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December, 2006

JTI, Gallaher Deal a Sign of Things to Come?

While the news of Japan Tobacco’s acquisition of Gallaher was not a big surprise in the industry, now that it’s pretty much a done deal some reverberations are being felt.

By acquiring Gallaher, which is strong in Russia, eastern Europe, and other regions where tobacco demand is expected to grow, JTI is looking to offset a decline in Japan, where sales of tobacco have been sluggish due to the graying population and the fact that fewer people smoke.

The company aims to increase shares in European markets in its efforts to eventually supplant BAT in the world's No. 2 position, behind Altria’s Phillip Morris (a profile of the tobacco giant appears in this issue of Tobacco International). For now, the move certainly reinforces JTI’s No. 3 ranking. The combined company would have annual global output of 600 bn cigarettes, JTI said.

“JTI wants to boost its global market share with one big purchase,” Fitch Ratings analyst Satoru Aoyama told Reuters. “We might say it is a strategy to survive.”

Added an analyst from Standard & Poors: “JTI aims to boost its earnings base in overseas markets, which are expected to grow. In the medium to long term, this acquisition should lead to a stronger business franchise, supported by an expanded brand portfolio and geographically diversified earnings sources.”

Overseas cigarette sales have been JTI's main source of profit growth in recent years, and in 2005 international sales overtook those in Japan for the first time.

In Japan, where the Tokyo-based company has a two-thirds market share, cigarette sales fell 1.3% in the six months to September from the same period last year to 2.02 tn yen ($17.19 bn). Sales volume fell 4.7% to 140 bn cigarettes.

Gallaher, meanwhile, earns 70% of its profits from the shrinking cigarette markets of Britain, Ireland, Austria, and Sweden. To offset this decline the company has been expanding into Russia, Kazakhstan, and Ukraine, and earnings there have risen sharply.

The deal makes moot the ongoing speculation that BAT or Philip Morris would make a bid for Gallaher. BAT has made it clear that it does not want to enter into a costly bidding war with JTI — although there is speculation that the company is open to a bid elsewhere within the tobacco industry, with a flurry of consolidation anticipated following the Gallaher deal. Analysts believe that BAT would probably be more likely to consider an approach for Altadis or Imperial Tobacco.

Meanwhile, Credit Suisse suggested that Philip Morris would be reluctant to let the combined JTI-Gallaher overtake its leading position in Russia, and could team up with Altadis to avoid antitrust issues. Other reports have suggested that Altadis may also be tempted to team up with private equity.

As with any industry, there is plenty of movement in the aftermath of a big deal. On the day the purchase was officially announced, for instance, shares of Altadis rose 1.3% on speculation the cigarette maker may receive a bid while Swedish Match, the world's second largest producer of smokeless tobacco products, increased 0.8%.

In any event, the deal is likely to ignite continued speculation of further deals and consolidations within the tobacco industry. Stay tuned.

- Michael Browne

Tobacco International - December, 2006

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