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July / August, 2007

Imperial’s Efficiency Moves Pay Dividends

By Joseph Finora

With Altadis deal moving closer to completion, Imperial positions to take on the future.

Imperial Tobacco Group PLC, had been making headlines in the business sections as a leading suitor for Franco-Spanish Altadis Group, the manufacturer of Fortuna, Ducados, Gauloises, and Gitanes cigarettes. On July 18, the company announced a proposed cash offer of €50 (US$68.89) a share, or €16.2 bn (US$22.3 bn) for Altadis. The Altadis Board advised that it would recommend its shareholders to accept the offer, which is significantly more than earlier reported. There remains the possibility Altadis can still fetch a higher price as the Spanish stock exchange is unlikely to approve the bid until September at the earliest. There would then be an additional 20 days for any further bids to be filed.

The move for Altadis represents a continuation of Imperial’s strategy to grow not just organically, but by acquisition. Consolidation provides complementary markets/brands, builds synergies, and increases efficiencies—all of which help to open up further business opportunities in profitable Western markets as well as those in developing regions.

Chief Executive Gareth Davis described the deal as “a great strategic fit” noting that it will “consolidate” Imperial’s position as the world’s fourth-largest international tobacco company. “This deal significantly enhances our operating platform and scale with an increased presence in profitable mature markets and improved emerging market opportunities,” he said. If the deal comes together, it will strengthen the company’s cigarette presence in such markets as Germany, France, Italy, Morocco, Russia, Poland, and Finland. It will also add Altadis’ prestigious cigar business to Imperial’s existing world leadership positions in fine cut tobacco, rolling papers and filter tubes.

Reflecting on a likely Altadis-Imperial marriage, consider that Imperial has a nearly 47% market share in Great Britain but only a 3.5% in Spain according to data supplied by Citigroup, which is one of the banks helping to advise on the proposed acquisition along with Morgan Stanley, Lehman Brothers, and ABN AMRO. Conversely, Altadis enjoys a 24% market share in Spain with virtually no exposure to Britain— making this a sensible union from a geographic and market-share viewpoint.

Imperial initially approached Altadis in March with a non-binding bid of m45 per share. This was rejected and followed by an improved offer of m47 a share, in April which was also rejected by Altadis. In addition to Imperial’s overtures, Altadis has also been targeted for takeover by private equity firms.

In May, private equity firms CVC Capital Partners and French firm PAI Partners collaborated on a bid for the company, but PAI Partners later withdrew. CVC Capital Partners had staked some m1.5 bn of its own equity according to published reports. Any takeover syndicate would probably involve a group of banks. Other industry-watchers note that CVC may still have a role to play in battle to acquire Altadis.

While pursuing Altadis, Imperial recorded a good year for 2006 and continued that pace through the first half of 2007. The Bristol, UK–headquartered Imperial makes Davidoff, JPS, and West cigarettes; Drum fine cut tobacco; Rizla, the world’s number-one rolling papers; as well as cigars, filter tubes, pipe tobacco, and snuff. For the first half of 2007 it stood at the top of the pack with other industry heavyweights Altria Group and Reynolds American in overall sales gains.

In the first half of 2007, Imperial’s cigarette volumes were up 5% at 90.7 bn compared to 86.3 bn for the first half of 2006 with revenue (less duty) reaching £1,514 mn up 1% from the prior year’s posting of £1,496 mn. Profit from operations climbed 11% to £658 mn vs. £592 mn one year earlier.

“In the first half of 2007 we delivered another strong performance, reflecting the continued successful execution of our growth strategy,” said Davis. “We maintained our organic growth momentum of the last two years, increasing our global cigarette volumes by 5% and making further cigarette-market share gains across all our regions.”

Key cigarette brands such as Davidoff, West, and JPS, supported by strong performances from other brands, led the surge which also saw a company-wide focus on accelerating the international development of Davidoff since acquiring the worldwide cigarette trademark last year, and cost-cutting moves. Sales of the brand increased by 10% as launching it in several new markets as well as introducing additional brand variants proved to be a positive move. In February Davidoff was launched in Mexico and a distribution agreement with RBH in Canada was signed in April.

Imperial Tobacco Group PLC is the world’s fourth-largest international tobacco company. The Group manufactures and sells a comprehensive range of cigarettes, tobaccos, rolling papers, filter tubes, and cigars in over 130 countries. It has some 14,500 employees and 31 manufacturing sites, both down from last year when it had 15,000 employees and 32 manufacturing sites. Imperial’s strategy of simplification and standardization has increased efficiencies and reduced costs, and the company’s goal is annual cost savings of around £30 mn over the next few years.

On the other end of the Atlantic, Imperial acquired Commonwealth Brands last April for US$1.9 bn (£974 mn). Based in Kentucky, it is the fourth-largest US cigarette manufacturer with 3.7% of the US cigarette market. It employs some 700 individuals and has a factory in North Carolina, which currently produces about 14 bn cigarettes on an annual basis. Early predictions call for a £50 mn additional US profit by 2009.

“We will continue to develop our brand and product portfolio in order to build on our cigarette volume growth and strengthen our world-leading position in other tobacco products,” continued Davis. “Further extending our geographic footprint provides additional growth opportunities and through the completion of the US$1.9 bn acquisition of Commonwealth Brands, the fourth-largest US cigarette manufacturer, we now have a sizeable presence in this vast and highly profitable market. This, combined with our ongoing commitment to reduce costs and effectively manage cash, means we are well positioned to build on our success and deliver more value for shareholders.”

“We are targeting around £50 mn additional profit in the US in 2009 through the launch of further brands and products,” said Davis in a statement. “As well as providing an enhanced operating platform, the acquisition provides us with access to the North American Free Trade Agreement region which will help us to be more competitive when developing our presence in Canada and Mexico, where we have recently launched Davidoff cigarettes.”

Commonwealth Brands manufactures and sells five high-quality discount cigarette brands across the US and Puerto Rico, which together account for 13.2% of the discount segment. The two key brands are USA Gold and Sonoma. USA Gold is the eighth best-selling cigarette brand in the US and Sonoma the 14th. Commonwealth Brands’ other cigarette brands include Montclair, Malibu, and Riviera and it is the exclusive distributor of Bali Shag and McClintock fine-cut products in the US, which are manufactured by Peter Stokkebye of Denmark.

In the UK, Imperial reported strong results, with annual average cigarette market share at 46.4% by May 2007. This reflects good performances from Lambert & Butler and Windsor Blue. Lambert & Butler increased market share to 16.7% following the reintroduction of the “Celebration Packs” and growth in the superkings variant. Richmond remained stable at 15.5% while Windsor Blue benefited from development in the economy sector, with the brand capturing a 2.4% market shareIn Britain, Embassy and Regal both have a market share of 7.72% each followed by Superkings at 7.31%. Lambert & Butler has a 6.99% market share and Richmond has 6.38%. A 3% decline is forecast in the UK cigarette market by the end of Imperial’s financial year on September 30, once public smoking bans in Wales, Northern Ireland, and England take hold.

Cigarette market share in Germany reported on May 1 was 21.2% with JPS and West making up the bulk of the business compared to 20.5% reported 12 months earlier. As in Liverpool, it closed operations in Lahr, Germany. The restructuring is expected to generate total annual cost savings of around £11 mn fromfrom the 2007–08 financial year.

The total white-stick market in Germany has declined by 7% partly as a result of an increase in cross-border trade following the change in the taxation of Singles from fine-cut tobacco to cigarette. The market is changing, with many former Singles consumers migrating to both factory-made cigarettes and Other Tobacco Products (OTPs). Imperial’s overall position has been aided by the huge success of JPS Red at the value end of the cigarette market, as well as the launch of fine cut products West and JPS Single Tobaccos in 2006, and West Quickies XL in January 2007 for the value-seeking, former Singles consumer.

The Western European region has seen pricing improvements in Spain, Greece, and other markets with Imperial growing cigarette share in most countries in the region although the company also reports that results have been adversely impacted by declines at travel-retail sales sites. On May 1, its “Rest of the World” region reported 7% volume growth to 60.7 bn from 56.9 bn 12 months earlier.

In Taiwan, Imperial has completed negotiations with the Ministry of Finance to build a factory in the north-west of the island at a cost of around £45 mn. Construction is now underway and should be completed by the end of 2008. Initial annual production will be around 6 bn cigarettes, broadly equivalent to current market share of 12.7 %, but the factory will have primary capacity for 15 bn cigarettes. Annual savings of £20 mn should start in 2010 as a reduction in overall supply-chain costs and an improvement in operational efficiencies takes effect.

Company-wide, duty-paid cigarette market volumes have dropped by a scant 1% during in the first five months of this year but a 3% decline is forecast by year end once public smoking bans in Wales, Northern Ireland, and England take hold. The UK market forecast is not good as it has been annually trending downward due to increased excise taxes and growing health awareness.

In the boardroomAlso looking to the future, there have been some changes in the boardroom: Iain Napier was appointed chairman Chairman to succeed Derek Bonham, who retired from the Board. Dr. Pierre Jungels has been named Chairman of the Remuneration Committee and Senior Independent Director in succession to Napier. Each change was made in early 2007.

Imperial’s strategy remains to continue to create shareholder value through both organic growth and by acquisitions while cutting costs. The desired outcome is consistent top-line growth, cost efficiency and effective cash deployment. A straight-forward recipe with potential record performance in 2007 after a healthy 2006 indicates that the formula is continuing to work.

Tobacco International - July/August, 2007

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