From Activism Monthly Premium (July 2014 edition)

When Shinzo Abe became Prime Minister of Japan in 2012, investor sentiment began to warm to a country long known for its overvaluations and prickly corporate governance. This year, the government drew Abe’s ‘third arrow’—corporate reform—from its quiver and let loose. Opinion is divided on whether the policy changes hit the bullseye, but an activist investor was taking note.

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The Children’s Investment Fund (TCI), which has a base in the City of London but operations globally, had already held stock in one of the country’s premier brands for a year when Abe took office. According to Oscar Veldhuijzen, the Partner at TCI responsible for the investment, Japan Tobacco stock was trading at “distressed levels” back in 2011. Since the beginning of that year, however, it has performed well, rising 143% to date. Yet Veldhuijzen believes there is more to come. He says the stock is still a “unique opportunity, poorly understood by investors.” At both the 2012 and 2013 annual meetings TCI put forward proposals to significantly increase the company’s dividend. Both times it was rebuffed by fellow shareholders, but analysts say the activist has “raised the bar” in terms of what can be considered a meaningful return to shareholders.

Repurchasing more shares could be an important symbol that the company should be valued at a multiple close to its peers, TCI says. While the stock is currently valued at 10-times earnings, TCI believes the company should be trading at a premium to its peers as it has faster sales and profit growth than competitors, but management of JT’s balance sheet has led to a 30% discount based on its enterprise value to operating profits. With a significant buyback, Veldhuijzen sees 15-times earnings as realistic, representing a 50% upside.

The Ministry of Finance’s Holding in JTI

Another policy TCI has advocated for the past three years is for JT to buy back the shares owned by the Japanese Ministry of Finance. In fact, the government has slowly relinquished its holding in the company over many years. In 1985, the state privatized a third of JT’s shares. In 2004, the Ministry of Finance sold shares down to 50.1% and more recently, after further urgings from TCI and with capital needed urgently to rebuild the country in the wake of the tsunami that hit the country in 2011, to 33%.

Yet as Veldhuijzen stated in a recent letter to Shinzo Abe, “further privatizations are crucial to the achievement of your economic growth targets, and JT’s full privatization would provide Japan with a strong boost in confidence from the international investor community.” In this it claims to have an important ally—the company itself. In addition to noting a company press release calling for full privatization “in order to manage the business competitively,” Veldhuijzen says that a member of the board discussed the letter to Abe with TCI the day before it was sent and approved of the sentiment.

Share Buybacks Over Acquisitions

Holding onto large amounts of cash is not unusual for Japanese companies. Indeed, in 2012, Japanese companies increased cash holdings to $2.2 trillion. Yet, in the board’s response to TCI, the company states that buying back shares would dampen its ability to make future investments. In 2012, it purchased Belgium’s Gryson NV for $661 million, and earlier this year acquired Zandera, maker of E-lites, and a leading e-cigarette brand in the United Kingdom. Financial details of this purchase have not been made public, but the company says that the deal will have little impact on its cash flow for the fiscal year, with a mixture of cash and debt used to complete this acquisition.

TCI sees little need for further large acquisitions and has actively tried to dissuade the company from making a bid for its rival, Imperial Tobacco. However, Erik Bloomquist, an analyst at Berenberg who covers the stock, thinks there are opportunities out there, including Gudang Garam, an Indonesian company.

As a result, a buyback seems unlikely to become a priority for the company. Indeed, JT appears philosophically opposed to TCI’s proposals. While the activist states in its proposal that the “capital structure of the company is underleveraged and the shares undervalued,” the company claims that it would have to borrow capital to finance an increase in dividends.

That may not be all bad news however. Further upside for the stock may come from pricing updates, with Veldhuijzen noting that most taxes are fixed, so increases in consumer products would have a larger impact on profits. There is plenty of room to raise prices in key markets like Russia and the domestic one, he thinks. Bloomquist also thinks there could be a significant earnings upside, with an increase in the Mevius brand (accounting for roughly half of JT Domestic volume) from a mid-price offering to a premium offering providing “at least” 15-20% profit upside.

This interview is taken from Activism Monthly Premium, July 2014. Activism Monthly Premium is a subscription-based print magazine bringing you the most comprehensive and up-to-date coverage of shareholder activism around the world. Readers of Hedge Fund Insight qualify for a 33% discount on a subscription to the magazine, which can be enjoyed by clicking this link.