As a result, GFB shipment volume was also flat year-on-year despite a decline in total shipment volume. Here, let me briefly comment on Russia. Industry volume continued to decline due to the impact of the tax hike in January, the increase of illicit trade, the increase in RRP and the worsening economic situation due to COVID. Also competitors did not follow our price increase in January in accordance with the tax hike creating, unfavorable price disparities that continued in the first half. This resulted in our shipment volume underperforming the industry, while our share performance has now stabilized. At the same time, while we managed to secure the profit levels through solid pricing, we also promptly responded to the pricing disparity by revising the prices of some of the products in May. Regarding Ploom model S launched in some areas in March, we are actively expanding distributions, as explained on this slide.

Moving to the next slide for financial results of the international tobacco business. Robust growth was driven by significant pricing gains in the first half. To elaborate, 70% of the expected pricing gains will materialize in these 6 months. Please refer to the slide for the main markets, which witnessed pricing gains. Significant pricing gains were driven by a comparatively favorable schedule as well as a favorable comparison of lower pricing in several markets year-on-year. On the other hand, these gains were partially offset by 2 factors: one, being the negative impact of volume variance, which was caused by lower shipment volume; and the second being deteriorated mix caused by accelerated down-trading under the weaker economic conditions. Consequently, as depicted on the slide, core revenue grew both at a currency-neutral basis as well as on a reported Japanese yen basis. We estimate the COVID impact on core revenue in the first half as an unfavorable JPY 20 billion.

Regarding the adjusted operating profit. Volume variance was positive and the solid volume performance was confirmed in some European markets where the unit prices were high. In addition, driven by robust pricing gains, which contributed to the top line growth, adjusted operating profit at a constant currency and on a reported Japanese yen basis recorded a double-digit growth rate. Despite lower costs due to COVID-19 restrictions, the net amount of cost increased due to enhanced operating expenses, including investments to our digital capability enhancement and the establishment of our global business service centers. We have also continued to invest in RRP and other brands. Looking at the FX impacts. Weakened foreign currencies mentioned in the slide have negatively affected our performance.

Moving on, I will explain our performance in the pharmaceutical business. Revenue decreased mainly due to lower overseas royalty income. On the other hand, adjusted operating profit increased by JPY 2.2 billion year-on-year to JPY 7.9 billion. The reason for this increase came from lower R&D expenses, marked by the successful completions of clinical trials as well as profit increase in Torii Pharmaceutical.

Looking at the COVID impacts. There were no material impacts to the top line. The processed food business was particularly impacted by the lower demand after the state of emergency declaration and restrictions on nonessential outings related to COVID. Significant decline was observed in the food service products in the frozen food and ambient foods as well as the seasonings businesses. Lower demand was also seen in our own bakery business. As a result, revenue decreased by JPY 3.6 billion year-on-year. Adjusted operating profit decreased by JPY 1.3 billion year-on-year to JPY 300 million. In the first half, COVID-19 impacted the top line negatively by an estimated amount of about JPY 4 billion.

Now I will talk about the revised forecast for 2020 from the next slide. Let me start by explaining the assumptions and outlines of the revised forecast. The forecast was revised based on the assumptions that the lockdowns already enforced in some places since mid-March will gradually be listed during the second half. In other words, the impact of wave 2 is not included in this revised forecast. Such impacts include the reintroduction of lockdowns in our key markets in the international tobacco business as well as another declaration of a state of emergency in Japan. We also expect a shift to economic recovery following the most severely affected April to June period, but we expect that they will carry on through the year-end, gradually tapering off.

In terms of the outlook of our operating environment. We expect that business momentum, mainly in the tobacco business, to remain firm in the second half of this year. On the other hand, with regard to the outlook for the next year and onward, it is necessary to assess how the economic situations, consumer behavior as well as regulations and taxation systems in each country or region will evolve. Looking back with similar economic crisis like the COVID-19 pandemic, there may be some risks of the decline of the total tobacco consumption, the current and acceleration of down-trading trends and changes in regulation and tax schemes following the changes of consumer purchasing power, all depending on the extent of damage to the economy. Such impact on the tobacco industry may surface with a lag. With these factors in mind, we will keep a close watch on potential risks. FX assumptions have been revised, reflecting recent trends. As a result of which we now expect that negative effects will expand more than the initial outlook. We would like to inform you though that there are no serious concerns related to funding at this time.

Regarding the shareholder return, the initially planned annual dividend per share remains unchanged. The revised forecast that I'm about to explain have been prepared based on the assumptions explained in this slide and reflecting the results of the first half of this year. We aim to achieve the revised forecast based on these assumptions. Slide 12 explains the revised forecast announced today based on the assumptions I explained in the previous slide. Revenue has been revised downward in the Japanese domestic tobacco, international tobacco and processed food businesses. Besides the impact of the foreign currencies in the international tobacco business, the main cause of this downward revision is due to the COVID-19 impact. And we will strive to mitigate the impact on profits due to the decline in the top line. Adjusted operating profit at constant currency has been revised downward, reflecting the conditions in the Japanese domestic tobacco and processed food businesses. However, with efforts to mitigate the impact of the top line decline in these businesses and with the upward revision in the pharmaceutical business, the forecast was revised downward by only JPY 7 billion from the initial forecast, resulting in a 1.3% year-on-year decrease in currency-neutral adjusted operating profit. On a reported basis, adjusted operating profit and operating profit has been revised downward, as shown in the slide, mainly due to the revision of foreign exchange assumptions.

The forecast for the profit attributable to the owners of the parent company has been revised downward by JPY 19 million, representing a 17.9% decline as a result of a reduction in the corporate tax burden, partially offsetting the decline in operating profit. Despite the impact of the decline in top line sales due to COVID-19, we expect our ability to generate cash to remain stable.

Next, I would like to explain the forecasts by business segment. Please see Slide 13 for details on the Japanese domestic tobacco business. The recent COVID-19 situation has led to changes in consumer behavior. Examples include changes of the places and opportunities for tobacco product consumption. Especially following the state of emergency declaration, the smoking environment was further restricted with restrictions, including temporary closures of some designated smoking areas, which had negative effects to RMC demand.

On the contrary, there is a tendency for increased smoking opportunities at home due to the restrictions on nonessential outings. Against this backdrop, consumption of RRP surged in these circumstances. Although these events had negative effects on the total tobacco demand, we understand that most of these effects were temporary under the emergency declaration. We believe that they have already been resolved with this declaration listed. However, our analysis indicates that some changes in consumption trends could imply smoking cessation and reduction and could have lasting effects due to the natural decline trend.

We will keep a close watch on trends. [ 12 JT ], a new initiative, is also listed on the lower left of the slide as a reference. In the wake of COVID-19, we confirm the changes to the level of digital acceptability. To capture this trend, we are now working to strengthening our digital marketing capabilities, and responding to the diversifying consumer behaviors and to address the purchasing behaviors through e-commerce and other channels. Amid changes in consumption trends, we have revised our volume assumptions in light of recent situations. The decline rate of RMC industry volume is revised downward from the initial assumption, reflecting the factors I have mentioned before. The RRP category size is expected to remain in the ballpark of around 25% of the total tobacco industry, although it is expected to extend more than initially anticipated, observing the trends so far. In light of these factors, the forecast for the total tobacco industry volume is revised downward from the initial assumption. RMC shipment volume is revised downward, reflecting the higher decline rate of the total demand compared to the initial outlook while we maintain the initial assumption for the RRP shipment volume. Based on these assumptions, we have revised our financial forecast for the Japanese domestic tobacco business, as shown on Slide 14.

Our core revenue forecast is revised downward by JPY 30 billion to JPY 510 billion due to significant impact on the top line of the Duty free business, considering its scale and temporary decline of the domestic market following the declaration of the state of emergency.

But let me comment about adjusted operating profit. There are 2 factors that influence the revised forecast for the adjusted operating profit. One being the duty fee business, and the second being the Japanese domestic market. In regard to the duty free business, the top line impact directly affects profit because while this has relatively high margins, there is little room for cost reductions. And under the COVID-19 situation, the top line of the duty-free business has been significantly impacted. Now in adopting new domestic market on the other hand, it is possible to mitigate the top line impact to the bottom line to a considerable degree by not only reducing general and administrative expenses under the restrictive operations due to COVID-19, but also by revisiting the priorities of initiatives and reducing nonessential costs while making necessary investments.

Considering these factors, adjusted operating profit is revised downward by JPY 10 billion to JPY 160 billion. Along with the announcement of our financial results today, we announced an application of approval of revision for retail prices accompanying the increase in the tobacco excise tax in October 2020. As we have communicated, the amendments of the retail price were determined taking into consideration the factors, including not only tax increase, but also lower demand and down trading following the price revision. We have applied for a JPY 50 increase in the retail price per pack in principle to ensure that the quality and brand equity of each product will be maintained or improved despite volume decline driving higher cost per unit. These factors have also been incorporated into the revised forecasts.

Next, I will explain the revised forecast for the international tobacco business. Please turn to Slide 15. The international tobacco business is broadly divided into mature and emerging markets. In the mature markets, we can confirm higher unemployment rates and a decrease in disposable income. But because economic stimuli by governments were implemented relatively faster, the economic damage to consumer is contained to a certain extent. On the other hand, we have confirmed the progress of down trading. Especially in Europe, fine cut products are functioning as a receptacle for this down-trading trend. And JTI offers the leading fine-cut products in Europe, which is expanding in our market share. Further, considering the stockpiling impacts, the decline in shipment volume up to the second quarter was limited, particularly in the European and other mature markets. However, in emerging markets, several faced severe lockdowns, which had a significant impact on the distribution of products and lower disposable income amid unstable economic conditions, which have led to volume declines and down trading. The revised volume assumptions are shown on the slide. These downward revisions are mainly due to the effects on total demand in the duty-free market and impact by COVID-19 in some emerging markets as well as the effect of the volume decline, mainly in Russia, Bangladesh and Turkey. This was partially offset by the increase in the total demand accompanying the restored domestic industry in the U.K. and France as well as by the strong volume performance in Europe, resulting from the increase in market share.

Next, I will explain the revised financial forecasts. Core revenue at constant currency has been revised downward by USD 500 million, reflecting the volume assumptions revised downwards. On a reported basis, the forecast has been revised downward, as shown on the slide, taking into account that the negative foreign exchange impact is expanding beyond initial assumptions. On the other hand, adjusted operating profit at constant current remained unchanged at a 10% growth rate due to the downward revision of the top line, the upside of pricing gains in the first half more than offsetting the increased down trading under COVID, and the cost reductions due to operational restrictions under COVID. Adjusted operating profit on a reported basis has been revised downward by JPY 38 billion due to the revision of the foreign exchange assumptions.

Regarding the outlook for the second half, we expect the growth rate to decelerate due to factors as shown on the slide.

In the next slide, I would like to explain the revised forecast for the pharmaceutical business. As you can see on the slide, the revenue forecast remains unchanged. However, the adjusted operating profit is revised upward by JPY 3 billion and is expected to be JPY 13 billion, down JPY 2.9 billion against the previous year with restriction from operations caused by COVID, leading to big pieces in both R&D expenses and cost of Torii Pharmaceutical.

Now let me discuss the revised forecast for the processed food business. The revenue forecast is revised downward by JPY 7 billion to JPY 153 billion, reflecting weaker demand for food service products and softening bakery business following the declaration of the state of emergency. The adjusted operating profit forecast is revised downward by JPY 2 billion to JPY 3 billion, reflecting lower top line. However, we will mitigate the impact of a lower top line by improving our product mix and cutting costs. We expect the impact of COVID-19 was the most significant in the second quarter under the emergency declaration with gradual improvement expected to follow. However, we will continue to monitor how the situation evolves.

Finally, please refer to slides 19 and 20. In Slide 19, I would like to cover the JT Group policy regarding community investment activities and our responses to the COVID-19 outbreak. Our group has been conducting continuous community investment activities to contribute to the development of inclusive and sustainable local communities. Even in these unprecedented times, we are determined to fulfill our role as a responsible community member.

Please turn to Slide 20 for closing remarks. The implications of COVID-19 remain very volatile as its effects continue to expand. We will respond to evolving consumer needs and changes in behavior in this new normal with flexibility and agility. We will also continue to invest in communities where we operate, as mentioned earlier. Regarding the outlook going forward, as mentioned in the previous slides, we expect to see solid business momentum through the end of this year. However, with regard to the outlook for the next year and onwards, notably in the mid- to long term, it is necessary to take into account the economic situation and its outlook, changes in consumer trends and trends in regulation and taxation in each country. Regarding the shareholder return, as shown on the slide, the initial planned annual dividend of JPY 154 per share remains unchanged. Thank you for your attention.

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