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February 25, 2010

Philip Morris International forms new company with 90% of Philippines cigarette market

Analyst Insight by Don Hedley.

PMI's deal with Fortune Tobacco Corp looks an excellent move both to optimize its brand portfolio in the Philippines and to consolidate and strengthen its position in the vital Asian market.

The Philippines subsidiary of Philip Morris International and the current market leader Fortune Tobacco Corp (FTC) are to merge to form a new company with a dominant 90% share of the Philippines cigarette market.

The new company will have the logical but unwieldy name of PMFTC. No financial details of the deal have been released other than a statement that the parties will hold 'an equal economic interest' in PMFTC. Philip Morris will retain its export business which ships cigarettes mainly to Thailand. Fortune Tobacco will maintain its interest in the distribution of the Winston brand owned (outside the US) by Japan Tobacco Inc,

The private company - Fortune Tobacco - is owned by Lucio Tan and was formed over 50 years ago during the presidency of Ferdinand Marcos. Prior to the merger, Philip Morris was second in the market to FTC. The Philippines is important to PMI, being its 12th biggest market.

The deal makes strategic sense, bringing PMI better coverage of the local market including the profitable medium- to low-priced segments where FTC is strong. PMI, through second brand in the market Marlboro, dominates the premium end of the Philippines cigarette market.

The Philippines is the 15th-largest cigarette market in the world, and the second-largest in Southeast Asia after Indonesia. According to Euromonitor International, retail sales of cigarettes in the Philippines in 2008 stood at 81.4 bn sticks, having grown by some 13% since 2003, with 56% of retail sales of cigarettes accounted for by FTC and 28% by PMI. Penetration of illicit trade was estimated as 22% in 2008 at some 21 billion sticks.

Key change in Philippines market

The key change in the Philippines tobacco market over the last decade has been the growth in share of PMI's subsidiary Philip Morris Philippines Manufacturing Inc (PMPMI). When PMI first sought to gain a foothold in the large Philippines market, about a decade ago, it was, essentially, a monopoly, and global players had to settle for licensing agreements and Philip Morris concluded such an agreement with La Suerte.

At the dawn of the new millennium, Western-based tobacco companies faced growing anti-tobacco groups in the Philippines leading to many court cases. In response Philip Morris decided, in 2002, to end its relationship with La Suerte, and established PMPMI to take full control of its Philippines business.

In 2003, PMPMI opened a P1.6 billion factory in Batangas, followed in January 2010, P1-billion-worth. Realising that it has no products able to compete with FTC's and La Suerte's low-priced brands, PMI acquired 4 low-priced brands marketed by Sterling Corp which has a licensing agreement with an Indonesian partner in which PMI has a stake. In 2003, PMPMI also introduced L&M, the second most popular brand in the world, to strengthen its portfolio in the mid-priced brand segment.

Pall Mall fails to become a competitor

Meanwhile BAT was also trying to grow in the Philippines market. The company made a licensing agreement with La Suerte, and planned to position Pall Mall, one of the company's global drive brands, as a mid-priced brand. But, in 2004, BAT fell foul of changes in the tax regime.

The company appealed but a ruling stated that Pall Mall was a super-premium brand, subject to a huge P27.16 per pack 'sin tax' in 2009 and P28.30 in 2011. This meant the equivalent of a 200% premium to Marlboro and made the Pall Mall price over 4 times the price of Fortune - FTC's leading brand in the mass market. As a result BAT pulled Pall Mall from the Philippine market.

The 2004 tax scheme also affected PMPMI's L&M brand (introduced in 2003), which was re-classified from mid-priced to a premium bracket, but if it meant losing Pall Mall as a competitor the company would certainly have viewed it as a price worth paying.

PMI's Asian strategy

According to analysts, a key motivation for PMI's decision to invest in the Philippines is a free trade agreement among ASEAN countries which reduced the import duty rate for selected products to 5% or less compared with previous import duty rates as high as 60%.

Tobacco products are included under this scheme by Thailand, Philippines, Singapore, Malaysia and Indonesia – hence PMI's exports from Philippines to Thailand. (PMI has manufacturing operations in the Philippines, Indonesia, and Malaysia but not Thailand.) PMPMI uses its facilities in the Philippines to consolidating tobacco leaves from suppliers and manufacturers elsewhere in Asia.

The Philippines deal may thus be seen in the context of PMI's wider Asian expansion and consolidation strategy. The company acquired the Indonesian cigarette company, Sampoerna, in 2003. In the Philippines, Sampoerna's trademark brands were being manufactured and sold by Sterling Tobacco Corp. PMI acquired Sterling's brands, including Bowling Gold, Stork, Miller, and Bowling Green in the low-priced cigarette segment where PMPMI had no presence in order to compete with Fortune Tobacco Corp, which dominated the low-priced segment.

Why this is a good move for PMI

The Sterling brands completed PMPMI's portfolio with flagship brands, Marlboro and Philip Morris King size in the premium segment and L&M in the mid price segment.

But, it was not enough: despite PMPMI's aggressive marketing, the company made little impression on FTC's leadership in the mid price sector where economic downturn was tending to push premium brand smokers to down-trade. This, and the way it strengthens the company's strategic presence in Asia, is why the merger looks a very good move for PMI.


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