Russia Will Continue to Feature Prominently in the Portfolios of Tobacco Multinationals (Part II)

Source from:  Tobacco Reporter  12/10/2013

The tobacco industry in Russia has thrived in part as a result of the country's traditional tolerance for smoking—but that lenient attitude appears to be waning. In June 2008, Russia joined the World Health Organization's Framework Convention on Tobacco Control (FCTC), committing itself to aggressively reducing tobacco consumption.

The State Duma, Russia's parliament, passed new regula-tions on public smoking that went into effect in June. Since the adoption of FCTC regulations by Russia and under the govern-ment and presidency of Vladimir Putin, Russia has effectively decided to fight smoking by Western-world rules, according to Khakhalev.

Between 2012 and 2014, excise taxes will increase by nearly 145 percent.   Controversy has arisen about proposed bans on the sale of cigarettes at small retail outlets and on the open dis-play of tobacco products. Some analysts note, however, that the "display" ban under discussion in Russia is less restrictive than those enforced in some other markets. The proposal appears to require vendors to turn cigarette packs so that their sides, rather than their fronts, face consumers. And kiosk owners would be able to avoid the sales ban by modifying their stores to allow customer to step inside.

Russia's true challenge pops up next year, when smoking regulations widen to include bans on passenger ships, train platforms and  the  long-distance trains themselves, which will take effect June 1, 2014. (The latter provision, in particular, bodes ill for Russia's traveling smokers, given the enormous distances in the country; a one-way train journey from Moscow to Vladivostok, for example, takes 6.5 days.) Tobacco taxes also are required to increase, and the country will set minimum prices for cigarettes.

"This means a steep increase of cigarette prices by increasing the excise tax and the prohibition of smoking in public places—some limitations are already enforced, but as of June 1, 2014, Russia will have a total smoking ban similar to the U.K., where smoking is only allowed on the street (at a set distance from build-ing entries) and in your own car and home," Khakhalev says.

A shift in the smoking habits of such a substantial market is sure to sting. Cigarette production began to decline after 2008, and ITG assumes this will continue for the foreseeable future due to weaker social and economic environments, and the impact of regulatory pressures which, it says, also threaten to promote illicit trade. "Nevertheless, we're focused on building our market share by making the most of the opportunities in the high-growth sectors," says Merrett.

Value brands have been disproportionately impacted by recent tax increases, and it is in this price sector that around three-quarters of ITG's product portfolio sits. "We've been tak-ing steps to address this and are confident of regaining some of our lost ground," says Merrett.

Smaller manufacturers will face challenges, too, with increased regulation and taxation, especially in the areas of sales volume and distribution, according to Lee. "However, KT&G is sure that, despite all of the challenges, we will prepare the right strategies and tactics for future success."

Russia's new regulations aren't just hurting the tobacco manufacturers, according to Moiseev, who says that due to the increased state regulations on alcohol and tobacco over the past two years, the number of retail outlets in Russia has dropped from 380,000 to 230,000. Moiseev, like Merrett, fears that the reduced number of legal places to purchase tobacco, alongside the increase of excise taxes, will boost the illicit cigarette market. 

"At the present moment, I evaluate the market for illegal cigarettes to be about 4–5 percent," Moiseev says. "In five years, I forecast black-market sales to grow to 20–25 percent."Moiseev also believes that the tobacco product display ban will lead to a reduction of the number of brands sold. "Taking into account legislative introductions, I suppose that 45–60 percent of brand modifications are under the threat of dis-appearance, and most probably will get away from the legal market," he says.

The future forecast

Despite the expected volume declines, analysts predict that cigarette manufacturers' profits will remain robust in Russia, driven by pricing and tax visibility over the next three years, with an absence of a long-term decline, according to Berenberg Bank. "Tax visibility supports pricing," says Berenberg Senior Analyst Erik Bloomquist. "The Duma approved 42 percent and 20 percent minimum excise tax increases in 2014 and 2015, respectively, and proposed a 28 percent increase in 2016—a much lower increase than the one proposed by the Health Ministry. With visibility on tax over the next three years and a high specific tax component that creates leverage for retail pric-ing, Russia remains an attractive profit growth market."

Berenberg adds that tobacco prices, since 2008, have risen at a mid-teen to mid-20 percent annual rate, in part due to inflation in overall price levels. As a result, the consumer has been "trained" to believe large price increases are normal. "This experience is true not only for tobacco," adds Kate Kalashnikova, also an analyst at Berenberg. "Russian quarterly CPI has been as high as 15 percent in 2008 and 10 percent in 2009 and although it has now moderated at 6–7 percent, it is still above the target range of 5–6 percent."

Berenberg believes the Russian tobacco consumer is under increasing pressure from price increases and the slowing econ-omy, but cigarettes are inexpensive in Russia on both a relative and absolute basis. "In the relative comparison we show that a pack of Winston is a little less than the cost of a Big Mac or a two-liter bottle of Coca-Cola, and is substantially less than a ticket to the cinema," says Bloomquist. "On an absolute basis, using minutes worked to make relevant comparisons, Russian tobacco prices are well below markets like Poland and Mexico, though above places like Japan or Spain."

The analysts also predict that volume decline will be con-centrated in the low-price segment due to the high rate of price increases, consistent with the trends seen in 2013, while the high specific tax component helps mid-priced to premium brands take a larger share.

Moiseev believes that the premium segment of legal ciga-rettes will most likely shrink by 15–20 percent. "Firstly, due to the increase of taxes and the turn of some consumers to the middle-price segment," he says. "Secondly, with regard to avail-ability of offers of illegal cigarettes in this segment, the middle-price segment will not change for the same reasons—a part of the middle-price segment will be occupied by illegal cigarettes, but these losses will be compensated for with consumers mov-ing away from the higher segment."  

Merrett says that ITG expects volume and share growth through its focus on modern cigarette formats, especially in the "value for money" segment. "Already, we were first to the market with 25 packs (through the Maxim brand) and  we pioneered the ultra slim long format through the launch of Davidoff Boudoir," he says. "We also expect to grow volumes by extending distribution to parts of the country with which we've no historical association for some of our brands, for instance the Maxim brand in the northwest. Last but not least, we've made considerable investments ahead of regulatory changes to support the development of our key strategic brands."

Kryvosheyev says that JTI, which owns two cigarette facto-ries in Russia, has been operating in a predictable regulatory and tax environment, and in this context, the country's biggest player hopes that the Russian government will continue with a policy that is "sustainable in the long term and will maintain gradual and balanced excise increases" with consideration for consumer budgets and pricing in line with neighboring countries. "With fewer tools available for communicating with consumers, we count on organic growth in Russia and will continue leveraging on our robust brand portfolio and well-balanced geographical footprint," he says.

There has also been talk of the possible takeover of Donskoy Tabak, or one of the two other smaller independents, by one of the multinationals or even by the China National Tobacco Co. (CNTC), although none have said they are pursing such a ven-ture. There is also talk of a former independent jumping back into the market. "If CNTC has plans to enter the Russian mar-ket, most probably it will be the acquisition of a ready enter-prise, not a 'greenfield' project," says Moiseev. "It's very dif-ficult to forecast what independent Russian factory will be the subject of such a merger. I can note that Bulgartabak has plans to restart its operation in Russia, which registered a Russia subsidiary enterprise, Bulgartabak Logistic, and it affects the licensed manufacturing at the premises of Pogar Cigarette & Cigar Factory."

The multinationals interviewed for this article were equivocal about their interest in Donskoy. "As you know, Imperial is always interested in attractive opportunities globally to develop its business," said Merrett. KT&G and JTI both declined to comment on possible mergers or acqui-sitions in Russia.

Despite the toughening tobacco regulations and rising con-cerns about illicit trade, Russia continues to present plenty of opportunity. Even though the spectacular growth of the past two decades has flattened and volumes are expected to shrink, profits are estimated to stay firm for the foreseeable future. As a result, Russia will remain a must-have market in the portfolio of every major cigarette manufacturer. Enditem