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Thank You for Smoking

The tobacco industry, the most vilified sector in the world, is in rude health.
Jason Karaian, CFO Europe Magazine
September 1, 2007

Despite efforts to convince the ethical investment industry that they conduct their businesses "responsibly," tobacco companies are universally excluded from ethical funds. Not that this has any effect on their financial performance. Bolstered by volume growth in emerging markets and pricing power in developed economies, the industry is thriving.

The public smoking bans, curbs on advertising, massive lawsuits and heavy taxes imposed on the much-maligned industry led many to believe that cigarette makers are "going down the drain," says Hermann Waldemer, CFO of Philip Morris International (PMI). But with healthy profit growth and cash flow, the shares of Altria, PMI's parent company, and its peers have comfortably outperformed the benchmark stockmarket indices in recent years. (See "Up in Smoke" at the end of this article.)

Lausanne-based PMI runs all of Altria's tobacco businesses outside of the US. After spinning off its Kraft food unit earlier this year, Altria is now expected to do the same with its international tobacco arm, possibly this month, distancing PMI from the hundreds of lawsuits faced by its American colleagues.

PMI sold more than 831 billion cigarettes last year, achieving 25% of world market share (excluding the US and China) and accounting for about two-thirds of Altria's tobacco-related revenue and profit. Billing itself as "the most profitable international tobacco company," it is a bellwether for the industry. Waldemer, a 20-year PMI veteran and former chairman of the German tobacco manufacturers association, is well placed to put the industry — past, present and future — into context.

Home and Away
More than 80% of the world's 1.3 billion smokers live in developing countries, according to the World Health Organisation (WHO). Sales in many of these markets are expected to grow modestly in the coming years, in sharp contrast to the developed world, where increasing health awareness and stricter regulation is driving down volumes across Europe, the US and Japan.

Generating around two-thirds of its sales in emerging markets, PMI spent more than $1 billion earlier this year buying out minority partners in Pakistan and Mexico. Profits, however, are another story. Around 60% of PMI's profits come from mature markets, where margins are 2.5 times higher than in emerging economies. Defending market share in these profitable markets kicked off a recent wave of consolidation in the industry, with Japan Tobacco buying UK-based Gallaher while Imperial Tobacco, also based in the UK, looks set to capture Franco-Spanish Altadis. Around 90% of the European market is now in the hands of the industry's four largest companies.

A WHO study found that every 10% increase in tobacco prices results in a 4% reduction in demand from high-income countries, half of the 8% reduction observed in low-income countries. This explains the durability of profits in mature markets, despite higher taxes and shrinking volumes. "In this context, 'mature' markets shouldn't have a negative connotation," insists Waldemer.

"The broad misperception of tobacco is that it's a dying industry, while the more sophisticated misperception is that there is no further growth in mature markets," notes Erik Bloomquist, an analyst at JPMorgan in London. With tax accounting for 60% to 80% of a packet's retail price, passing tax rises to sales prices generates disproportionately beneficial growth in manufacturers' revenue that "drops straight through to Ebit," he notes.

PMI and its competitors aren't resting on their laurels, though, redoubling efforts to defend bottom lines by cutting costs in their home markets. PMI expects productivity gains worth $200m this year as a result of rationalising its manufacturing footprint, centralising procurement, and opening a finance and HR shared service centre in Krakow. "You have heard a lot more from us on these initiatives lately," says Waldemer. "We want to communicate that there is a tremendous focus on costs and efficiency."

There is also value to be tapped from cash-rich balance sheets, especially at PMI and its largest rival, British American Tobacco (BAT), both of which sat out the recent round of large-scale takeovers. In March, BAT boosted its dividend by 19% and pledged to buy back £750m of its shares each year, up from £500m previously. Assuming PMI is spun off, JPMorgan's Bloomquist expects the company to act "as aggressively as it can" to buy back shares without slipping into negative shareholder equity.

Death and Taxes
Operating in one of the most aggressively regulated industries also requires careful management. "Ideally, a government wants to reduce consumption and grow or maintain tax revenues," notes Waldemer. "Is that bad for cigarette companies? It sounds like it is, but it's not necessarily so." Along with its surprisingly bright financial prospects, this is another apparent contradiction in the tobacco industry. "Governments want decent, fair and enforced regulation, and that's also what we and the financial markets want," says the CFO. A price war in Spain, for example, was stemmed last year when the government set a minimum tax on cigarettes instead of a regime based on a percentage of the sales price, hurting cut-price upstarts more than the established players. "Excise tax increases are not something that we are automatically against — it's more complicated than that," says Waldemer. "When we say that we encourage regulation, it's because we want predictable, clear rules of the game."


In a politically sensitive sector such as tobacco, predictable regulation is never assured. This must make the headlong rush into emerging markets, with the general volatility this entails, doubly risky. Again, perception doesn't reflect the reality, Waldemer says. Although perceived as courageous to spend nearly $5 billion on the 2005 takeover of Sampoerna in Indonesia, PMI gained a "superb, modern company," the CFO boasts. Only minor deficiencies were found when it implemented Sarbox's Section 404 there, he adds.

As for China, home to a third of the world's smokers, the rules of the game are truly different. The national tobacco monopoly is served domestically by some 130 cigarette factories producing 900 brands. In 2005, PMI announced a landmark deal for licensed production of Marlboros inside China and a joint venture that will sell Chinese brands abroad. However, Altria's CEO, Louis Camilleri, recently lamented that "developments in China have been slower than we originally hoped," but still expects full-scale production to begin by the end of the year.

"You need patience in China," says Waldemer with characteristic calm. "Will China have a meaningful impact on our bottom line in the next few years? No. Remember, though, that it was not so long ago that there were monopolies across Europe."

Despite public perception, plenty of growth opportunities remain to keep tobacco companies on a roll.

Jason Karaian is a senior editor at CFO Europe.





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