Explainer: How is Japan's government connected with Russia's biggest cigarette maker?

© Reuters. FILE PHOTO: A smoker picks a Japan Tobacco (JT) Inc.'s Mevius Lights cigarette in Tokyo, Japan May 12, 2017. REUTERS/Issei Kato

By Rocky Swift

TOKYO (Reuters) - Japan's government has severed banking and trade ties with Russia over Moscow's invasion of Ukraine, but a tobacco company in which it owns a one-third stake is still operating there and churning out Winston and Camel brand cigarettes. The government's inaction on Japan Tobacco (OTC:JAPAF) Inc's puts the administration in an awkward position as it steps up sanctions.

Here's what's at stake:

WHY IS RUSSIA SO IMPORTANT TO JAPAN TOBACCO?

Japan's population is shrinking, and domestic smoking rates are declining, making revenue overseas increasingly important for Japan Tobacco (JT).

Russia, the world's fourth-biggest tobacco market, is JT's biggest overseas market, generating an estimated 12% of group revenue and 20% of operating profit. JT has the largest market share in Russia at almost 40%, with 4,000 employees in four factories, producing brands including Winston, Camel, and Mevius, formerly known as Mild Seven.

HOW HAS JT REACTED TO RUSSIA'S INVASION OF UKRAINE?

JT said soon after the invasion that it had halted production at its factory in the central Ukrainian city of Kremenchuk, saying at the time that its 900 employees were safe.

Last month, the company said its Russian subsidiary would suspend investment, marketing, and the launch of a heated tobacco product. But it said manufacturing would continue, although those activities could be suspended amid "unprecedented" challenges.

Other Japanese companies are taking a "wait-and-see" approach as well. Trading houses Mitsui & Co and Mitsubishi Corp are holding on to stakes in a liquefied natural gas (LNG) project in Russia, from which Shell (LON:RDSa) Plc has announced plans to exit.

WHY IS THIS A POLITICAL HOT POTATO FOR THE GOVERNMENT?

Japan has joined with Group of Seven economies in a steady escalation of sanctions to try to pressure Russia to end hostilities.

But its stance has come in for criticism; on the one hand it says it stands by Ukraine, but on the other hand it controls a major company doing business in Russia and reaps a large portion of the profits of that enterprise.

JT is one of Russia's biggest individual tax payers, accounting for 1.4% of the nation's total budget revenue in 2020, the company's website says.

WHAT DOES IT MEAN FOR INVESTORS?

JT's shares have sunk more than 5% since Russia's invasion, which Moscow calls a special military operation, as business prospects in the region darken. The benchmark Nikkei index has gained 5%.

The company's shares have lagged the broader market's performance for the last five years, but remain popular among investors for their ample dividends. JT pays out about 75% of profits compared to an average 30% among other Japanese companies. That provides about 100 billion yen ($815 million) to the Japanese government each year, based on Reuters estimates over the past three years.

WHAT NEXT?

JT is the third-biggest tobacco seller in the world and some analysts believe it will have to exit Russia eventually as other major brands pull out. Rivals British American Tobacco (NYSE:BTI), Philip Morris International Inc (NYSE:PM) and Imperial Brands (OTC:IMBBY) have announced their intention to exit the country.

Such a decision doesn't come without risk though. The company could face huge losses if Russia decides to seize its assets, so a less risky option would be to sell its assets to a Russian partner.

Even if JT stays on, trade sanctions could interrupt its business, especially if it isn't able to import tobacco leaves.

WHY IS JAPAN IN THE TOBACCO BUSINESS IN THE FIRST PLACE?

JT is a legacy company from Japan's history of government-controlled monopolies in tobacco and salt. The company operates a museum in Tokyo dedicated to the history of those commodities in Japan.

JT in its current form was founded in 1985, and while the government has reduced its stake over time, the Ministry of Finance is mandated to hold at least one-third of its shares in a business that the government sees as important for fiscal revenues and the wider economy.