Tuesday, April 26, 2005

Saddle up Cowboy; We’re Taking Cancer to China

Yeee-haw!!! Altria (parent of Phillip Morris and Kraft) last week announced plans to take the Marlboro man to China. If the deal goes through, it would mark a significant opportunity for Phillip Morris to gain market share in the world’s largest cigarette market. The Wall Street Journal reports that China accounts for one-third of all cigarettes smoked worldwide and is still growing. This is a contrast to the declining industry stage that the cigarette market is facing in the United States, one of Phillip Morris’ major markets. If Phillip Morris can effectively penetrate the Chinese market, it would be a source of continued growth for the cigarette manufacturer.

So what kind of market opportunities are we talking about? A recent analyst report by AG Edwards analyst Christopher Growe cited that people from China smoke approximately 1.8 trillion sticks with a market growth rate of 1-1.5%. May seem like slow growth, but when looked in nominal terms (18 – 25 billion sticks every year) and when compared to a 3% declining U.S. growth rate, it is easy to see why there is a push to enter the Chinese market. Put another way, a 10% market share in China would be equivalent to Phillip Morris’ 50% market share they currently hold in the United States. Smoking is heavily ingrained in the Chinese lifestyle with over 60% of Chinese men smoking. An astonishing 11% of southwest China’s total budget is dedicated to tobacco, and this has Western manufacturers salivating for a piece of the action.

Expansion into China is not a requirement for Phillip Morris, but it is a nice kicker for the cowboy. Marlboro is the largest cigarette brand in the world with 800 billion sticks per year. While the addition of 2 billion sticks would not increase sales tremendously, tapping the Chinese market could be a huge future lever to continue revenue and profitability growth for Phillip Morris in what is thought of as a mature and declining industry.

So how would the deal work? The Journal reports that the deal would involve cooperation with two large divisions of the current tobacco monopoly (Longyan and Baisha Group). Under the arrangement, Phillip Morris would have the capacity to license approximately 2 billion sticks. Phillip Morris would provide technical assistance and in return would receive royalty payments. Altria gets opportunities for revenue growth while China receives technical and managerial expertise from overseas to help streamline their state owned cigarette manufacturers. Although the deal would not open up the entire Chinese market to Phillip Morris, it may provide them the relationships necessary to further penetrate the market going forward.

Recently many overseas companies have attempted to break into the Chinese market through license arrangements with current Chinese manufacturers. Gallaher Group and Imperial Tobacco Group, although sizably smaller than Phillip Morris, already have agreements to license cigarettes in China. These license agreements are bad news for other rivals, such as British American Tobacco, who had plans to build a $1.5 billion dollar factory in China. This factory was supposed to be capable of producing 100 billion cigarettes annually, which would threaten Phillip Morris position as the number one manufacturer in the world in terms of sticks manufactured annually. It appears as though the way for foreign cigarette manufacturers to enter the China tobacco market will be through license agreements; direct factories appear to have failed, as in the case of BAT.

But hold on cowboy, Phillip Morris isn’t necessarily riding into the sunset. The Chinese government controls production through state-owned cigarette manufacturers. As a result, the government controls who and how manufacturers make profits. Cigarettes are noticeably cheaper in China with an average price of $1.16 for a pack of 20. Under the proposed agreement, Marlboros produced in China would not be subject to expensive import tariffs, so market prices would be similar to locally made premium cigarettes. However, it is important to note that it is not expected that Phillip Morris will be competing heavily against state owned manufacturers. Proof of the importance of the tobacco industry to China was no more evident than when China gained entrance to the WTO in 2001. Chinese officials insisted that the sale and distribution of tobacco be excluded from the list of market opening commitments it would make to the rest of the world.

This is a win-win for both Phillip Morris and the Chinese government. Increased revenues in a difficult market to penetrate for Phillip Morris; technological and managerial best practices and know how for the Chinese government. Sounds like both sides will be having drinks at the okay-corral to celebrate.

By: Steve Lyons

Jasmin Fung


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