Tobacco Primer - C S

24 March 2014 Europe Equity Research Consumer Staples (Tobacco)

Tobacco Research Analysts Jimmie Bork 44 20 7883 9941  [email protected] Charlie Mills 44 20 7888 0325 [email protected] Pieter Vorster 27 11 012 80 64 [email protected] Nicolas Sochovsky 44 20 7883 8075 [email protected] Alex Molloy 41 44 333 05 83 [email protected]

THEME

Industry primer We transfer coverage of Philip Morris International (maintain Neutral, TP US$85), British American Tobacco (downgrading to Neutral, new TP 3,500p) and Imperial Tobacco (maintain Outperform, new TP 2,700p) to our European Consumer Staples team. ■

 After a decade or more of little/no volume growth, the past p ast five years have seen global tobacco volumes (ex. US/China) decline. Most markets have seen growth rates slow meaningfully; the global declines in each of the past five years have been worse than in any of the previous 10.

■

Several reasons can explain this, some of which are cyclical (pressure on disposable incomes, increased unemployment) while some might be considered more structural (illicit trade, renewed focus from authorities, higher excise duty hikes, advances in new technology).

■

The higher rates of excise duty are, however, a double-edged sword. While this puts pressure on market volumes, it is price that has always been the real driver of industry margins/returns. The industry has been able to take advantage of government-induced inflation, which has been highly profitable. The past few years have also seen the highest levels of pricing by the industry.

■

Thus the past five years have been characterised by weaker volumes, but the higher pricing has helped industry margins up to record levels; the industry has seen particularly strong increases in margins.

■

We believe the markets will return to their previous, rather more steady declines (rather than the steeper falls of late), although not for a year or so.

■

Then there is new technology. The media coverage far outweighs the reality  –   –  e-cigarettes are still a very small part of the market and data show a levelling-off in sales recently. Many smokers have been willing to try the products, but technology still has a long way to go for e-cigarettes to have a big impact on tobacco sales. That is not to dismiss the threat/opportunity  – it  – it could undermine the current brand franchises like any new technology  – but  – but we believe the tobacco giants will dominate the new industry whatever its size. Industries in long-term decline also have a habit of consolidating, especially when integration yields major benefits. Press reports suggest some US consolidation is possible (FT 03/03/14). In due course we expect the Big 4 global players (PMI, BAT, IMT, JT) could become the Big 3. Figure 1: Tobacco: 1: Tobacco: Ratings and TPs

Sanjeet Aujla 44 20 7888 0353 [email protected] Kieran McGrath 44 20 7888 9216 [email protected]

Rating British American Tobacco Imperial Tobacco

 

Ticker  

BATS.L

OUTPERFORM   IMT.L

 

Philip Morris International

NEUTRAL

 

NEUTRAL

PM

CCY

Share price

Target price

Up-/downside

2014 PE

EV/NOPAT

GBp

3215

3500

9%

15.4x

15.1x

4.5%

GBp

2418

2700

12%

11.5x

14.1x

5.4%

USD

80.4

85.0

6%

15.6x

17.5x

4.7%

Div yield

Source: Credit Suisse estimates

DISCLOSURE APPENDIX AT THE BACK OF THIS REPORT CONTAINS IMPORTANT DISCLOSURES, ANALYST CERTIFICATIONS, AND THE STATUS OF NON-US ANALYSTS. US Disclosure: Credit Suisse does and seeks to do

business with companies covered in its research reports. As a result, investors should be aware that the Firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. CREDIT SUISSE SECURITIES RESEARCH & ANALYTICS

BEYOND INFORMATION® Client-Driven Solutions, Insights, and Access

24 March 2014

Key charts: The story in brief Figure 2: Market 2: Market volumes have deteriorated since 2008 … T MA

Euromonitor

Figure 3: …but pricing has been strong Retail sales (cc)

Top 4 tobacco

Volumes

Pricing

10%

3% 8%

2% 1%

6%

0%

4%

-1% 2%

-2% -3%

0%

-4%

-2%

-5%

   0    0    0    2

   1    0    0    2

   2    0    0    2

   3    0    0    2

   4    0    0    2

   5    0    0    2

   6    0    0    2

   7    0    0    2

   8    0    0    2

   9    0    0    2

   0    1    0    2

   1    1    0    2

   2    1    0    2

   3    1    0    2

-4%

Source: Euromonitor, Company data, TMA

Source: Company data, Thomson Reuters

Figure 4: Price/volume 4: Price/volume relationship consistent with

Figure 5: Pricing 5: Pricing always better for industry margins

history 40.0%

2.0% 2000

1.5%

Elasticity 0.3-0.5

2001

1.0%     h    t 0.5%    w    o    r    g 0.0%    e    m-0.5%    u     l    o-1.0%    V

35.0%

R² = 0.8444

2007 2008 2002 2006 2004 2005

30.0%

1999 2003 25.0%

2012 2009

-1.5%

2011

20.0%

-2.0% -2.5% 0%

2%

4%

6%

2010 8%

15.0%

10%

Price/mix (constant currency) Source: Euromonitor (Cigarette + OTP)

Source: Aggregated margin of BAT, IMT, PMI and JT

Figure 6: e-cigarette 6: e-cigarette sales look to be maturing (US data)

Figure 7: 7: Declining  Declining industries consolidate

Retail Retail sales sales (m USD) USD)

Top 4 tobacco % international market (ex China, USA)

Volume Volume (m units, units, RHS) RHS)

16

3

14

3

12 2

10 8

2

6

PMI: Fortune Fortune 75%

IMT: Altadis Altadis BAT: STG, Tekel Tekel

70% 65%

 JT: Gallaher 

1

4 1

2 0

80%

   1   1   1   2   2   2   2   2   2   3   3   3   3   3   3   3   4    1   1   1   1   1   1   1   1   1   1   1   1   1   1   1   1   1   c    b   r   n   g   p   v   n   r   y    l   c    b   p    t   g   t   u   u   c   e   e   c   e   e   p   u   u   e   o   a   a   a    J   e    S   O   D   F   A   J    A   S   N   J    M   M    A   O   D   F

Source: AC Nielsen data for the US

Tobacco

0

60% 55% 50% 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Source: Euromonitor

2

24 March 2014

Table of contents Key charts: The story in brief New world, new reality? Background So what has happened to industry volumes? 1: Increased levels of unemployment 2: Decline in disposable incomes 3: Excise duties have risen at a faster rate in the past four years 4: Illicit trade has increased significantly 5: The rise of e-cigarettes New technology  Availability Technology What comes after e-cigarettes? Regulation Tax US market – market – the test market for e-cigarettes? Will tobacco companies win this market? Profitability Summary Prospects – Prospects – where to from here? Economic indicators improve? Excise duty pressures Illicit trade – trade – a structural issue Credit Suisse outlook Industry consolidation Possible US/China entry? China US Possible Top 4 merger?

Tobacco

2 4 4 7 9 10 11 12 14 15 16 16 18 19 19 20 21 22 22 24 24 24 27 27 28 31 31 31 32

3

24 March 2014

New world, new reality? ■

■

Has the long-term dynamic of the tobacco industry gone through a structural change? Or a blip?  Are e-cigarettes pivotal for the industry?

We think that based on the past five years trading alone, the first is a reasonable question to ask. Market volumes/pricing over this period are in stark contrast to the preceding years. New technology (e-cigarettes) validates this question further. History is generally a good guide to the future in consumer staples, but is it thus for the tobacco industry?

Background It is surely not courting controversy to declare that smoking tobacco is perceived as a dying habit, be that a statement on the health implications, or simply a comment on consumer trends.

Since 2008 industry volume growth has slipped by 200bps….

Historically, the global market (and here we exclude the US and China) was actually showing little or no growth depending on which data source one preferred to use. Euromonitor shows small growth, TMA a small decline, while for the Top 4 tobacco companies, organic growth was slightly better. We exclude China and the US for two reasons: ■

The sheer size of the Chinese market (almost half of global volumes) distorts the international market.

■

The three major international producers, which are the subjects of this report, do not operate in either of these countries.

Since the financial crisis, all sources agree that volume growth has been c2% lower than before. At the same time pricing has been higher than ever before. It might reasonably be argued that not much has changed  –  a slightly higher pricing more than offsetting the weaker volumes. However, there is more to it than that.

Weaker volumes…. but higher pricing has kept organic growth at similar levels

It is important to recognise at the outset that pricing relates to retail prices (including retailer mark-up and excise duty), not the manufacturers' selling prices. Figure 8: Global market (excl. China and US) volume

Figure 9: Growth in tobacco market (retail selling prices)

growth, 2000-2013

TMA

Euromonitor

Top 4 tobacco

Retail sales (cc)

Volumes

Pricing

10%

3% 8%

2% 1%

6%

0%

4%

-1% 2%

-2% -3%

0%

-4% -5%

-2%

   0    0    0    2

   1    2    0    0    0    0    2    2

   3    4    0    0    0    0    2    2

   5    6    7    0    0    0    0    0    0    2    2    2

Source: Euromonitor, TMA, company data

Tobacco

   8    9    0    1    0    0    1    1    0    0    0    0    2    2    2    2

   2    3    1    1    0    0    2    2

-4%

Source: Euromonitor

4

24 March 2014

The role of price in this industry is crucial to not just the manufacturers, but also to retailers and especially governments. Declining volumes have not proved an impediment to the tobacco companies' growth (their EPS comfortably exceeding that of other staples over the past decade). Although industry consolidation has played a part (we discuss this again later in the report), it is the unique selling architecture of the industry that drives the top line (as we see above) and also (importantly) profits.

Pricing has always been the key metric in this industry

Figure 10: Global revenues (ex. China and the US)  – industry has defended its share of the profit pool by keeping the same proportion of retail sales over time

450

+6-7% organic CAGR

400

 $413bn

 $361bn

350  $294bn

22%

250

22%

12%

200

12%

300

22% 11%

150 100

67%

66%

66%

50 0 2005

2008 Taxes

Trade

2012

Manufacturers

Source: PMI data

 As governments raise tobacco taxes, the industry typically matches them with price increases of its own – this is a generalisation, but over the past eight years as the value of the market has risen 6-7% per annum, the industry's take of the final selling price has not changed, according to data presented by PMI.

The tobacco industry has been adept at raising prices to pass on excise price increases

 As the manufacturer’s take is only c20% of the final selling price, a 5% rise in price by the producer only equates to a 1% rise for the final customer, all else being equal  – a novel feature for tobacco among staples companies. Even in spirits the manufacturer has a little over half of the final retail selling price. Figure 11: Net sales as a % gross sales – suggests that retail pricing has been marginally more than the manufacturer's pricing

PMI

BATS

44% 42% 40% 38% 36% 34% 32% 30% 2005

2006

2007

2008

2009

2010

2011

2012

Source: Company data. Gross sales are net of sales/promotional incentives. Net sales also exclude excise

Tobacco

5

24 March 2014

The accounts of the major tobacco companies tell a slightly different story. Consider the net revenue (i.e. ex taxes) as a percentage of the gross revenue (i.e. including taxes) of the major players over the past eight years. Geographic trends/mix, acquisitions and restrictions on trade promotion will have played a part, but both BAT and PMI have seen their net sales fall as a percentage of gross sales (so taxes have gone up more than manufacturers' selling prices). We exclude IMT due to significant M&A (notably Altadis) distorting the comparatives (Figure 12). The correlation with government excise duty increases has meant that industry pricing has been, and looks set to remain, strong. For the three large Europe-based companies, price has averaged 5% per annum for the past eight years (and over 6% for the past four years) against, by way of illustration, just over 2% for other staples sectors.

Raising prices with government price hikes has been highly remunerative for the tobacco industry

Figure 12: Price a greater contributor to top line growth for tobacco relative to staples Staples

Tobacco

Staples average

Tobacco average

9.0% 8.0% 7.0% 6.0% 5.0% 4.0%

3.0% 2.0% 1.0% 0.0% 2005

2006

2007

2008

2009

2010

2011

2012

Source: Company data (IMT, BATS, PMI), Credit Suisse research

Price is not only the single largest contributor to top-line growth, but it also accounts for over 100% of the profit growth. PMI each year breaks out the components of its profit growth  –  below we simply aggregate the past seven years' data to illustrate the importance of price to PMI, the industry leader.

Price the key driver of profits

Figure 13: Tobacco profit growth – it's all in the price  – PMI case in point

21000    ) 19000   m    D    S17000    U    (   n   o    i    t 15000   u    b    i   r    t 13000   n   o   c    T    I 11000    B    E    I    M 9000    P

11,394 506 1,958

220% of profit growth

13,493

2,763

1,024

8,350

7000

5000 2006 EBIT

Price

Mix

Volume

Investment

FX, M&A, other

2013 EBIT

Source: Company data

Tobacco

6

24 March 2014

So the past five years may have been characterised by weak volumes and higher prices, but it is the latter that is more important to profits. For all the pressures on volumes industry margins have proved particularly strong over the same period, the increases far outstripping what had come before. Figure 14: Aggregated margin of the Top 4 tobacco companies

45.0% "Big 4" 40.0%

"Big 4" ex JT

35.0% 30.0% 25.0% 20.0% 15.0%

Source: Company data, Credit Suisse estimates

While we believe the market is aware of the facts, it is important to set the ground rules and the extent to which this industry relies on price. However, pricing is a double-edged sword, while it is (very) good for profits, it can, and does, put continued stress on industry volumes. Each price hike or excise increase is accompanied by another lurch-down in consumption industry volumes. The elevated pricing of the past four years, as excise duties have picked up, has put additional stress on cigarette volumes (Figure 9).

Price elasticity very apparent – so past five years has meant the weakest volumes

So what has happened to industry volumes? Figure 8 and Figure 9 indicate that the level of pricing has gone up more, and so volumes have suffered. However, this is only a part of the picture. A closer look at the volume softness points to EEMA and EU (Figure 16  shows the volume trend pre-2008 vs post2008). Growth rates in Asia-Pac and the Americas have not really changed.

Tobacco

7

24 March 2014

Figure 15: Price versus volume for tobacco: elasticity is in

Figure 16: Notable deterioration in EEMA and EU regions

line with historical rates (0.3-0.5) 3%

2.0% 2000

1.5%

Elasticity 0.3-0.5

2001

1.0%

R² = 0.8444

2007 2008 2002

    h    t 0.5%    w    o    r 0.0%    g    e    m-0.5%    u     l    o-1.0%    V

2006 2005

2004 1999 2003 2012 2009

-1.5%

2011

-2.0% -2.5% 0%

2%

4%

6%

2010 8%

Price/mix (constant currency) Source: Euromonitor (Cigarettes + OTP)

10%

    ) 2%    R    G    A 1%    C     (    2 0%    1    0    2      8 -1%    0    0 -2%    2     h    t    w-3%    o    r    g -4%    e    m-5%    u     l    o    V-6%

Improved AsiaPac*

Americas* EEMA

EU

Deteriorated

-7%

-5% -4% -3% -2% -1% 0% 1% 2% 3% 4% 5% Volume growth 1998-2008 (CAGR) Source: Company data, Euromonitor. *Excludes China and USA

That is not to say all markets are in decline  – big markets such as Indonesia and India have grown in the low-to-mid single digits over the past five years. However, increasing health concerns together with the ever-tightening government clampdowns (be it taxes, packaging and labelling restrictions, smoking bans in public places, health warnings or consumer education) have set the overall industry in long-term structural decline. The trend in each case is well set as authorities continue to tighten legislation/tax.

Some markets are still growing despite the health/economic pressures

Figure 16 showed the change in growth rate by broad region, but the same message can be found by looking at the top 30 countries (by market size/volume)  – again showing the generally deteriorating growth rates of the past five years (2008-13) versus that seen in the five years previously (2003-08).

Most markets have slowed in the past 4-5 years

Tobacco

8

24 March 2014

Figure 17: Top 30 volume markets (ex China/USA) – South and Eastern Europe volumes deteriorated in 2008-13 8% Improved relative to 2003-08 trend 6% Indonesia 4%

Saudi Arabia

2%    )    3    1      8 0%    0    0    2    R    G    A    C    ( -2%    h    t   w   o   r   g   e   m -4%   u    l   o    V

India

Philippines  Algeria

Canada

Thailand Vietnam

Romania

 Argentina

South Korea

France

Kazakhstan

Brazil Germany

UK  Mexico

Egypt

S Africa

Pakistan

UAE Italy

Turkey

 Japan Russia

-6% Taiwan Poland

-8%

Ukraine -10%

-12% -10%

Spain

-8%

-6%

-4%

Deteriorated relative to 2003-08 trend

-2%

0%

2%

4%

6%

8%

10%

 Volume growth (CAGR 2003-08)

Source: TMA, 2008-12 where 2013 data is not available yet (e.g. Vietnam, Pakistan, Thailand, Taiwan, UAE, Romania, S Africa, Saudi Arabia)

We suggest there are five macro factors at work here:

1: Increased levels of unemployment

Below we show the change in unemployment in these two key regions (EU and EEMA), comparing the rate in 2012 with that in 2008 (there has been an increase in unemployment in virtually every market). Similarly, the market growth rates have deteriorated (comparing the growth rate pre 2008 with that seen post 2008). Put simply, unemployment has gone up and the market growth rates have slowed (most countries lie in the bottom right-hand quadrant of Figure 18 and Figure 19).

Tobacco

9

24 March 2014

Figure 18: Deterioration in EU cigarette volume growth

Figure 19: Deterioration in EEMA volume growth (2008-

(2008-2012 v 1998-2008) versus change in unemployment

2012 v 1998-2008) versus change in unemployment (2012

(2012 v 2008)

v 2008)

4%

Germany

France

    ) Sweden Austria    2    1    '   United    8    0    ' 0% Kingdom Belgium    s    v    8 Finland Poland    0    '   Switzerland    8 Denmark Portugal    9    ' -4%     ( Italy Netherlands Ireland    h    t Norway    w Estonia    o    r    g    e -8%    m    u    l    o    v    n    i    e-12%    g    n    a Latvia    h    C

Lithuania

-16% -3%

0%

3%

6%

9%

12%

Greece

Spain

-3% 15%

18%

Change in unemployment rate (from 2008 to 2012) Source: Euromonitor, IMF

5%   Saudi    8 Israel    0  Arabia    ' Morocco South Slovakia   s   v  Africa 0%  Algeria    8 Macedonia Georgia    0   Slovenia    '   Romania Hungary Nigeria    8    9 -5%    ' Estonia    ( Croatia Russia CzechTunisia    h    t Kazakhstan Egypt  Azerbaijan   w   )   o Turkey -10%   r    2   g   1    '   e Iran Latvia   m   u -15%    l Lithuania Ukraine   o   v Bulgaria   n    i Serbia   e -20% Bosnia   g   n   a    h    C -25% 2%

7%

12%

Change in unemployment rate (from 2008 to 2012) Source: Euromonitor, IMF

2: Decline in disposable incomes

The decline in real disposable incomes in Europe has been a reasonable indicator for overall cigarette volume growth/declines in Europe (Figure 20).

Figure 20: EU – Pressure on disposable incomes has hit cigarette volumes

EU indsutry volumes (12m rolling)

EU real disposable incomes (RHS)

4%

4%

2%

3%

0%

2%

-2%

1%

-4%

0%

-6%

-1%

-8%

-2%

-10%

   0    0    1    2    3    3    4    5    6    6    7    8    9    9    0    1    2    2    3    0    0    0    0    0    0    0    0    0    0    0    0    0    0    1    1    1    1    1    1    4    3    2    1    4    3    2    1    4    3    2    1    4    3    2    1    4    3    Q    Q    Q    Q    Q    Q    Q    Q    Q    Q    Q    Q    Q    Q    Q    Q    Q    Q    Q

-3%

Source: EU market volumes as indicated by PMI, Disposable incomes as estimated by Oxford Economics

Tobacco

10

24 March 2014

3: Excise duties have risen at a faster rate in the past four years

Whether it is a new-found zeal on health concerns, or tighter fiscal budgets and the need to find more income, or indeed a combination of these  – either way European countries have all been increasing their levies on the tobacco industry at a higher rate over the past four years than previously. The European Union gives numbers that support this notion, notably over the past three years.

Figure 21: Selling prices and excise per 1000 sticks in the

Figure 22: % increase in excise duty across the EU f or

EU

tobacco products Prices (EUR per '000 stick)

9.0%

Excise

8.0%

300

7.0%

250

EU expansion

6.0%

200

5.0%

150

4.0%

100

3.0%

50

2.0% 1.0%

0        0        0        0        2

       1        0        0        2

       2        0        0        2

       3        0        0        2

       4        0        0        2

       5        0        0        2

       6        0        0        2

       7        0        0        2

       8        0        0        2

       9        0        0        2

       0        1        0        2

       1        1        0        2

Source: Credit Suisse research based on EU releases

       2        1        0        2

       3        1        0        2

0.0% 2006

2007

2008

2009

2010

2011

2012

2013

Source: Credit Suisse research based on EU releases

The same can be said for the EEMA region  – although we do not have uniform data from the EU, we can see that the percentage of the selling price accounted for by excise duty has risen significantly in the major markets across the region over the past four years (Figure 23).

Figure 23: Excise duty as a % of the selling price for major markets in the EEMEA region

90.0% 80.0% 70.0%

2008 2012

60.0% 50.0% 40.0% 30.0% 20.0% 10.0% 0.0%

Source: Credit Suisse research based on Euromonitor data

Tobacco

11

24 March 2014

Fine-cut, or roll-your-own (RYO), has historically offered some growth, although this has also slowed sharply. RYO has historically enjoyed preferential excise tax treatment in most European countries, although this is beginning to be eroded. In 2012, lost excise tax on cigarettes outweighed the increase in tax revenues collected from growth in fine-cut products in a number of big European markets, notably Italy and Spain  –  where authorities increased excise on fine-cut tobacco in Q4 '12 and Q2 '13, respectively. Figure 24: Pressure on tax revenues as fine-cut no longer

Figure 25: Growth in fine-cut (RYO) slowing as tax gaps

offsets declining cigarette excise

close (e.g. Spain, Italy)

Change in tobacco excise revenues (m euro)

EU RYO vol growth

1,000 €

8%

800 €

7%

600 €

6%

400 €

5%

200 €

4%

0€

3%

-200 €

2%

-400 €

1%

Significant excise increases on fine cut tobacco (e.g. Italy, Spain)

0%

-600 € 2009

2010 Spain

Italy

2011

2012

-1%

Germany

Source: The European Commission, Credit Suisse research

Source: Euromonitor, Company data

Fine-cut tobacco volumes in Europe have been roughly flat since the excise increases, which have put prices more in line with cigarettes in these markets (Figure 25).

4: Illicit trade has increased significantly

The illicit trade has been a persistent thorn in the side for both the tobacco industry and governments. It accounts for ~10% of cigarette volumes in the past decade but has increased sharply over the past four years coinciding with the weaker industry volumes.  Arguably, the factors highlighted above have themselves all contributed to this increase. The drivers behind the illicit trade are in general; ■

Tax differentials between countries, which make it attractive to move volumes from low-excise countries across borders.

■

What represents the interest of one country might not represent the interest of another  –  collecting excise taxes and stemming the illicit trade in Country A versus profits and employment in Country B.

■

There are frequently strong local, often political, interests in the ownership of the illegal exporters.

■

Excise duty represents a large proportion of the selling price of tobacco, rendering a significant opportunity to the illegal trade that avoids such duty. The fines are small compared with the profits that can be achieved.

■

Price increases are a fundamental part of the tobacco industry structure  –  there is persistent pressure on pricing, particularly at times of lower disposable incomes and higher unemployment.

Tobacco

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24 March 2014

Not all sources agree on the extent of contraband/illicit trade, which is hard to measure. Euromonitor puts the figure at 12% globally, while KPMG, in a specially commissioned report, puts the figure at 11% in the EU. Figure 26: Global illicit trade as a % of market (ex China

Figure 27: Contraband and counterfeit share of EU

and US) – volume

market – volume

14%

12.0%

12%

10.0%

10% 8.0%

8% 6.0%

6% 4.0%

4% 2.0%

2%

0%

   8    9    9    1

   9    9    9    1

   0    0    0    2

   1    0    0    2

   2    0    0    2

   3    0    0    2

   4    0    0    2

   5    0    0    2

   6    0    0    2

   7    0    0    2

   8    0    0    2

   9    0    0    2

   0    1    0    2

   1    1    0    2

   2    1    0    2

   3    1    0    2

Source: Euromonitor to 2012, Credit Suisse estimate 2013

0.0% 20 06

200 7

20 08

20 09

20 10

20 11

2012

Source: KPMG

Not surprisingly, the penetration of illegal products into the total tobacco market has a strong economic sensitivity – with the illegal trade increasing when the consumer is under increased pressure. We illustrate the point by comparing the percentage of illicit trade with unemployment rates (1yr lag) in countries with high unemployment ( Figure 28). Figure 28: Illicit penetration sensitive to changes in unemployment (for countries with unemployment rates above 8%)

Illicit % total consumption

Unemployment rate (1 year lag)

14% 13%

R^2 = 0.89

12% 11% 10% 9% 8% 7% 6% 2006

2007

2008

2009

2010

2011

2012

2013

Source: Euromonitor, KPMG, IMF Note : No 2013 data available yet

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24 March 2014

The regions where illicit trade has stepped up are EEMA (in particular) and western Europe – consistent with some of the market data illustrated above ( Figure 16) showing that volumes have been weakest in these regions. Figure 29: Illicit increase across regions

Figure 30: Acceleration mainly driven by MEA and W EU

Increase in illicit penetration (2007-12)

Global illicit penetration W Europe

7% 6.0%

MEA

6% 14%

5%

12%

4% 3.0% 3%

10%

2.8% 1.9%

2%

8% 1.1%

1%

6% 4%

0% MEA

W Europe

Source: Euromonitor

Asia

Americas E Europe

   4    0    0    2

   5    0    0    2

   6    0    0    2

   7    0    0    2

   8    0    0    2

   9    0    0    2

   0    1    0    2

   1    1    0    2

   2    1    0    2

Source: Euromonitor

5: The rise of e-cigarettes

e-cigarettes may have only taken a modest share of the total tobacco market, but their coverage in the media has been high. The press has regularly reported on the size, growth, implications, penetration and potential of this market. We discuss this in more detail in the following section.

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24 March 2014

New technology In contrast to the market issues explored previously, the threat (or opportunity) from new technologies can be considered more structural in nature. Reduced-risk products are still only a modest part of total tobacco consumption. e-cigarettes today account for roughly 0.3% of global volumes, with 1-2% penetration rates in a couple of markets ( Figure 32), but growth has been exponential.

e-cigarettes – a lot of media attention, but still very small in global terms

The category has attracted considerable attention over the past two years as e-cigarettes receive extensive publicity and impressive distribution in a number of developed markets. The US is probably the best test-case region given its early adoption of e-cigarettes and the detailed market data available here to help track the industry (Figure 31). Figure 31: US sales: e-cigarettes established as the preferred tobacco "alternative"

Snus

e-cigarettes

1400 1200    ) 1000   m     $    ( 800   s   e    l   a    S 600    S    U

400 200 0 2007

2008

2009

2010

2011

2012

2013e

Source: Snus based on Reynolds and Swedish Match, e-cigarettes based on PMI presentation (Nov 2013)

We will look more closely at the US later, but f irst provide some background information: The potential for new technologies should be reviewed on the basis of four key factors: ■

Availability:  thus far e-cigarettes have mainly been launched in Europe and North  America.

■

Regulation:  There is currently no consensus on how to regulate reduced-risk products with country and government/health lobby attitudes ranging from highly favourable to advocating an outright ban on e-cigarettes. or regulating them as a medicine.

■

Tax: thus far there is no consensus on how to categorise them. Should they be taxed?  At what rate? If they are to make a meaningful dent in tobacco sales, a considerable loss of revenue to the various exchequers would ensue.

■

Technology: formulation challenges remain; the e-cigarette experience does not fully mimic that of smoking a cigarette in the eyes of the consumer and hence full adoption has remained low.

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Availability e-cigarettes have been launched mainly in Europe and the US. Penetration rates remain low (under 2% of the tobacco and related products market), with global retail sales around $2-3bn compared with c$780bn for the total tobacco c ategory.

Thus far only really seen in developed markets

The increasing involvement of the global tobacco manufacturers might change the landscape, but thus far launches have been in relatively wealthy countries with high tobacco taxes. Figure 32: e-cigarette as a % of total market remains small thus far (2013 data) e-cigarettes % of volumes 1.6% 1.4% 1.2% 1.0% 0.8% 0.6% 0.4% 0.2% 0.0% USA

W Europe

Global

Source: BAT survey (CMD 2013)

Currently, margins on e-cigarettes for retailers are large (and small on tobacco). Little surprise then that the new technology is afforded significant shelf space, over and above its share of sales.

Technology Surveys of smokers show high awareness and trial of e-cigarettes; however, thus far trial rarely leads to regular, or exclusive, use of e-cigarettes (Figure 33). Figure 33: Low conversion to exclusive use of e-cigarettes

CDC survey (USA) Oct '11 100% 100% 94% 90% 80%

CDC May '13

BAT survey (EU & USA) Sep '13

75%

70% 60% 50%

41% 35%

40% 30%

23%

20% 5%

10%

11%10%

0%  Awareness

Trial

Regular use

N/A N/A 2% Exclusive use

Source: US Centers for Disease Control and Prevention, Company data

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24 March 2014

Lorillard (the US market leader in e-cigarettes) claimed at its recent Capital Markets Day that awareness was now close to 100%, 43% had trialled the product and that there was 26% repeat usage based on survey data. The low conversion suggests that the consumer does not think e-cigarettes are a substitute for the feel and flavour of cigarettes. Reasons for the slow or low uptake of e-cigarettes voiced by users include: ■

Smokers seem willing to try, but the experience appears to fall short

The technology does not match the nicotine delivery profile. A traditional cigarette delivers a fast and high concentration of nicotine to the bloodstream. This contrasts with e-cigarettes where the uptake is slower and not as impactful (Figure 34).

Figure 34: Cigarettes still the better option for nicotine delivery

Cigarettes

e-cigarettes

20

  n   o    i    t 18   a   r 16    t   n   e14   c   n12   o   c    d10   o   o 8    l    b   e 6   n    i    t 4   o   c 2    i    N

0

0

5

10

15

20

25

30

35

40

45

50

Time (minutes) Source: Data from PMI Capital Market Day (2012) ■

The new technology lacks the 'bite' of a traditional cigarette. The burning or kick sensation from inhaling smoke is absent in an e -cigarette.

■

Taste is still an issue with many consumers…

■

…and it would appear that the satisfaction and finite nature of a single cigarette is not matched.

So while consumers are showing a willingness to try an alternative nicotine delivery mechanism, the current technology is still found to be lacking. Not all e-cigarette users are those who are looking to give up smoking and some are using the new technology in place of other more traditional quitting methods – gums, patches, prescription drugs, hypnosis, etc.

e-cigarettes used mainly by those trying to quit? No

 AC Nielsen research for the UK from 2013 showed 47% of those who tried e-cigarettes did so as a part of their NRT (nicotine replacement therapy), but that 53% were trying the product in its own right. The reasons given for trying e-cigarettes  –  again we draw on AC Nielsen's study in the UK  –  are all related to reductions in tobacco intake or as a substitute to traditional forms of nicotine intake.

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24 March 2014

Figure 35: What are the benefits of e-cigarettes (UK sample)

 Alternative to smoking Doesn't make me smelll Route to reduce intake Harm reduction Instead of patches Convenience Price Complement existing habit Point of entry 0%

20%

40%

60%

80%

100%

Source: AC Nielsen study in the UK (2013)

We note that price was not one of the main factors highlighted in Nielsen's survey, despite the price differential between e-cigarettes and normal cigarettes  –  a topic that might be tested if taxes start to be imposed on this burgeoning category. What comes after e-cigarettes?

New technologies are being developed by the major tobacco manufacturers. PMI and BAT are making steady progress on different technology platforms, including heat-not-burn. Initial consumer trials of PMI's heat-not-burn product have indicated a more favourable consumer experience and willingness to adopt the product (Figure 36). Perhaps the closer proximity to a traditional cigarette widens the appeal of reduced-risk products . US start-up Ploom has already introduced a product that heats small pods of real tobacco. The product was introduced in the US in 2012 and was launched in Austria (May 2013) and Japan (Dec 2013) through Ploom's partnership with Japan Tobacco. PMI and BAT aim to launch heat-not-burn products within the next few years. PMI estimates that the market could be 30-50bn units, with profitability in line with cigarettes (Figure 37). An assertion that would be highly sensitive to the eventual regulation and taxation of reduced-risk products, in our view, for which there is currently no consensus. Figure 36: Promising consumer tests

Figure 37: PMI expects profits in line with cigarettes

Survey data from CDC and initial PMI test results

Profit per '000 unit (USD)

Purchase intention

Adoption 30

80% 70%

25

60% 50%

20

40%

15

30% 20%

10

10%

5

0%  Japan sample

Italy sample

PMI's platform 1 (heat-not-burn) Source: CDC, PMI (CAGNY '14)

Tobacco

Profit per '000 unit (USD)

US market E-cigarettes

0 PMI cigarettes

PMI EU region

Platform 1

Source: Company data, Management estimates (CAGNY 2014)

18

24 March 2014

Regulation Right at the heart of regulating reduced-risk products is a major conflict; indeed it is a clash that exists throughout the industry. Health versus taxes. While encouraging the uptake of the apparently more healthy (or less unhealthy?) e-cigarette may be positive for the health of the nation, it does, as things currently stand, mean a cons iderable drop in the excise takings of a country if consumers switch. Should e-cigarettes be subject to excise duty or not? Should the numerous restrictions on cigarette advertising, smoking in public places, retailing etc. apply to e-cigarettes as well? What is clear is that there is no consensus right now. The debate continues in the media, and countries are all taking very different lines. Here are a list of examples, by no means exhaustive, but illustrative of the different direction many are taking: ■

Indonesia, Argentina, Brazil (with a large tobacco industry), Turkey, Singapore: ban on e-cigarette sales

■

South Korea: internet sales banned

■

 Australia: online purchase (imports) for personal consumption allowed

■

World Health Organisation: Advise strongly against use of e-cigarettes

■

Canada: health authorities issued warnings against use of e -cigarettes

■

Malaysia: requires a prescription and only sold through pharmacies

■

Romania: considered as medicinal product

■

Italy: has implemented excise taxes on e-cigarettes

■

The EU: has proposed legislation to allow member states to determine most aspects of regulation with some restrictions on nicotine content and product standards

■

The US: few restrictions, but with variations by state. e-cigarettes are included under existing smoking bans in over 100 cities (e.g. New York, Boston and Seattle)

To ban/restrict or not to ban/restrict?

Tax Just as there is no accord on regulating e-cigarette usage, so there is no consensus on tax. If the new technology is to have a meaningful impact on the sales of cigarettes there will be an ensuing loss of excise duty to the various exchequers. This needs to be weighed against the health implications  – should regulators not encourage consumers towards the healthier option?

Tax structure yet to evolve on the new technology

We think that a tax will be applied to e-cigarettes, albeit at what rate and what structure remain to be seen. Thus far the only two major countries to have implemented taxes on e-cigarettes are: ■

Italy – the same level of tax as roll-your-own

■

Latvia – the same tax as standard cigarettes

In the US, Minnesota is thus far the only state to have implemented a tax on e-cigarettes (at 95% of the wholesale price), although others are considering it. We think 2014 is likely to see significant developments on this front.

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19

24 March 2014

US market – the test market for e-cigarettes? The US market is certainly the most advanced when it comes to the e-cigarette category. From a base of under $10m in 2007, sales are estimated to have reached over $1bn in 2013, almost double that recorded in 2012 (Figure 31). ■

Sales are increasing at a rapid rate and the established tobacco manufacturers (Altria, Reynolds and Lorillard) have all launched their own versions of the product.

■

Lorillard acquired e-cigarette maker blu at the beginning of 2012 and has quickly established itself as the market leader (Figure 38).

Figure 38: Lorillard's blu brand now ~50% share in retail

New technology – threat?

Figure 39: Growth has moderated in the past few quarters, despite distribution expansion

LO e-cigarette net sales (m USD)

Mkt share

 $70

60%

 $60

50%

Retail sales ($m 12m trailing, implied from LO mkt share)  $600  $500

 $50

40%

 $40

 $400

30%

 $300

20%

 $200

 $30  $20

10%

 $10

 $100  $0

 $0

0%

Q2 12 Q3 12 Q4 12 Q1 13 Q2 13 Q3 13 Q4 13

Q2 12Q3 12Q4 12Q1 13Q2 13Q3 13 Q4 13 Source: Company data, management estimates of retail market share

Source: Company data

Taking Lorillard's reported e-cigarette sales and its management's estimates of its own market shares over the past 12 months would imply market growth has been moderating in the past couple of quarters (Figure 39). Lorillard claimed at Q4 that increased distribution in previous quarters had exaggerated growth rates and that volumes were flat in Q4 (with prices coming down).

Recent data point to a market past its peak – have e-cigarettes burnt out?

Numbers from AC Nielsen (measuring retail sales in four-week periods) show sales peaking midway through 2013, and declining month-on-month since then (and unit sales remaining broadly flat). Notable too are the big jumps in January every year as consumers try to break the smoking habit. Numbers from Reynolds Capital Markets Day also suggest that e-cigarette's share of the cigarette market is moderating (Figure 41)  –  perhaps an indication of low repeat purchases as some surveys have suggested.

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24 March 2014

Figure 40: Monthly e-cig sales level off in US retail…

Retail sales (m USD)

Figure 41: …and penetration stabilises

Volume (m units, RHS)

16

Equivalent share of total cigarettes 3

14

1.0% 0.9% 0.8% 0.7% 0.6% 0.5% 0.4% 0.3% 0.2% 0.1% 0.0%

3

12 2

10 8

2

6

1

4 1

2 0

   1   1   1   2   2   2   2   2   2   3   3   3   3   3   3   3   4    1   1   1   1   1   1   1   1   1   1   1   1   1   1   1   1   1    t   c   b   c   b   r   n   g   p   v   n   r   y    l   p   t   u   g   e   c   e   e   p   u   u   e   o   a   a   a   J   u   c   e   e    A    O    J    J    M   M    A   O   D   F    S    A   S   N    D   F

Source: AC Nielsen

0

   2    2    2    3    1    1    1    1   -   -   -      t   c   n   c   v   o   e   a    O    N    D    J

   3    1      b   e    F

   3    3    3    3    1    1    1    1     r     r   -     n   a   p   y   a   u    M    A    M    J

   3    1      l   u    J

   3    3    1    1   -     g   p   u   e    A    S

   3    1      t   c    O

Source: MSAi shipments to retail (from RAI CMD 2013)

Will tobacco companies win this market?

It might be argued that the tobacco companies are best placed to win in the e-cigarette marketplace given their distribution strengths, marketing expertise and scale. Bulls might highlight that the leaders in the US e-cigarette are the leading tobacco companies  – which is true, but the share of e-cigarettes is not the same as their s hare of tobacco currently.

New technology – opportunity?

Figure 42: US market shares of e-cigarettes and cigarettes (%) Market share of cigarettes

Market share of e-cigarettes

Lorillard  Altria

10 57

46 0

Reynolds Fin Brand

27

0 20

NJoy Others Total

6

11 13

100

100

Source: AC Nielsen, 12m trailing based on February 2014 release

This is a matter of timing, and phase of development: Altria and Reynolds only very recently entered the market; so their success will need to be monitored. Does being a large tobacco company offer a big advantage? It would appear so: ■

Lorillard: has taken blu's market share from 11% when it was acquired (April 2012) to 46% today.

■

Reynolds launched VUSE in Colorado in July 2013, and by October it claimed to account for 61.6% of the e-cigarette market in the state.

Being a major tobacco incumbent appears to be a significant advantage in the e-cigarette market

Figure 43: Tobacco companies' entry into e-cigarettes Date

enture

Imperial Tobacco BAT

2013 Bought Dragonite Int’l for $75m 2012 Bought a UK start up in 2012, launched Vype in the UK in 2013

PMI Lorillard

2014 Building a $500m plant in Italy and expects to enter the market in 2014/15 2012 Acquired blu in the US for $135m, now the market leader

Reynolds  Altria

2013 Launched VUSE in Colorado in 2013 2013 Launched Mark Ten in two states. Bought Green Smoke in 2014 for $110m

Source: Company releases

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24 March 2014

Profitability  Another important consideration is the profitability of this new technology. If it is to make significant inroads into the traditional tobacco trade, what are the implications for profits? To simply look at the margins is misleading in our view and we think it is better to look at the implied profit per pack of cigarettes or cigarette equivalents. Figure 44: Profit per pack of cigarettes (or equivalent) for leading names ($/pack of 20)

1.00 0.90 0.80 0.70 0.60 0.50 0.40 0.30 0.20 0.10 0.00 Lorillard

Altria

Reynolds LO Blu

Vapor  Corp

PMI

Imperial

BAT

Source: Credit Suisse estimates based on latest available company releases

The Lorillard numbers reported for blu, or indeed the results of the public company Vapor Corp (both US), imply profits lower than the tobacco companies in the US, but higher than their European counterparts on an equivalent basis. It is perhaps a little early to draw definitive conclusions as such a nascent technology has yet to settle down in price and the tax structures have yet to be put in place. With barriers to entry so low, we would expect price erosion and/or competition to lower the current returns.

Summary ■

e-cigarettes remain a small part of the global tobacco market owing partly to availability, regulation and limitations of the current technology.

■

Interest is high and a large number (over a third) of smokers seem willing to try the new technology…

■

…however , thus far e-cigarettes have not been able to match the experience of a cigarette for the consumer.

■

Other technologies are emerging; more promising products are being developed by established cigarette manufacturers. The UK market leader commented that the group is on its 10th-generation product today versus three years ago (e-lites). Technology is improving at a rapid pace.

■

If the technology can match the experience of the 'real thing', then reduced-risk products could go a long way.

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24 March 2014

■

There is no consensus on regulation yet: a number of markets have banned ecigarettes (e.g. Indonesia, Thailand, Argentina, Brazil, Mexico, Lithuania, Egypt, GCC, Iran and Norway).

■

Current regulation gives e-cigarettes an advantage in a number of markets, but regulation is emerging and further penetration is likely to result in more restrictions on marketing, points of sale, age limits, etc. Note that the UK has just banned sales to under 18s.

■

Nor has there been any accord on excise duty

■

e-cigarettes have experienced rapid growth in the US over the past two years, with a proliferation of brands available in the market. However, launches by tobacco manufacturers such as Lorillard and Reynolds have achieved market leadership in the segment after a relatively short period in the market. Current incumbents have a significant advantage based on the US experience.

■

There are signs that growth of e-cigarette sales has moderated and share of the cigarette market (on an equivalent basis) is stabilising in the US, even declining. A pause for breath, or an indication of a technology shortfall?

■

e-cigarettes may be an opportunity for revenue, but we see them as a threat to industry profitability.

■

 A final thought – traditional terminal growth for a tobacco company in a DCF might be zero or even negative. Do e-cigarettes give tobacco valuation a terminal growth?

We believe the greater threat, however, is to the brand equities of the tobacco companies. While they may well embrace the new technology and build their own e-cigarette brands, the barriers to entry are low. The tobacco companies have a built-in advantage with distribution, but what value then to ascribe to Marlboro (ranked the 8 th most valuable brand in the world by CNN and Millward Brown*)? The brand value destruction wrought by ecigarettes (if the new technology gets to the required level) could be significant. Years of brand building could count for little. There is no other consumer staple where this risk exists.

(*) Interestingly Interbrand no longer recognises Marlboro as being in the top 100 after being ranked 9th 10 years ago

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Prospects – where to from here? The higher volume declines over the past five years are, in our view, due to: (1) Increased levels of unemployment ■

Reductions in disposable incomes

■

Increased levels of excise duty/price hikes

■

■

 All leading to, and further exacerbated by increased levels of illicit trade Growth in e-cigarettes and new technology (given e-cigarettes are still under 0.5% of the market their impact has perhaps been rather less than the column inches dedicated to them in the world media)

Economic indicators improve? On the first two trends there are macro forecasts that might offer some encouragement; both unemployment levels (Figure 45) and disposable incomes (Figure 46) are forecast by most economists to improve over the next few years (at least in the EU, which has been one of the weakest regions). Figure 45: EU unemployment expected to stabilise in

Figure 46: …and disposable incomes improve

2014…

Oxford Econ

IIF

EU volumes

IMF

EU real disposable incomes (RHS)

2%

3%

13%

3% 0%

2%

12%

2%

-2%

11%

1% -4%

10% 9%

-6%

8%

-8%

7%

-10%

1% 0% -1% -1% -2% -2%

-12%

Source: IMF, IIF, Oxford Economics

   7    0    2    Q

   7    0    4    Q

   8    0    2    Q

   8    0    4    Q

   9    0    2    Q

   9    0    4    Q

   0    1    2    Q

   0    1    4    Q

   1    1    2    Q

   1    1    4    Q

   2    1    2    Q

   2    1    4    Q

   3    1    2    Q

   3    1    4    Q

-3%

Source: Oxford Economics

Excise duty pressures On excise duty the position is less clear. A few countries have a long-term explicit agenda clearly laid out: e.g: ■

UK – 2% price increases over UK inflation

■

Brazil – 8% and 5% pass-on pricing over the next two years

■

Russia – tax increases, which will push retail prices up by 15-20% p.a. over next three years

■

■

 Australia – 12.5% per annum tax increase over the next three years Philippines  –  15-20% and 3-6% price increases p.a. on economy and premium brands, respectively, over the next five years.

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24 March 2014

However, these are the minority. In general excise duty varies widely by country. If we compare the average price in the 50 biggest markets (by volume) and see the tax component in the selling price, the range varies from a $10 tax per pack (20 sticks) in the UK and Australia to ¢10 in some countries. These numbers should be interpreted with some care, as there is also a difference in quality from country to country. Figure 47: Average price per pack (20) in countries – split between tax and "other" Tax component (USD per pack)

Net sales

14 12 10 8 6 4 2 0

   l   a   n   n   o    d   a   a   a   a   a   a   a   e    t   y   a   n    i   a   a    l   a    d   a   y   y   a    K   a   s   e   y   m   A   l   n   e    h    l   e    i   o   n   a    i   a    i   a    i   a   n   s    i    i   a   a   c   n   n    i    i   n    i    i   n   p   m   i    l   e   r    d   c   n   u    S   a    i   c   e   n    i   r   a   a   c   c    i   r    i   a   e   z   s   s   r   a   e    i    j     i   a    i    b    i   s    b    i   y   a    i   a   c   a    t    U   d   r    i   a    t    k   r   u    l   c   w   r   n   a   n   n   a    i   e    h   n   e    d   p   p   e   z   a   s    I   r    b   y   s   m   a   g   n   n   e   e    t    I   r   a   a    l    t   n   r   s   r    f   g   o    i   a   x    i    I    t   a   r   a   m   l   o   a   r   n    l   n    l   g    U   a    S   r   e   e    h   r    E   t   u   n    i   g   g   s    i    C   a   z   u   e   p   o    B   u    l   u   n   r    C    A    b   a   s   m   a   r    F   r   e   o    k    C   e    T   o    N   h    A    S   r    M   h   e   p    R   l    k    i    i    A   J    P   a    T   u   o    T    K   u   e   o    h   e    G   e    B   g    A    i    l   n    C   o    U    d   e   a    i   r    V    T    h    H   M    A    M   z    R   t    d   e   z   n    G    t    h    C    I   u    V    A   u   a    A   e   o   a    K   P    N    S    S

Source: Credit Suisse research based on TMA data

The concern here is the sheer volume of excise duty that some countries are missing out on. Consumers' ability to pay from one country to the next will vary greatly, so a more meaningful picture might be drawn by comparing the price of a cigarette to disposable income – or as a percentage of the average hourly wage, as we highlight in Figure 48. Figure 48: Packet of cigarettes expressed as a % of the average hourly wage 60% 50% 40%

2000 2008 2012

30% 20% 10% 0%

Source: OECD database, TMA

 A quick scan of some of the largest markets shows that the real cost of a packet of cigarettes has risen, and continues to do so in every market.

Tobacco

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24 March 2014

In part this reflects the economic backdrop where average wage inflation has slowed (or gone into reverse given the unemployment backdrop). However, it is striking that if we compare the increase in the cost of a packet of cigarettes as a percentage of the hourly wage (2008-12 versus 2000-08) versus the change in volume growth, all the countries with high price pressure lie in the bottom right-hand quadrant (i.e. the pace of cigarette inflation has accelerated, as has the rate of decline in consumption). Figure 49: Increase in rate of tobacco inflation (as % hourly wage) has led to an increase rate of decline in consumption

10%      8    0   s   v 5%    8    0      0    0    (   e 0%    t   a   r    h    t    )   w   2 -5%   o   r    1   g   e   m -10%   u    l   o   v   n    i   e -15%   g   n   a    h    C

Canada France   Germany Belgium Korea

 Austria

 Australia

UK  Italy

Netherlands  Japan Hungary USA 

Poland Czech

Greece

-20% -2%

-1%

0%

1%

Spain

2%

3%

4%

5%

6%

Change in rate of price pressure (pack % hourly wage) 2000-08 vs 2008-12 Source: TMA, OECD database

Excise duty increases on tobacco have consistently been above other indulgences (Figure 50), leading to large increases in relative pricing. Figure 50: UK retail price indices for beer, tobacco, wines/spirits, etc 500 450 400 350 300 250 200 150 100 50 0

   0   1   2   3   4   5   6   7   8   9   0   1   2   3   4   5   6   7   8   9   0   1   2    9   9   9   9   9   9   9   9   9   9   0   0   0   0   0   0   0   0   0   0   1   1   1    9   9   9   9   9   9   9   9   9   9   0   0   0   0   0   0   0   0   0   0   0   0   0    1   1   1   1   1   1   1   1   1   1   2   2   2   2   2   2   2   2   2   2   2   2   2

Soft drinks

confectionery

beer  

tobacco

Wine & Spirits

RPI

Source: ONS

We do not have the data for all countries but the UK is illustrative  – over the past 20 years tobacco prices are up over 350% versus under 100% for the RPI, with not dissimilar numbers for beer, wines and spirits.

Tobacco

Has tobacco reached an inflection point in the historical pricing model?

26

24 March 2014

Illicit trade  – a structural issue There are continuing actions to limit the illicit trade, which include: ■

Funding and intelligence gathering for government agencies (e.g. European AntiFraud Office, Interpol, and Customs agencies).

■

Legislation to create deterrents and improve enforcement.

■

Regulate sale of essential materials used in cigarette manufacturing (e.g. chemicals, machinery, paper, etc.).

■

Pressure on known supplier countries to lower production quotas (e.g. Belarus).

Implementing measures to stem the illicit trade at its source is likely to remain a major challenge for the industry, but progress is being made  – significant revenues can be lost if this is allowed to persist. However, as we highlighted earlier the following factors make the illicit trade attractive to some: ■

Low penalties

■

Conflicts of interest between exporting and importing countries

■

Political interests

■

Large tax discrepancies that continually increase

No material reverse in quantum of illicit trade

It is hard for us to see how a meaningful reduction will be seen in the illicit trade. We also note that four years of a high level of illicit trading has left the consumer familiar with the concept of buying cheap illegal cigarettes. We think it is less of a concern to the public than it might have been.

Credit Suisse outlook Overall our outlook for the next 3-5 years are that: ■

The macro drivers for the industry should improve somewhat and volumes are likely to recover – but not to previous levels. We see continued pressures on smoking and no let-up from the health and government lobbies. We assume volumes will continue to decline.

■

The Illicit trade will remain a problem in our opinion  – the price gaps are simply too large and consumers have learnt to buy illicit tobacco. Supply routes are well established and prevailing conflicts between countries are too numerous for this to materially close.

■

New technology and e-cigarettes are likely to remain an important but modest new avenue for the industry. A material change in technology could change this.

■

Declining industries have a habit of consolidating and tobacco has a strong history in this regard. Assets are declining and we believe we are getting closer to the possibility that there may be some consolidation among the majors.

Tobacco

27

24 March 2014

Industry consolidation Much like its brewing counterpart, the global tobacco industry has been consolidating for a number of years. Over the past decade the market share (world ex US and China) of the top four names has gone from about 60% to almost 80%.

Consolidation has been a key plank of industry development…

Figure 51: Top 4 tobacco companies comprise almost 80% of the international market

Top 4 tobacco % international market (ex China, USA) 80% PMI: Fortune IMT: Altadis BAT: STG, Tekel

75% 70%

 JT: Gallaher 

65% 60% 55% 50% 2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

Source: Euromonitor

With large synergies gained, and modest multiples paid, we think this process has helped fuel the outperformance in earnings growth seen in tobacco (versus other staples). However, future opportunities for further consolidation are beginning to look rather limited  –in Europe and Latin America markets are dominated by the Big 4 (PMI, BAT, Imperial Tobacco and Japan Tobacco). A few isolated possibilities remain in EEMA and  Asia (Figure 52)  –  these are either state-owned assets, or predominately domestic operations, e.g. in Indonesia, Korea, Vietnam, Egypt, Iran, Bangladesh and Thailand.

…but there are fewer opportunities around now

Figure 52: Still some options in Asia and EEMA

Market share not held by Big 4 tobacco 45% 40% 35% 30% 25% 42%

20% 15% 10%

18%

5% 0%

10%

4% EU

EEMA

Asia (ex China)

Americas (ex USA)

Source: Company data

Tobacco

28

24 March 2014

Figure 53: Global Tobacco landscape  – market shares of the Big 4 tobacco companies Volumes (bn) Growth '07-12 PMI BATS JT IMT Other Europe

Germany Italy Spain Poland France UK Greece Czech  Austria Netherlands Hungary Belgium EEMA

Russia Turkey Ukraine Egypt Iran Belarus Romania Kazakhstan  Algeria Saudi Arabia South Africa Nigeria Morocco Serbia  Azerbaijan Tunisia Uzbekistan Bulgaria  Asia

-5%

38%

20%

17%

21%

4%

83 79 57 52 52 43 23 21 14 12 12 11

-1% -3% -10% -6% -1% -3% -9% -2% 1% -3% -6% -1%

36% 53% 31% 36% 40% 7% 37% 42% 35% 32% 38% 30%

19% 23% 12% 29% 16% 7% 19% 20% 6% 27% 37% 32%

4% 21% 20% 10% 17% 39% 13% 7% 33% 16% 5% 11%

26% 3% 28% 23% 23% 45% 12% 14% 19% 11% 13% 16%

15% 0% 9% 2% 5% 1% 20% 17% 6% 14% 8% 11%

1235

-1%

25%

22%

23%

12%

18%

370 99 83 78 56 33 31 30 30 26 22 17 16 15 14 14 13 9

1% -4% -9% -2% 0% 12% -1% 0% 4% 6% -2% 1% 1% -9% 4% -2% 5% -15%

26% 46% 32% 17% 0% 0% 19% 47% 40% 62% 3% 2% 9% 51% 0% 15% 4% 13%

21% 22% 17% 8% 14% 16% 50% 7% 1% 15% 86% 80% 0% 19% 27% 0% 92% 13%

37% 26% 28% 0% 32% 22% 23% 43% 3% 0% 4% 10% 2% 7% 25% 2% 1% 0%

9% 4% 22% 0% 0% 2% 0% 3% 11% 9% 0% 7% 81% 0% 29% 1% 1% 0%

7% Donskoy, KT&G 2% European tobacco 1% 75% Eastern Co 55% Iranian Tobacco, KT&G 60% Neman Tobacco 8% 0% 45% SNTA  14% 7% 1% 8% 23% Adris Grupa, Monus, Karelia 19% European tobacco 83% RNTA, MTK   2% KT&G 74% Bulgartabac, Karelia

1196

1%

27%

16%

12%

3%

Indonesia  Japan India Philippines Vietnam Korea Bangladesh Pakistan Thailand Taiwan  Australia Malaysia

303 197 102 102 83 89 75 64 39 36 19 14

5% -6% 0% 2% 4% -1% -2% 3% -4% -3% -4%

36% 28% 12% 85% 2% 19% 0% 47% 22% 0% 38% 12%

8% 13% 8% 1% 31% 12% 44% 49% 2% 8% 42% 63%

0% 60% 0% 6% 1% 7% 0% 0% 0% 39% 0% 20%

0% 0% 0% 0% 10% 0% 0% 0% 0% 12% 19% 0%

 Americas

298

-3%

38%

49%

4%

0%

10%

Brazil  Argentina Canada Mexico Colombia Chile Venezuela

87 43 32 34 15 14 11 287 2500

-5% 1% 2% -6% -5% 1% -3% -5% 4%

17% 75% 34% 74% 51% 4% 8% 0% 0%

64% 25% 51% 26% 49% 96% 92% 0% 1%

0% 0% 15% 1% 0% 0% 0% 0% 0%

0% 0% 0% 0% 0% 0% 0% 3% 0%

19% 0% 1% 0% 0% 0% 0% 97% 99%

USA China

Other Companies

520

-

Private label

Karelia, STG

42%

56% Gudang, Djarum 0% 80% ITC 8% Mighty 56% Vinataba 62% KT&G 56% Dhaka, Abul Khair, Nasir   5% 76% Thailand Tobacco Mono 42% Taiwan Tobacco & Liquor   1% 6% AKJ Marketing

Altria, Reynolds, Lorillard CNTC

Source: Company data, Euromonitor. Asia excludes China, Americas excludes USA

Tobacco

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24 March 2014

Declining cigarette volumes in mature markets and economies of scale across the production and supply chain have, in our view, made tobacco an industry with scope for consolidation over time.

Figure 54: M&A multiples average 12.8x on EV/EBITDA (LTM) EV/EBITDA multiple (LTM) 30

2001-2003

1999-2000

Weighted average

2004-2006

2007-2008

2009->

25 20 15 10 5 0

    k    R    J    a    R     b    a    T    a    i    r    t    s    u    A

   s    o     d    c    s    n    a    a    r    m    I    B    n    a    i    s    a     l    a    r    t    s    u    A

   a    t    i    e    S

   r     k    s    t    o    a    o    t    c     b    n    a    c    a    a    c    u    a    T     b    D    b    a   -    a    a    i    H    t    e    T    r    t    p    g    s    r    g    u    o    i    L    A    C

   e    F    a    t    n    a    S

   s    r    o    a    G    d    r    n     h    s    a    c    I    i    a     l    T    a    y    A    i    n    t    e    e    s    c    t    a    c    n    T    o    e    o     l    t     d    a    N    n    n    S    m    t    i    T    o     k    c    s    a    i    m    r     h    t    t    a     b    a    s    i    n    i    D    a    S    a    r    s    i     l    s    a     k    a    e    g    e    o     b     b    e    S    o    t    i    S    t    a    r    e     l    t     l    T    a     l    m    w    l    a    a    n    a    o    T    o    t    P     h    U    s    n     d    t    I    g    A    a    w    m    s    L    n    L    a    p    e    i    r     f    t     d    i    o    A    e    e     k     l    n    o    i    L    G    v    M    o     l    o    o     h    a    a    C    m    e     d    o    C    n    R    c    a    I    M    o    e    R    B    c    r    m    S     l    i    c    s    e    i    n    a    e    e    x    u    m    g    n     h     b    o    i    o    e    o    t    e    o    a    t    J    H    C    R    n    M    T    E    e    e    B    t    n    E

Source: Company data, Thomson Reuters

Takeover multiples in tobacco have been relatively stable averaging roughly 13x EV/EBITDA (LTM) (Figure 54). The bulk of these transactions have been private assets taken over by larger public tobacco companies. However, the more notable examples of consolidation between public companies (e.g. Sampoerna, Altadis and UST) have been done with bid premiums of roughly 30% to the share price (Figure 55). Figure 55: Bid premium to share price (at close prior day) Bid premium to share price (close)

Average

60% 50% 40% 30% 20% 10% 0% Sampoerna (PMI)

Conwood (RAI)

Altadis (IMT)

Rothmans (PMI)

US ST (Altria)

Source: Thomson Reuters

Tobacco

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24 March 2014

So what is next? If M&A is to remain a possibility we believe it is a choice between: ■

Selecting one of the remaining assets identified in Figure 53

■

Buying minorities in emerging markets (e.g. ITC, Souza Cruz, BAT Malaysia, etc.)

■

Entering (or re-entering) the US (we assume China will remain closed)

■

The Top 4 becoming the Top 3

Possible US/China entry? Throughout this report we have largely ignored the US and Chinese market because of the limited direct exposure of the international tobacco companies. The two markets account for almost 40% of global retail sales combined (2013 data), a considerable profit pool for the industry. China

The Chinese market is a state monopoly operated by the China National Tobacco company- CNTC- (in a rare public disclosure net income was reported to be over $18.6bn in 2010 and delivering over $110bn in annual tax revenues)  –  the largest tobacco company in the world. The international names all have indirect access to the market through licence agreements or JVs with CNTC, but remain an insignificant proportion of the market.

China – a state monopoly, unlikely to change any time soon

International involvement is likely to remain limited and is at best a long-term option.  Announcements following the Communist Party's Third Plenum (Q4 2013) suggest that there are no immediate plans to overhaul industries with entrenched state-owned enterprises (SEOs) and tobacco remains a good fit for a government seeking to extract higher dividend payments from state-owned companies to help public finance. US

The US market is dominated by three domestic companies (Altria, Reynolds and Lorillard) with some degree of indirect exposure from the international tobacco companies. Figure 56: US market shares in tobacco (2013) IMT 2%

Vector  2%

Others 2% Lorillard 9%

Reynolds 27%

 Altria 58%

Source: AC Nielsen ■

Figure 57: US market growth of cigarettes (volume)

0% -1% -2% -3% -4% -5% -6% -7% -8% -9% -10%

Source: TMA

PMI was spun off from Altria in March 2008. There are some agreements between the two entities such as a strategic agreement to commercialise NGPs (next-generation products) in the US and abroad. There are agreements also on brands, extensions, marketing and positioning. Having split the company five years ago, it would be a volte face t o merge, while any other interest in the US is prohibited as a party of the original de-merger.

Tobacco

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24 March 2014

■

Imperial Tobacco  has a small position in the US following the acquisition of Commonwealth (April '07), but remains a distant number 4 with a ~3.5% market share (same as in 2007). Imperial lacks the financial capacity to buy its way into the Top 3 (e.g. acquire Lorillard) and management has abandoned the ambition to compete across the whole market (it now chooses to concentrate its efforts on the 21 states where it has a more meaningful presence). A merger of equals with Lorillard would enable Imperial to compete more effectively and give Lorillard distribution in Europe to launch e-cigarettes. However, this seems unlikely following Lorillard's acquisition of UK-based e-cig maker SKYCIG (Oct '13

■

The most speculated upon push into the US will likely remain BAT  buying out the remaining stake in Reynolds (04/03/2014). BAT currently owns a 42% stake in the company following the merger of B&W's US tobacco business and RJ Reynolds in 2004. The transaction came with a clause limiting BAT's ownership to 42% for 10 years, which is due to expire in July 2014. The structure indemnified BAT from any US litigation risk at a time when this was a much greater concern for the industry and investors, but these risks have since subsided.

■

Press reports (notably the FT 03/03/2014) suggest that Reynolds in the US may bid for or merge with Lorillard.

Possible Top 4 merger? The one possible outstanding piece of consolidation is a merger/takeover within the Top 4. Most permutations would be fraught with anti-trust issues; however, a joint break-up of Imperial (the smaller of the Top 4) would be feasible and is a possibility that has been widely discussed in the media and by the industry over the years. We try to illustrate this using a traffic light system in Figure 58, with red indicating a serious issue, and green where we believe there are no serious concerns.

Mergers among the Big 4 are fraught with anti-trust issues…

Interpreting our table: ■

 A combined share of under 25% is fine (green) – that is to say the deal should be able to go through even if some remedies are required.

■

If one of the parties in the combination has less than a 5% share then that is fine (green).

■

 A combined share of 25-40% may constitute a a problem, but may get through, maybe with some modest disposals (orange).

■

Everything else is red (serious anti -trust issues that would require a brand disposal).

Tobacco

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24 March 2014

Figure 58: Market share implications by region of a potential Imperial Tobacco takeover by one of the other three large players IM T v ols IMT share 109 Europe 21%

Germany Italy Spain Poland France UK Greece Czech  Austria Netherlands Hungary Belgium EEMA

Russia Turkey Ukraine Belarus Kazakhstan  Algeria Saudi Arabia Nigeria Morocco  Azerbaijan Tunisia Uzbekistan  Asia

Vietnam Taiwan  Australia New Zealand

22 2 16 12 12 19 3 3 3 1 2 2 148 34 4 18 1 1 3 2 1 13 4 0 0 36 9 4 4 0

26% 3% 28% 23% 23% 45% 12% 14% 19% 11% 13% 16%

PM I+IM T

BA T+IM T

JT+IMT

62% 56% 59% 59% 62% 52% 48% 56% 55% 43% 51% 46%

                       

45% 26% 40% 52% 38% 52% 31% 34% 26% 38% 50% 48%

30% 24% 48% 33% 40% 84% 25% 21% 53% 27% 18% 27%

36% 49% 54% 2% 50% 51% 71% 8% 90% 27% 16% 5%

           

30% 26% 39% 18% 10% 12% 24% 87% 81% 55% 1% 93%

46% 30% 50% 24% 46% 14% 9% 17% 83% 50% 2% 2%

12% 12% 57% 26%

       

41% 20% 61% 92%

11% 50% 19% 20%

12%

9% 4% 22% 2% 3% 11% 9% 7% 81% 27% 1% 1%

       

3%

10% 12% 19% 20%

Source: Credit Suisse estimates based on TMA data (Tobacco Merchant’s Association )

 Although this is a fairly subjective assessment it shows the major problems faced in several markets and that some divestitures could be forced on any would-be consolidator. This would throw up the thorny issue of cross-ownership of brands. This is never a satisfactory state of affairs for any brand owner, but is not unheard of: for example, when JT bought Gallaher various brands were licen sed out in regions of overlaps. ■

Benson & Hedges: BAT has the brand in most of Asia, and MEA. JT owns the brand in the EU, Philippines and Thailand; PMI holds the brand in Canada

■

Peter Stuyvesant, again BAT (Europe, Africa, New Zealand), Imperial Tobacco (Australia, Germany), PMI (Canada)

Furthermore some brands are licensed by their owners to other producers: ■

Imperial: Davidoff is licensed to KT&G in Korea (strategic alliance)

■

Imperial: Gauloises and Gitanes are licensed to BATS in Switzerland and Liechtenstein

Tobacco

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24 March 2014

■

Imperial: Gauloises and other brands are licensed to BATS in the Netherlands

■

Imperial: Gitanes licensed to BATS in Argentina

■

Imperial: Davidoff and West are licensed to PMI in Mexico

■

BATS, PMI and JT: Brands licensed to CNTC in China and CNTC brands licensed to internationals

■

BATS: License all brands to state monopoly in Algeria, Iran and Egypt

■

PMI: Marlboro was licensed to JT in Japan (1972), but bought back (in 2005)

■

PMI: License manufacturing of Marlboro to Imperial in Morocco

■

PMI: License all brands to state monopoly in Egypt and Algeria

Thus, while anti-trust problems exist, and are significant, they are not insurmountable, in our view.

Tobacco

34

24 March 2014

Companies Mentioned (Price as of 20-Mar-2014) Anheuser-Busch InBev (ABI.BR, €72.87) Beiersdorf (BEIG.DE, €69.65) British American Tobacco (BATS.L, 3214.5p, NEUTRAL, TP 3500.0p) Carlsberg (CARLb.CO, Dkr522.0) Danone (DANO.PA, €49.44) Diageo (DGE.L, 1791.5p) Gudang Garam (GGRM.JK, Rp45,450) Heineken (HEIN.AS, €46.32) Henkel (HNKG_p.F, €76.5) ITC Ltd (ITC.BO, Rs355.9) Imperial Tobacco (IMT.L, 2418.0p, OUTPERFORM, TP 2700.0p) Japan Tobacco (2914.T, ¥3,030) KT&G Corp (033780.KS, W79,000) L'Oreal (OREP.PA, €116.35) Nestle (NESN.VX, SFr64.55) Oriflame Cosmetics (ORIsdb.ST, Skr152.7) Pernod-Ricard (PERP.PA, €80.39) Philip Morris International (PM.N, $80.43, NEUTRAL, TP $85.0) Reckitt Benckiser  (RB.L, 4846.0p) SABMiller  (SAB.L, 2802.5p) Souza Cruz (CRUZ3.SA, R$21.24) Swedish Match (SWMA.ST, Skr204.9) Unilever (UNc.AS, €27.81)

Disclosure Appendix Important Global Disclosures

The analysts identified in this report each certify, with respect to the companies or securities that the individual analyzes, that ( 1) the views expressed in this report accurately reflect his or her personal views about all of the subject companies and securities and (2) no part of his or her compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this report. 3-Year Price and Rating History for British American Tobacco (BATS.L) BATS.L Date 04-May-11 28-Jul-11 15-Sep-11 18-Nov-11 27-Feb-12 20-Apr-12 23-Oct-12 04-Jan-13 28-Feb-13 25-Apr-13 27-Jun-13 12-Dec-13

Closing Price (p) 2653.50 2857.00 2755.50 2888.00 3159.00 3244.00 3164.00 3174.50 3434.50 3591.00 3439.00 3142.50

Target Price (p) 2740.00 2900.00 3030.00 3080.00 3250.00 3400.00 3430.00 3380.00 3600.00 3800.00 3700.00 3550.00

Rating N O

NEUTRAL OUTPERFORM

* Asterisk signifies initiation or assumption of coverage.

3-Year Price and Rating History for Imperial Tobacco (IMT.L) IMT.L Date 25-Mar-11 11-May-11 13-Jun-11 18-Nov-11 01-Mar-12 01-May-12 05-Nov-13

Closing Price (p) 1896.00 2197.00 2056.00 2275.00 2534.00 2556.00 2382.00

Target Price (p) 2330.00 2420.00 2350.00 2500.00 2660.00 2700.00 2600.00

Rating O

* Asterisk signifies initiation or assumption of coverage. OUTPERFORM

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3-Year Price and Rating History for Philip Morris International (PM.N) PM.N Date 26-Apr-11 22-Jul-11 18-Nov-11 10-Feb-12 03-Apr-12 12-Feb-14

Closing Price (US$) 67.59 72.11 73.09 80.44 88.98 78.44

Target Price (US$) 72.00 77.00 79.00 85.00 90.00 85.00

Rating O

N

* Asterisk signifies initiation or assumption of coverage.

OUTPERFORM NEUTRAL

The analyst(s) responsible for preparing this research report received Compensation that is based upon various factors including Credit Suisse's total revenues, a portion of which are generated by Credit Suisse's investment banking activities As of December 10, 2012 Analysts’ stock rating are defined as follows: Outperform (O) : The stock’s total return is expected to outperform the relevant benchmark*over the next 12 months. Neutral (N) : The stock’s total return is expected to be in line with the relevant bench mark* over the next 12 months. Underperform (U) : The stock’s total return is expected to underperform the relevant benchmark* over the next 12 months. *Relevant benchmark by region: As of 10th December 2012, Japanese ratings are based on a stock’s total return relative to the analyst's coverage universe which consists of all companies covered by the analyst within the relevant sector, with Outperforms representing the most attractive, Neutrals the less attractive, and Underperforms the least attractive investment opportunities. As of 2nd October 2012, U.S. and Canadian as well as European ratings are based on a stock’s total return relative to the analyst's coverage universe which consists of all companies covered by the analyst within the relevant sector, with Outperforms representing the most attractive, Neutrals the less attractive, and Underperforms the least attractive investment opportunities. For Latin American and non-Japan Asia stocks, ratings are based on a stock’s total return relative to the ave rage total return of the relevant country or regional benchmark; Australia, New Zealand are, and prior to 2nd October 2012 U.S. and Canadian ratings were based on (1) a stock’s absolute total return potential to its current share price  and (2) the relative attractiveness of a stock’s total return potential within an analyst’s coverage universe. For Australian and New Zealand stocks, 12 -month rolling yield is incorporated in the absolute total return calculation and a 15% and a 7.5% threshold replace the 10-15% level in the Outperform and Underperform stock rating definitions, respectively. The 15% and 7.5% thresholds replace the +10-15% and -10-15% levels in the Neutral stock rating definition, respectively. Prior to 10th December 2012, Japanese ratings were based on a stock’s total return relative to the average total return of the relevant country or regional benchmark.

Restricted (R) : In certain circumstances, Credit Suisse policy and/or applicable law and regulations preclude certain types of communications,

including an investment recommendation, during the course of Credit Suisse's engagement in an investment banking transaction and in certain other circumstances. Volatility Indicator [V] : A stock is defined as volatile if the stock price has moved up or down by 20% or more in a month in at least 8 of the past 24

months or the analyst expects significant volatility going forward.  Analysts’ sector weightings are distinct from analysts’ stock ratings and are based on the analyst’s expectations for the fun damentals and/or valuation of the sector* relative to the group’s historic fundamentals and/or valuation: Overweight : The analyst’s expectation for the sector’s fundamentals and/or valuation is favorable over the next 12 months. Market Weight : The analyst’s expectation for the sector’s fundamentals and/or valuation is neutral over the next 12 months. Underweight : The analyst’s expectation for the sector’s fundamentals and/or valuation is cautious over the next 12 months. *An analyst’s coverage sector consists of all companies covered by the analyst within the relevant sector. An analyst may cover multiple sectors.

Credit Suisse's distribution of stock ratings (and banking clients) is: Global Ratings Distribution

Rating Outperform/Buy* Neutral/Hold* Underperform/Sell* Restricted

Versus universe (%)

Of which banking clients (%)

43% 40% 14% 2%

(53% banking clients) (50% banking clients) (45% banking clients)

*For purposes of the NYSE and NASD ratings distribution disclosure requirements, our stock ratings of Outperform, Neutral, and Underperform most closely correspond to Buy, Hold, and Sell, respectively; however, the meanings are not the same, as our stock ratings are determined on a relative basis. (Please refer to definitions above.) An investor's decision to buy or sell a security should be based on investment objectives, current holdings, and other individual factors.

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Credit Suisse’s policy is to update research reports as it deems appropriate, based on developments with the subject company,  the sector or the

market that may have a material impact on the research views or opinions stated herein. Credit Suisse's policy is only to publish investment research that is impartial, independent, clear, fair and not misleading. For more detail please refer to Credit Suisse's Policies for Managing Conflicts of Interest in connection with Investment Research: http://www.csfb.com/research and analytics/disclaimer/managing_conflicts_disclaimer.html Credit Suisse does not provide any tax advice. Any statement herein regarding any US federal tax is not intended or written to be used, and cannot be used, by any taxpayer for the purposes of avoiding any penalties. Price Target: (12 months) for Imperial Tobacco (IMT.L) Method: Our target price is derived using an APV with a 7year explicit forecast and a 8 year fade to a terminal growth rate of 0% and 50bps margin

expansion per annum. We use a 8.5% cost of equity, 5.5% cost of debt and a 22% tax rate. Risk:

In addition to the risks of higher taxation, tougher regulation and volume decline in the developed world that all tobacco stocks face, the company-specific risks include: (a) deteriorating trading conditions in its key profit pools (UK, Germany, Spain, France and the US), (b) implementation of plain packaging in UK, (c) US federal excise tax hike, (d) taxation changes in fine cut tobacco, reducing and eliminating its tax advantage relative to cigarettes sooner than we expect, (e) potential liabilities from the investigation of the Offic e of Fair Trading in the UK market, and (f) reduced risk products achieve mainstream appeal (up-/downside risk)

Price Target: (12 months) for Philip Morris International (PM.N) Method: Our target price of US$85 is derived using APV, with a 7yr explicit forecast period and an 8yr fade to a terminal growth rate of 0.5% and

50bps of margin expansion per annum driven by pricing. We use an 8.5% cost of capital, a 4.5% cost of debt and a 29.3% tax rate. Our target price implies the shares will maintain a current 12m fwd PE of 15x. Risk:

Risks to PM's achievement of our target price are: (1) the secular decline of the cigarette industries in developed countries, (2) Illicit product taking share from the legitimate trade (3) the potential for increased future regulation and taxation of cigarettes worldwide, (4) the significant dependence on the Marlboro brand, (5) increasing intolerance of smoking, (6) the volatility of earnings as a r esult of currency fluctuations (USD), and (7) reduced risk products achieving mainstream appeal (up-downside risk)

Price Target: (12 months) for British American Tobacco (BATS.L) Method: We use an APV with an 8.5% cost of equity capital, 5% cost of debt, a 7-year explicit forecast window and an 8-year fade to 0.5% terminal

growth. Our target price implies that BAT shares will sustain a forward P/E multiple of roughly 15x in 12 months is justified by the visibility on pricing and margin expansion. Risk:

 time, which we believe

’

Risks include (a) Increasing taxation and regulation, in particular plain packaging, (b) Tougher competition or market deterioration in key strongholds such as Brazil, South Africa, Canada, Australia, and Malaysia, (c) M&A risk, (d) FX movements (in particular the USD, euro, Brazilian real and South African rand, (e) Litigation risk, especially in Canada, and (f) reduced risk products achieving mainstream appeal (up-/downside risk).

Please refer to the firm's disclosure website at https://rave.credit-suisse.com/disclosures for the definitions of abbreviations typically used in the target price method and risk sections. See the Companies Mentioned section for full company names

The subject company (IMT.L, PM.N, BATS.L, 2914.T, SWMA.ST, 033780.KS, ABI.BR, BEIG.DE, DANO.PA, DGE.L, HEIN.AS, NESN.VX, OREP.PA, ORIsdb.ST, SAB.L) currently is, or was during the 12-month period preceding the date of distribution of this report, a client of Credit Suisse. Credit Suisse provided investment banking services to the subject company (IMT.L, PM.N, 2914.T, ABI.BR, DGE.L, HEIN.AS, NESN.VX, OREP.PA, ORIsdb.ST) within the past 12 months. Credit Suisse provided non-investment banking services to th e subject company (IMT.L, PM.N, BATS.L, 2914.T, DANO.PA, DGE.L, HEIN.AS, NESN.VX, ORIsdb.ST) within the past 12 months Credit Suisse has managed or co- managed a public offering of securities for the subject company (PM.N, 2914.T, HEIN.AS, NESN.VX, ORIsdb.ST) within the past 12 months. Credit Suisse has received investment banking related compensation from the subject company (IMT.L, PM.N, 2914.T, ABI.BR, DGE.L, HEIN.AS, NESN.VX, OREP.PA, ORIsdb.ST) within the past 12 months Credit Suisse expects to receive or intends to seek investment banking related compensation from the subject company (IMT.L, PM.N, BATS.L, 2914.T, SWMA.ST, CRUZ3.SA, 033780.KS, ABI.BR, BEIG.DE, DGE.L, HEIN.AS, NESN.VX, OREP.PA, ORIsdb.ST, PERP.PA, SAB.L) within the next 3 months. Credit Suisse has received compensation for products and services other than investment banking services from the subject company (IMT.L, PM.N, BATS.L, 2914.T, DANO.PA, DGE.L, HEIN.AS, NESN.VX, ORIsdb.ST) within the past 12 months

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 As of the date of this report, Credit Suisse makes a market in the following subject companies (PM.N, ORIsdb.ST).  As of the end of the preceding month, Credit Suisse beneficially own 1% or more of a class of common equity securities of (NESN.VX, ORIsdb.ST, SAB.L). Credit Suisse and its related bodies corporate have a substantial interest greater than 5% in (ORIsdb.ST) Credit Suisse has a material conflict of interest with the subject company (NESN.VX) . Credit Suisse assisted Nestlé in the strategic review of its personal care strategy and options for its 30% shareholding in L'Oréal. Credit Suisse has a material conflict of interest with the subject company (OREP.PA) . Credit Suisse assisted Nestlé in the strategic review of its personal care strategy and options for its 30% shareholding in L'Oréal. Important Regional Disclosures

Singapore recipients should contact Credit Suisse AG, Singapore Branch for any matters arising from this research report. The analyst(s) involved in the preparation of this report have not visited the material operations of the subject company (IMT.L, PM.N, BATS.L, 2914.T, SWMA.ST, CRUZ3.SA, ITC.BO, 033780.KS, ABI.BR, BEIG.DE, CARLb.CO, DANO.PA, DGE.L, GGRM.JK, HEIN.AS, HNKG_p.F, NESN.VX, OREP.PA, ORIsdb.ST, PERP.PA, RB.L, SAB.L, UNc.AS) within the past 12 months Restrictions on certain Canadian securities are indicated by the following abbreviations: NVS--Non-Voting shares; RVS--Restricted Voting Shares; SVS--Subordinate Voting Shares. Individuals receiving this report from a Canadian investment dealer that is not affiliated with Credit Suisse should be advised that this report may not contain regulatory disclosures the non-affiliated Canadian investment dealer would be required to make if this were its own report. For Credit Suisse Securities (Canada), Inc.'s policies and procedures regarding the dissemination of equity research, please visit http://www.csfb.com/legal_terms/canada_research_policy.shtml. Credit Suisse Securities (Europe) Limited (Credit Suisse) acts as broker to (IMT.L, DGE.L, ORIsdb.ST). The following disclosed European company/ies have estimates that comply with IFRS: (IMT.L, BATS.L, SWMA.ST, ABI.BR, BEIG.DE, CARLb.CO, DANO.PA, DGE.L, HEIN.AS, HNKG_p.F, NESN.VX, OREP.PA, ORIsdb.ST, PERP.PA, RB.L, SAB.L, UNc.AS).  As of the end of the preceding month, the subject company (ORIsdb.ST) beneficially owned 5% or more of the total issued share capital of Credit Suisse Group. Credit Suisse has acted as lead manager or syndicate member in a public offering of securities for the subject company (PM.N, 2914.T, DGE.L, HEIN.AS, NESN.VX) within the past 3 years.  As of the date of this report, Credit Suisse acts as a market maker or liquidity provider in the equities securities that are the subject of this report. Principal is not guaranteed in the case of equities because equity prices are variable. Commission is the commission rate or the amount agreed with a customer when setting up an account or at any time after that. To the extent this is a report authored in whole or in part by a non-U.S. analyst and is made available in the U.S., the following are important disclosures regarding any non-U.S. analyst contributors: The non-U.S. research analysts listed below (if any) are not registered/qualified as research analysts with FINRA. The non-U.S. research analysts listed below may not be associated persons of CSSU and therefore may not be subject to the NASD Rule 2711 and NYSE Rule 472 restrictions on communications with a subject company, public appearances and trading securities held by a research analyst account. Credit Suisse Securities Johannesburg (PTY) Ltd ............................................................................................................................ Pieter Vorster Credit Suisse Securities (Europe) Limited......... Jimmie Bork ; Alex Molloy ; Charlie Mills ; Nicolas Sochovsky ; Rogerio Fujimori ; Sanjeet Aujla

For Credit Suisse disclosure information on other companies mentioned in this report, please visit the website at https://rave.creditsuisse.com/disclosures or call +1 (877) 291-2683.

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