1) Investment highlights
- The US FDA’s announcement last week of a plan to cut the amount of nicotine in cigarettes sent shares of Altria, British American Tobacco, and Philip Morris International down sharply, and KT&G also felt the impact, tumbling 4.6% on Monday.
- The US’ percentage of KT&G’s tobacco exports (18.5% of consolidated sales) is not meaningful and its product lineup is comprised of mostly low-nicotine products. Thus, we do not believe US regulations will affect company fundamentals.
- Rather, we note: 1) the most outstanding earnings stability among peers; 2) domestic market risks not beyond expectations; 3) escalating tobacco export momentum; and 4) attractive valuations.
2) Major issues and earnings outlook
- Domestic tobacco market: We forecast 73.7bn cigarette sticks to be sold in 2017 (-3.4% YoY) due to an unfavorable YoY base, graphic warnings which affected sales at the beginning of the year, and competition from iQOS, an e-cigarette brand launched by Philip Morris International, which chipped away at KT&G’s market share.
1) Gruesome tobacco warning labels cut 1Q17 tobacco sales by 4.8% YoY to 16.8bn sticks, which was in line with our expectation. We predicted price resistance would fade away in 2Q and indeed, sales declined just 2.2% YoY.
2) iQOS’s market penetration in June could eat into the market share of traditional tobacco in 3Q (-3.8% YoY) but the impact will lessen in 4Q (-2.2% YoY).
3) With competitors’ inventory clearance at the beginning of the year coming to a close, KT&G’s market share has rebounded to 60% in 2Q (+0.7%p YoY). Given the ASP hike upon the company’s better product mix, we estimate domestic tobacco sales will dip just 0.8% YoY to KRW1.83tn in 2017.
- Tobacco exports (including overseas subsidiary sales): We forecast 2017 sales at KRW902.4bn (+8.6% YoY) on both qualitative and quantitative growth (sales volume +4.8% YoY, ASP +3.8% YoY likely).
- Red ginseng: Sales inched up just 0.3% YoY due to sluggish domestic sales caused by the drop in the number of Chinese inbound travelers. However, backed by its diversified product portfolio combined with a successful lineup extension including Everytime and Women’s Balance, 2017F sales should grow 6.2% YoY to KRW1.18tn.
3) Share price outlook and valuation
- Even with negative news flows, earnings remain steady. We maintain BUY and our target price of KRW136,000 based on 9.8x 12-month-forward EBITDA.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.