Consolidation endgame in sight – but is there one more big throw of the dice?

Author: Don Hedley

Date published: 27 Jul 2007

The acquisition of Gallaher by Japan Tobacco made the big six international companies into the big five and further consolidation into the big four looks certain following the Altadis acceptance of Imperial's offer. But is there a big three out there on the horizon and could consolidation become fragmentation?

Consolidation in the tobacco industry is approaching its endgame following the Japan Tobacco acquisition of Gallaher and the acceptance by Altadis of a bid from Imperial Tobacco. In prospect also are two major privatisations in Turkey and Egypt. The governments of both countries are thought to be close to selling their state-owned monopolies, Tekel and Eastern Tobacco, in 2007 or 2008.

Japan Tobacco, with some help from Imperial and Gallaher, has been the main driver of consolidation in recent years as the company has striven to lower its dependence on the Japanese market and forge an international business. However Japan Tobacco is still some way behind PMI and BAT, whose dominance of the previous phase of consolidation made these two companies truly global in reach. The primary acquisitions by Japan Tobacco have been R J Reynolds' international brands and Gallaher, which, as well as second place in the UK market, gave the company the leading share of Russia, Europe's biggest cigarette market.

Corporate ambitions

Japan Tobacco has stated that it wishes to overtake BAT as number two company in the world while BAT's stated ambition is to overtake Philip Morris. Despite this, BAT did not try to outbid Japan Tobacco for Gallaher despite the opportunity to gain a major share of its home market, and, chose not to involve itself in the Altadis takeover battle, either as a bidder for the Franco-Spanish company, or as a counter bidder for Imperial.

Both Philip Morris and BAT seem currently to prefer organic growth, using their global brands - Marlboro for Philip Morris, and the four so called 'global drive brands' (Dunhill, Kent, Lucky Strike and Pall Mall) for BAT. In fact Japan Tobacco, which also has global brands (Camel, Winston and Salem), would have to continue its acquisitive spree and acquire both Altadis and Imperial in order to get close in global market share to BAT. The acquisition of Imperial/Altadis by BAT however would drive the UK based company past Philip Morris, but is such an acquisition possible or would it be ruled out by Competition Law?

Global company shares – the big four 2007

Volume share (excluding China)	2007
Philip Morris	18.7
BAT*	17.1
Japan Tobacco	10.8
Imperial (inc Altadis)	5.6
Share of big 5	52.2

Source: Euromonitor International

Note: * includes total sales of associates

Why don't the big two join in?

Philip Morris appears disinclined to consolidate its number one global market share by acquisition at the present time, though the company recently announced it would pay $1.1 billion to increase its stake in its joint venture in Mexico with Grupo Carso SA to 80% from 50%. Some analysts hold the view that Altria is currently distracted from acquisitions by internal restructuring. Altria, Philip Morris's parent company, recently spun off Kraft Foods, and there has been some speculation that the cigarette business might follow the same path, with PMI floated off.

Although BAT is a highly acquisitive company (particularly Rothmans in 1999 and American Tobacco in 1994), its last major corporate move - the formation in 2004 of Reynolds American consisting of the US business of Brown & Williamson and RJ Reynolds Tobacco Company in which BAT has a 42% share – was regarded more as a strategic retreat from the US market. So is BAT no longer interested in acquisitive expansion? Another of the company's stated objectives is to expand its share of all the leading markets in which it operates to 25%, while cutting costs further is also a top priority: the company is three years into a five-year restructuring which it claims has reduced costs by £482 million. Perhaps the conclusion has been reached that M&A is no longer the way forward for BAT. But perhaps not.

Consolidation drivers

A key aspect of consolidation is to increase business in emerging markets. Japan Tobacco announced the completion of the acquisition of Gallaher group on April 19th 2007 (at $15 billion the biggest ever foreign acquisition by a Japanese company). The purchase made Japan Tobacco market leader in Russia – Europe's biggest market by volume at 370 billion cigarettes a year while two out of three Russian men are smokers, according to World Bank figures, double the ratio in the US and U.K.

According to perceived tobacco industry wisdom, acquisitions are the quickest way of increasing market share, through introducing strong international brands into new markets. The right acquisitions can also save money: Imperial Tobacco's acquisition of Reemtsma, the German cigarette maker, in 2002 yielded synergies worth 12% of sales.

Analysts estimate that most Western markets will decline in volume by 2 to 4% per annum in the medium term as prices go up and consumers smoke less and look for discount brands or smuggled cigarettes. On the other hand, in emerging markets, which account for some 75% of world volumes, consumers accustomed to state-owned products are tending to switch to fashionable Western brands to confirm their new middle class status.

From four into three – can it work?

Assuming that the Imperial acquisition of Altadis goes through (final bids must be in by October 2007), the question is, does this mark the end of consolidation among the world's big four tobacco companies? The answer to the question is - probably but not definitely. In other words one further major consolidation play is possible though it would not, for regulatory reasons, be straightforward.

When deciding whether mergers are viable the issue is the effect on competition within the markets where both companies have significant market shares. In the case of a prospective acquisition of Imperial/Altadis both the individual regulatory authorities of the countries concerned and also the EU regulatory authority – the Competition Directorate of the EU Commission would be called into play. The rules on competition are complex but, based on previous actions by relevant authorities such as the UK Office of Fair Trading and the Bundeskartellamt in Germany, the situation is as follows:

Simple guide to takeovers involving EU markets

Mergers giving a market share of over 50%	Definitely blocked
Mergers giving a market share of 40-50%	Probably blocked
Mergers giving a market share of under 40% where it is believed that competition in the market will be impaired	Possibly blocked
Mergers giving a dominant share in an important market sector	Possibly blocked
Megers adjudged to adversely affect competition within a pan European context *	Possibly blocked

Source: Euromonitor International

Note * EC Merger Regulation 20th January 2004 states ‘A concentration which would significantly impede effective competition, in the common market or in a substantial part of it, in particular as a result of the creation or strengthening of a dominant position, shall be declared incompatible with the common market

Who could take over Imperial/Altadis?

The only company of the remaining top four which could possibly be acquired, is the smallest of the four – the merged Imperial/Altadis. But which of the big three would be best placed to acquire Imperial/Altadis? Philip Morris International can be immediately eliminated: with five major markets in the EU and also Australia where market share would rise above 50% it is definite that Imperial/Altadis could not be acquired by PMI.

JTI is more viable but, with 50% plus of UK, Ireland, Spain and Austria following the merger, major sell-offs would be required, particularly in the UK and Ireland and the EU regulatory authority might well become involved. Overall, the deal does not look worth the trouble.

This leaves BAT. Here also there would be the risk of the deal being blocked by the EU even if it was lucky enough to escape a referral to the national regulatory authorities in all the target countries but the UK and Australia. However, in the case of the BAT acquisition of Imperial/Altadis there would be clear commercial benefits and a major psychological boost. The company would happily divest its existing UK business to become, via he Imperial business, market leader in the UK – the company's home market and one where it is already a substantial manufacturer. And even even after other possible divestments, BAT's share of the global market would definitely rise to over 20% (including total volume sales of associate companies), thus enabling the company to fulfil its long term objective of overtaking Philip Morris as global leader.

Consolidation endgame – BAT for global market leader?

	Markets where share rises over 50% in event of merger	Markets where share rises to 40-50% in event of merger
BAT acquires Imperial/Altadis	UK, Australia,	Ireland, Germany, France, Spain, Benelux, Poland
JTI acquires Imperial/Altadis	UK, Ireland, Spain, Austria, Ukraine	France, Russia
PMI acquires Imperial/Altadis	Germany, Spain, UK, France, Australia, Poland

Source: Euromonitor International

Not consolidation but fragmentation

Of course just because consolidation has been the dominant trend in the tobacco industry for the past 20 years does not mean it will always be the case: there is an ebb and flow to corporate life as assets are churned in different ways to add shareholder value. For example there has been a trend in the tobacco industry which has run in parallel with consolidation: this is demerger. For many years the accepted wisdom within the tobacco industry was to use the unrivalled cash generation of the tobacco business to buy other businesses with better long term prospects and better p/e (price/earnings) ratios. Thus BAT owned financial services and retail businesses, Philip Morris became the world's largest consumer products company with Kraft and other businesses, RJR was a major food company called RJR Nabisco while Imperial Group was into food and beer and even owned Howard Johnson in the US. Then corporate thinking changed and it was decided that the non tobacco businesses were being undervalued by the association with tobacco. The trend became demerger and the floating off of Kraft drew a line under the strategy of tobacco/consumer product conglomerates.

CNTC at the gate

Demerger has been succeeded by what may become a new trend: RJR did not stop at spinning off its non tobacco businesses but also sold off its International tobacco business. Now there is talk of PMI being floated off by Altria. Should this happen a new permutation, and a new trend might be added to the global corporate tobacco industry mix: should PMI be spun off from Altria, a PM USA could decide to make overseas acquisitions, even perhaps a company as large as Imperial/Altadis. This would not however be defined as consolidation but as fragmentation. However a more likely fragmentation scenario for the industry might involve private equity. The CVC Capital Partners attempt to acquire Altadis is a recent example of this phenomenon, a slight variation on the leveraged buy-out of RJR Nabisco by KKR described in the best seller Barbarians at the Gates.

As was proved before, private equity can summon the financial muscle to take over any company, and the cash flow offered by tobacco businesses will always be attractive to private businesses where the depressive effect of tobacco on price/earnings ratios is not an issue.

But private equity is not the only alternative to consolidation. Another kind of fragmentation could be achieved as a result of major national companies following the same path as Japan Tobacco and building international businesses on the back of the formidable wealth generated by dominance of a huge home market. Several major national companies are capable of establishing international businesses but there is one capable of changing the corporate structure of the global tobacco business. The impact of CNTC, the world's largest tobacco company by volume sales, deciding to channel its cash flow into acquiring overseas tobacco businesses would be, not so much profound as seismic.