Consumer

Shelly Banjo is a Bloomberg Gadfly columnist covering industrial companies and conglomerates. She previously was a reporter at Quartz and the Wall Street Journal.

Japan Tobacco Inc., the world's fourth-largest tobacco manufacturer, is trying to keep up with a pack of industry mergers by biting off most of the Philippines' Mighty Corp.

The deal is a smart one, but Mighty alone won't be enough to help the Japanese firm stand its ground as the world's tobacco companies converge.

Blowing Smoke
Shares in Japan Tobacco have underperformed other global cigarette makers, as well as the broader stock market index
Source: Bloomberg

In addition to the 45 billion pesos ($890 million) to buy the manufacturing and distribution assets of the number two Philippine cigarette maker, Japan Tobacco has spent $35 billion since 1999 to acquire overseas competitors, according to Bloomberg News.

Yet instead of gaining global market share, the company's position actually shrank to 8.4 percent in 2016 from 9.6 percent in 2007, according to Euromonitor International. 

Lighting Up
More than 80 percent of global cigarette sales are concentrated among just six companies; M&A is likely to consolidate the industry further
Source: Euromonitor International
Note: British American Tobacco reflects recent purchase of Reynolds American.

That's because global competitors are spending more to grow as smoking rates decline, regulations tighten, and pricing power becomes even more important to maintaining profits.

Earlier this year, British American Tobacco Plc paid $49 billion to buy the 58 percent of Reynolds American Inc. it didn't already own (Reynolds itself bought rival Lorillard for $25 billion in 2014).

In January, the U.K.'s Imperial Brands Plc formed a joint venture with state-owned China National Tobacco Corp., the largest cigarette seller by market share, laying the groundwork for an all-out takeover bid down the line.

And as Gadfly's Tara Lachapelle has long speculated, it's just a matter of time before a reunion sparks between Philip Morris International Inc. and its former parent company, Altria Group Inc.

Japan Tobacco's failure to be as acquisitive as competitors isn't its only problem. The other is that it has been late to the smoking alternative party, only rolling out a rival product for the first time last month. “Clearly they were caught napping,” Exane BNP Paribas analyst Eamonn Ferry told Bloomberg News. It's also trailing competitors when it comes to the research and technology behind the new category, from electronic cigarettes and chewing tobacco to vapor and cessation products.

This difficulty is most visible in its home market, according to research from Mitsubishi UFJ Morgan Stanley, which initiated coverage on the company last week at "neutral." It derives 32 percent of its revenue from Japan, and has about a 60 percent market share. 

But Philip Morris's iQOS HeatSticks, which employ new technology that heats tobacco rather than burning it, have caught on in Japan as consumers move to products that claim to reduce the risk of smoking-related diseases. As Philip Morris makes inroads, Japan Tobacco's not in a good place to defend its preeminent position.

The Japanese cigarette maker's stock price reflects investor disappointment. Its shares hardly budged Thursday on news of the Philippines deal and are down 12 percent for the year compared to a 25 percent jump in Japan's Topix Index. Valuations aren't great: a forward P/E of 16 trails the 17.6 multiple for BAT and 22.7 at Philip Morris.

Japan Tobacco, whose roots stretch as far back as the mid-1800s, is moving in the right direction by pursuing new smoking alternatives and outbound M&A. But it remains distracted with other business units, including food and pharmaceuticals. It's coming from behind and it will take too long to catch up with competitors that are only growing larger. Wiser to consider a tie-up with Imperial Brands, Altria or Philip Morris, which could all make a case for a merger that makes sense. Japan Tobacco, if you can't beat 'em, join 'em.

To contact the author of this story:
Shelly Banjo in Hong Kong at sbanjo@bloomberg.net

To contact the editor responsible for this story:
Jennifer Ryan at jryan13@bloomberg.net