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August, 2008

Rejuvenated Imperial Rolls Brands Forward

By Joseph Finora

An in-depth look at the recent workings of one of the world’s biggest tobacco companies.

An expanded and fortified Imperial Tobacco Group continues to evolve following its Altadis and Commonwealth Brands acquisitions, completed in January ’08 and April ’07 respectively. And while the immediate forecast calls for some rough weather, the international tobacco firm is forging ahead, armed with a stronger brand lineup and an increased set of operational efficiency and revenue synergy targets.

It’s estimated that the integration of the Imperial and Altadis businesses is expected to generate annual operating efficiencies of approximately € 300 mn by the end of the company’s fiscal year in September 2010. This should rise to approximately ››400 mn by the end of its 2012 fiscal year. The one-time cash cost of achieving these efficiencies is estimated to be approximately € 600 mn, more than the e470 mn previously estimated, reflecting the fact that these updated efficiency targets are higher than initially thought.

In mid-June, Imperial announced the details of a restructuring program that it is proposing to “implement progressively over the next three years as part of the integration of Imperial and Altadis.” The projects will affect sales, marketing, manufacturing, and central support functions. Imperial employs roughly 40,000 people globally, and the restructuring projects will potentially reduce this number by 2,440 with the closure of six of the company’s 58 manufacturing facilities.

In the first half of its current financial year, Imperial’s cigarette volumes were up 34% to 121.1 bn from 90.7 bn in 2007. Tobacco net revenue rose 39% and adjusted profits were up 38%. However, profits from operations fell by £94 mn - about 14% - chiefly as a result of accounting adjustments relating to the Altadis acquisition.

Along with some organic growth from Imperial’s brands, strong contributions also came from Commonwealth Brands and Altadis. Imperial reported cigarette and fine-cut tobacco share gains in such key markets as the United States, Germany, France, and Spain. Enhanced profit delivery in Imperial’s “Rest of the World” region was also reported through increased volumes and improving market shares of a number of cigarette brands, such as West. On a global level, Davidoff volumes grew 4%, JPS rose 10%, and “encouraging growth” was described for Fortuna and Gauloises Blondes, two brands which Imperial gained through the acquisition of Altadis.

“We have had a great start to the year with a strong performance from our core operations and an encouraging initial contribution from Altadis,” said Gareth Davis, Chief Executive. “A review of the activities of the Group as a whole has enabled us to update the targeted operational efficiencies to be generated through integration. We also expect to be able to achieve annual revenue synergies from the Group’s enhanced operating platform and brand and product portfolios.”

Imperial, the world’s fourth largest international tobacco company, is headquartered in Bristol, UK, and offers products in over 160 countries. It manufactures, markets, and sells a full line of tobacco products including cigarettes, cigars, rolling papers, and tubes, as well as fine-cut tobacco, including roll-your-own and make-your-own tobaccos, pipe tobacco, snuff, and snus. Its traditional international brands include Davidoff, West, Rizla, Drum, and Golden Virginia; it also has a strong line-up of regional brands including Lambert & Butler, Classic, JPS, Horizon, Maxim, and Excellence. By acquiring Altadis it picked up such prestigious cigarette brands as Fortuna, Gitanes, and Gauloises as well as such highly regarded cigar brands as Cohiba, Don Diego, H. Upmann, Partagas, Montecristo, Hoya de Monterrey, Dutch Masters, and many others.

Commonwealth Brands, formerly the fourth-largest US cigarette manufacturer, added such brands as USA Gold and Sonoma, respectively the eighth and 14th best-selling US cigarette brands. Commonwealth also added such lesser US cigarette brands as Montclair, Malibu, and Riviera to the Imperial stable, and it is the owner of the Bali Shag and McClintock fine-cut tobacco products in the US.

In April 2008, Imperial introduced its Davidoff cigarette brand to the US market, initially focusing promotional activity in ten key cities. It has also since added the Rave cigarette and fine cut tobacco brand to its US portfolio through the acquisition of Lignum 2. As a result, Imperial’s total US fine cut tobacco market share has risen to around 7%.

“Operationally, we performed well in our core European markets and were very active building our presence in the USA,” continued Davis. “It is also pleasing to see the Group generating real momentum in our Rest of the World region, where we see considerable opportunities for growth. Davidoff’s international development and volume growth was another highlight, supported by a strong performance from JPS and good progress from Gauloises and Fortuna.”

Adding further comment, Davis noted, “Our strengthened cigarette portfolio and world leadership in cigar, fine-cut tobacco, and papers provides plenty of scope to grow and develop our business. Combined with our focus on reducing costs and effectively managing our cash, we remain very well placed to continue to deliver long term sustainable value for our shareholders.”

Recent Changes
It’s certainly been a busy time for Imperial Tobacco since the acquisition of Altadis was completed. In February 2008, Bob Dyrbus - Imperial’s Finance Director - was also appointed Chief Executive Officer of Altadis, following the numerous inevitable resignations from the Altadis board that followed the completion of the deal.

In March, Imperial announced it agreed to dispose of its 49.95% share in Aldeasa, S.A. to Autogrill España S.A., a subsidiary of Autogrill S.p.A, for € 275 mn. Aldeasa is a Spanish-based airport duty-free retailer which generated sales of approximately € 830 mn in 2007. Aldeasa had operated as a joint venture between Altadis and Autogrill since 2005.

Then in April, Imperial agreed to divest a number of fine-cut and pipe tobacco brands to Philip Morris International for € 254 mn. The divestment of a small number of brands in certain European markets was a condition of the European Commission’s approval of the Altadis acquisition and includes the fine-cut tobacco brands Interval, Bergerac, Santoya, and Wervicq (France), Van Nelle (Italy and the Canary Islands) and Picadura (Spain), as well as the pipe tobacco brands Bergerac (France) and Kilta (Finland). It is not anticipated that this divestment will not adversely affect the operational and financial performance of Imperial in any material way.

Finally, in May, Imperial extended its mandatory cash offer for Compañía de Distribución Integral Logista, S.A. (Logista) at € 52.50 per share. Prior to the offer, Altadis owned 59.62% of Logista. As a result of the offer, Imperial now owns 100% of this important Western European/Moroccan logistics business, although it has stressed it will continue to be run on a stand-alone basis.

Maintaining Its Rights
In May, Imperial Tobacco announced it would issue £4.9 bn ($9.6 bn) of discounted stock to help pay for the £11.3-bn Altadis. Known in Europe as a Rights Issue, it offers shares at a discount to existing shareholders. In a June 12th announcement, Imperial announced it received valid acceptances with respect to 329,215,281 new shares, representing approximately 97.19% of the total number of new shares offered to shareholders.

Opinion is mixed among seven investment-research firms which follow Imperial, with two weighing in with “unfavorable” opinions, one “favorable,” one “most favorable,” and two registering “neutral/hold,” recommendations. While the strength that may come with increased volume and synergy-based savings are widely viewed as favorable factors, competition - especially from a newly unleashed Philip Morris International - remains tough. In the first six months of its current financial year, Imperial saw a 6% drop in the UK cigarette market, as England and Wales joined Scotland in banning smoking in public places, and with rising prices and taxes also eating into demand. In Germany, the cigarette market dropped by 5% as tax increases reduced demand and more smokers moved to low-priced, less profitable brands. In the US, where Imperial claims just a 4% market share, the overall market dropped by 5%, a result of the reversal of a 2006 inventory build-up.

In common with its peers, Imperial is trying to gain a beachhead in developing/emerging markets. According to some industry analysts, it does not have the heavy-hitter brand to give it the clout it may need, although the addition of international Altadis brands such as Gauloises and Fortuna will help with selected expansion into markets where the enlarged Group has no presence. With the Altadis acquisition, new markets for Imperial already include Morocco, Finland, and Argentina. Business is also benefitting from enhanced positions in Russia, Poland, Austria, Lebanon, and the United Arab Emirates. Declines in mature markets due to smoking bans and taxation are expected to be offset by gains in newer markets, where regulations are not as restrictive and the cost of doing business not as high. Continental Europe remains its main profit center, but it is facing competitive pressure from BAT and the aforementioned Philip Morris International.

Imperial continues to do much of its business in Europe, with some 60% of its profit derived from Western markets such as the UK, Germany, France, and Spain in its last financial year. Indeed, following the acquisition of Altadis it is now Europe’s second-largest cigarette company. Its other lines, such as its Other Tobacco Products, are relatively small in comparison, but still the company can boast being the world leader in cigars, fine-cut tobacco, and rolling papers.

A new risk on the horizon appears to be in the form of a range of various tobacco control proposals put forward by the British government, including one requiring cigarettes to be packaged in plain packs. The government has already launched a public consultation on the proposals, which also include prohibiting displays in shops, raising the minimum pack size to 20, and banning vending machines.

Imperial, along with other tobacco manufacturers, has made it clear that it will be making its views known to the government as part of the consultation process. Speaking during Imperial’s half-year results presentation in May, Chief Executive Gareth Davis said, “We will be making very strong representations opposing such unnecessary and disproportionate proposals.”

Plain packaging could possibly dictate that the only color would be in the graphic health warnings, which are meant to dissuade would-be smokers. This would impact all cigarette companies doing business in the UK, and in the midst of a declining market, any additional restrictions are considered a further tightening of the channels in which tobacco firms can negotiate. No one knows whether smokers will remain loyal to brands without distinctive packaging.

Some anticipate that such a move would make it virtually impossible for a new brand to establish itself, or for brand extensions to take root, thus stifling competition and innovation. Others say it will encourage black-market, smuggling, and counterfeit cigarette activities. In the Queen of England’s speech scheduled for November, it is expected there will be a “National Health Service Reform Bill” announced. This could provide the springboard from which to launch any of the proposals put forward by the government.

Imperial remains a company in transition. While it has strengths such as strong cash flow plus a foundation of reliable, if not superstar brands, the company remains a steady performer. Evolving with a shifting and dynamic international tobacco business must surely remain a key focus for Imperial as it aims to further cement its position in the upper rankings of the international tobacco industry.

Tobacco International - August, 2008

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