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May, 2007

British American Tobacco:
An International Heavy Weight Rolls Forward

by Guido Jungbluth

With brands sold in 180 markets around the world and international consolidation percolating at a level never before seen, British American Tobacco Plc (BAT) continues to move forward.

It was in the eye of a storm of rumor concerning a possible bid for Spanish rival Altadis along with several private equity firms, according to newspaper reports, which found BAT in the middle of a bidding war with Imperial Tobacco Group plc. earlier this year. British American Tobacco, whose brands include Lucky Strike, Kent, Pall Mall, Montana, and Dunhill, it had been speculated, would probably maintain Altadis' cigarette and cigar brands, including Gauloises, but sell its distribution business. However, company statements squashed any takeover rumors, noting that there are "no sensible major acquisitions prospects" for British American Tobacco, straight-talking chief executive Paul Adams said in an interview, arguing that tobacco stock valuations remain extravagant. "If there was an acquisition out there that we thought was sensible and do-able we would have done it by now," said Adams. "Asset prices are very fully priced."

BAT's global reach holds 52 factories
in 44 countries.
Other tobacco-industry watchers disagree. Mark Hall with Market Street Advisors in Smithfield, NC says BAT "definitely" will remain a key international player and intimates that it's too early to say worldwide consolidation has run its course. "BAT has the history and tradition of key brands and the infrastructure in place to expand to all corners of the world," Hall says. "Currently BAT's in 180 countries with many more within reach."

Last December, Japan Tobacco Inc. made a bid for BAT's local competitor Gallaher Group plc. Since that point, it's been speculated that BAT would move to merge or somehow consolidate with Imperial Tobacco Group plc. In a unique twist, the death of Anton Rupert, a South African billionaire who held 24% of outstanding BAT shares has also contributed to speculation about the company's future.

While it remains to be seen if others agree with Adams' note that high tobacco prices will cool industry mergers and acquisitions, British American Tobacco keeps rolling along. Profit rose 7.3% in 2006 thanks to growing tobacco sales in developing markets. Revenue rose 5% to 9,762 mn pounds while separately, its "Global Drive Brands" achieved overall volume growth of 17%. Net income rose to 1.9 bn pounds ($3.7 bn) from 1.77 bn pounds in 2005, the London-based company reported, handily outpacing the 1.78 bn-pound predicted by London and New York market watchers.

The company said it plans to raise its share buyback target to 750 mn pounds of shares each year from 500 mn pounds previously as developing-market sales continue adding to its bottom line. Global cigarette volume was 689 bn sticks, up 2% with over 300 brands on sale in over 180 markets. It is the world's second-largest tobacco concern behind Altria and has a 42% interest in Reynolds American. BAT maintains "largest market share" in 50 countries according to company-supplied data and has 52 factories in 44 countries plus four separate cigar, roll-your-own, and pipe tobacco plants in four countries. There are 55,145 employees on its payroll.

Chairman Jan du Plessis remarked in a statement that, "2006 has been a good year and we can look ahead with confidence to achieve further growth and shareholder value. Over the past five years, BAT has delivered an average annual total shareholder return of 26%." Not bad when one considers the numerous challenges global tobacco companies have been facing such as high taxation, excessive litigation, piracy/smuggling, political risk, negative publicity, and competition. "The increasing trend in tobacco use in developing countries will continue," notes Hall. "As the developing markets prosper with enterprise the use of tobacco products is thought of as a luxury product. We should see the use of leisure items increase in the developing world while the same brands simultaneously get footholds in developing markets."

In Europe, profit was slightly lower in 2006 at 781 mn pounds due to "competitive trading conditions" in a number of markets and a change in terms from the sale of Etinera. Excluding these items, profit grew by 9 mn pounds with strong growth coming from Russia, Hungary, Italy, and France. This offset declines in Spain, Germany, Poland, The Netherlands, and Ukraine.

Speaking for the power of brands backed by good distribution and strong quality standards, volume for Lucky Strike rose in Spain, France, Italy, and Indonesia but was hurt in Germany and Japan. Pall Mall maintained a strong pace clocking a 40% volume increase due to success in Spain, Greece, Russia, Poland, and Bangladesh.

Volume for Kent grew 16% with Russia, Romania, Ukraine, and Chile leading the way and good share growth coming in Japan as well. Dunhill notched a 6% rise in South Korea, Taiwan, South Africa, Australia, Taiwan, and the Middle East, but instability in Malaysia hurt sales in that country.

Adams, who served as Asia-Pacific regional director for BAT has significant know-how in developing markets and can guide the firm through the foreseeable future. This may explain BAT's limited growth in mature and/or developed markets where restrictions continue to dampen tobacco business activity. For the third quarter tobacco sales volumes in Asia-Pacific grew 3.4% and in Latin America by 3%. BAT's growth in these areas has been largely via acquisitions while it simultaneously aims to establish its brands in emerging/developing markets around the world where regulation is often less stringent and a bright future can be established. Working in such areas however can potentially expose the company to political and foreign currency risk.

Finance director, Paul Rayner described strong growth in Iran as "quite substantial," noting that the "only significant risk operating there is political." BAT owns factories in Iran and also delivers cigarettes, mostly Kent and Montana brands, from Turkey.

In the Philippines, British American Tobacco is fighting a legal battle in the Philippines to reduce excise charges on Lucky Strike, one of the group's leading brands. BAT representatives have been working to persuade that country's Supreme Court that its current excise classification of Lucky Strike is unreasonable. The brand's classification had been changed in 2003 by the Philippines Bureau of Internal Revenue four years ago, making it difficult to compete against local concerns.

Last December 2006 BAT agreed to pay a $15 mn settlement to Ghanaian shareholders as a result of closing its production operation in that country.

BAT maintains over 300 brands on sale
in over 180 markets.
In developed markets, such as North American and Western Europe, BAT is navigating in an entirely different set of waters highlighted by litigation while being viewed simultaneously as generators of significant cash while a health risk to the overall population. Very few will come to the defense of tobacco companies in developed markets so governments view them as a nearly endless well from which to draw tax revenue. Others have tried to extract huge sums from the tobacco companies by taking them to court to pursue often well-publicized health claims.

BAT's US litigation exposure has been limited due to its position in Reynolds American Inc. In 2004, when R.J. Reynolds Tobacco combined with Brown & Williamson Tobacco, it removed BAT from possessing a wholly-owned subsidiary operating in the US market. It owns 42% of Reynolds American but its American partner supervises Brown & Williamson's legal issues. While also producing Pall Mall and Lucky Strike in the US, Brown & Williamson also manufacturers KOOL, the second-leading menthol in the US.

Consider that last April, the Supreme Court of Canada refused to exclude foreign tobacco companies from the province of British Columbia's suit to recover billions of dollars in costs for treating smoking-related diseases. The high court denied an appeal request by four American and four British companies of a lower British Columbia court's decision that they may be held liable even if they do not directly sell tobacco products in the province. Four of Canada's other nine provinces have brought forward legislation similar to British Columbia's. If successful, the provinces would be able to pursue tobacco companies. Total Canadian claims could reach C$80 bn (US $70 bn).

Nevertheless, in mature markets, BAT's market share has remained steady while overall consumption continues to decline. Consider BAT's Pall Mall. Its cigarettes and roll-your-own products climbed 40% in 2006. The performance enabled the mid-priced brand to be the best-selling in the stable. The changing Western European retail tobacco landscape saw taxes increase and as a result, initiated new-found demand for an established, middle-market smoke and roll-your-own product as smokers worked to lower their own cash outlays and still get a good smoke. Pall Mall is also a market leader for roll-your-own practitioners in Germany and is experiencing growth in such third-world markets as Bangladesh and Vietnam, as western brands begin to win converts often from lesser-quality, local products.

In Italy BAT sold its Toscano cigar business to the Bologna-based Maccaferri Group for 95 mn in cash late last year. The transaction, which includes factories in Lucca and Cava de' Tirreni, is expected to close later this year. Francesco Valli, British American Tobacco Italia's managing director, said in a statement, "Toscano is a true Italian brand and we are delighted that it is to be acquired by the Maccaferri Group which has a strong Italian heritage." Overall in Italy 2006 was a good year for BAT as a cost-cutting program took effect adding increased efficiency and margins improved after price increases despite a domestic brand decline.

BAT also announced that its operating company in The Netherlands has begun consultations to close its factory in Zevenaar and relocate production to Germany and Poland. The factory should close in 2008, eliminating nearly 600 (560) jobs as British American Tobacco's Europe Region moves to further concentrate its European Union manufacturing in Germany and Poland. The Zevenaar factory manufactures cigarettes for The Netherlands and other markets across Europe. Coincidentally, German profit fell slightly for BAT in 2006 due to lower pricing power and increased excise taxes. Again, efficiency moves helped ease the pain and Pall Mall and Lucky Strike experienced market-share growth in the country.

Jan Withag, managing director, British American Tobacco Manufacturing B.V. said: "We regret this conclusion, but it is unavoidable. We are grateful to our employees for their commitment and loyalty during what has been a difficult period and will actively support them in securing new futures." BAT anticipates a restructuring charge of approximately 235 mn (of which some 175 mn would be cash), the majority of which is likely to be charged in 2006. Annual savings, once full benefits have been realized, would reach some 40 million.

Separately, BAT also stated it would close its cigarette factory in Mauritius next June to concentrate on product distribution in the Indian Ocean nation. "This change is part of our overall multi-national strategy to review production in various countries in light of production cost increases," said Kabir Kaleechurn, a company spokesperson. All BAT cigarette brands now made in Mauritius will be produced in South Africa and Kenya. The company however, will continue buying tobacco leaves from Mauritius growers although annual production there has fallen from an average of 720 tons earlier this decade to 350 tons in 2005.

BAT Chief Executive Paul Adams.
In another deal with regional ramifications, British American Tobacco and Philip Morris International (PMI) signed a trademark-transfer agreement allowing each company to consolidate certain brand ownership. PMI will acquire ownership of the Muratti Ambassador brand in certain markets and acquire the L&M and Chesterfield trademarks in Hong Kong and Macao. In return, BAT acquired the Benson & Hedges trademark in certain African countries and will receive a net payment of $115 million.

BAT is also moving to acquire a minority share in Chiletabacos. The largest tobacco company in Chile which annually sells some 13 bn sticks. BAT already has a stake in the company through its wholly owned subsidiary Inversiones Precis Limitada S.A. and should offer to acquire the balance of Chiletabacos. The transaction will be funded from the Group's existing resources. Similarly British American Tobacco has confirmed that it has considered making an offer for the 25% of shares in its Brazilian subsidiary Souza Cruz that it does not already own but the company does not currently intend to make such an offer according to a posting on its website (britishamericantoabcco.co.uk).

BAT is also moving forward with snus. Backing the product with two of its biggest brands, Peter Stuyvesant and Lucky Strike, in South Africa-where snus is virtually unknown. BAT is also marketing snus in Sweden where it's more popular than cigarettes, has started sales in Norway, and begun a pilot in Japan. The company is first introducing it under cigarette brands to see if the lines could be further extended into the snus marketplace.

Sadly, as a sign of the increasingly regulated world in which we live, BAT like its competitors has taken its last lap around the race course. British American Tobacco exited Formula One at the Brazilian Grand Prix after eight years of Lucky Strike sponsorship. This ends a link to motor sport dating to the 1960s but the move reflects demands of the International Marketing Standards of 2001. As Jimmi Rembiszewski, marketing director, said: "We're very proud of the team's sporting achievements and wish them every success in the future, but our time is over."

Fortunately for BAT, it continues winning races in the marketplace.

Tobacco International - May, 2007


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