Will Imperial Tobacco''s Acquisition of Dragonite''s International Business Provide the Desired Boost in Entering E-cigarette Segment?

Source from:  Tobacco Reporter  12/11/2013

In September, a clearly learned person writing from France had a letter published in a U.K. newspaper, The Guardian, in which he mentioned, in Latin and in translation, a line from the Roman comic playwright Plautus: "They eke out a miserable existence by taking each other's washing in."

Did you find that amusing? When I first read it, I fell about laughing, but when I tried it out on friends and relatives, the reaction was decidedly mixed, and I started wondering why there was such a stark division in attitude to the busi-ness model described by Plautus. Perhaps, I thought, it was something to do with people's approach to commerce. Those people who found it funny did so because they saw the "busi-ness" the washer-folk were involved in as a pseudo business and therefore absurd, while the others took the view that what the washer-folk were doing was not absurd and therefore not funny; they were plucky people who in difficult circumstances were at least trying to do something.

I was still wondering about the washer-folk when it came time to write a piece on Imperial Tobacco. The timing was not good because there were about three weeks to go until the company released its year-end (Sept. 30) results, so I was looking at the company's website and couldn't help but be drawn by some-thing I found a little odd in the section listing its news releases. By my reckoning, in the nine months from January to the end of September, Imperial issued 198 such releases, 131—or two-thirds—of which were headed: "Transactions in own shares."

I cannot help feeling that buying back shares is rather like taking each other's laundry in; it involves business activity, but is it leading anywhere? If you take in each other's laundry, you don't seem to be advancing what I assume is the purpose of the business: earning a profit so as to put bread on the table.But can the same criticism be applied to buying back shares? Does buying back shares advance the core business of selling tobacco products or is it a diversion? I suppose that to answer this question one needs firstly to answer another question: What is the purpose of buying back shares?

I'm not the best person to answer such a question, but it's not difficult, given the Internet, to grasp the fundamentals in relation to buybacks in general: i.e., not Imperial's buybacks in particular.

I have to say that some of the fundamentals seem a mite odd to somebody not involved with company finances, but presum-ably they make sense to CFOs. For instance, one of the reasons for buying back shares is that this activity signals to "the market" that the company's board thinks the company is strong. That in itself is not odd, but what I was reading on the Internet went on to suggest that the market accepted such an evaluation "since the board knows the best about the company." Surely, the mar-ket would have to be terribly naïve to think along those lines. Wouldn't the market think, "Well, the board would say the com-pany was strong, wouldn't it?" And wouldn't the market wonder why, if boards always know best, some companies go bust?

On the other hand, some of the fundamentals seem gratu-itous, but again they might seem reasonable to those involved. For instance, executives' pay is said to be sometimes linked with their ability to meet earnings per share (EPS) targets, and it doesn't take a genius to figure out that if you cannot increase your profit to improve your EPS, reducing the denominator of that vulgar fraction will provide a nice little earner.

Mostly, however, the reason behind buybacks seems to center on the idea that, for a company with the sort of cash reserves that might attract a predator, this is a good way to protect itself and, at the same time, provide shareholders with a bonus that over-comes the problem of introducing fluctuations into dividend payments over time and that is possibly, in the parlance of our time, tax efficient.

Cash allocation

Given the way the world works, or stumbles along, there is noth-ing intrinsically wrong with share buybacks, though doing so at a time when factories are being closed and people are being laid off would surely give some people pause for thought. If for no other reason, they might be worried that the people put out of work are or were customers.

But returning particularly to Imperial, the importance of share buybacks was made clear in a presentation given by the company in Paris in June. When the presentation looked at the company's earnings model, it had this to say: "This [the earnings model] has been more or less the same for a number of years and against which we've consistently delivered. It's about sales growth of 2 to 4 percent, both its quality and sustainability, that's important for the continuation and delivery against the earnings model. And then there's the 1 to 2 percent on both cost opti-mization and cash utilization plus around 2 percent from share buybacks to deliver annual earnings growth in the range of 6 to 10 percent."

But one of the drawbacks to buying your own shares can be that cash used in this process is not used for R&D and related matters, which tend to keep a company competitive. And you might be forgiven for wondering whether something hasn't gone astray in this regard at Imperial. But actually not, accord-ing to the presentation mentioned above. "We are translating consumer needs into new product, pack and brand experi-ences," the company said. "We have further strengthened our R&D capability through a reorganization and creation of a new Innovation & Development department. Manufacturing innovation holds all required capabilities from engineering,
packaging, ingredients, blends and non-tobacco materials. This team focuses entirely on successful up-stream product innovation. Product development services down-stream innovation initiatives. Aspiration and passion, as well as flexible resource allocation, are key success factors."

But there seems to have been little research into e-cigarettes if the outcome is anything to go by. At a time when licit tobacco product volume sales are falling, and when some of those sales are being vacuumed up by e-cigarettes, Imperial seems to have lagged behind at least most other major tobacco companies in getting into this business. And this is saying something because the other major tobacco companies have not exactly been fast off the blocks.

Imperial's first "e-vapor" product is due to appear through the company's Fontem Ventures unit in 2014. Compare this approach to that of U.S.-based Lorillard, which in October announced that it had acquired Skycig, an e-cigarette business  based in the U.K.—Imperial's backyard. In making the announce-ment, Murray Kessler, Lorillard's chairman, president and CEO, said it had been Lorillard's mission to be first and best in the e-cigarette category, and that with the acquisition of Skycig, its mission was now a global one. And he had a point. In April last year, Lorillard acquired the U.S.-based e-cigarette company Blu Ecigs. "The acquisition provides Lorillard with the leading brand, offering the best consumer experience and unique social networking features in the rapidly growing e-cigarette category," Lorillard said in announcing that acquisition.

It has to be remembered, too, that the e-cigarettes issue is not only about business success. It is about harm reduction and the messages that the tobacco industry puts out, as Kessler clearly appreciates. In September, he said that it was time to seize the moment and encourage tobacco users to move down the risk "continuum" from the most harmful to less harmful products. Kessler was commenting in USA Today in response to an editorial titled, "E-cigarettes threaten to undo years of gains: Our view." In his reply titled, "E-cigarettes could reduce harm: Opposing view," Kessler said that regulatory actions, including tax policy, should be used to encourage cigarette smokers to switch.

But perhaps this is unfair. Imperial announced at the beginning of September that it had agreed to buy Dragonite International's e-cigarette unit for $75 million, though the deal was then—and now as I write this on Oct. 14—still dependent on the approval of Dragonite's shareholders. And, according to one report, the deal was the result of a competitive sale process in which offers for the acquisition of the "e-vapor business" were solicited from several different potential purchasers.

Dragonite's founder, Hon Lik, invented the e-cigarette, and the company is said to have an extensive portfolio of global patents and pending patents related to these products. Indeed, I believe that if the deal goes through, Imperial will benefit from payments from at least one company for use of certain patents, and it could benefit from some of the lawsuits now in progress over alleged patent infringements. But going forward, some e-cigarette companies have now patented their own technologies.

Imperial—and British American Tobacco (BAT)—needed to do something. In July, analysts at Canaccord Genuity down-graded their recommendations on Imperial and BAT because of the growth in sales of e-cigarettes, according to a piece by Nick Fletcher in The Guardian quoting Canaccord's Eddy Hargreaves and Alicia Forry.

The analysts were quoted as saying that they believed e- cigarettes would prove to be the most significant development in the history of the organized tobacco industry, stretching back some 200 years. Consumers worldwide would migrate from tobacco smoking to e-cigarettes at an accelerating rate through 2020.Maximizing opportunities

One of the odd aspects of Imperial's seemingly tardy approach to e-cigarettes and the "most significant development in the his-tory of the organized tobacco industry stretching back some 200 years" is the fact that this is a company strong on product diver-sification. It has an impressive portfolio of products that includes cigarettes, cigars, hand-rolling tobaccos, cigarette papers, filter tubes and snus.

Speaking on the announcement of Imperial's interim management statement following the nine months ended June 30, CEO Alison Cooper said, in part, that the company was continuing to focus on maximizing opportunities for its total tobacco portfolio in the EU against a backdrop of weak industry volumes.

At that stage, it said that its underlying stick equivalent vol-ume (cigarettes and fine-cut) had declined by 5 percent, and its reported stick equivalent volume had declined by 7 percent. Imperial's key strategic brands were said to have outperformed market trends with an underlying volume decline of 1 percent and with growth in total market share, though reported volume was down by 4 percent. But the best news came in respect of the company's "excellent" fine-cut tobacco performance and "good growth in premium cigar and snus"

Imperial had a number of initiatives to describe in its man-agement statement. It had appointed Peter Corijn, formerly of Procter & Gamble, as group marketing director to lead the com-pany's international marketing and brand development strategies. And it described its realigned footprint, which is based on the "strategic role of the market rather than its geographic prox-imity, with markets prioritizing returns or growth." "Returns markets are typically mature; in these markets we have relatively large shares (mostly above 15 percent) and our objective is to  maximize return on invested capital over the long term by grow-ing profits, whilst actively managing our market share," accord-ing to the statement.

"Growth markets are mainly large profit and/or volume pools, where we typically have shares below 15 percent and where our total tobacco approach provides many opportunities for share and profit growth both now and in the future."Our sales structure has been aligned to this new market classification, and this will strengthen our ability to deliver high quality sales growth over the long term. We intend to transition to this as a reporting structure from our 2013 full-year results."But there was little to say on "e-vapor" products. "In addi-tion, we continue to make good progress with our initiatives in the e-vapor sector through our subsidiary Fontem Ventures and remain on track to launch our own products in 2014," the statement said.

Perhaps, though, it's not difficult to see why the big tobacco companies have taken so long about getting around to embrac-ing e-cigarettes. In an interesting Agence France Presse piece by Tom Hancock in October, Hon was quoted as saying that China's state-run tobacco industry was wary of the competition from e-cigarettes and apparently tried to discourage their sale. "All tobacco companies disliked our products, especially the large ones, and they have influence over governments," Hon was quoted as saying. "It's like how the inventor of a perpetual motion machine would receive pressure from the energy industry." Enditem