Operations and Analysis

016 Japan Tobacco Inc. Annual Report 2016 Operations & Analysis

Industry Overview 017 Review of Operations 020 Risk Factors 038 JT Group and Sustainability 042 Industry Overview Special Feature 044

Please be reminded that this section is intended to explain the business operations of JT to investors, not to promote sales of tobacco products to encourage smoking by consumers.

Tobacco Business In general, the market dynamics are distinctively different between Tobacco industry mature and emerging markets. In Market dynamics mature markets, industry volume There are many types of tobacco tends to decline reflecting various products available in today’s factors such as limited economic marketplace. Cigarettes remain the growth, tax increases, tightening most popular choice for consumers, regulations, and demographic while fine-cut, cigars, pipe tobacco, changes, among others. In addition, snuff, chewing tobacco and waterpipe down-trading is prevalent in these tobacco continue to draw consumers’ markets. Consumers are inclined to interest, with some of these seek more value as they feel tobacco product categories increasing products become less affordable their volumes worldwide. in the context of limited growth of disposable income. Recently, these In addition, the next generation of trends have been observed in EU emerging products such as vapor countries, resulting in industry products has become widely popular. contraction and down-trading Especially the market size of ‘E-Vapor’ in many markets. slightly decreasing according products or ‘Electronic Cigarettes’ to a survey conducted in 2017*. (e-cigarettes) has been expanding In emerging markets, on the other hand, at a fast rate in markets such as the total consumption tends to increase, However, more importantly, industry U.S. and Europe, reaching global sales driven by population growth and value continues to grow even in the of approximately US$10 billion in 2016. economic development, particularly current difficult operating environment, The products use vaporized liquid in Asia, the Middle East and Africa. mainly driven by price increases. This is solutions often containing nicotine, As their disposable income increases, a sign of the resilience of the industry. and vapor is inhaled to offer consumers look for quality and trade These trends – decline in volume and a different experience. As E-Vapor up to products in higher price bands. increase in value – are expected to products do not use tobacco leaf, continue in the years ahead. they were not regulated or taxed as Overall, when we exclude China, tobacco products, however, regulation global industry volume has been * Source: JT estimate (2016 data, as of July 2017). or taxation of E-Vapor products is being developed in some markets.

Another type of emerging products Top market players referred to as ‘T-Vapor’ or ‘Tobacco- Share of market (%) vapor’ has been growing particularly 2012 2013 2014 2015 2016 in Japan. Unlike E-Vapor, T-Vapor Philip Morris International Inc. 25.0 24.6 24.6 24.8 24.6 products use tobacco leaf and British American Tobacco Plc. 18.0 18.2 18.5 19.2 19.4 are therefore taxed and regulated Japan Tobacco Inc. 14.1 14.2 13.9 14.1 14.4 as tobacco products in principle. Imperial Brands Plc.** 6.7 6.5 6.4 6.7 6.6 Although the T-Vapor market is Source: JT estimate (2016 data, as of July 2017). still in its making, we expect further Excluding China National Tobacco Corp (CNTC). innovation and product offerings ** Company name changed to Imperial Brands Plc. as of February 2016. will drive growth in this category, as market players take keen interest Top 10 countries by volume in this new growing market. Billion units Country 2012 2013 2014 2015 2016 Approximately 5.5 trillion cigarettes China 2,461.6 2,490.5 2,549.5 2,489.5 2,350.5 are consumed around the world, Indonesia 302.5 308.3 314.3 320.4 316.1 reaching global sales of approximately Russia 370.8 346.3 316.2 292.5 278.4 US$700 billion in 2016. China is by U.S. 292.7 279.5 270.6 269.9 263.4 far the largest market, accounting Japan 197.4 194.1 186.2 182.3 173.9 for over 40% of global consumption, Turkey 95.3 91.7 94.7 103.2 105.5 but it is almost exclusively operated Egypt 77.6 80.2 83.2 86.4 90.0 by a state monopoly. Indonesia, Bangladesh 76.3 78.6 80.6 83.4 86.1 Russia, the U.S. and Japan are the India 102.1 100.9 95.9 88.1 84.9 next four largest markets, according to Philippines 102.5 86.7 82.3 79.4 79.1 a survey conducted in 2017*. Source: JT estimate (2016 data, as of July 2017).

Japan Tobacco Inc. Annual Report 2016 017 Industry Overview continued

extended health warnings, minimum to a decline in industry volume. packaging requirements or Often, tax increases coincide with restrictions on the use of additives, an increase in illicit trade, which among others. We expect to see could, in turn, affect our business. EU member states complying with these restrictions by May 2017. Competition These moves to commoditize Excluding China, two-thirds of world tobacco products will undermine industry volume is produced by four fair competition among tobacco major global tobacco companies, manufacturers trying to meet namely Philip Morris International increasingly diverse consumer Inc., British American Tobacco Plc., preferences. Worse, they could Japan Tobacco Inc. and Imperial Regulations result in an undesired increase Brands Plc.** The competition The regulatory environment in illicit trade, as commoditized within the industry is intense continues to be more restrictive for products with less uniqueness and, as consumers’ needs and the tobacco industry. Restrictions on are easier to counterfeit and more preferences continue to diversify, promotions and advertisements are difficult to detect when smuggled. a strong portfolio with established the most common around the world. brands is increasingly important An increasing number of markets Recently, new standards or frameworks to support market share gains. are introducing bans on smoking for reduced risk claims have been Therefore, major global companies in public places and promoting established in a few countries such are focusing on brand equity larger health warnings on product as the U.S. and part of Europe. enhancement to strengthen their packaging, in some cases with In order to gain official approval brand portfolios by introducing pictorial health warnings. There are from governments, activities in innovative products. Competition also some markets where displaying developing reduced risk claims in the vapor products category tobacco products at retail stores have been intensified among major has been intensifying as recently is banned. global tobacco manufacturers. the products have subsequently been launched in many markets. Recent regulations are focusing Taxations In addition to the pursuit of organic more on the product itself. Plain Tobacco products are subject to growth, M&A is an effective way packaging, or branding ban, has excise or similar taxes in addition to to supplement growth opportunities been introduced in some markets value-added tax in most of countries in this industry. and furthermore, regulators are as governments seek to secure their becoming more aggressive by revenue or promote public health. restricting ingredients and emissions, Excise taxes were raised in various following the guidelines on these markets during the past year, and attributes proposed by the in general, tax increases are passed Framework Convention on Tobacco onto prices. Therefore, repeated tax * S ource: JT estimate (2016 data, as of July 2017). Control. In Europe, the European increases in a short period of time, ** The company name of Imperial Tobacco Group Plc. was Tobacco Product Directive adopted or steep tax increases, could lead changed to Imperial Brands Plc. as of February 2016.

Top brands

Billion units Brand Company 2012 2013 2014 2015 2016 Marlboro • Philip Morris International Inc. • Altria Group Inc. 414.1 395.9 391.4 392.5 385.8 Winston • Japan Tobacco Inc. • Reynolds American Inc.*** 135.0 140.8 132.6 135.0 141.5 Pall Mall • British American Tobacco Plc. • Reynolds American Inc. 102.5 105.7 110.1 109.3 108.2 L&M • Philip Morris International Inc. • Altria Group Inc. 96.0 98.6 98.7 103.2 102.5 Mevius • Japan Tobacco Inc. 84.4 83.7 79.1 77.3 76.2 Camel • Japan Tobacco Inc. • Reynolds American Inc. 62.9 62.7 66.8 71.0 71.3 Rothmans • British American Tobacco Plc. 20.8 25.8 34.8 50.5 69.2 Cleopatra • Eastern Co SAE 52.5 53.7 56.2 59.3 65.9 Gudang Garam • Gudang Garam Tbk PT. 62.3 64.1 66.5 66.1 64.8 Kent • British American Tobacco Plc. 63.6 61.8 60.2 62.0 62.6

Source: JT estimate (2016 data, as of July 2017). Excluding China National Tobacco Corp (CNTC). *** Brand owned by Imperial Brands Plc. from 2015.

018 Japan Tobacco Inc. Annual Report 2016 Operations & Analysis

Worldwide Pharmaceutical Market* (USD BN) Pharmaceutical In Japan, the main market for our pharmaceutical business, original Market dynamics drugs comprise the majority of the The global pharmaceutical market market in terms of net sales. The continues to grow, reaching sales Japanese generic drug market share 963.4 964.4 993.6 1,061.3 1,072.0 of approximately US$1,072 billion for prescription drugs is still small in 2015*. North America, the largest compared with that in the U.S. market in the world, shows more than and Europe. However, its market 2011 2012 2013 2014 2015 10% growth over the previous year. size has been expanding more recently due in part to government 2015 Regional Composition* In emerging countries, demand promotion of generic drugs in order for modern medicine is also rapidly to control medical care expenses. North America 42.6% growing due to multiple factors, Europe 22.2% including growing consciousness In Japan, the Government determines China 10.7% of health, increase in population, the price of pharmaceutical products Japan 7.6% and development of public healthcare with revisions being made every two Others 16.9% systems, among others. Facing a years. In April 2016, the latest round rapidly aging society and a fiscal deficit, of price revisions led to an industry- the governments in these markets try wide reduction of drug prices by to contain healthcare costs through 7.8% on average. wider promotion of generic drugs. Competition In addition, patents of commercially The pharmaceutical industry is successful drugs have been expiring highly competitive worldwide. during recent years, which accelerates Our pharmaceutical business the global trend of industry consolidation. focuses on building a R&D-led operational platform. Based on Mature markets take majority of this platform, original compounds shares in global pharmaceutical are developed and marketed as markets. North America is the largest leading products in major global market and accounts for approx. 43% markets. As such, we face of the worldwide market, followed by competition with Japanese and * Copyright©2016 Quintiles IMS. Created based on IMS World Review Executive 2016. Europe and Japan, representing 22% multinational pharmaceutical Reprinted with permission. and 8%, respectively*. companies.

Processed Food For the Japanese processed companies, resulting in stronger food industry, we expected to price negotiation power against Market dynamics see additional price-increases in manufacturers. We are also seeing JT’s processed food business is imported raw materials and prices an increase in private label brands. operated by our subsidiary TableMark of raw materials remaining at high Co., Ltd. (TableMark) which plays levels, mainly due to current weaker Japanese Frozen Food Market (JPY BN) a main role. TableMark focuses yen effect. The processed food on frozen food products, such as business is also significantly frozen noodles, frozen rice and frozen impacted by the development in the baked bread, ambient processed food wholesale and retail sales channels, represented by packed cooked rice, particularly by their consolidation. 859.3 899.2 977.1 988.3 1,015.6 seasoning business utilizing our yeast We will continue to monitor the technology and bakery business. development of these channels,

especially in the area of M&A. 2011 2012 2013 2014 2015 The size of the Japanese frozen food Source: Japan Frozen Food Association. market in 2015 on a consumption Competition basis including imports was ¥1,015.6 TableMark is competing against 2015 Share of Market by Frozen Food Manufacturer billion, up 2.8% year-on-year. major players like Maruha Nichiro, Nichirei, Ajinomoto and Nissui as Maruha Nichiro 22.2% Regarding the domestic production well as a multitude of mid-or small- Nichirei 21.8% of frozen food, the production scale producers. We are seeing a Table Mark 11.8% monetary amount increased mainly polarization of retailers as well as Ajinomoto 11.0% as manufacturers amended the retail reorganization and oligopolization Nissui 8.3% prices to adjust the increase in raw of the wholesale sector led by Others 24.9% material costs. sogo-shosha, the general trading Source: The Nikkei Business Daily.

Japan Tobacco Inc. Annual Report 2016 019 Review of Operations Message from the President of Tobacco Business

We will continuously strive to achieve sustainable growth of the Group’s Tobacco Business under the new organization structure. Mutsuo Iwai President, Tobacco Business

To strengthen the operation “Global Tobacco Strategic “President, Japanese Tobacco of our tobacco business, we Committee” is an advisory committee Business” was appointed to be fully established “Global Tobacco for the President of the Tobacco in charge of the Japanese domestic Strategic Committee” and Business and is composed of JT and tobacco business, reporting directly appointed “President, Japanese JTI Executives. Its principal objective to the President of the Tobacco Tobacco Business” as of is to facilitate future growth strategy Business, in order to accelerate January 1, 2017. Under this new of the Group’s Tobacco Business. business decision-making. organization structure, we will The Committee will discuss the overcome present and future mid- to long-term growth strategies Meanwhile, by delegating the major challenges. Our tobacco business, for the overall tobacco business roles and responsibilities for the Japanese and international including resource allocation related operations in Japan, the President tobacco businesses as a whole, to business investments and provide of the Tobacco Business will be will remain committed to advice and recommendations to the able to better facilitate the overall achieving our target of mid to President of the Tobacco Business. management of tobacco business. high single-digit profit growth rate over mid- to long-term. Members of the Committee will be: • President, Tobacco Business (Chairman), • President, Japanese Tobacco Business, • Head of Tobacco Business Planning Division, • JTI Chief Executive Officer, • JTI Deputy Chief Executive Officer, • JTI Chief Operating Officer etc.

Tobacco Business Organization Chart

As of January 1, 2017 Position in bold is newly established JT CEO JT Deputy CEO

Advice President, Recommendation Global Tobacco Tobacco Business Strategic Committee

President, Japanese Tobacco JTI CEO Business

Japanese Tobacco International Business Tobacco Business

020 Japan Tobacco Inc. Annual Report 2016 Operations & Analysis

Message from the President of Tobacco Business 020 International Tobacco Business 022 Japanese Domestic Tobacco Business 028 Pharmaceutical Business 032 Processed Food Business 036 Tobacco Business Value Chain

We focus on fundamental research • Maintain existing products to and product technology development, comply with regulatory changes. taking advantage of our global research • Develop new technologies and platform, in close collaboration with improve production processes R&D other functions. In particular, focus to maintain competitiveness areas in our R&D activities are: and increase efficiency. • Drive product innovation to enhance Create value for the • Develop products and analytical equity from various aspects, including business through capabilities in line with market needs tobacco leaves, blends, filters, printing innovation and quality and our anticipation of regulatory trends. techniques and packaging. • Develop emerging products.

Tobacco leaf is the most important • Maintain good relationships with material for our products, and we external suppliers to ensure sufficient dedicate our efforts to strengthen our supply at competitive prices. capability to ensure a stable supply Procurement of quality leaf in the long-term. With regard to non-tobacco materials, we aim to mitigate cost increases due • Increase the proportion of leaf to design enhancements and investment Ensure stable supply from our vertical integration bases in innovative products by, among others, of quality tobacco leaf in Africa, Brazil and the U.S. effectively managing procurement lot-size. • Enhance sustainability of tobacco farming by helping farmers to improve productivity as well as taking initiatives to support their communities.

Our emphasis on product quality • Ensure high quality of products is increasing to meet consumer and enhance flexibility in the expectations for innovative offerings. manufacturing process, overcoming In addition, we consistently pursue complexity in manufacturing due to Manufacturing an optimal manufacturing footprint an increase in number of products. which ensures efficient and timely • At the same time, seek efficiency by containing cost increases through Support top-line growth by product deliveries to markets. continuous improvement and delivering quality products • Strengthen our ability for business reviewing of manufacturing footprint continuity in times of emergency. for further optimization.

Our strategic focus is placed on • Implement responsible marketing our flagship brands and we strive to programs, in compliance with enhance their equity through effective applicable laws and regulations communications with consumers. as well as our internal global Marketing marketing principles. • Allocate appropriate resources Enhance equity to support GFB’s equity building. of flagship brands

There are various sales channels for • Strengthen relationship with key tobacco products such as supermarkets, accounts, leveraging our trained convenience stores, street and train sales forces. station kiosks, small independent • Develop trade marketing initiatives Sales & retailers and vending machines. Key for each market, taking into account channels are different depending on the channel development as well Distribution the market and we develop win-win as consumer trends and relationships with them to increase competitors’ actions. Expand product availability the availability of our products. by leveraging our trade marketing excellence

Japan Tobacco Inc. Annual Report 2016 021 Review of Operations continued International Tobacco Business

FY2016: Results for the fiscal year ended December 31, 2016

The core mission of JTI is to be the profit growth engine of the JT Group. Thomas A. McCoy President and Chief Executive Officer, JT International

2016 was our sixth consecutive We also invested further toward our Total Shipment Volume year of double-digit profit growth vision to become a global leader in at constant currency. We were emerging products. Following the once again the fastest growing acquisition of Logic in 2015, JTI 398.7 tobacco company, further became a leading E-Vapor player in (BnU) strengthening our business the key markets of the USA, the UK + fundamentals, competitiveness and France. And we continued our 1.2% and our role as the profit growth international expansion. Year-On-Year Change engine of the JT Group. For 2017, the operating environment Share gains, together with benefits is expected to remain challenging, Global Shipment Volume from acquisitions, enabled JTI primarily due to regulatory changes to achieve a total shipment in Europe and continued price volume growth of 1.2%, our best competition mainly in CIS+. Despite 283.7 performance since 2012. In addition, these anticipated challenges, JTI (BnU) our Global Flagship Brands, now is targeting another year of strong + including Natural American Spirit, earnings growth and we are confident 3.7% grew volume for the second that we will continue to deliver Year-On-Year Change consecutive year. sustainable growth over the long term.

This positive volume combined Our strategies Core Revenue with robust pricing across all clusters The core mission of JTI is to be the profit drove core revenue and adjusted growth engine of the JT Group. Using operating profit growth at constant the “4S” model as guiding principle, JTI 10,490 currency. Importantly, this solid has developed a clear and actionable (US$ MM) top and bottom-line performance strategic growth agenda. + was achieved while continuing our 1.5% strategic investments behind Global JTI’s strategic growth agenda sets Year-On-Year Change Flagship Brands, seeding markets and out three key priorities: emerging products; investments that • Organic growth in markets where + are strengthening the business and JTI’s presence is established. 8.5% Year-On-Year Change paving the way for continued growth • Expansion of our geographic At Constant Currency over the mid to long-term period. footprint in emerging markets for future growth. In seeding markets our strategic • Develop a leadership position Adjusted Operating Profit investments are paying off, with in emerging products. strong GFB volume growth driving a significant year-on-year core revenue Our key strategic drivers are: 3,095 increase at constant currency. • Build and nurture (US$ MM) outstanding brands. - We plan to continue investing • Enhance productivity 5.0% in these initiatives going forward continuously. Year-On-Year Change to increase their contribution • Maintain focus on responsibility to revenue and profit growth. and credibility. + • Strengthen human resources 13.4 % Year-On-Year Change as a cornerstone of growth. At Constant Currency

022 Japan Tobacco Inc. Annual Report 2016 Operations & Analysis

We believe the combination of these portfolio, and most notably Winston, We also gained market share in fine strategic initiatives and continuous Camel and Mevius. As a result, GFB cut, notably driven by growth in the improvement provide the right mix in our total shipment volume key markets of France, Italy, Spain balance between short-term grew to 71.2%, an increase of 1.7 and the UK, as well as the addition profitability and sustainable percentage points versus prior year. of Natural American Spirit. long-term growth. Looking into the clusters, GFB Importantly, across our Top40 markets, In line with our “4S” Model to deliver volume was very strong, increasing we grew total and GFB share of value long-term sustainable growth, our at mid-single digit growth rate in to 23.6% and 17.0%, respectively. company goal is to be the most South & West Europe and double- successful and responsible tobacco digit growth rate in North & Central Financials company in the world. As a result, Europe and Rest-of-the-World. In Core revenue grew 8.5% at constant we have developed a Responsible CIS+, GFB market share gains could currency driven by robust price/mix Business Framework, which defines not offset the GFB volume decline and shipment volume growth. Price/ 12 relevant business topics to support due to industry volume contraction. mix contribution increased by US$721 this goal. Action plans are now being million. All clusters contributed to the implemented and include, but are not BnU price/mix increase, notably driven by limited to: respecting human rights South North Rest- Russia, Turkey and the UK. The South across our value chain; developing & & of- & West Europe cluster generated West Central the- Total reduced-risk products; and building Europe Europe CIS+ World JTI US$45 million in price/mix, combined sustainable supply chains. Total with US$77 million from North & shipment Central Europe, US$289 million 2016 Performance Review volume 65.2 54.2 141.4 137.9 398.7 from CIS+ and US$310 million Volume & Share GFB from Rest-of-the-World. shipment Total shipment volume grew 1.2% to volume 58.6 33.6 107.1 84.4 283.7 398.7 billion cigarette equivalent units, our best performance since 2012. This Overall as a company we grew total positive achievement was supported and GFB share of market. Across our by acquisitions and favorable trade Top40 markets, JTI’s market share Cluster breakdown inventory adjustments, mainly in the grew to 25.7%, a 0.3 percentage first quarter. point increase versus prior year, Rest-of- including gains in the key markets 22% the-World 35% 36% The performance in South & West of France, Italy, Spain and Taiwan. CIS+ Europe and North & Central Europe 26% North & was strong, driven by continued 24% Central Europe Our GFB market share in our Top40 35% market share gains fully offsetting South & markets was up 0.7 percentage points 31% West Europe the impact of industry contraction, 21% to 18.2% as GFBs continued to gain 14% notably in the UK. In these two share in France, Italy, Russia, Spain, 16% 19% 21% European clusters, our fine cut Taiwan and the UK demonstrating volume increased 8.1%, led by once again the strength of our Shipment Core Adjusted volume Revenue Operating France, Germany, Hungary, Italy, GFB portfolio and the value of our (reported) Profit Spain, Switzerland and the UK. In continued equity building investments. (reported) Rest-of-the-World, total volume was up significantly driven by positive performance in seeding markets and Adjusted Operating Profit (US$ MM) supported by our acquisition in Iran. The industry volume contraction across the CIS+ cluster and lower +13.4% -5.0% market share resulted in total volume declining. +690 -258 -598 +3.0 GFB shipment volume increased 3.7% to 283.7 billion cigarette equivalent units, including the addition of two 3,257 3,693 3,095 billion cigarette equivalent units from Natural American Spirit. This second consecutive year of volume growth 2015 Volume Price/ Other 2016 at FX 2016 reported Mix constant reported was driven by the strong equity of our currency

Note: The selection of Top40 markets is based on profit contribution.

Japan Tobacco Inc. Annual Report 2016 023 Review of Operations continued International Tobacco Business

FY2016: Results for the fiscal year ended December 31, 2016

Pricing was also the key driver of our 2017 Outlook 13.4% increase in adjusted operating We entered 2017 with confidence in profit at constant currency. South & our business fundamentals, positive West Europe, CIS+ and Rest-of-the- GFB momentum and the continuation World all delivered double-digit of our strategic investments. adjusted operating profit growth These efforts were rewarded by the at constant currency. In North & Top Employer Global certification However, we expect the operating Central Europe, adjusted operating in 2015, 2016 and 2017, recognizing environment will be challenging, profit only grew low single-digit 33 countries for their exceptional primarily due to tightening at constant currency as we employee environment. In 2017, JTI regulations and price competition. increased investments to support is ranked number one by the Top the integration of Natural American Employers in Europe, Middle East This will overshadow the continued Spirit and to strengthen our position and Asia Pacific regions. volume and share growth of our Global ahead of new regulations in the UK. Flagship Brands and the increasing Expanding the business footprint top-line contribution from seeding 2016 Key highlights To complement our robust growth, markets and emerging products. Broadening the base for future we conducted a number of footprint sustainable growth expansion during the course of 2016. Despite the anticipated operating In 2016, we continued to invest in challenges, we are confident in seeding markets. We define these In July 2016, the JT Group won a achieving 9% adjusted operating as markets where JTI has a limited bid to acquire a 40% equity stake in profit growth at constant currency, presence and where we have identified National Tobacco Enterprise Ethiopia driven by the significant efficiencies growth opportunities through sustained S.C., the Ethiopian state tobacco generated by the planned and and focused investments. company. This great opportunity already implemented manufacturing will further expand our presence optimization programs. Initiatives focused on strengthening in Eastern Africa following our our brand portfolio and equity, as acquisition in Sudan in 2011. We will continue our investment well as expanding our distribution strategy toward brand equity network and trade partnerships. To address the different growth building, seeding markets and opportunities in the Americas, in emerging products to ensure These investments generated February 2016 we completed the long term sustainable growth and solid results, with our total volume purchase of a 50% stake in La strengthen our role as the profit growing 29% versus 2015. This was Tabacalera in the Dominican Republic. growth engine of the JT Group. driven by Global Flagship Brands, La Tabacalera has more than 100 which increased their volume by years of experience in the cigarette On March 31, 2017, Thomas A. McCoy more than 30%, led by Winston, and cigar business and was the first will be retiring and stepping down Camel and Mevius. company in the Dominican Republic from JTI as President and Chief to be certified under the International Executive Officer. He will be This volume momentum delivered Standard ISO 9001:2000 at the end of succeeded by Eddy Pirard, JTI’s significant year-on-year core revenue 2003. Operated as a joint venture with Executive Vice President Business growth at constant currency. the Government of the Dominican Development, Corporate Affairs and Republic, this provides JTI with a Corporate Communications. This These seeding initiatives are strategic asset in the Caribbean. management change will not affect important as they will enable JTI JTI’s strategy as confirmed by Eddy to benefit from a more balanced Lastly, we also strengthened our Pirard during the company’s full year geographic footprint. As a result, business footprint in Bolivia with the results investor meeting in Tokyo: they support our sustainable earnings acquisition of BIS Overseas Bolivia “As of April 1, my Excom colleagues growth over the mid to long term. S.R.L., the second largest tobacco- and I will lead JTI in achieving its specific distributor in the market. objectives and financial targets for People, cornerstone of our growth This new addition will accelerate the current year, while working hard A major enabler of our strategy are JTI’s expansion in Bolivia and and developing new plans to further the approx. 27,000 employees of JTI enhance our presence across enhance our business fundamentals worldwide. To ensure sustainable future Latin America. and competitiveness, to ensure growth, we continuously invest in our continued and sustained growth people by setting high standards and in the long term.” fostering a diverse work environment where our employees excel. This allows JTI to recruit the best candidates and develop their skills and competencies across the organization.

024 Japan Tobacco Inc. Annual Report 2016 Operations & Analysis

Please be reminded that this section is intended to explain the business operations of JT to investors, not to promote sales of tobacco products to encourage smoking by consumers.

Global Flagship Brands (GFB) Portfolio Our GFBs form the core of our brand portfolio. We have nine GFBs providing a well-balanced portfolio to address consumer needs globally.

Winston is the leading brand of the JTI portfolio. Launched in 1954, Winston became the world’s second biggest cigarette brand as of 2007. Winston is now sold in more than 120 markets following the 2016 launches in Nepal, Laos, Ivory Coast and Dominican Republic.

In 2016, Winston volume grew 5.5% to 139.3 billion cigarette equivalent units. Winston’s continued performance is driven by a comprehensive portfolio architecture comprised of two sub-families – Core and XS.

Winston Core family, of which the lead styles are Winston Blue and Red, is Winston’s global bestseller. In 2016, Winston Core grew volume by 2%, primarily driven by business expansion in the Rest-of-the-World. The XS family, which grew double-digit in 2016, is a more progressive range with a refined taste signature and features such as the LSS technology (Less Smoke Smell) and the new water-activated filter recently launched in Russia as Winston XS Plus AQUA. GLOBAL SALES Winston recorded double-digit volume growth in 34 markets and record market share in 20 markets, including Russia, France, 139.3BnU Iran, Italy, the Philippines and Taiwan. As a result, Winston strengthened its global market share by 0.3 percentage points to 9.1% in JTI’s Top40 markets.

Camel is the world’s most inspiring tobacco brand since 1913, a global icon of creativity with over 100 years of tobacco experience. With its distinctive taste signature, Camel is sold in almost 100 markets with 4 new market launches in 2016: Iran, Myanmar, Namibia and Thailand.

2016 set a new record year for Camel driven by volume and share growth for the third consecutive year. The brand reached 52.2 billion cigarette equivalent units, an increase of 2.5% versus 2015. Camel’s market share reached 3.3% in JTI’s Top40 markets, gaining 0.1 percentage point versus prior year.

This positive performance was driven by strong growth momentum in Camel’s European strongholds such as Belgium, Czech Republic, Germany, Italy, the Netherlands, Portugal, Spain, and also in emerging markets like the Philippines and South Africa, the latter entering Camel’s cluster of markets exceeding 1 billion cigarette equivalent units.

GLOBAL SALES Camel continues to build relevance amongst adult smokers driven by its iconic and international brand equity together with product quality enhancement and innovation. Capsule 52.2BnU and modern line products continued to be the key growth driver in 2016 with line extensions now representing one-third of Camel’s total volume.

Japan Tobacco Inc. Annual Report 2016 025 Please be reminded that this section is intended to explain the business operations of JT to investors, not to promote sales of tobacco products to encourage smoking by consumers.

Global Flagship Brands (GFB) Portfolio continued

LD is one of the top bestselling tobacco brands in the world and a key value proposition globally. Constantly increasing its footprint, LD is now present in 50 countries and became the first Global Flagship Brand to launch in the US market. Relevant portfolio expansions combined with a focus on modern formats (versus 2015, compact format grew 53% and capsules increased 31%) and successful migrations continued to build the brand as a stronghold in the JTI portfolio.

In a highly competitive value segment, LD delivered 47.6 billion cigarette equivalent units in 2016. Industry size contractions and competitive price pressures in CIS+ resulted in a volume decrease of 3.9% versus prior year.

Outside CIS+, LD volume continued to grow, notably at double-digit rates versus prior year in the Rest-of-the-World cluster. The brand achieved its highest ever market share in Canada, Latvia, Montenegro, Singapore and Taiwan. In Kazakhstan, LD became the leading brand with a historical GLOBAL SALES high share of market of 21.3% in December 2016. Overall, LD reached a 3.4% market share in JTI’s Top40 markets. 47.6 BnU

Launched as Mild Seven in 1977 and rebranded in 2013, Mevius is the top-selling brand in Japan with over 30% market share. Internationally, Mevius enjoys consumer popularity in Asian markets, and is expanding geographically to new markets.

For the full year of 2016, Mevius’ international volume recorded an inspiring growth of 4.7%, to close at 17.9 billion cigarette equivalent units, driven by significant growth in South East Asia and World Wide Duty Free, while maintaining a steady growth momentum in stronghold markets.

Mevius continued to grow its share of the premium segment in its top Asian markets. In Taiwan, Mevius remained the number one brand with a share of market of over 20%, enhancing its leadership in premium by exceeding a 60% share of segment. In JTI’s Top40 markets, Mevius’ market share reached 0.7%.

GLOBAL SALES

17.9 BnU

026 Japan Tobacco Inc. Annual Report 2016 Operations & Analysis

Please be reminded that this section is intended to explain the business operations of JT to investors, not to promote sales of tobacco products to encourage smoking by consumers.

Global Flagship Brands (GFB) Portfolio continued

Originally established in 1873, Benson & Glamour is JTI’s leading super slims brand Hedges has a proud British heritage. In introduced in 2005. In 2016, mainly due 2016, B&H volume increased 10.7% to 13.4 to the industry size contraction in Russia, billion cigarette equivalent units driven by GLOBAL SALES its volume declined 8.0% to 5.9 billion the success of B&H Blue in the UK. B&H cigarette equivalent units. GLOBAL SALES increased its market share 0.1 percentage 5.9BnU 13.4 BnU point to 0.8% in JTI’s Top40 markets.

Audacity, uncompromised excellence Natural American Spirit joined the JTI and noble characters define Sobranie, portfolio in January 2016. This brand one of the oldest luxury cigarette offers a unique positioning as the only since 1879. In 2016, Sobranie grew volume by 7.0% to 2.9 billion cigarette global exclusively “additive-free” GLOBAL SALES premium cigarette. Present in ready- equivalent units. made cigarettes and fine cut, Natural 2.9BnU GLOBAL SALES American Spirit is available in 16 2.0BnU countries, following the launches in Greece and Ireland. Volume grew 6.7% to 2.0 billion cigarette equivalent units. Launched in 1964, Silk Cut established its premium credentials as one of the first low tar brands in the 1970s. In 2016, Silk Cut volume declined 7.4% to 2.5 billion cigarette equivalent units due to industry GLOBAL SALES volume contraction in Ireland and 2.5BnU the UK.

Other Tobacco Products Portfolio

Fine Cut E-Vapor In this category which encompasses roll-your-own and We continued to enhance our efforts to further develop JTI’s make-your-own products, JTI’s fine cut volume and share presence and portfolio in E-Vapor. The acquisition of Logic continued to grow. provided JTI with the opportunity to become a leading E-Vapor player in the world’s three largest markets in value, namely With an 8.1% increase, our fine cut volume growth has continued the USA, the UK and France. in 2016, driven by the strong performance of our GFB fine cut volume (+17.7%) and the acquisition of Natural American Spirit. Our E-Vapor portfolio encompasses all possible variants such as e-pens, closed tanks and open tanks with our own e-liquids. JTI’s fine cut market share was up in 11 of our 15 key markets for this category, essentially located in Europe. While the category is evolving rapidly from a product and regulatory standpoint, JTI holds a 12.4% share of value in the We will continue to enrich our fine cut product pipeline with USA and 12.3% in the UK market where we hold the number innovative product features to keep delivering solid results three position. JTI holds the number one E-Vapor company in this category. position in Ireland and is the number one closed tank proposition in France with Logic Pro.

We expanded further our presence in 2016, entering Austria, Shisha Germany, Italy and Korea. We will continue investing in this JTI entered the shisha tobacco business in 2013, and since then growing category to strengthen our portfolio and pursue we have continuously improved the quality of the products, in more geographical expansion. addition to rationalizing the portfolio, rejuvenating the offering and expanding our presence.

In 2016, we returned to volume growth reaching 19,000 tons (+3.8%), despite the continued geopolitical tensions in the Middle East, a key geography for shisha tobacco.

Japan Tobacco Inc. Annual Report 2016 027 Review of Operations continued Japanese Domestic Tobacco Business

FY2016: Results for the fiscal year ended December 31, 2016

Profit grew by quality top-line as well as cost optimization initiatives despite severe conditions. Chito Sasaki President, Japanese Tobacco Business

Our operating environment continues Looking forward, we will maintain our Sales Volume to be challenging, mainly due to the role as a highly competitive platform of ongoing industry contraction and an profitability for the Group by means of intensifying competition in Tobacco- quality top-line growth, the optimization 106.2 Vapor (T-Vapor) category. of investments in cigarette as well (BnU) as the increased emphasis on - However, we are committed to taking T-Vapor category. 2.8% various measures to secure our Year-On-Year Change leadership position and to achieve Performance Review quality top-line growth. In January (volume/financial) 2016, we acquired Natural American • Revenue and profit grew mainly Core Revenue Spirit (NAS) business outside the U.S. through Mevius price increase and have been pursuing the top-line and the acquisition of NAS. synergy. In April, we also took a price –– JT sales volume decreased 649.7 increase of Mevius without tax hike. 2.8% to 106.2 BnU mainly (JPY BN) Driven by these initiatives, we have due to the decline of cigarette + strived for strengthening our brand industry volume, partly offset 1.2% portfolio as well as growing revenue. by the addition of NAS. Year-On-Year Change –– Core revenue increased 1.2% Regarding Ploom TECH, through the to ¥649.7 billion, mainly because test marketing in Fukuoka city and our of the Mevius price increase. Adjusted Operating Profit online store, we have become more –– Adjusted operating profit grew confident in the superior features 2.4% to ¥260.2 billion driven by of the product, such as no smell of the pricing, the benefits from 260.2 tobacco smoke and good usability. initiatives to strengthen our (JPY BN) competitiveness and effective + cost management. 2.4% Year-On-Year Change

Sales Volume (BnU) Core Revenue (JPY BN) Adjusted Operating Profit (JPY BN)

-2.8% +1.2% +2.4%

109.2 106.2 642.2 649.7 254.1 260.2

FY2015 FY2016 FY2015 FY2016 FY2015 FY2016

028 Japan Tobacco Inc. Annual Report 2016 Operations & Analysis

Performance Review Going forward, we will keep Outlook (Market share) investing in our core brands to We continue to pursue the • Our total and Mevius cigarette further reinforce our brand equity. maximization of our top-line as well market shares were resilient in as the optimization of investment the context of severe competition. As a result of these investment in cigarette. However, revenue and –– In FY2016, JT market share initiatives, our market share profit are forecast to decrease in increased 1.2 percentage including Mevius remained solid. 2017, mainly due to cigarette industry points to 61.1%. volume contraction impacted by the Our strategies expansion of T-Vapor category. We respond to changes in the Share evolution of JT and MEVIUS (%) operating environment with an aim Despite this challenging to generate stable profit. Meanwhile, environment, the Japanese domestic we continue to invest in order to tobacco business is committed achieve sustainable profit growth. to fulfilling our role as a highly 60.1 62.4 59.8 60.7 61.4 competitive platform of profitability In terms of cigarette, we are striving in the mid- to long-term. Towards for maximizing our top-line through this goal, we will make necessary 32.0 33.2 29.8 31.1 31.5 market share gains with a particular investment in T-Vapor and core focus on our core brands. At the brands to further build our business same time, we will optimize our foundation which will underpin our Oct-Dec Jan-Mar Apr-Jun Jul-Sep Oct-Dec 2015 2016 2016 2016 2016 investment in cigarette. With these sustainable profit growth from 2018 efforts, we will secure and improve and beyond. JT profitability in this category. MEVIUS Regarding Ploom TECH, our priority is to complete the planned Amid the intensifying competition, production capacity enhancement, we continued to invest in sales which will lead to the expansion of promotion and brand equity its sales area. Also we will effectively enhancement with a focus on communicate with consumers to Mevius. Furthermore, with the improve awareness of this product addition of NAS, we can offer a and promote better understanding compelling brand portfolio to of its feature. consumers in each price segment.

Please be reminded that this section is intended to explain the business operations of JT to investors, but not to promote sales of tobacco products to encourage smoking by consumers.

Japan Tobacco Inc. Annual Report 2016 029 Please be reminded that this section is intended to explain the business operations of JT to investors, not to promote sales of tobacco products to encourage smoking by consumers.

Our core brands

PRESTIGE

Natural SHARE OF American Spirit SEGMENT* 52.5%

• The Natural American Spirit brand was born in the U.S. in 1982, and introduced to Japan in 1996. • JT Group has completed the acquisition of the Natural American Spirit business outside the United States in January 2016 and been expanding its markets such as Japan, Germany, Switzerland, Italy, Spain and the UK. • The Natural American Spirit brand vision is unchanged even after its phenomenal growth globally with the idea to provide the most premium, additive-free, all natural tobacco product. • The Natural American Spirit family comprises a line-up of 8 cigarette products as well as 3 Roll-your-own products.

PREMIUM

SHARE OF Seven Stars SEGMENT* 44.3%

• Launched in 1969, Seven Stars featured Japan’s first domestically produced charcoal filter in pursuit of better taste. • Since its launch, Seven Stars has consistently offered unique value in terms of taste, aroma, and product design. • Seven Stars Original soft package with 14mg tar had been the most sold product in the Japanese domestic market for 9 years until 2016. • The Seven Stars family comprises a line-up of 19 products.

SUB-PREMIUM+

SHARE OF MEVIUS SEGMENT* 99.6%

• Evolved in 2013 from Mild Seven, MEVIUS has commanded the No.1 share in the Japanese domestic market for more than 30 years. • Its regular products offer smooth taste as well as menthol products allow consumers to enjoy premium and high quality products with only 100% natural menthol. • The MEVIUS family comprises a line-up of 38 cigarette products as well as 3 capsule products for Ploom TECH, JT’s tobacco vapor product.

SUB-PREMIUM

SHARE OF Winston SEGMENT* 32.5%

• First introduced in 1954 in the United States, and today Winston is the second largest cigarette brand in the world. • In 2015, CABIN and CASTER were migrated into Winston in Japan. Winston has three types of taste, “Bitter”, “Straight” and “Sweet”, in both Regular and Menthol segment. • The Winston family comprises a line-up of 29 products.

* JT total. 2016 results. As of December 31, 2016

030 Japan Tobacco Inc. Annual Report 2016 Operations & Analysis

Please be reminded that this section is intended to explain the business operations of JT to investors, but not to promote sales of tobacco products to encourage smoking by consumers.

Ploom-TECH

Tobacco-vapor with a newly developed concept Ploom TECH offers clearer tobacco taste without ash or smell of tobacco smoke provided by unique technology with no combustion and no direct heating of tobacco. It makes a new way to enjoy tobacco that helps to avoid annoying those nearby. In addition, Ploom TECH is activated merely by inhaling, making it possible to enjoy the experience immediately and at any time, also easy to hold and carry.

Japan Tobacco Inc. Annual Report 2016 031 Review of Operations continued Pharmaceutical Business

FY2016: Results for the fiscal year ended December 31, 2016

We aim to build a unique, world-class pharmaceutical business driven by R&D and to increase our market presence through original and innovative drugs. Muneaki Fujimoto President, Pharmaceutical Division

We strive to strengthen the profit [Licensed compounds] Revenue base through R&D promotion • Elvitegravir (Anti-HIV) of “first-in-class” compounds –– E/C/F/TAF (single-tablet regimen and value maximization of “Genvoya”): Launched by Gilead 87.2 each product. Sciences, Inc. in the U.S. and EU (JPY BN) • Trametinib (Melanoma) + Strategy –– For use in combination with 11.6 • Promote R&D of “first-in-class” dabrafenib: Approved in Japan Year-On-Year Change (JPY BN) compounds and seek optimum and EU timing to out-license them • Maximize the value of each product Business results Adjusted Operating Profit (financial overview): Performance Overview • Revenue grew ¥11.6 billion driven [Development in Japan] by an increased royalty from our 9.7 • “Genvoya Combination Tablets”: license partners, mainly Genvoya. (JPY BN) a novel anti-HIV drug, Launched Milestone revenue associated with + by Torii Pharmaceutical (July 2016) the progress in drug development 12.0 • “Descovy Combination Tablets also supported the strong result. Year-On-Year Change (JPY BN) LT/HT“: novel anti-HIV drugs, • Adjusted operating profit Launched by Torii Pharmaceutical improved by ¥12.0 billion (January 2017) achieving a record high profit due to revenue increase.

Revenue (JPY BN) Adjusted Operating Profit (JPY BN)

+11.6 +12.0

9.7 75.6 87.2

-2.3

FY2015 FY2016 FY2015 FY2016

032 Japan Tobacco Inc. Annual Report 2016 Operations & Analysis

Value chain

R&D • Aiming at discovery of “first-in-class” Continue to strengthen R&D capability, a compounds, enhance pre-clinical research cornerstone of our pharmaceutical business capability and build development strategies By focusing our resources on specific tailored to accomplish the objective. therapeutics areas, we continue to • Translate innovation into medicines that are strengthen our R&D capability which both approvable and commercially viable. enables us to create innovative drugs. • Focus mainly on the fields of metabolic diseases; viral infection; and autoimmune/inflammatory diseases to best leverage our expertise. • Allocate adequate resources in R&D in light of time-consuming and costly development process.

Manufacturing • Remain focused on quality Ensure a reliable supply of quality products assurance and safely control. We are proud of ourselves with a • Maintain optimal sustainable supply chain that delivers high manufacturing arrangements. quality products to our patients. We also • Continuously strive to reduce pursue efficiency in our manufacturing environmental impacts, as arrangements; products marketed in evidenced by operation and Japan are mainly produced by Torii maintenance of the ISO 14001 Pharmaceutical to maximize intra-group certificate by our Sakura plant. synergies, while outsourcing to contract manufacturers where appropriate.

Sales & Promotion Torii Pharmaceutical is marketing our • Strengthen our marketing capabilities Build marketing competence on our MRs products in Japan through approximately by leveraging the marketing support In the pharmaceutical industry, medical 500 highly-trained MRs. Outside Japan, system, which integrates various representatives (MRs) play a crucial instead of directly marketing our products, clients’ information. role in successful sales and promotion we receive royalties based on sales • Build a sales and marketing strategy by providing medical and scientific performance from our license partners for to meet the existing and future knowledge with clients. At the same time, the compounds for which we out-license market needs in the changing they collect valuable information from the the right to develop and market. business environment. medical front which could be reflected • Provide extensive training programs in the ongoing or future R&D activities. to MRs and expand their knowledge to earn trust from our clients.

Japan Tobacco Inc. Annual Report 2016 033 Review of Operations continued Pharmaceutical Business

Japan Tobacco Inc. Clinical Development (as of February 6, 2017)

In-house development

Code Potential Indication/ (Generic name) Dosage form Mechanism Description Location Phase 1 Phase 2 Phase 3 Preparing to file Filed Origin JTZ-951 Anemia associated with HIF-PHD inhibitor Increases red blood cells by stimulating production of erythropoietin, chronic kidney disease/Oral an erythropoiesis-stimulating hormone, via inhibition of HIF-PHD. Japan In-house Overseas

JTE-052 Autoimmune/allergic JAK inhibitor Suppresses overactive immune response via inhibition of Janus kinase diseases /Oral, Topical (JAK) related to immune signal. Japan In-house; Co-development with Torii JTE-051 Autoimmune/allergic Interleukin-2 inducible Suppresses overactive immune response via inhibition of the signal diseases/Oral T cell kinase inhibitor to activate T cells related to immune response. Overseas In-house JTT-251 Type 2 diabetes PDHK inhibitor Decreases blood glucose by activation of pyruvate dehydrogenase mellitus/Oral (PDH) related to carbohydrate metabolism. Overseas In-house JTK-351 HIV infection/Oral HIV integrase inhibitor Suppresses blood HIV levels by inhibiting the activity of integrase, an enzyme involved in the replication of HIV. Japan In-house JTE-451 Autoimmune/allergic ROR antagonist Suppresses overactive immune response via inhibition of ROR diseases/Oral related to Th 17 activation. Overseas In-house JTT-751 Iron-deficiency Oral iron replacement Corrects iron-deficiency anemia by using absorbed Iron for In-license (Keryx Biopharmaceuticals); (ferric citrate) anemia/Oral synthesis of hemoglobin. Japan Co-development with Torii * additional indication

Clinical trial phase presented above is based on the first dose.

Licensed compounds

Compound (JT’s code) Licensee Mechanism Note trametinib Novartis MEK inhibitor Inhibits cellular growth by specifically inhibiting NSCLC, trametinib+dabrafenib the activity of MAPK/ERK Kinase (MEK1/2). U.S., EU, Japan marketing approvals submitted Anti-ICOS MedImmune ICOS antagonist Suppresses overactive immune response via monoclonal inhibition of ICOS which regulates activation antibody of T cells. JTE-052 LEO Pharma JAK inhibitor Suppresses overactive immune response via inhibition of Janus kinase (JAK) related to immune signal. JTZ-951 JW HIF-PHD inhibitor Increases red blood cells by stimulating Pharmaceutical production of erythropoietin, an erythropoiesis- stimulating hormone, via inhibition of HIF-PHD.

034 Japan Tobacco Inc. Annual Report 2016 Operations & Analysis

Japan Tobacco Inc. Clinical Development (as of February 6, 2017)

In-house development

Code Potential Indication/ (Generic name) Dosage form Mechanism Description Location Phase 1 Phase 2 Phase 3 Preparing to file Filed Origin JTZ-951 Anemia associated with HIF-PHD inhibitor Increases red blood cells by stimulating production of erythropoietin, chronic kidney disease/Oral an erythropoiesis-stimulating hormone, via inhibition of HIF-PHD. Japan In-house Overseas

JTE-052 Autoimmune/allergic JAK inhibitor Suppresses overactive immune response via inhibition of Janus kinase diseases /Oral, Topical (JAK) related to immune signal. Japan In-house; Co-development with Torii JTE-051 Autoimmune/allergic Interleukin-2 inducible Suppresses overactive immune response via inhibition of the signal diseases/Oral T cell kinase inhibitor to activate T cells related to immune response. Overseas In-house JTT-251 Type 2 diabetes PDHK inhibitor Decreases blood glucose by activation of pyruvate dehydrogenase mellitus/Oral (PDH) related to carbohydrate metabolism. Overseas In-house JTK-351 HIV infection/Oral HIV integrase inhibitor Suppresses blood HIV levels by inhibiting the activity of integrase, an enzyme involved in the replication of HIV. Japan In-house JTE-451 Autoimmune/allergic ROR antagonist Suppresses overactive immune response via inhibition of ROR diseases/Oral related to Th 17 activation. Overseas In-house JTT-751 Iron-deficiency Oral iron replacement Corrects iron-deficiency anemia by using absorbed Iron for In-license (Keryx Biopharmaceuticals); (ferric citrate) anemia/Oral synthesis of hemoglobin. Japan Co-development with Torii * additional indication

Clinical trial phase presented above is based on the first dose.

Japan Tobacco Inc. Annual Report 2016 035 Review of Operations continued Processed Food Business

FY2016: Results for the fiscal year ended December 31, 2016

If we are going to prepare food for those who matter to us most, we wish to do so cordially and with care. This is our desire when running our business at TableMark. Atsuhiro Kawamata President and CEO, TableMark

TableMark began its operation Performance Overview Revenue as a food manufacturer with The processed food business frozen and ambient processed is primarily engaged in business food, bakery items and seasoning concerning frozen and ambient 164.1 as our business pillars. In particular, processed food, mainly staple food (JPY BN) we strive to provide high value- products such as frozen noodles, - added products by focusing frozen rice and packed cooked rice, 1.8 on staple food such as frozen seasonings including yeast extracts Year-On-Year Change (JPY BN) noodles, frozen rice, packed and oyster sauce, and bakery chain cooked rice and frozen outlets in the Tokyo metropolitan area. baked bread. Adjusted Operating Profit Business results Strategy (financial performance): • Increase the attractiveness • Revenue decreased despite 5.0 of our offerings with a particular favorable sales of staple products, (JPY BN) emphasis on staple food offset by the decline of sales of * + products by meeting consumer other products. 2.3 needs with our own expertise. • Adjusted operating profit increased Year-On-Year Change (JPY BN) • Minimize negative impact of by 2.3 billion yen year-on-year as rising raw material costs and better product mix, cost reduction weak yen. efforts and the strong yen enhanced the profit margin.

* Staple food products: frozen noodles, frozen rice, packed cooked rice and frozen baked bread.

Revenue (JPY BN) Adjusted Operating Profit (JPY BN)

-1.8 +2.3

165.8 164.1 5.0 2.7

FY2015 FY2016 FY2015 FY2016

036 Japan Tobacco Inc. Annual Report 2016 Operations & Analysis

Value chain

R&D Procurement Strive to develop innovative products to meet Ensure procurement of safe and quality raw materials consumers’ needs • Review of quality assurance certificates • Leveraging our own know-how, we aim to submitted by our suppliers. develop value-added products to meet diversified • Inspections and monitoring of agrochemical consumers’ needs. residues and regular inspection at processing • Frozen baked bread products have been plants, in compliance with JT Group’s internal developed which allow consumers to enjoy the standards, the Food Sanitation Act and other taste of freshly baked bread at home. TableMark’s relevant laws. original techniques for fermentation, baking and • Examination of safety of production sites for freezing recreate and preserve the taste and raw materials sourced abroad. texture of fresh bread. • As for agricultural farms, inspections are • New process for making frozen udon noodles, made not only for soil and water but also in called “Tamnenjikomi Aya Jyukusei-ho” was terms of how products are cultivated and how developed. This process enables us to offer agrochemicals are handled. Breeding farms higher quality and value-added udon products. are also inspected.

Marketing Production Strive for effective marketing Prioritize safety and follow established to improve product awareness quality control procedures • We analyze the market from • JT Group is pursuing the adoption of the consumers’ point of view and, by HACCP system, ISO22000 and FSSC22000 in combining the technology owned our and business partners‘ factories. Under the by TableMark, we strive to provide ISO22000 and FSSC22000 standard, continuous products with new values to increase improvements are made following effective rules our presence in the market. We strive to control sanitation and other key issues. These for effective marketing in order to rules are based on the HACCP concept, and their improve consumer awareness of effectiveness is tested using scientific evidence. our products. • All of JT Group’s 31 factories in and outside Japan have achieved the ISO22000 or FSSC22000 certification.

Sales & Distribution Food Safety Control Increase penetration to retail outlets Ensure safety control at all levels of the value chain • Strive to enhance profitability through • Independent food safety management division is our initiatives to increase our presence responsible for overall safety control, ensuring that in supermarkets and convenience stores, consumers can continue to enjoy our products safely. by offering a wider range of products • External food safety experts provide assessment and while also seeking better shelf space. advice regarding our initiatives – their knowledge and • TableMark products are also sold to viewpoints are actively incorporated into our business. restaurants and other public facilities.

Japan Tobacco Inc. Annual Report 2016 037 Risk Factors

The JT Group operates Disruptive Pressure from diverse businesses, namely tax increases illicit trade tobacco, pharmaceutical, 1 2 and processed food. In Tobacco products are subject to excise Illicit trade is a major concern not only addition, we conduct our or similar taxes in addition to value- for the tobacco industry, but for wider business on a global basis, added tax. Excise taxes are increasing society. For the tobacco industry, it in most markets where we operate undermines legitimate tobacco business. extending to Europe, CIS as governments seek to secure their For society, illicit trade reduces excise countries, Africa, the Middle revenue or promote public health. revenue for the government, often fuels In general, value-added tax is also organized crime, and may increase health East and others. Due to this increasing. As a general principle, concerns due to poor manufacturing diversity and these changing we fully pass on any tax increase standards and improper product handling. to consumers by adjusting our sales The tobacco industry has been fighting environments, we are prices. In addition, to the extent against illicit trade, which takes the exposed to various risks. possible, we increase our prices more forms of contraband, counterfeit than the tax increase, considering and illicit whites. the financial impact of an expected volume decline. A tax increase within Illegally traded products in a market a reasonable range is manageable tend to increase after a steep tax through such a price increase as well increase. Regulatory actions seeking as our efforts to support top-line and to commoditize packages and products Considering such circumstances, we pursue efficiency. Most governments could also trigger the acceleration of illicit have put in place a risk management are aware that a substantial tax trade because such commoditization framework. Under the framework, increase or repeated tax increases could make counterfeit manufacturing relevant divisions are assigned to can reduce their revenue and they easier and detection of illicit products carefully monitor the development take a rational approach. However, more difficult. We take a zero tolerance of events that may adversely impact in the past we have experienced tax approach towards all these criminal the JT Group and prevent their increases in some markets that have activities with an emphasis on materialization where possible. disrupted our business. eliminating contraband products. Risk description and potential impact When risks materialize, we promptly Risk description and potential impact A disruptive tax increase on tobacco An increase in illicit trade could reduce respond in order to minimize their products could result in a large legitimate industry volume, leading to a unfavourable impacts. In reviewing industry volume decline due to lower decline in our shipment volume, revenue risks, the magnitude of potential consumption and, in many cases, and profit. In addition, the industry bears impact and likelihood of occurrence increased illicit trade. In addition, the cost to combat illicit trade, resulting are most prudently assessed among down-trading to lower priced products in pressure on its earnings. Furthermore, other factors. Material risks, which could be initiated or accelerated. it is possible that low quality counterfeits could have a significant impact on our Our shipment volume, revenue and and improperly handled smuggled sustainable profit growth and business profit could decrease due to these products damage the credibility of continuity, are reported to the negative reactions by consumers. genuine brands, as well as the reputation of their owners. CEO together with the request Measures to address the risk for approval to implement • Promote the understanding Measures to address the risk countermeasures against them. of relevant authorities that a • Engage with governments, regulatory disruptive tax increase does not bodies and law enforcement agencies The following section describes certain necessarily serve their purpose. to eradicate illicit trade. risks which potentially have a material • Optimize our product offerings • Ensure we buy from and sell to only impact on our business operations and to capture the potential changes reputable business partners following financial results, but is not intended in consumer preference. our rigorous compliance initiatives. to be an exhaustive list of the risks we • Enhance our geographical portfolio • Raise awareness among individual face. In addition, it is possible that risks to limit the negative impact of consumers of the negative a disruptive tax increase in a consequences of purchasing that are currently considered immaterial specific market. illegally traded products. or even unknown could turn out to be • Further improve efficiency to material in the future, as the business protect revenue and earnings. environment changes. • If a disruptive tax increase takes place, find an optimal price for This section should be read each product which minimizes together with the forward looking the unfavorable influence in and cautionary statements the market. contained in this annual report.

038 Japan Tobacco Inc. Annual Report 2016 Operations & Analysis

Tightening tobacco Country 3 regulations 4 risks

Working together with authorities: The tobacco industry is highly regulated Our tobacco business has consistently In 2007, JT International Holding in various aspects, and regulations could expanded our earnings base to secure B.V. and JT International S.A., influence our business performance and long-term growth by making acquisitions, JT Group subsidiaries, entered financial results. Among the regulations entering new markets and increasing a cooperation agreement with on products, for example, we may incur share in markets where we had limited the European Commission, the additional costs in order to comply with presence. Geographical expansion may executive branch of the European ingredients and packaging requirements. increase our exposure to country risks. Union (EU), and 26 EU Member In any market where we operate, we States as part of efforts to combat Furthermore, the regulatory attempt to may face economic, political or social illicit trade. In 2009, the United commoditize tobacco products could lead turmoil which may negatively affect Kingdom joined the agreement. to an increase in illicit trade and negatively our operations and financial results. influence our legitimate business. Under the terms of the agreement, Risk description and potential impact the JT Group contributed US$50 Business activities of tobacco companies Political instability, economic downturn, million annually in the first five are also restricted. With more prohibitive social unrest or other unfavorable years from its execution and regulations on communication with developments in a certain market could contributes US$15 million annually consumers, our ability to effectively disrupt our business, leading to lower in the subsequent ten years. This market products becomes further volume, revenue and profit in the market. financial contribution is to be used limited, and our top-line performance to support anti-smuggling and may be adversely impacted. Measures to address the risk anti-counterfeiting initiatives led • Avoid overdependence on a small by the EU or EU Member States. As a responsible organization, the number of markets as sources JT Group abides by applicable laws of profits by expanding the pool In 2010, JTI-Macdonald Corp., a JT and regulations wherever we operate. of highly profitable markets. Group Canadian subsidiary, also That said, we believe that laws and signed a similar agreement with regulations should differ country by the Government and Provinces country, reflecting legal, social and of Canada. cultural background. We endeavor to hold constructive dialogues with governments and regulators for a reasonable and balanced approach towards tobacco regulation.

Risk description and potential impact Further tightening of tobacco regulations on marketing activities could undermine our strategy for top-line growth as we lose opportunities to enhance brand equity. Moreover, certain regulations may impose on us additional compliance costs. These may negatively influence our volume, revenue and profit.

Measures to address the risk • Identify ongoing regulatory initiatives as early as possible by promptly collecting accurate information. • Endeavor to hold constructive dialogues with governments and regulators for reasonable and balanced regulations that meet their objectives.

For further details, please refer to ‘Regulation and Other Relevant Laws’ contained in this annual report.

Japan Tobacco Inc. Annual Report 2016 039 Risk Factors continued

Instability in the Unfavorable Natural 5 procurement of 6 developments 7 disasters key materials in litigation

Across its businesses, the JT Group JT and some of its subsidiaries are Our operations may be disturbed by natural procures raw and processed materials defendants in lawsuits filed by plaintiffs disasters such as earthquakes, typhoons, for product manufacturing. seeking damages for harm allegedly caused floods, volcano eruptions and others. by smoking. As of December 31, 2016, Japan is one of the most important markets In particular, we strive to procure key 20 smoking and health-related cases were for the JT Group’s businesses and subject materials in the required quantity and pending in which one or more members of in particular to various natural disasters. at reasonable costs. Our key materials the JT Group were named as defendant or The Great East Japan Earthquake was include agricultural products: most for which JT may have certain indemnity devastating. The impacts on the JT Group notably, tobacco leaf for the tobacco obligations pursuant to the agreement included casualties among our employees, business, and grains for the processed for JT’s acquisition of RJR Nabisco Inc.’s physical damage to our factories, and food business. Availability of agricultural overseas (non-U.S.) tobacco operations. supply shortages of certain tobacco products is often affected by natural JT and its subsidiaries, who are defendants product materials. Our tobacco business phenomena, such as weather conditions. in such lawsuits, believe that we have was forced to temporarily suspend product In addition, there is a growing concern valid grounds to defend the claims in such shipment and limit shipment volume for that agricultural production costs may lawsuits; however, we cannot predict the an extended period. increase, due to the high demand in outcome of any pending or future litigation. energy resources, global population We have developed a Business Continuity increases, and economic growth in Risk description and potential impact Plan to minimize the impact of such emerging countries. A decision unfavorable to us disasters, with a particular emphasis on could materially affect our financial the optimization of the global supply chain. Risk description and potential impact performance due to the payment of Insufficient supply of key materials monetary compensation. Critical media Risk description and potential impact could lead to inability to manufacture coverage of such lawsuits may reduce Natural disasters could cause damage our products, subsequently resulting social tolerance of and strengthen to the JT Group as well as our suppliers, in the loss of revenue and profit. regulations on smoking. Such media trade partners and consumers, leading to Furthermore, the increase in coverage may also prompt the filing disruption of our business and negatively procurement costs driven by higher of a number of similar lawsuits against impacting financial results. production costs for agricultural JT or its subsidiaries, resulting in products would directly pressure increased litigation costs. Measures to address the risk our earnings. • Continuously review the Business Measures to address the risk Continuity Plan and revise it Measures to address the risk • Continue to build well-organized as necessary. • Reinforce ability to procure key teams coordinating with external • Carry out emergency drills to materials by building a strong legal counsel to defend ourselves increase employees’ preparedness relationship with suppliers. In against these lawsuits. against disasters. the case of tobacco leaf, further • Continue legitimate and appropriate • Insure key assets such as buildings, promote internal sourcing. business operations. For further machinery, equipment and inventory • Promote efficient use of materials details, see section regarding to recover financial losses as by continuously reviewing the ‘Litigation’. appropriate. manufacturing process and product specifications where possible.

040 Japan Tobacco Inc. Annual Report 2016 Operations & Analysis

Currency 8 fluctuations 9 Competition

As the JT Group operates globally, Furthermore, if we liquidate or sell a The JT Group competes fiercely in we are exposed to the risks associated group subsidiary which we acquired both domestic and international tobacco with currency fluctuations. The reporting in a currency other than Japanese yen business with our competitors. currency of the JT Group consolidated or impair a substantial value of such financial statements is Japanese Yen, a subsidiary, the gain or loss from the In the Japanese domestic tobacco while the financial statements of our transaction includes the currency market, import of tobacco products international subsidiaries are reported in fluctuation impact. Specifically, the was deregulated in 1985, followed by the other currencies such as Russian ruble, impact comes from the difference provisional suspension of custom duties Euro, British pound, Taiwanese dollar, in the exchange rates of the relevant on imported tobacco in 1987. Since then, U.S. dollar, and Swiss franc. currency against Japanese yen at the competition has intensified each year, time of the acquisition and at the time as smokers’ preferences diversify and Therefore, exchange rate fluctuations of of such transaction. as our competitors pursue aggressive these currencies against Japanese Yen promotional activities. influence the Group’s reported financial Risk description and potential impact results. As for the financial reporting of Fluctuations of exchange rates against In the overseas tobacco markets, the JT the international tobacco business, JT Japanese yen affect the JT Group’s reported Group expanded its business organically International Holding B.V. consolidates financial results. Reported financial results as well as through M&A, by acquiring the the financial results of the international of our international tobacco business in non-U.S. tobacco operations of RJR Nabisco tobacco subsidiaries and reports its U.S. dollars are similarly influenced by the Inc. and thereafter acquiring Gallaher Ltd. consolidated financial statements in fluctuations of exchange rates against the As a result, we are in competition with global U.S. dollars. We often communicate the U.S. dollar. In addition, we are exposed to players in the international tobacco business financial performance of our international the exchange rate fluctuation risks when or with local competitors with strength in tobacco business in U.S. dollars, which a group company makes a transaction in specific markets. is affected by exchange rate fluctuations a currency other than its reporting currency. against the U.S. dollar. In principle, we Market share can fluctuate due to a number do not hedge these risks which arise from Measures to address the risk of factors, including increasing regulations, the translation of financial statements. • Mitigate the risk through hedging increases in health awareness, changes activities such as derivative contracts, in smokers’ preferences or changes to However, we hedge against risks which possession of interest bearing debts economic conditions of each market. It arise when equity denominated in each in a foreign currency etc. can also fluctuate from competitors’ pricing functional currency of the JT Group strategies or strength of brand equity. is translated into Japanese yen to be Moreover, market share can fluctuate in the consolidated by using foreign currency- short-term due to new product launches by denominated interest-bearing debts each market player and the accompanying and part of these are designated as promotional activities. net investment hedges. In addition, many companies make transactions Risk description and potential impact in currencies other than their reporting Fluctuation of our market share may currencies for day-to-day operations. affect the JT Group business performance. Such transactions also involve the risk of In addition, price competition (price exchange rate fluctuations. We mitigate reductions or brand repositioning, among these transaction risks through hedging others) aimed at increasing market share, activities; however, it is not possible to may negatively affect our profit margins. completely eliminate them. Measures to address the risk • Optimize our product portfolio by: -- developing and providing products that can capture changing consumer preferences and needs -- placing brands with strong brand equity in each price category • Provide product support by enhancing trade marketing capability and effective promotional initiatives. • Further improve efficiency to protect revenue and earnings. • Avoid overdependence on a small number of markets as sources of profits by expanding the pool of highly profitable markets.

Japan Tobacco Inc. Annual Report 2016 041 JT Group and Sustainability

Our approach to sustainability is underpinned by our management principles known as the “4S” model. We strive to fulfill our responsibilities to our valued consumers, shareholders, employees and the wider society, carefully considering the respective interests of these four key stakeholder groups, and exceeding their expectations wherever we can. We believe that pursuing this model enhances corporate value and helps us to meet and exceed stakeholders’ interest in the most balanced way possible.

Summarized below are material issues for the JT Group. If you wish to learn Contents more about our approach and commitment to sustainability or specific programs, ‘JT Group Sustainability Report FY2015’ is currently available on JT Group website. The FY2016 report will be available on our website Our strategic approach in June 2017. This report will be compiled in accordance with the Global Reporting Initiative (GRI) G4 Sustainability Reporting Guidelines ‘Core’ level.

Our way of doing business JT Group Materiality Assessment We carried out our first materiality assessment covering the entire JT Group, which allowed us to arrive at a final list of 22 material issues ranked by level Our people of importance to the JT Group and our external stakeholders in 2015 – see matrix below. In 2016, we carried out various initiatives in our business and supply chain, taking each materiality into consideration. Our planet

Our contributions to society JT Group materiality matrix

Our tobacco business Corporate Laws and governance and regulations transparency s r h Product safety Supply chain Our pharmaceutical business g and product management ld e H i responsibility o h

e Product innovation Respecting

k and intellectual human rights a

Our processed food business t property l s a n r e In focus: t x -- Respecting human rights Environmental Information Responsible Litigation impacts of security marketing -- Illegal trade o e products e t

c Anti- Being a Anti-bribery Illegal trade

n competitive responsible and corruption a m

t behaviour employer u r i o d Workplace Collaborations Employee Equality and e p health and and development and diversity in M m

I safety partnerships talent management the workplace

Environment Contributions Political and to society regulatory Tax practices decision-making processes

Medium High JT Group Sustainability Report and GRI G4 index: Importance to the JT Group www.jt.com/csr/report/ index.html Value chain boundaries Supply chain Our Company Our customers and consumers

042 Japan Tobacco Inc. Annual Report 2016 Operations & Analysis

Respecting human rights Through ARISE, we work with communities to improve In 2016 we launched the JT Group Human Rights their understanding of the long-term value of education, Policy that aligns with the UN Guiding Principles on and the future prospects that it can bring. ARISE also Business and Human Rights. The Policy was developed works to replace lost income through Family Support in consultation with stakeholders, and it formalizes and Scholarships, which can enable parents or guardians details our commitment to respect human rights within to send their children to school. our operations and in our value chain. From 2017 onward, we will carry out research on potential human rights risks Supply chain management related to our stakeholders. The results of this work will In 2016 our international tobacco business made guide the development of our human rights due diligence significant progress on developing an IT-based process, which includes the identification, management, supplier life cycle management system that will enable monitoring, and reporting of key issues. assessment of Tier 1 suppliers against our standards, including on key compliance, environmental and social Child labor prevention risks. The system will be implemented in 2017 alongside Our ARISE program launched in 2012 aims to address our Agricultural Labor Practices program for directly roots causes of child labor in tobacco growing. The contracted tobacco farmers and merchants. program, which covers Brazil, Malawi, Zambia and Tanzania, tackles social and economic factors that Agricultural Labor Practices (ALP) tempt farmers to employ children. Our ALP defines minimum requirements for farmers we source tobacco on preventing and eliminating child This program aims to ensure that children are not part labor, respecting workers’ rights, and applying health of the workforce by providing education and engaging and safety measures at the workplace. From 2016 we with tobacco farming communities in various ways. started to extend the scope of ALP to cover third party This ranges from providing educational materials, tobacco leaf suppliers, and our objective is to implement after-school tutoring, and mentoring, to vocational ALP throughout our supply chain by 2019. training for older children in farming schools.

Japan Tobacco Inc. Annual Report 2016 043 From tobacco leaves to consumers

The supply chain of our international tobacco business, growers and countless supply partners around the JTI, ensures that the necessary quality products are world, we have been adapting our procurement models produced and delivered to all markets at the right and supplier life cycle management system over the time and at the optimal cost. This is a large and diverse past few years to ensure a most responsible and process flowing from farmer to consumer, and including sustainable approach. a wide range of procurement, manufacturing and distribution activities. This is particularly the case for tobacco leaf procurement. While we are committed to securing the long-term When it comes to procuring quality tobacco leaf as well as supply of quality leaf at the best cost, we strongly believe non-tobacco materials and services, we continue to put in creating shared value – for both the JT Group and the sustainability first. Working with more than 38,000 tobacco tobacco farming communities in which we operate.

PROCURE MAKE & PACK NON TOBACCO FINISHED GOODS MATERIALS IN FROM 25 380+ FACTORIES DIRECT SUPPLIERS

INPUT FROM DISTRIBUTION 120+ & SALE IN MARKET 120+ PLANS COUNTRIES

PROCURE THRESH & PROCESS TOBACCO LEAF PROCESS LEAF NON FINISHED FROM IN TOBACCO 38,000 5* IN VERTICALLY INTEGRATED THRESHING 2 FARMERS & FACTORIES FACTORIES 35 INDEPENDENT MERCHANTS

044 Japan Tobacco Inc. Annual Report 2016 Special Feature

To JTI, this means much more than securing fair returns In the area of processing and manufacturing, our to growers. It means taking effective action on issues international tobacco business continues to optimize including child labor, deforestation, or the reduction of its global footprint and focus on delivering continuous environmental impacts of tobacco farming across the improvement and excellence in execution throughout entire leaf supply chain. In order to be successful in these all manufacturing activities. With a current portfolio of areas, we seek to build stable, long-term and mutually 5 leaf processing facilities and 25 finished goods factories, beneficial relationships with our leaf merchants, growers we are well placed to overcome the increasing regulatory as well as their communities. challenges and remain a most competitive industry player.

PROCURE MAKE & PACK NON TOBACCO FINISHED GOODS MATERIALS IN FROM 25 380+ FACTORIES DIRECT SUPPLIERS

INPUT FROM DISTRIBUTION 120+ & SALE IN MARKET 120+ PLANS COUNTRIES

PROCURE THRESH & PROCESS TOBACCO LEAF PROCESS LEAF NON FINISHED FROM IN TOBACCO 38,000 5* IN VERTICALLY INTEGRATED THRESHING 2 FARMERS & FACTORIES FACTORIES 35 INDEPENDENT MERCHANTS

* Two of these threshing facilities are integrated in our finished goods factories.

Japan Tobacco Inc. Annual Report 2016 045