Philip Morris Eyes Godfrey Philips Brands, Tobacco Business within FDI Rulebook

Source from:  Economic Times 01/06/2016

Global tobacco giant Philip Morris International has initiated talks with its Indian partner, KK Modi-led Godfrey Philips India (GPI), in an attempt to take control of the cigarette brands. After working together for 36 years, the current round of discussions about a company in a highly restricted sector that bars any foreign direct investment in manufacturing of tobacco or tobacco products like cigarettes, centre around creating legal structures that comply with regulations, said sources aware of the matter.

One structure being considered involves a possible splitting of Godfrey Philips India - the listed flagship - into two with one entity focussing solely on manufacturing with the other housing all the GPI brands including Four Square, Red & White and Cavenders, along with its marketing and distribution infrastructure. In the structure envisaged the former stays under Indian control and acts as a contract manufacturer while Philip Morris will take over the latter.

If the talks fructify, marketing and distribution in all likelihood will be done through India Philip Morris (IPM) - a separate joint venture (JV) entity that is already in place for exclusively promoting sales of PMI's flagship Malboro cigarettes in India. Philip Morris has 50.1 per cent stake in IPM while the remaining equity is between GPI and K.K. Modi Investment & Financial Services Private Ltd.

IPM is likely to buy the entire GPI brands portfolio along with its marketing and distribution network as part of the deal being considered. As per company information, GPI cigarettes are distributed through a pan-India network of 800 exclusive distributors, and over 800,000 retail outlets.

Philip Morris Inc had joined hands with the KK Modi Group way back in 1979. In 2003 it bypassed its Indian partner to launch its launch its biggest brand Malboro in India on its own, through an arrangement with a local distributor.

Another option being considered is a demerger of GPI into a real estate and a core tobacco business wherein PMI takes a higher and potentially controlling shareholding in the tobacco piece in exchange for a proportionately lower shareholding in the real estate business without any new funds being invested, in order to comply with the current FDI rules. Such a demerger will require approvals from the stock exchanges, courts and other shareholders. But this model hinges on the total and relative value of the two parts.

Philip Morris is already a co-promoter of GPI. As per the latest shareholding data, Philip Morris Global Brands Inc owns 25.10% of GPI while KK Modi and family own a 46.96% block, taking the total promoter stake to 72.06%. The rest is widely held among institutions and public. The current market cap of GPI is Rs 7,232.61 cr.

These discussions however are still early stage and a transaction is not yet certain. One of the sources cited said the expectation of high premium by the Modi family could act as a deal breaker. However another source added that there are meetings between both sides that are scheduled in London later this week. This however could not be independently verified.

Responding to ET's detailed questionnaire, a PMI spokesperson declined to comment on what he described as market speculation. KK Modi, President & Managing Director of GPI told ET, he has "no comments to make."

GPI Stock Surge

Seemingly anticipating a transaction, the GPI stock in the last 3 months has surged 106%, from Rs 674/share to close on Tuesday at Rs 1391.05/share after touching a lifetime high of Rs 1660.25 on 3 December. In comparison both the industry bell weather ITC and the Sensex declined 1.32% and 5% respectively in the same period.

Experts argue that a transaction involving splitting the company into two separate entities with shareholders receiving shares in both, would be better for non-promoter minority shareholders as there would be an open offer requirements and shareholders will have a choice to decide whether they want to remain invested. According to Navroz Mahudawala, Managing Director, Candle Partners, a Mumbai based investment bank, in case the transaction involves sale of business / brands / IP to another company, the listed company (and not shareholders) will receive a consideration which then becomes a tax unfriendly mechanism as the company pays a dividend distribution tax while distributing dividends to shareholders. Also, no open offer formalities are required.

Cigarette consumption is steadily declining in India. But unlike most other markets where cigarettes constitute over 90% of tobacco consumption, in India, it is just about 11% as consumption is dominated by chewing tobacco followed by beedis. According to the latest data on cigarette consumption provided by the health ministry to Parliament, total consumption for 2014-15 was 93.2 billion sticks --10 billion less than in 2012-13. Production of cigarettes too fell from 117 billion to 105.3 billion sticks in the same period.

ITC dominates the Rs 35,000 crore Indian cigarette market --- estimated sales of 10,800 crore sticks last year --- with an 80% share of the market while Godfrey Phillips India controls only around 7-8%, as per industry estimates. Ninety per cent of GPI's approximately Rs 4400 crore revenues come from cigarettes and tobacco products. The rest includes confectionary & mouth fresheners (approx. Rs 160 crore), tea (approx. Rs 100 crore) and other traded products.

Since cigarettes have been a low growth area in recent times, the company enhanced its focus on the mouth freshener market. "Pan Vilas" was launched in 2010 & has now achieved a Rs 160 crore turnover. The company has plans to increase its portfolio in this segment. It has also been spending heavily on brand building in this segment with the brand being the official sponsor of KKR team of IPL. Besides mouth fresheners (confectionary), the other areas of growth identified by the company are food & beverages & contemporary tea products.

The company is also a sizeable exporter of cigarette & tobacco products. Its exports for FY 2015 were Rs 610.5 crore & it grew 24% over FY 2014. It has two cigarette manufacturing facilities and

During the year ending March 31, 2015, the company reported gross revenues of Rs. 4453 crore as against Rs. 4193 crore during corresponding previous financial year, a growth of almost 6.2%. The profit after tax was higher at Rs. 183.08 crore against Rs. 170.64 crore in FY 2014. Due to the constant pricing pressure in the cigarette market, EBITDAs declined from Rs 405 crore (16.4%) to Rs 393 crore (15.2%).

However the company's performance in H1 2016 has substantially improved having reported an EBITDA of Rs 201.7 crore (16.3%) and PAT of Rs 112.68 crore. Over the last 5 years, the company's sales have grown at a CAGR of 10.9%, while PAT has grown at a CAGR of 9.1%.

"For a long time Philip Morris have been trying to get access to the Indian market and be more relevant with local brands, teams and the marketing spend. Unlike the west, the emerging markets still have some upside left for Big Tobacco. But in a highly regulated market like India, it will not be easy to pull off a transaction easily."

Confronted with the stringent FDI rules, Japan Tobacco Inc, had closed its India JV JT International Indian Pvt Ltd, surrendering its licence to manufacture five billion cigarettes per annum to the government. Efforts by the largest shareholder BAT to have a greater control and say in the affairs of ITC has also faced stiff resistance from the government and as well as the local management that has traditionally been influential. Enditem