Exports of HNB Cigarettes to Drive Earnings Growth
The author is an analyst of Shinhan Investment Corp. He can be reached at sanghoonpure.cho@shinhan.com. – Ed.
KT&G’s earnings growth this year will hinge on exports of heat-not-burn (HNB) cigarettes through partnership with Philip Morris International. The company currently exports HNB cigarettes to 23 countries with plans for further market expansion. We need to focus on exports to Japan, which started at the end of October 2020. Its market share in Japan will likely grow at a faster-than-expected pace, considering: 1) higher penetration of HNB cigarettes (30% as of 4Q21) vs. Korea (16%) thanks to earlier introduction; 2) significantly larger market size (5.4 times that of Korea); 3) strong preference for products with reduced smell as in Korea; and 4) brisk demand from consumers seeking out new products. The COGS ratio tends to increase in the early phase of market entry with the focus placed on selling HNB devices for market share gains, but this should be seen as an investment to eventually sell tobacco sticks.
Leading exporter in Korea
There are concerns that KT&G’s overseas cigarette earnings, a determinant factor of enterprise value, may be lackluster this year. Consumption in the Middle East, which is a major market for the company, is still sluggish, and on top of that, sales operation in the US has been suspended at the end of 2021. However, we believe exports will recover gradually from bottom levels. The company will ramp up marketing efforts in the Middle East once local demand returns to pre-pandemic levels. Strong growth in Indonesia and new markets like Central/South America should help to offset losses from the suspension of the US operation.
Reinitiate coverage with BUY for a target price of KRW100,000
We reinitiate our coverage of KT&G with a BUY rating for a target price of KRW100,000. We used the sum-of-the-parts method to properly value business units with different structures. The stock is currently trading at the low end of its historical valuation band and at a 20% discount to global cigarette peers. With the negative impact of COVID-19 already priced in at current share price levels, earnings and share valuations are highly likely to improve upon recovery in exports. KT&G is the only company in the global tobacco market that is seeing market share gains for both combustible and HNB cigarettes. We are positive about its low reliance on imports of raw materials and limited impact of grain price volatility on earnings.