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May, 2008

U.S. Tobacco Cooperative

Altria Group:
the Evolution Continues

by Joseph Finora

As time goes on, Altria grows, be it through the parting of ways with former associates, or by concentrating the development of its own brands from within using innovative strategies.

In early 2008 Altria Group, Inc., announced 2007 earnings as well as the long anticipated spin-off of Philip Morris International (PMI) to shareholders. The spin-off formally took place in March on the heels of a solid but not financially spectacular 2007. As part of the split, investors received one share of Philip Morris International for each share of Altria and now find themselves owning two very different tobacco countries stemming from the same root. The announcement was made less than a year after Altria spun off its Kraft Foods Inc., unit. PMI Chairman and Chief Executive Louis Camilleri then bullishly noted that each company will ultimately find itself in the “top 10 list” in their respective categories in the not-too-distant future.

“Today’s announcement underscores our long-term commitment to build shareholder value,” said Camilleri, at a press conference announcing the break-up. “The PMI spin-off and related actions position our international and domestic tobacco businesses for future success as stand-alone companies with unique and formidable strengths, including leading brands, strong cash flow, experienced leadership and solid growth prospects.”

“This marks an interesting time for Altria and Philip Morris International,” says Mark Hall, a financial adviser at Market Street Advisors in Smithfield, North Carolina who follows the company. “Each is entering a new phase but each will do so on a foundation of financial strength and seasoned management with good brands, good distribution and a proven way of doing business.”

Camilleri went on to add that “2007 was a watershed year,” for Altria which posted strong underlying earnings growth and witnessed a number of strategic actions that should further strengthen its tobacco businesses for the long term. “While we are by all means not immune to the current economic uncertainties,” Camilleri said, “we enter 2008 with solid momentum and I am confident that both Altria and PMI are well positioned to not only weather these uncertainties, but to deliver strong results this year and beyond.” Its cigarette-brand portfolio consists of such well-known names as Marlboro, L&M, Parliament, and Virginia Slims.

While US cigarette shipments fell nearly 8% in 2007 Marlboro brand’s retail share grew by nearly one percentage point to 41.2%, bolstering Altria’s total US market share to 50.6% from 50.1%, outpacing a slight gain at Lorillard and a share loss at R.J. Reynolds. Further, 2007 profits were squeezed from a year earlier due to costs associated with a plant closing in Cabarrus, North Carolina, developing snuff and relocating corporate facilities to Richmond, where it also opened its $350 mn, 450,000-square-foot Center for Research and Technology facility, which is expected to employ some 500 workers. Building on last year’s strategy, future North American success is expected to come from innovation and product development in a challenging domestic market rife with erratic volume, smoking bans, competition, legal challenges, increasing taxes and an inflationary environment. Conversely, Philip Morris International (with headquarters in New York, and its Operation Center in Switzerland) is expected to be somewhat insulated from litigation that has distracted its predecessor (officially PMI is an advocate for comprehensive and cohesive tobacco industry regulation throughout the world). Tobacco-industry observers are expecting PMI to take advantage of numerous growth opportunities on the world stage, possibly being more aggressive than it has been thanks to financial strength that may among other things, enable it to grow through key acquisitions.

While each of the new companies will for the most part deliver many of the same brands (though PMI will offer many local and international brands not available in the US), North American operations will focus on increasing market share in what can only be described as a shrinking and occasionally hostile market, continuing to reduce costs and increase efficiency while rolling out product line extensions, such as non-cigarette tobacco products. Philip Morris International, however, free from the legal and taxation issues that have at the least distracted the formerly combined company from its basic business issues, will set its sights on growth across the globe as it continues to enter new markets and make strategic acquisitions. The Big Emerging Market (BEM) countries promise to be a fertile frontier for a company which already has roots in Asia, Latin America and parts of Africa. Andre Calantzopoulos is PMI’s post-spin-off Chief Operating Officer and is based in Lausanne, Switzerland.

Camilleri’s optimistic forecast supported by the strong numbers investors have come to expect from Altria as well as established brands, marketing know-how and healthy balance sheet have put the new companies near the top of Wall Street’s shopping list.

Altria Awkening.
Altria will continue to own 100% of PM USA, as well as have complete ownership of machine-made cigar company John Middleton, Inc., and Philip Morris Capital Corporation. It also has a nearly 30% stake in brewer SABMiller plc. The now Richmond, Virginia-based Philip Morris USA has also been expanding tests of Marlboro Snus in the Dallas–Fort Worth and Indianapolis markets, while Marlboro MST is being tested in the Atlanta area as it attempts to catch industry-leader UST Inc., the maker of Skoal. “This is a company that can never be counted out,” says Hall. “It has foresight and the ability to make things happen.”

In late 2007 Altria announced that it signed an agreement to sell its famed headquarters building at 120 Park Avenue in New York City for approximately $525 mn to a subsidiary of Global Holdings, Inc., a private, US-based real estate investment company, which is part of Eyal Ofer family interests. Altria said that it will record a pre-tax gain of approximately $440 mn upon closing the transaction. The 643,000 square-feet building has served as Altria’s corporate headquarters since it opened in 1982 and housed approximately 500 employees. Altria previously announced that it will eliminate approximately 400 of those positions as part of the relocation to Richmond, Virginia, which took place in early 2008.

In North America, Altria now expects to possess greater focus, with most of its corporate resources directed toward building a leadership position in the US tobacco industry, which despite a long list of negatives remains one of the world’s largest, most profitable and highly sought-after markets. And despite what critics may offer, the company has definite growth opportunities. Altria Group has historically moved on strengths which include great brands, deep capital access and talented management. Its ability to leverage resources, such as a vast and experienced sales and distribution network and an ability to make key acquisitions like it did with John Middleton, Inc., last November for $2.9 bn in cash while developing new products and line extensions should not be discounted.

“This acquisition, which takes place on the eve of Altria Group, Inc.’s intended restructuring, is being undertaken to enhance our long-term growth momentum in the US market and create shareholder value,” said Michael E. Szymanczyk, Chairman and CEO of Philip Morris USA (PM USA). “The acquisition is both strategically compelling and financially attractive. It fits squarely with our announced strategy to grow our US tobacco business beyond cigarettes and complements our recent initiatives in the smokeless category.”

John Middleton, Inc.’s operating revenues were estimated at $360 mn in 2007. Over the 2003 to 2007 period, operating revenues and operating income are estimated to have grown at compounded annual rates of approximately 10% and 13%, respectively, driven by the strength of the Black & Mild cigar brand franchise. In 2007, total company cigar volume was anticipated to reach 1.2 bn units.

“While there may be some cost savings, captured predominantly through procurement synergies and the elimination of duplicative expenses, the real appeal of this acquisition is to capitalize on PM USA’s sales, distribution and marketing infrastructure and expertise,” Szymanczyk said. “Further, PM USA will contribute its strong capabilities, resources and focus on corporate responsibility, including youth smoking prevention.”

The plan is to accelerate Black & Mild brand’s market share growth momentum in the years ahead by leveraging the expertise and capabilities of both John Middleton, Inc. and PM USA. The US cigar market is the world’s largest with an estimated total consumption of 10.5 bn units or more than 40% of the global trade. It is comprised of three segments: large machine-made, small machine-made and hand-rolled premium cigars. Founded in 1856, John Middleton, Inc. participates in the large machine-made cigar segment, which has projected volume of 5.3 bn units in 2007 and pipe tobacco. The segment is estimated to have grown volumes at a compound annual rate of approximately 4% over the 2003 to 2007 period and is highly profitable. Middleton features strong brand equity, high brand awareness and solid volume and share growth momentum. The Black & Mild brand is a leading large machine-made large cigar in the US, with a retail market share of approximately 25.3%, an increase of 2.2 share points from the prior year. The Black & Mild five-cigar pack is the best-selling large machine-made cigar package in the US. It operates two manufacturing facilities in King of Prussia and Limerick, Pennsylvania. It has approximately 550 employees with close to 90% dedicated to manufacturing. It will continue to operate from its current Pennsylvania facilities. Orrin Ridington, Jr., the current President, will continue to lead operations from Limerick, working closely with the PM USA management team to best capitalize on each company’s strengths.

A Fast Start
Philip Morris International is at various stages of innovative rollouts. A mature company, PMI products are sold in over 160 countries. In 2007, it held a 15.6% share of the international cigarette market outside of the USA and reported revenues net of excise taxes of $22.8 bn and operating income of $8.9 bn. It owns 7 of the top 15 brands in the world and has a strong mix of international and local products that seek to appeal to a wide array of adult smokers. It has offices in 68 countries and 75,000 employees. PMI boats 59 manufacturing facilities in 32 countries. Its top-ten brands by volume are: Marlboro, L&M, Philip Morris, Bond Street, Chesterfield, Parliament, Lark, A Mild, Morven Gold, and SJI Sam Soe. It is the market leader in 11 of the top 30 international markets and number-two in an additional eight markets.

Marlboro Filter Plus, is being aimed at some 50 new markets across Europe and Asia. Its package resembles a cell phone - the customer slides the top of it upward and then backwards as PMI, in the face of marketing restrictions is banking on distinctive packaging to help its brands, each of which are aimed at the hi-end smoker, to stand out from the competition which it hopes to leave on the shelves. Marlboro Mix 9, a high-nicotine, high-tar clove cigarette that kicked off last year in Indonesia. PMI hopes to also ship it to other Southeast Asian markets. The Marlboro Filter Plus, is on sale in South Korea where it has “performed strongly,” as well as having early positive results from Russia, Kazakhstan, and Ukraine where smoking rates are increasing and government restrictions are minimal. Marlboro Filter Plus uses a special filter made of carbon, cellulose acetate and tobacco which should provide a smooth taste with relatively less tar. As part of its arrangement to produce Marlboros in China, PMI will market Chinese-made brands in other countries for the state-run China National Tobacco Corp. On the technology front, PMI’s Heatbar, a gadget that heats a cigarette without generating a significant amount of smoke met with a cool reception from smokers. Its fate is uncertain but the intention is genuine, to help smokers in places where they cannot smoke. Marlboro Intense, which as the name implies, is a short but powerful cigarette designed to give those who must step outside to smoke the opportunity for a robust experience in about seven quick puffs.

Wall Street Watches
While most of Wall Street is keen on the future of both PMI and Altria, risks remain in the equation. “Internationally, tobacco companies have been subject to far fewer consumer lawsuits,” notes Argus Research analyst Paul Kleinschmidt. “However the potential exists for further actions in virtually all international jurisdictions. In addition the industry has been stung with fines and restrictions on advertising and marketing in many countries and has also suffered from smoking bans in many public places.”

Looking at North American prospects, Gregory Warren, CFA and analyst at Morningstar, Inc., notes “Philip Morris USA faces some serious headwinds.” Considering a steady US smoking decline, Warren’s forecast is sanguine. “While PM USA has been able to mitigate some of the volume shortfall (and sustain its margins) by raising prices, it’s only a matter of time before price elasticity becomes a problem and sales become harder to generate.”

Esther Kwon, CFA, a tobacco-industry analyst at Standard & Poor’s offers an optimistic outlook. “Altria continues to grow its top line through acquisitions, funded primarily from its significant operating cash flow,” she notes. “Our fundamental outlook for the tobacco sub-industry for the next 12 months is positive, reflecting improvement in the litigation environment and positive pricing trends. Also, we see competitive pressures in the US cigarette market easing.”

Consider that in April, the US Circuit Court of Appeals for the Second Circuit reversed the certification of a nationwide class action of “lights” smokers made earlier by a lower court in 2006. The reversal was a meaningful victory for the tobacco industry, which sought up to $800 bn against Philip Morris USA and other cigarette makers over light cigarette marketing.

In a separate legal matter, Philip Morris USA filed two lawsuits in federal court in January in the Eastern District of New York against importers, C.H. Rhodes of Flushing, N.Y., and US Sun Star Trading Inc. of Brooklyn, New York. The goal of the lawsuit is to end the importation, distribution and sale of counterfeit cigarettes and the unauthorized use of Philip Morris USA’s trademarks.

These suits came about after two seizures by US Customs and Border Protection at the Port of Newark in 2005 and 2006. In the 2005 a record 12,500 cartons of counterfeit Marlboro cigarettes was seized. In 2006 nearly 4,000 cartons were seized by authorities. “We will take action to protect our brands and the legitimate channels through which our products are distributed and sold,” said Charlie Whitaker, Vice President, Compliance and Brand Integrity at Philip Morris USA, which continues pursuing numerous strategies to fight the sale of counterfeit, illegally imported, stolen, and untaxed or under-taxed cigarettes.

Altria Group Inc., and Philip Morris International may be going their separate ways but each has grown from a common root. While they are each moving forward, the two new entities are powered with a strong history and bright future.


Tobacco International - May, 2008

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