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December, 2007

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Marlboro Man Pioneers New Territory

By Joseph Finora

Following the spin-off of its Kraft Foods holdings last year, Altria is pursuing plans to divorce its US and international arms. Untethered from the litigation tangles of the US market, Philip Morris International will be free to explore growing global markets, while Philip Morris USA looks for a future in smokeless with the help of a state-of-the-art research facility.

At the time of publication, late in the third quarter of 2007, all the ingredients for a smokin’ year were adding up for Altria Group, Inc. Most notably, a lower tax rate, favorable currency positions, and a focus on cost-cutting helped as third-quarter diluted earnings per share were $1.24, up $0.19 (or 18.1%) versus the prior year.

“In the third quarter, we continued to witness improvement in our business fundamentals, which generated robust earnings growth,” said Louis C. Camilleri, Chairman and Chief Executive Officer of Altria Group, Inc. “In addition, we took numerous steps to accelerate our growth by investing behind product innovation and announcing our intention to pursue a further restructuring of our company.”

While both Philip Morris USA (PM USA) and Philip Morris International (PMI) posted strong operating income results, PM USA garnered strong growth through cigarette volume increase. Consider that PM USA’s shipment volume was down only 1% during the quarter while the entire industry was down roughly 3%–4%. Simultaneously, PMI enjoyed a favorable pricing climate with volumes up 0.6%, while the European Union’s overall cigarette volume dropped nearly 5%.

“Third-quarter revenue was better than expected for Altria,” said Bradford M. Pine, a Registered Principal with Cantella & Co., Inc. in New York. “The company raised its guidance for the balance of 2007 partly due to a lower tax rate but also thanks to strength in international sales and a weaker dollar behind it.”

While Altria is by many standards an established company, it is no stranger to change and regularly on the move. Early this year it spun-off its Kraft subsidiary and struck a long-term license agreement to manufacture, distribute and market Altadis’ Gauloises and Gitanes brands in select Asian countries. Earlier this year it announced plans to maximize its worldwide cigarette production by moving US-based cigarette production for non-US markets to PMI facilities in Europe, and to consolidate manufacturing for the US market by closing its Cabarrus, North Carolina facility and moving all US production to its Richmond, Virginia plant. It also began testing Marlboro Moist Smokeless Tobacco in a test market. Recently the company reached an agreement in principle to acquire an additional 30% stake in its Mexican tobacco business from its joint venture partner, Grupo Carso, S.A.B. de C.V., which was completed in early November 2007. The company noted that in 2008, it will very likely to spin off its international tobacco unit. It is also moving its corporate headquarters from New York City to Richmond, Virginia, where annual projected savings from the move are expected to be $250 mn. Richmond is also the site for the company’s new Center for Research and Technology.

Altria announced on November 1, 2007, that it entered into an agreement to acquire 100% of John Middleton, Inc., a leading manufacturer of machine-made large cigars, from privately held Bradford Holdings for $2.9 bn in cash. The net cost of the acquisition, after deducting approximately $700 mn in present value tax benefits arising from the terms of the transaction, is $2.2 bn. John Middleton, Inc.’s operating revenues are projected to reach $360 mn in 2007, generating operating income of $182 mn. Over the 2003 to 2007 period, operating revenues and operating income are estimated to have grown at 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 is expected to reach a level of 1.2 bn units. “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 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.”

Shifting Production, Reducing Smoke
Altria is currently begun the process of sourcing some 57 bn cigarettes from Cabarrus, North Carolina to facilities in Europe and will close its Cabarrus manufacturing facility by the end of 2010 where it currently has approximately 2,500 employees. PM USA said that it plans to source its production of cigarettes sold in the US from its manufacturing facility in Richmond.

“PM USA recognizes the profound impact the closing of the Cabarrus cigarette manufacturing facility has on employees and their families. As the company works to reduce manufacturing overcapacity, it will address the adverse impact on employees by relocating as many as possible to jobs in Richmond and offering separation benefits to those it cannot relocate,” Mike Szymanczyk told reporters.

In July it was announced that PMI had reached an agreement in principle to acquire an additional 30% stake in its Mexican tobacco business from its joint venture partner, Grupo Carso, S.A.B. de C.V. PMI had held a 50% stake in this Mexican tobacco business. The transaction brings PMI’s stake to 80%. Grupo Carso would retain a 20% stake in the business which has a value of approximately $1.1 bn and is expected to close smoothly. It is expected the transaction should increase Altria’s annualized net earnings by approximately $0.03 per share.

Last August, PM USA announced the introduction of Marlboro Moist Smokeless Tobacco into one test market. Marlboro Moist Smokeless Tobacco is to be offered in Original and Wintergreen flavors and will be available in Long Cut and Fine Cut varieties. “Marlboro Moist Smokeless Tobacco represents premium quality and flavor and will be introduced at an attractive price for the adult moist smokeless-tobacco consumer,” said Szymanczyk, in a statement. “This new offering builds on the premium-tobacco experience that Marlboro represents.”

Marlboro Moist Smokeless Tobacco was introduced in the Atlanta, Georgia market to evaluate consumer acceptance. While retailers ultimately will determine the product’s price, Philip Morris USA anticipates it to sell for around $3.00 a can, midway between the highest-priced and lowest-priced products in the Atlanta market.

“Smokeless tobacco is the largest tobacco category behind cigarettes and has been growing for a number of years,” said Szymanczyk. “Introducing Marlboro Moist Smokeless Tobacco is a natural fit for our growth strategy.” PM USA’s growth strategy is to add tobacco or tobacco-related products that are adjacent to its existing business of cigarettes. Philip Morris also is adding more Marlboro branded products to its lineup, including Marlboro Smooth and Marlboro Virginia Blend cigarettes.

The steady decline of US cigarette volumes pose yet another reason for PM USA to continue with a nationwide introduction of its smokeless product lines in the near future. Early consumer-test results are positive for smokers looking for a tobacco product when they can not light up. Smokeless is growth opportunity for Philip Morris USA as it will use the well-established and trusted Marlboro name to sell the new products. Observers believe that Marlboro Snus will attract the majority of smokers considering going smokeless (snus have been heralded by some public health advocates as paths to cigarette cessation). Current plans also call for Marlboro Moist, which is to be priced at a level in between premium and price-value and therefore may draw customers from both price points in a segment that’s estimated to grow at an annual rate of 5%–6%, providing PM USA with a way to maintain and/or grow earnings outside of cigarettes in an environment where consumption has been declining.

“In the US, Philip Morris is facing declining smoking rates,” said Cantella’s Pine. “Plus there’s the possibility of lawsuits and growing excise taxes. The decision to focus on smokeless provides new opportunity.”

Breaking Up
Altria also announced plans to spin off Philip Morris International with the intention of giving it a greater ability to pursue international opportunities. Meanwhile, on the US side, Altria will continue its role as parent company to PM USA, owning 100% of PM USA and Philip Morris Capital Corporation, as well as its 28.6% economic interest in SABMiller plc. PM USA produces one-half of the cigarettes consumed annually in the US and will probably more vigorously pursue the smokeless category. At the same time, Altria Chief Executive Camilleri will become PMI’s new CEO while Michael Szymanczyk will become CEO of Altria Group, Inc. Currently, international operations, which span some 160 countries, are managed through PMI’s offices in Lausanne, Switzerland and headed by André Calantzopoulos, President of PMI. If and when the spin-off is completed, PMI’s headquarters will be in New York City with its Latin America and Canada region headquarters and Lausanne will serve as its Operations Center. André Calantzopoulos will serve as President and CEO of PMI.

International cigarette volume is expected to grow some 1%–3% annually over the next 20 years, largely thanks to access to new customers in emerging markets. It is expected that PMI will be able to penetrate this segment thanks to its brand strength, experience, distribution, and relationships with other brands—not to mention its financial muscle. PMI is currently the world’s second-largest tobacco company, second to China National Tobacco and has leading positions in Western Europe, Latin America, and Japan. PMI entered into a licensing agreement with the China National Tobacco Corporation (CNTC) in 2005 to produce Marlboro cigarettes there. Chinese production of Marlboro cigarettes began in 2006. Shortly thereafter the Chinese government prohibited the construction of new cigarette factories, including joint ventures with foreign partners, as part of a government-led effort to reduce smoking in a country that annually consumes nearly 2 tn cigarettes.

“The key to success with Marlboro is to stay relevant to our existing adult smoker base, particularly among legal age (minimum age 18) to 29 year-olds, and to respond to changes in consumer preferences and trends,” said Calantzopoulos at the JP Morgan Global Tobacco Conference last June in London. “We intend that Marlboro remain the modern market leader through enhanced consumer understanding and innovative leadership.”

The strategy coming from the Altria boardroom behind the break-up is that it will create two very strong, independent companies. It’s hard to argue with this idea as each will have robust balance sheets, tested leadership, powerhouse brands, and in-depth marketing and distribution support. Altria filed with the Securities and Exchange Commission in September to prepare for the spin-off. Altria shareholders would receive one share in the international company for each share of Altria owned as of the Record Date for the Distribution. The Altria Board expects to finalize its decision and announce the precise timing of the spin-off at its January 30, 2008 meeting. It is expected that Altria will maintain its 28.6% economic interest SABMiller after the split.

“A Philip Morris International would be insulated from US litigation,” said Pine. “It should have a lot of growth potential internationally and be more aggressive because of increased financial flexibility and possibly make more acquisitions.”

“We believe this increases the likelihood that a stand-alone PMUSA eventually purchases the smokeless tobacco firm UST,” noted Morningstar tobacco-industry analyst Greggory Warren, CFA, who adds that litigation sill remains the biggest risk facing the company.

“We expect sales volume to grow,” notes Standard & Poor’s tobacco-group analyst Raymond Mathis, who cites brand investments, acquisitions, line extensions and new product introductions to help electrify the market. Higher prices, a “positive mix shift” and improving volume trends should keep sales percolating both domestically and internationally. The Kraft spin-off, while not only generating significant cash, also had the effect of lowering Altria’s debt-interest expense. Mathis, while acknowledging the inherent risk, notes that domestic litigation pressure should continue to “ease.”

PMI fans should note that the company is already benefiting overseas from such factors as increased pricing, cost savings and favorable currencies yet results in key markets still have room for improvement. This was made evident analyzing third-quarter results as the German market has been hit by tax-driven price increases and stringent vending machine regulations. The Czech market was hurt due to tax-related price increases in the second quarter, while most competitors took price increases in the third quarter. The Polish market saw volumes decline significantly due to tax-laden price increases as well. Tax increases are taking their bite from profits as emerging markets rush to catch-up with their Western neighbors and close budget gaps that have become exposed since entering the free market. Additionally, PMI’s cigarette market share in the EU declined by 0.6% to 39.1%, and its volume in the region declined by 4.8% compared to the same period one year ago.

Consider that in 2006, PMI cigarette volume rose by 27 bn units, or 3.4%, to 831.4 bn units, driven by the full-year inclusion of acquisitions of Sampoerna in Indonesia and Coltabaco in Colombia, as well as volume growth in Eastern Europe and in other markets such as Argentina, Poland, France, and Mexico. Excluding the one-time factors, PMI cigarette volume was up by 0.4% to 804.7 bn units. PMI net revenues excluding excise taxes were up 3.9% to $20.8 bn, driven by acquisition volume and higher prices in many markets, partly offset by the impact of price competition in Spain, Argentina, Poland, and the Czech Republic and unfavorable currency rates.

Pioneering Research and Technology Center
Philip Morris USA has opened a new Center for Research and Technology with the objective of reducing the harm caused by smoking. The $350 mn, 450,000-square-foot Center for Research and Technology nearly doubles the company’s research space and gives the Richmond-based scientists and engineers one facility to collaborate on new projects. Currently there are about 100 employees at the center but some 500 are expected to be there by the end of the year.

“The investment is large and we’re pretty sure that it will bear fruit for Philip Morris USA both in terms of volume and profitability in the years ahead,” said Dinyar Devitre, Altria chief financial officer.

Devitre said the center will give the company “a much brighter future” through improvements of current products and the development of new and reduced-risk tobacco products. He said it also would give the nation’s largest manufacturer “a leg up in the smokeless category.”

A Philip Morris USA spokesman said the company’s future growth is going to come from innovation and will be driven by the development of new products. The plan is to offer smokers new and innovative cigarettes while reducing potential harm. Unlike an introduction from a start-up company, new PM USA products will benefit from Philip Morris USA’s marketing and distribution know-how and name-recognition. Each will have the same look and taste of other PM USA products and possibly benefit from Food and Drug Administration oversight which could set guidelines, thus limiting any potential liability by setting the standard for warning labels and ingredient listings. Whether new tobacco products will actually pose less of a health risk than their predecessors depends on the products that come out of the lab—so far, PM USA is not talking about what’s in the pipeline or how the research will pay dividends in the future. But as declining volume, smoking bans, competition, and increasing taxes eat into the company’s bottom line innovations may help the cash-rich PM USA maintain its leading position.

The Fights Go On
Philip Morris USA filed lawsuits in September against retailers selling counterfeit versions of the company’s Marlboro cigarettes. The company filed three suits against 105 retailers in federal courts in New York and New Jersey in an attempt to stop the sale of counterfeit cigarettes and the unauthorized trademark usage.

“The sale of counterfeit cigarettes undermines the value of Philip Morris USA’s brands and the legitimate channels through which our products are distributed and sold,” said Charlie Whitaker, Vice President, Compliance and Brand Integrity, PM USA. The suits are the result of the company’s periodic marketplace purchases of cigarettes. Each of the named defendants sold counterfeit cigarettes during recent purchases in New York or New Jersey.

Separately, PM USA filed two lawsuits in federal court against Internet site operators engaged in the sale of illegally imported cigarettes bearing PM USA’s trademarks, including the Marlboro mark.

The lawsuits allege that the websites are selling cigarettes that have been imported in violation of the Imported Cigarette Compliance Act of 2000. In some instances, the defendants have also made false statements about the legality of these sales. The Internet-based cigarette vendors named in this lawsuit fail to comply with applicable tax laws and the federal Jenkins Act, which requires Internet cigarette retailers to report all sales to the purchaser’s home state taxing authority. The suits, filed in the United States District Court for the Southern District of New York, name as defendants the owners or operators of www.paylessmoke.com and www.cigmall.net, as well as a number of related websites. 

By this time next year Altria may exist in another form, split into a US and international division. In any case, it promises to be a vigorous, innovative company powered by desirable brands, alert management, and a determined vision.


Tobacco International - December, 2007

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