How A Handful of Multinationals Came to Dominate the Global Tobacco Industry (Part I)

Source from:  Tobacco Reporter  10/30/2013

The tobacco industry has changed dramatically over the past 20 years. A market once occupied by dozens of cigarette manufacturers is now dominated by four major private corporations: Philip Morris International (PMI), British American Tobacco (BAT), Japan Tobacco (JT) and Imperial Tobacco (ITG). In this article, Tobacco Reporter  reviews two decades of mergers and acquisi-tions, and speculates about the future. Has consolidation run its course, or is there room for more?

The roaring 1990sThe 1990s were a tough time for many tobacco manufac-turers. The decade saw multimillion-dollar trial verdicts in favor of smokers in the United States, while government regulations began to strangle the industry throughout the Western world. However, from a global perspective, demand for tobacco products remained strong, and Asia still offered plenty of tobacco consumers.

While tobacco manufacturers had occasionally been buy-ing other companies to achieve synergies and benefits of scale, consolidation kicked off in earnest with the collapse of com-munism in Eastern Europe. As the Iron Curtain opened in the early 1990s, the multinationals suddenly gained access to hundreds of millions of additional consumers.

Darryl Jayson, vice president of the Tobacco Merchants Association (TMA), says the most impactful merger of the decade was the first one: PMI's acquisition of the Vereinigte Cigarettenfabrik factory in Dresden, East Germany, in May 1990, a few months before the German reunification.

"This began a five-year-long 'shopping spree' by the multi-nationals at the time (BAT, PMI, R.J. Reynolds International), whereby key production facilities in Poland, Hungary, Russia, the Czech Republic and Kazakhstan were bought," says Jayson. "Combined with a tremendous outflow of cigarettes from the U.S., this fertile period laid the groundwork for creating the truly 'multinational' cigarette makers around the world. Only a few other sectors (such as beverages) were able to mimic the scope achieved by the multinational cigarette makers."

In 1992, PMI acquired the Eger Tobacco Factory in Hungary and acquired a majority holding in state-owned Czech Republic Tabak for $420 million. Later that year, R.J. Reynolds International acquired Russia's AS Petro. Then, in 1994, BAT acquired the American Tobacco Co., and R.J. Reynolds International extended its holdings in the former Soviet Union with the purchase of Yelets. SEITA, the French tobacco monopoly, was privatized in 1995.

Simon Evans, group press officer of ITG, says another major move came in 1996, when, after 10 years as part of Hanson, Imperial regained its corporate independence and ITG was listed on the London Stock Exchange as a FTSE 100 company.

"Between 1997 and 2008, around £17 billion was spent on acquisitions, transforming [Imperial Tobacco], which, at that time, had only a very small presence outside the U.K., into the world's fourth-largest international tobacco manufac-turer," says Evans. ITG went on to acquire Rizla, the world's  No. 1 manufacturer of rolling papers, in 1997, and Van Nelle, a Dutch manufacturer of roll-your-own tobaccos, in 1998, for £185 million and £650 million, respectively.

In 1998, BAT Industries divested its financial services busi-nesses and became British American Tobacco, a separately quoted company on the London Stock Exchange. Then, in 1999, BAT, the world's second-largest tobacco company, merged with Rothmans International, the fourth-largest. This allowed BAT to add several major brands to its portfolio, including the vastly popular Dunhill.

The decade ended just like it began: with a bang. Having witnessed multinationals moving into new markets, a hither-to domestic player, JT, decided to jump onto the world stage. JT purchased R.J. Reynolds International in 1999 for a stag-gering $8 billion and established JTI, allowing the Japanese firm to enter the international cigarette market.

The 21st century

By 2001, a little more than 50 percent of global tobacco sales were controlled by the multinationals. The new century witnessed further market consolidations that translated into an even greater dominance by the leading companies. This decade also saw China's 2001 entry into the World Trade Organization, whetting the appetites of Western firms. China is the world's largest cigarette market but has remained frus-tratingly off-limits to foreign manufacturers. Thus far, mul-tinationals' hopes for a sales boost similar to that following the opening of the Soviet bloc have not materialized in China.

Some have suggested that, for the Chinese government, join-ing the WTO was more about creating overseas opportunities for its domestic firms than allowing foreigners to sell their products in China.

While China's WTO membership didn't boost the multi-nationals' mergers and acquisitions in that country, consolida-tion in the West continued rapidly. The first big acquisition of the new century was that of Reemtsma Cigarettenfabriken, in 2002, by ITG. Imperial paid £3.2 billion for the German firm. "This acquisition marked a strategic evolution of Imperial's business and reinforced its commitment to become a global tobacco company," says Erik Bloomquist, senior analyst, Berenberg Bank. "The transformational Reemtsma deal gave us an expanded footprint in Central and Eastern Europe, as well as the Davidoff and West cigarette brands," says Evans.

In 2004, R.J. Reynolds Tobacco Co. joined forces with Brown & Williamson (BAT's U.S. operations) to create Reynolds American—a stronger, more sustainable business in which BAT retains a 42 percent share.

Then, in 2007, JTI—barely eight years old at the time—asserted itself on the world market by acquiring all out-standing shares of the Gallaher Group. The move propelled the company to the No. 1 spot in Russia and the No. 2 spot in the U.K. Antonina Marinova, vice president of business development at JTI, says the Gallaher acquisition transformed the group's business considerably, increas-ing its scale and enhancing its presence in key markets. Gallaher also brought to JTI new product categories, such as Virginia-blend tobacco products.

And JTI didn't stop there. In 2009, the company began its acquisition of tobacco leaf operations in Africa, Brazil and the United States, following the path of BAT in vertical integra-tion (Philip Morris followed suit with acquisitions of farmer contracts from leaf merchants). JTI's leaf tobacco production business became known as Global Leaf. "This ensures JTI can secure a reliable source and supply of quality tobacco to meet our long-term business needs," says Marinova. "It also means that we have end-to-end control over the supply chain."

And as the new century went on, the Big Four continued to make strides. Imperial's acquisition of Commonwealth Brands (£974 million in 2007) gave it a presence in the U.S. market, and its Altadis acquisition (£11 billion in 2008) added Gauloises, Gitanes, Fortuna and the Habanos cigar brands to its portfo-lio. Prior to becoming an acquisition target itself, Altadis had bought a 50 percent stake in the Cuban tobacco monopoly.

"This acquisition-led strategy transformed Imperial into the most total tobacco company in the world—our targeted invest-ments enabling us to develop the most comprehensive and bal-anced brand and product portfolio in the industry," says Evans.

In December 2011, JTI entered into a long-term strategic cooperation agreement with San Francisco, California, USA-based Ploom to market and sell new-generation alternative tobacco products of the same name outside of the U.S. The same year, it purchased Haggar Cigarette & Tobacco Factory, with operations in Sudan and South Sudan.

Shortly after, JTI purchased Gryson of Belgium, thereby increasing its presence in the European RYO markets. In 2013, it purchased Al Nahkla, a leading Egyptian water pipe tobacco company, adding yet another new product category to its portfolio.

The future

Although the world tobacco market is now highly concen-trated, there are still possibilities for expansion. The govern-ment of Japan recentlyannounced the selloff of a portion of its 50 percent stake in JT. BAT and PMI have shown interest in Egypt, where the market is currently controlled by Eastern Tobacco. Euromonitor International recently called Egypt the top growth tobacco market by volume over the next 40 years and forecasts it will become the fifth-largest tobacco market in the world. Much will depend on the Egyptian government, which owns 66 percent of Eastern and has thus far been reluc-tant to part with a firm that generates substantial tax income and jobs—an important consideration in a country plagued by widespread poverty and unemployment.

While China has remained largely closed to foreign cigarette manufacturers, considerable consolidation has occurred among its domestic tobacco companies, as Beijing seeks to create an industry comprised of fewer but stronger enterprises. The number of cigarette factories in China has declined from more than 100 at the start of the century to perhaps 30 today. In a twist seldom mentioned, Bloomquist hints at another intriguing possibility that would turn the conventional world-view upside down: What if the China National Tobacco Corp.

How the Big Four stack up

The global tobacco market produces around 5.5 trillion cigarettes a year, according to Companies & Markets, a global aggregator of business infor-mation. The biggest single market is China, where the industry is state-owned, with some 350 millionsmokers who account for more than 40 percent of the global total.

Damaged by economic uncertainty and growth of the illicit trade in key markets, the tobacco industry suffered a down year in 2012, with volume growth in cigarettes maintained only by the huge Chinese market, while value growth was down significantly on previous years. Several markets saw value decline in 2012—a first indication that industry pricing power may be weakening.

Philip Morris International is the largest of the multinational tobacco companies, with a 15.7 percent share of the global market. It owns the most popular and valuable tobacco brand in the world, Marlboro, which was worth $67 billion in 2010 and held a 7.3 percent total share of all the tobacco brands sold globally in 2012, according to the Tobacco Merchants Association (TMA). The almost universal consum-er name recognition of global brands can act as a potential shield against advertising restrictions. The establish-ment of licensing　agreements and joint ventures with local tobacco industries has extended PMI's market reach. One of the most important of these agree-ments is Philip Morris International's partnership with the China National Tobacco Corp., under which it manu-factures limited quantities of cigarettes in China.

British American Tobacco ranks as the second-largest multinational tobacco company, with 12.1 per-cent of the global market in 2011. Although British American Tobacco has around 300 brands in its portfo-lio, it regards Dunhill, Kent, Lucky Strike and Pall Mall as its most impor-tant global drive brands. Currently, British American Tobacco has a  higher proportion of its business in developing countries than Philip Morris　International.

Japan Tobacco  grew from a largely domestic company to an interna-tional one through the acquisition of other companies and brands. JTI held a 9.1 percent share of the glob-al market in 2011, according to the TMA. The international business has a strong portfolio of brands led by Winston (the second-largest interna-tional brand in the world and fastest- growing over the past decade), and Camel (sold in more than 100 countries). Mild Seven—recently rebranded as Mevius—is the top- selling premium charcoal-filtered brand in the world.

Imperial Tobacco Group is the smallest of the four international tobacco companies, with a 5.9 per-cent global market share. Among the multinationals, it is the most con-centrated in a few markets. ITG has expanded significantly since the mid-1990s through brand acquisitions as well as market share increases. Since its acquisition of Reemtsma in 2003, ITG has become the second-largest tobacco company in Germany and the fourth-largest international tobacco company in the world, manufactur-ing and distributing cigarettes, loose tobaccos, cigars and smoking-related paraphernalia such as cigarette papers, filters and tubes.  —T.S.D.(CNTC) decides it wants a larger share of the global market? "We think the CNTC could relatively easily buy PMI or BAT due to its very high cash generation," says Bloomquist.

Bloomquist also believes JTI is interested in one of the Indonesian companies—most likely Gudang Garam—because it would fill a hole in its Asia-Pacific business. "We think it could materially contribute to JTI's future tobacco profit growth," he says.

Goldman Sachs has suggested that low debt levels, strong cash generation, below-average valuations and the lack of organic growth among the multinationals have created the right conditions for the Big Four to become the Big Three. Industry experts seem divided on the buyer in this scenario—either JTI or BAT—but most seem to agree on the most likely acquisition target—ITG.

Marinova wouldn't comment on any future mergers or acquisitions, but didn't rule them out either. "JTI is always looking for potential opportunities to grow its business in line with its long-term business strategy of expanding its geographi-cal footprint in new markets and segments," Marinova said.

And while tie-ups of such magnitude would raise concerns among competition watchdogs in other lines of business, Jayson believes they would be less of an issue in the tobacco industry. "With the high degree of cigarette excise taxa-tion, it would be difficult for the companies to be accused of monopoly pricing in a particular market in this day and age, so I would doubt that any government would block this type of merger from taking place," he said. "If the financial plan is sound, any merger can be achieved." A greater hindrance to further consolidation, according to Jayson, is the dwindling number of attractive acquisition targets. "With Bulgaria final-ly privatizing, there isn't much hanging on the tree," he said.

Evans says that, today, Imperial is focused on a sustainable sales growth strategy. However, he adds, the company's track record of acquisitions is good, and ITG remains keen to do more. "We've consistently demonstrated our ability to swiftly integrate acquisitions, extract the synergies and maximize the value for our shareholders," says Evans. "However, given the structure of the industry today, these are likely to be bolt on product or market-specific deals rather than multinational deals of any great scale. Additionally, strategic alliances con-tinue to offer further growth opportunities. We're a trusted partner and have a strong track record of developing many successful strategic alliances and joint ventures over the years."

Bloomquist is skeptical that Imperial would be purchased by other players. "We do not think either BAT or JT sees Imperial's portfolio as strategically compelling in its geogra-phies (though Morocco and West Africa are attractive assets, as is the Habanos cigar business), nor are its brands required to fill a hole in the BAT and JT portfolios," he says. "We are also skeptical of Altria being interested in Imperial."

In other possibilities, Bloomquist thinks Swedish Match could eventually become part of a larger group. "PMI or Imperial make the most sense in our view," he says. He believes further state privatizations are likely, but only over a long time horizon and predicated on political stability. "We doubt the CNTC will be privatized in that time period [five years], as it is a key source of government funding." Tobacco contributes between 8 and 10 percent of China's state budget.

While all these possibilities are fascinating, they are just pos-sibilities. With the industry already heavily consolidated, contin-ued growth may not lie in ever-greater volumes but in product differentiation. Cigarette consumption has been declining in the West and will eventually level off in emerging markets as well. To survive in such an environment, the industry will need to offer products that meet consumers' rapidly changing expectations, including reduced-harm tobacco products and e-cigarettes.

To paraphrase a famous English naturalist, in the new envi-ronment, it may not be the strongest—or the biggest—of species that survive, but those that are most adaptable to change. Enditem