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December, 2006


A Growing Tobacco Empire

By Michael Browne

Imperial Tobacco looks back on a very successful 2006, while setting its sights on the year ahead.

In a year that saw Imperial Tobacco observe its 10th anniversary as a public company, the Bristol, UK-based tobacco manufacturer had plenty of other reasons to celebrate. Impressive sales and volume increases, the acquisition of Norwegian tobacco distributor Gunnar Stenberg, as well as the deal to take control of the world-renowned Davidoff cigarette trademark, had the company feeling justifiably upbeat as the calendar year came to a close.

Imperial’s success in 2006 is reflected in the 7% growth in cigarette volumes and share gains across all regions that the company experienced. In the UK, a good performance from its existing strong brand portfolio was complemented by the successful national launch of Windsor Blue. In Germany, its second largest market, the JPS brand continued to grow strongly. And, in the Rest of Western Europe and Rest of the World regions, Imperial has grown its shares in most markets.

At home in the UK, according to c.e.o. Gareth Davis, “We grew our cigarette market share, further enhancing our market-leading position.” This, despite the fact that the company estimates the cigarette market was down 3% to 49.1 bn pieces (2005: 50.8 bn) with consumer downtrading continuing. The value and economy sectors now account for more than 40% of the total UK cigarette market, while the fine-cut tobacco market grew to 3,250 tons, up from 3,000.

While profits were up in the UK, cigarette volumes were down 2% to 23.4 bn pieces. According to the company, the profit performance reflects improvements in cigarette market share and the benefits of price increases, which more than offset market volume declines and downtrading.

“We delivered an excellent operational performance in the UK,” said Davis, “growing our cigarette market share to 45.5% (compared to 44.5% the previous year).” Windsor Blue, launched nationally in January 2006 in the economy sector, grew to 2.2% market share in September. New variants Superkings and Smooth and the relaunch of the celebration packs grew the UK’s No. 1 cigarette brand Lambert & Butler to a 16.2% share, while the No. 2 brand, Richmond, benefited from a packaging improvement and continued to perform well with a market share of 15.5%. Reflecting downtrading dynamics, Imperial’s Regal, Embassy, and Superkings brands remained under pressure.

The launch of Windsor Blue marked a strategic departure for the company. According to Davis, “We saw a gap in our portfolio. Lambert & Butler had done very well, but that's a higher-price brand. Richmond had also done extremely well, but we saw the gap at the bottom of the market that we weren't in —the so-called ‘economy segment.’ So we decided to put a brand in there and it was Windsor Blue that got the vote. I am pleased to say it has been very successful and I would anticipate it will carry on growing. I think that segment of the market will remain very buoyant.”

The company remains optimistic, despite increased regulation on smoking throughout the UK. Earlier this year, Scotland passed a smoking ban in public places (including pubs), and next year England, Wales, and Northern Ireland will follow suit. Commenting on the effect of the Scotland ban, Davis said, “It's been very similar to what we've seen in other countries where they have introduced a smoking ban in public places. In April, initially, straight after the Chancellor's budget, we saw about an 8% decline in the market. We reckon about 5% was down to the smoking ban and the rest was down to the budget increase. By the time we got to late August and September — it had been a pretty buoyant summer in the UK market — the effect, we would judge, is somewhere between 2% and 3% down on the rest of the UK. So, all the indications are the same as we saw in [The Republic of] Ireland [which passed a smoking ban in 2004]. There's an initial hit and then the problem ameliorates over time.”

Davis continued: “I think it will be very similar in Wales and Northern Ireland because the timing will be the same as the Scottish ban. In England the ban will be somewhat later in the summer. And, of course, people are outside the pubs then and a lot of the English pub estates compared to, say Scotland, have significant outdoor premises. So I think we will probably see slightly less effect in England in those summer months.

“I think obviously as the winter months set in, then people are less likely to stand outside of pubs. But what we have seen, of course, is they are less likely to go into pubs at all. We've seen off-license sales growing and people obviously choosing to drink and smoke at home. So the net effect, I think it is fair to say, we see as very manageable.”

In other positive news for Imperial, a ruling by the European Union's highest court in late November will prevent consumers from being able to buy cheap cigarettes and alcohol on the Internet from other EU states.

The European Court of Justice ruled that duty is charged in the EU state where goods are bought for personal use, but only if transported by the purchaser, effectively ruling out cheap online sales for consumers in high-duty countries like Britain.

"In the best possible outcome for the European tobacco industry, the European Court of Justice ruled that cross-border cigarette purchases must be both purchased for personal consumption and be transported personally across state borders," said JP Morgan analyst Michael Smith.

"This effectively eliminates any risk that Internet sales would undermine industry profit," he said.

The German Market
West Singles Tobaccos have become a successful replacement for Singles in Germany
Imperial continues to have success in Germany, its second largest market, where the company grew its market share to 20.7% (2005: 19.4%) driven by an excellent performance from its JPS brand. JPS captured the majority of market share growth in the low-price branded cigarette segment, with market share up to 3.8% (2005: 1.7%).

“That segment of the market, the branded lower-price segment, has grown remarkably over the last couple of years,” said Davis. “It's barely two years old and by the end of September it was around 16% of the total market. That segment of the market is growing very strongly and JPS has had an enormous share of that growth. So that has lifted our share. Also, Davidoff has been remarkably resilient for a premium brand. It's held its share of 1.1%, which is very creditable. So overall our share has grown over the year and continues to grow month on month.”

Dealing with the cessation of Singles, which were otherwise known as “modern” make-your-own tobacco products, continues to be a huge issue for the industry in Germany, but Davis believes the company is making good progress. Since the European Court of Justice ruled in November 2005 that singles Singles should be taxed as cigarettes rather than fine-cut, the company was forced to review its strategy. When the new tax went into effect April 1, Imperial ceased production of Singles, which were no longer considered a value proposition for customers.

Singles were pre-rolled cartridges of tobacco designed to be inserted into filter tubes with a special device resembling a pen. They were extremely popular among value-seeking German smokers until autumn 2006 when they finally disappeared from retailers’ shelves. The issue for the industry has been how to manage the inevitable migration of consumers to alternative tobacco products.

But, Davis said, “If we look at the signs so far, as I said, we've seen the growth of JPS in that lower-price branded cigarette segment, which is very encouraging. Our traditional fine-cut roll-your-own brands, Drum and Van Nelle, have had a very good year in Germany and there we've grown volumes by about 17% over the last year and our share has grown also.

“And then our new product, West and JPS Single Tobaccos, which are a substitute for the withdrawn Singles, have grown very well. In fact, they're exceeding our expectations at the moment and we are seeing week-on-week growth of those products. So, so far it looks to be going quite well.”

Imperial will also be introducing West Quickies XL in mid-January. The new Quickies are 180mm long tobacco rolls, designed to be cut by the consumer into shorter rolls and inserted into filter tubes. West Quickies XL fit into all frequently used filter tube formats in the German tobacco market; the tobacco rolls can be most effectively cut with the specially designed and also newly launched West Cutter tool. West Quickies XL give the consumer the option of choosing the length of each cigarette he or she smokes.

Davis acknowledges that cross-border sales have grown very steeply as well since Singles ceased to be manufactured — from the high teens to the low 20% range. “That's a worrying trend,” he said, “not only for us, but for the German government as well as it affects their revenue. So, steady as she goes at the moment. The migration of customers is going just about as we would have expected and I think our broad portfolio across the different product categories gives us a really good chance to make good the fracture caused by the Singles judgment from the European Court of Justice.”

After announcing plans to prohibit smoking in schools, public buildings, and most restaurants in early December, Germany's ruling coalition rescinded the proposal on constitutional grounds, saying that an outright federal ban could infringe on individual states' rights. Such a smoking ban would have brought Germany, Europe's biggest tobacco market, closer in line with the 13 of 25 European Union states to have introduced legislation to outlaw smoking in public places. A nationwide smoking ban might not survive a challenge from tobacco users in the courts, so the decision to ban smoking will now be up to Germany's 16 federal states, which have extensive rights that cannot be overridden by Berlin.

More than a quarter of Germany's entire population of 82.4 million people smoke, according to a 2005 study. Earlier this year, the government passed a law restricting cigarette advertising.

Growing the World Over
In 2005, Imperial acquired the Skruf brand.
Tobacco consumption in Western Europe has fallen 2% to 2.5% annually the past several years due to tax increases, prohibitions on advertising, and smoking bans, according to one tobacco industry study. More than 20 European Union countries enacted bans on most forms of tobacco advertising in time to meet a 2005 deadline.

But Imperial’s market share continues to grow in most of Western Europe, though the total regional cigarette market was down by 3% in 2006 and the regional fine-cut tobacco market down 2%. However, the value segments in both cigarette and fine-cut tobacco have grown as a result of consumer downtrading and an increasingly competitive pricing environment. According to the company, Imperial’s volumes have grown by 14% with the improvements in market shares more than offsetting the market volume decline.

Noting that growth in volume, Davis said, “That is a tremendous performance and I think that gives us confidence to go on further building that share and that's how we would plan to tackle further market volume decline. That's been happening in the UK for 20 years; the market has been declining but Imperial has continued to grow its share and grow its profit quite aggressively.”

In the Netherlands, Imperial’s cigarette market share grew to 8.9%, up 4% from the previous year, driven by the strong growth of West and JPS. In January 2006, the company entered into a distribution agreement with Altadis. Fine-cut tobacco market share remained stable at 51.1% with Zilver and Evergreen benefiting from the downtrading dynamic.

In Belgium, domestic cigarette share rose to 10.2% from 9.5%, driven by the growth of Route 66 and supported by the stabilization of the Bastos brand.

After the introduction of smoking bans in Italy last year, the initial market decline is beginning to slow with an overall estimated cigarette market decline of 5% this year. Imperial’s cigarette share is slightly down at 1.5% (from 1.6% in 2005), with minimum pricing, introduced by the Italian Government in August 2005, reducing the company’s ability to develop its portfolio.

In Ireland, with the overall cigarette market size up slightly to an estimated 5.7 bn, Imperial’s cigarette market share was unchanged at 26.2% with a strong performance from Superkings.

The company grew its cigarette share in France to 3.6% (from 3.3%) thanks to the success of the JPS family. Imperial maintained its position in the fine-cut tobacco sector with a robust performance from the market leader Interval at 14.9%, while its overall fine cut-tobacco share declined from 29% to 28%.

In Spain, JPS was also credited with growing Imperial’s cigarette market share to 6.4% from 5.1%. However, trading conditions remain challenging following excise tax increases in February 2006, which were mainly absorbed by tobacco manufacturers, reducing the estimated profitability of the market by more than 30%.

In Greece, Imperial’s cigarette market share increased to 8.4% from 7.0% due to a strong performance from Davidoff in the premium segment, now up to 3.3% from 2.7%, supported by West.

Fine-cut continues to be a strength for Imperial throughout its European markets. “We are undoubtedly the world leader in other tobacco products, particularly fine-cut,” said Davis, “and we have three of the world's top four brands. We are getting some challenges though, particularly from downtrading within fine-cut. And we have launched some low-price brands ourselves, particularly in the Netherlands where our share has come under pressure in recent years. I'm pleased to say we've managed to stabilize that and started to turn it around a little bit with the launch of some new brands.”

According to Davis, it’s all about “defending our position, stabilizing it and then pushing it forward. Beyond that, it's then pushing roll-your-own into new markets. In a lot of the accession markets in Europe where the cigarette taxes are rising rapidly, we're starting to see the emergence of a roll-your-own segment and we've launched some pretty innovative products into many of those markets over the last 12 months and will continue to do that.”

The company acknowledges there are some challenges to its growth in Western Europe, most significantly further regulatory changes that will lead to moderate reductions in market size. But Davis remains optimistic.

“We believe the breadth of our product portfolio continues to provide us with future opportunities for growth,” he said.

As for the Rest of the World, Imperial continued to experience volume and market share gains in many of its markets, including Australia, Asia, Central Europe and Africa and the Middle East. While overall performance was strong in these regions, Davis admits that margins are lower.

“Our overall operating margin as a company is just under 43%,” he said, “whereas our Rest of the World margins are just under 23%. That's not too bad in many ways. If I look back to the time of our Reemtsma acquisition in 2002, the Rest of the World margins were about 18%. So we've grown significantly year-on-year. In fact, this last year we've grown the Rest of the World margin by 2%. So it's certainly going in the right direction and it's very dependent on the skew of the business. The more business there is in the higher-margin markets like Asia, the duty-free business, Africa, etc., then the higher the overall margin will be. If the skew is more toward Russia, Eastern Europe, and Central Europe, then the lower the overall margin.

“It's really a question of getting a good cocktail: a blend of margins, a blend of development going forward that actually fits the business well. I think we've got it just about right but obviously there's always going to be more to do in that direction.”

Coming to America?
In 2006, Imperial took control of the world-renowned Davidoff cigarette trademark.
Having conquered Europe and much of the rest of the world, Imperial acknowledges that it has been monitoring developments in the United States for a considerable period of time and is encouraged by the recent positive developments in the litigation landscape. As the second largest market in the world, representing 7% of world cigarette volumes and a significantly higher percentage of world profit, the United States offers “great potential for the Group,” said Davis. Imperial currently sells and distributes papers and tubes in the States and has a basic infrastructure in place.

Recently, Imperial submitted an application to join the country’s Master Settlement Agreement, which exempts tobacco companies from tort liability from state governments in exchange for a combination of yearly settlement payments to the states. The timing for this move seemed right for the company.

Said Davis: “For a new entrant like ourselves — and remember, we're not buying past liabilities — this is a straight, organic new entry. So the risks associated with going into the U.S. for us today are no greater than going into many other markets. That's why we've had the change of heart.”

He added, “I think if you get into the United States and you have moderate success, then that also gives confidence to build a platform to expand into other parts of the Americas. And those are currently all white spots for us.”

Indeed, growth through market expansion and acquisition seems to be the company’s modus operandi going forward. A good example is its purchase of the Davidoff cigarette trademark in September. Imperial has been the long-term licensee of the brand, but its ownership will give the company greater latitude in expanding an already successful cigarette brand.

“Over the last four years [Davidoff] has done exceptionally well and this last year has been no exception,” said Davis. “We've grown it by 6% up to 14 bn sticks worldwide. But I think what ownership gives us is the confidence to invest more fully in the brand and expand its geographic footprint. It's already in a hundred markets around the world and we are seeing terrific opportunities by extending the portfolio of SKUs of Davidoff, different types of offerings, and also going into more markets around the world. We think it's a very strong, sought-after brand and it's got great potential for us.”

Much the same thinking went into the company’s acquisition of Gunnar Stenberg, the Norwegian distributor of tobacco products and accessories, this past February. Gunnar Stenberg distributes a range of products in Norway, including cigarettes, fine-cut tobacco, snus, and filter tubes as well as Rizla rolling papers. The acquisition has provided the opportunity to launch Imperial Tobacco Group cigarette brands in the Norwegian market.

The deal complemented Imperial's purchase of a 43% stake in the Swedish snus manufacturer Skruf in September 2005, with a commitment to purchase the balance of the shares by mid-2009.

In the 10 years since Imperial de-merged from Hanson, the company has made “tremendous progress,” said Davis. “When we de-merged we were very much a UK-based company. We are now a major international player — the fourth largest international tobacco group in the world — and now we have a great portfolio of brands to sell around the world and increase our international footprint.”

Tobacco International - December, 2006

U.S. Tobacco Cooperative

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