Joergens'  Instablog

Transnational Tobacco Companies (TTCs) in China

1.Introduction

I was motivated to write this article because I was disappointed by the business results of Philip Morris International (PMI) in China.
In order to gain a better understanding of the difficulties involved in accessing the Chinese cigarette market I surveyed many writings available online and in print.
I also communicated with the Investor Relations Departments of cigarette companies to verify my findings and to obtain additional information, and I complemented all these sources by my own observations in China.

The article starts by providing an overview of the market size and a brief description of the role of the industry regulator State Tobacco Monopoly Administration (STMA) as well as its affiliate China National Tobacco Corporation (CNTC).
The article's main emphasis is on describing the various attempts foreign cigarette companies have made to enter the Chinese market during the last three decades.
I then highlight today's situation. The article ends with a summary of the topics discussed added by my conclusions.

2. Market Characteristics

Market Size

China accounts for more than one third of global cigarette consumption, making it the biggest market in the world, with an estimated 350 million smokers.

Although exact figures on cigarette consumption vary slightly, all recent statistics I have found indicate that Chinese consume well over two trillion cigarettes per year.

According to The Economist; "It [China's tobacco industry] makes and sells more than two-fifths of the world's cigarettes - 2.4 trillion in 2011, 3% more than in 2010. [1]

What's more, China is one of very few countries were cigarette consumption is actually increasing; from 1.8 trillion in 2004 to approximately 2.4 trillion in 2011.

Even more astonishing, the volume of cigarettes sold is projected to reach 2.75 trillion in 2015. [2]

The Role of STMA and CNTC and an overview of Chinese cigarette brands

The Chinese tobacco industry is regulated by STMA, which is a department of China's National Development and Reform Commission and thus a state body, whose responsibilities for the industry are very general, e.g. "formulating development strategies for the tobacco industry, conducting industrial restructuring, guiding the rational layout of the tobacco industry, formulating investment plans". See here for reference and more details.

Under its jurisdiction is China National Tobacco Company, which is state owned.CNTC carries out the marketing, production, distribution, and sales of all tobacco products, local as well as imported, in China.

According to an article in Hong Kong's South China Morning Post, the top selling brand was ZhongHua ("China") with estimated sales of CNY 76 billion = US$ 11.46 billion.

Moreover, five other brands register more than CNY 40 billion each in sales, equivalent to US$ 6 billion.

Although the article does not provide more specific brand names, I do know of the following popular brands in China; ZhongNanHai, HongTaShan, ShuangXi, and some other prestigious brands, some of which are significantly more expensive than premium foreign brands. See here for more information on the social significance of expensive cigarettes in China.

Cigarette Industry as Significant Source of Tax Income

Both STMA and CNTC are very important entities to the Chinese government.

The article China Dependent On Tobacco In More Ways Than One states: "[omission] tobacco plays an important role, providing Beijing's biggest single source of tax revenue.
In the following, I have made on overview of CNTC's profit and taxes paid to the state during the period from 2009-2011,by using two different sources:

Year	Profit	Taxes Paid To The State	conversion
	in billion CNY	in billion CNY	in billion US$
2009	516.8	411.5	76/60.52	[3]
2010	604.5	498.8	91/75.23	[4]
2011	753	600.12	119/95.10	[5]

Remark: In my online source for the figures from 2011 it appears as if the figures for Profit and Taxes Paid To The State have changed place and I have corrected accordingly.

3. Transnational Tobacco Companies in China

Since America's and Europe's consolidation of the tobacco market in the last fifteen years, three cigarette companies emerged as truly globall players: Philip Morris International (PMI), British American Tobacco (BAT), and Japan Tobacco (JT).
In the following historic review I focus on these three companies and I refer to them as TTCs, Transnational Tobacco Companies.

Soon, after the founding of the People's Republic of China in 1949 foreign tobacco companies were forced out of the country.

BAT, which had been in China since 1903 and by 1924 had established a market share of 82%, was expelled in 1956, losing its largest source of foreign earnings. [6]
From then on, the market was completely left to the Chinese, who established a state monopoly.

Twenty years later, after the death of Mao Zedong in 1976 and a brief political power struggle Deng Xiaoping evolved as China's new leader in 1978. In the same year he initialized steps for political and economical reform with the aim of modernizing the country and opening it up to the world.

It was an auspicious opportunity for foreign tobacco companies seeking to reenter the market.

One document states that as early as 1977 two officials from the Commercial Office of China, visited PM's offices in Bern, Switzerland.
A PM memo records the officials' "express[ing] again their readiness to promote trade between Philip Morris and China". [7]

Now, in 2012,we look back at thirty-five years during which the powerful foreign tobacco industry has tried to access the Chinese market. In the following, I have broken down these 35 years into three main phases.

Phase One 1977-1988
Facing Bureaucracy, Joint-Venture Aspirations, Ray of GATT

Although TTCs were able to ride on the wave of political reform in China and to profit from the easing of political tension with the United States, however, in reality entering the market was very challenging as the Chinese bureaucracy created many barriers;
with trade strictly controlled by the Ministry of Foreign Trade and with tensions between central and provincial governments.

During this early phase TTCs focused on the sale of new and reconditioned machinery to the outdated Chinese factories and at the same time started to explore Joint-Venture possibilities.

However, all data indicate that the process from negotiations to actual production was very slow and arduous, as the following example of RJ Reynolds demonstrates.

In 1985, the Los Angeles Times writes in an article that "since 1981, Reynolds has cooperated with the Xiamen cigarette company to produce Camel filters for tourist outlets inside China, the first American brand produced here"

I would like to emphasize that "cooperation" does not mean an equity Joint-Venture. It was more sort of production and management know- how transfer in exchange for the right to manufacture the brand in China.

What's more, the cigarettes were not meant for the general public but sold in so called "Friendship Stores" that were reserved to foreigners in China.

According to the same article from 1985, it took three more years for Reynolds to have its brand domestically sold under a new agreement signed in 1984.

In a second article from 1988 the Los Angeles Times reports again about this factory, noting that Reynolds has an equity JV in China; "R. J. Reynolds began production today of its best-selling cigarettes in the first joint-venture cigarette factory in China."

However, it seems that Reynolds was particularly bold in establishing a JV, much more the exception than the rule in those early years in China.

BAT on the other hand, remained cautious. According to BAT management, the Chinese guidelines on JVs made it "difficult to identify positive profit sources " for the foreign JV partner." [8]

Philip Morris International also stayed on the sideline, even in its business plan for 1989-1993 it simply stated: "We will concentrate our efforts on fostering good relations with the.. (CNTC) . . . through technical assistance projects, and will consider investing in a joint venture if CNTC is willing to pursue one". [9]

Lastly, Japan Tobacco was still focusing on its national market and on other markets in the region. According to my knowledge, Japan Tobacco was not pursuing JV opportunities during that time in China.

In sum, all indicates that nothing really happened from 1978 to 1988. Other than a small scale JV by RJ Reynolds, foreign tobacco companies mainly coped with Chinese bureaucracy, conducted some equipment sales and technology & management transfer.
At the same time, they were restricted in their export attempts to China by high import taxes.

In contrast to that, the Chinese government established its industry regulatory body, the State Tobacco Monopoly Administration, in 1982.

However, in 1986 another political decision gave reason for hope as China submitted its membership application to GATT, which later was integrated into the WTO.

It was a wonderful opportunity, as GATT membership negotiations provided foreign tobacco companies a platform to push their business objectives.

Phase Two - 1989 to 2005

Global Politics, WHO and Big China versus Big (but foreign) Tobacco

Very unfortunately, three years later TTCs' fortune turned. In 1989 the Tiananmen Square incident put their ambitious plans on hold.

The Most Favoured Nation (MFN) trade clause, which was restored by the United States in 1980 and subject to annual Presidential extension, was suddenly at stake.

After 1989, the annual renewal of China's MFN status was highly debated in U.S. Congress and legislation was introduced to either terminate China's MFN status or to impose additional conditions relating to improvements in China's actions on various trade and non-trade issues.[10]

Non-trade issues meant political issues. In other words, China internal and geo-political circumstances were already impeding TTCs' ambitious plans and the problem was likely to intensify. TTCs had to do something about it.

According to the article Eyes On The Prize, page 295; ""In 1994, Bill Webb of PM mentioned the courting of the Chinese Minister of Foreign Trade and Economic Cooperation over export rights at a goodwill luncheon: "Philip Morris is a staunch supporter of free trade and is actively working to gain support for MFN [most favoured nation] status for China on a permanent and unconditional basis".
Webb cited a letter recently written to President Clinton, and said that the TTCs had contacted "at least 20 members of Congress to underscore the importance of this issue." [11]

However, at the same time, TTCs asked their governments for support to lift market barriers, the same source states: "Recently,
it was discovered that President Clinton's Trade Representatives were secretly pressuring China into accepting American cigarettes and tobacco as a condition of America's support for China's entry into the World Trade Organization." [12]

In hindsight, the easing of social tensions in China, the successful development of its economy, as well as American companies' lobbying were all factors that eventually allowed China to obtain the MFN status on a permanent basis in 2000. One year later China even gained WTO accession.

But what happened to the Joint-Ventures?

Many online documents I have sighted mention JV activities such as: "In 1991 Rothmans formed a joint venture in Shandong to produce three brands [omission] and in 1993 PM concluded a joint venture to manufacture Marlboro in Shanghai". [13]

However, by 2004 latest it had become evident that all these JVs had failed to meet TTCs' ambitious business plans, mainly due to production restrictions imposed by STMA.
See the following revealing report by 21st Century Economic titled Fate of Sino-Foreign Joint-Venture Cigarette Factories at Stake
for more details.

In short, according to industry experts only three Joint-Ventures were ever approved by authorities and I briefly summarize their fate in the following;

In 2001 Japan Tobacco acquired RJ Reynolds International and inherited their JV Huamei (China-American) Tobacco Corporation, which Japan Tobacco exited in 2004.

In the same year Japan Tobacco also exited its own JV with Shanghai GaoYang:JapanTobacco-Shanghai GaoYang International Tobacco Company.

BAT acquired Rothmans in 1999 and inherited their JV: Shandong-Rothmans Tobacco, later renamed HuaYing (Chinese-British) Tobacco Corporation, BAT exited this JV in 2004.

Interestingly, in summer of 2004 BAT, for whatever reason, announced that it would build its own cigarette factory in China. This made a big headline back home in the UK:
" BAT breaks China barrier ".

I quote from the article; "British American Tobacco is to become the first foreign company to manufacture cigarettes in China, the home of one in three of the world's smokers. The London-based firm said yesterday it has signed a deal with a local partner, China Eastern Investments, to build its biggest plant - an £800m factory capable of producing 100bn cigarettes a year."

However, Chinese authorities never gave their final approval for this factory, in fact, quite the opposite happened.
China signed the World Health Organization's Framework Convention on Tobacco Control (FCTC) in 2003 and ratified it in August 2005. And even half a year earlier, on February 7, 2005, it was announced that China would not approve any new cigarette factories, including joint ventures, in its new efforts to cut down on smoking. What a difference a year makes!

I would say the period around 2004/05 marked the culmination of the struggle between big foreign tobacco companies seeking local production to lower cost and to circumvent import tax versus the powerful Chinese government protecting its lucrative monopoly.

In the following I quote from Beijing Review's Year 2005 article Time To Inhale , by Matt Young, where it says; "Some industry-protective voices say Western brands aren't expanding into China. Rather, they say, they're only shifting around in a zero-sum game that only the Chinese Government truly wins by learning Western manufacturing and marketing virtues but maintaining its monopoly."

I arrive at the same conclusion. In addition, I would say China has gained precious time. In these three decades China was able to grow its economy tremendously, supported by the United States' export market. Yet at the same time, China kept its very lucrative cigarette market basically closed.

I have identified that the only progress between 1978 and 2005 were the gradual reduction in import duty and the abolishment of a retail license, previously necessary for the sale of imported tobacco products.

I quote from Tobacco International s September 2007 edition;
"A reduction for the import duty on cigarettes from 65% ad valorem to 25% has caused China's cigarette manufacturers to strive to improve quality and limit competition from imports."

As for the retail license, I quote again from the article Time to Inhale ;The Chinese also removed the need for retailers to have a special license to sell international imported tobacco products, although importation remains highly controlled and regulated, [by STMA] [omission].

No wonder that by around 2004/05 TTCs' share of the Chinese cigarette market was still negligible. In the following I quote two different sources to give the reader an idea of the numbers.

One article estimates that imported cigarettes accounted for less than 0.1 percent (equivalent to 1.8billion sticks) of the total Chinese market, which was about 1.8 trillion sticks p.a. at that time.

Yet another source, Tobacco International, mentions slightly higher numbers, stating that "China reported the clearance of 2.567 bn cigarettes through customs in 2004 and imports rose 4.4% to 2.679 bn in 2005."
The article also indicates the goods value: "The value for China's cigarette imports remained steady at $51.9 mn in 2005, compared with $51.2 mn in 2004."

To be frank, that is peanuts for the industry.

Phase Three - 2006 to 2012
License Manufacturing, Reverse JV, and Today's New Modesty

So what strategies have TTCs adopted to cope with the new situation and where do they stand today in terms of market access and market share?

It seems that apart from exporting cigarettes to China the only viable option to TTCs is to have their cigarettes manufactured in license at CNTC's factories and to find means to cope with still existing import quotas and sales restrictions.

And so on 21st December 2005, the CNTC and PMI announced the establishment of a long-term strategic cooperative partnership.
"Further agreements provided for the licensed manufacture and sale of "Marlboro" cigarettes in China and establishment of an international equity
joint venture company in Switzerland. [Omission], "Marlboro",
owned by PMI, will be produced under license at CNTC's affiliate factories, and will be distributed by CNTC's official distributors nationwide in China. " [14]

In other words, PMI helps CNTC to sell its Chinese cigarette brands in international markets through a Sales Joint-Venture in Switzerland in exchange for license manufacturing of Marlboro and usage of CNTC's sales network in China.

The interested reader can find a 2008 update on the results of that cooperation here. The news article says that: "Even with limited imports, Marlboro retail sales grew 153% from over 1 billion cigarettes to almost 3 billion cigarettes between 2003 and 2008."

However, after having spoken to PMI Investor Relations it is my understanding that since 2008, with the start of license manufacturing of Marlboro by CNTC in China, the import of Marlboro to China has ceased.
According to Investor Relations, the only imported PMI brand is Parliament, "in very small numbers".

According to PMI's website licensed production of Marlboro in China began in August 2008 at two Chinese cigarette factories.
The data that I have gathered from PMI's press releases and from Investor Relations are reflected in the following chart:

Marlboro China shipment volume from license manufacturing at CNTC in China, in billion sticks

2008	2009	2010	2011
0.7	1.3	1.5	1.9

The chart shows that in 2011 there were 1.9 billion Marlboro cigarettes manufactured in license and for retail through CNTC's network in China.

In addition to domestic production, Duty Free is an additional supply side to be considered.
Duty Free cigarettes are manufactured in PMI's global factories
and thus any cigarette that finds its way into China through Duty Free increases the quantity of PMI's brands consumed in China.

Cities such as Beijing, Shanghai, Guangzhou (Canton) and Hong Kong are significant international transport hubs, and Chinese Customs has a very generous Duty Free allowance, with 400-600 cigarettes per visitor.

Unfortunately, PMI does not release Duty Free sales figures.

Nevertheless, I believe it is justified to conclude that PMI holds less than 0.2 percent of market share in China, i.e. less than 4.8 billion cigarettes of the total 2.4 trillion consumed in 2011.

British American Tobacco, despite its high ambitions, has less business than PMI in China today. As mentioned before, BAT has exited its Joint Venture in 2004. And I could not find any indication on license manufacturing online.
When I inquired on BAT's manufacturing activities in China, Investor Relations simply replied: "BAT currently exports a small number of cigarettes to China every year."

As for exact cigarette sales figures, BAT does not reveal such figures in its Annual Report. Investor Relations stated that they
"do not give out shipment data for individual markets including China."
Thus it appears that BAT has nothing to boost about, no domestic production, sales only through export to China which is limited by a quota, and in addition to that Duty Free sales.
However, I have observed that its most prominent brand, State Express 555 was not available in the Duty free shops I visited in China. I will further investigate as to why.

As for Japan Tobacco, Investor Relations has informed me that despite giving up their two Joint-Ventures, Mild Seven is produced in small quantity on a contract manufacturing basis in one of its former JVs, mainly for export business.

In addition, the brand Memphis is produced in the JV that Japan Tobacco inherited from Gallaher but exited in 2004, I assume output is very low.

Fortunately, Japan Tobacco releases its China sales figure in its Annual Report. However, for some reason JT combines the sales figure from its "China Division" with Duty Free sales in Japan.
Moreover, the "China Division" sales figure includes Hong Kong and Macao.
Thus their sales figure for mainland China still remains unclear.
Perhaps this is done on purpose to conceal modest sales figures for mainland China.

The "China Division" sales figures that can be found in JT's Annual Report [15] are as in the following, measured in billion sticks:

2002	2003	2004	2005	2006	2007	2008	2009	2010	2011
5.8	6.0	5.4	5.1	3.2	3.4	3.5	3.6	3.6	3.5

Looking at the chart, it is reasonable to arrive at the following two conclusions;
Firstly, JT's sales in mainland China is most likely stagnating since 2007, with a market share of probably less than 0.1 percent in 2011.
Secondly, we know that last year's 3.5 billion cigarettes made up for less than one percent of JT's overseas market sales, which was at 428.4 billion cigarettes in 2011. [16]

In other words, Japan Tobacco's cigarette sales in mainland China is very modest, both in relation to the market and also in relation to JT's international business.

Thus all three TTCs have very modest sales and revenues in China.

4. Summary & Conclusions

The Chinese cigarette market is the biggest in the world, with approximately 350 million smokers and a consumption of 2.4 trillion sticks in 2011.

It is also the biggest source of tax income for the Chinese state, with cigarette consumption, profits, and taxes paid to the state all continuously on the rise.

The market is heavily regulated and protected by a state body, the State Tobacco Monopoly Administration (STMA). Under its roof is the market monopolist China National Tobacco Corporation (CNTC), which produces and sells all cigarettes in China.

The initial euphoria amongst foreign tobacco companies after China's political reform was soon dampened by the persistent bureaucracy and government protection of the cigarette market. Measures included high import taxes and restrictions on both retail sales and manufacturing of foreign cigarettes in China.

Even hopes for Joint-Venture production were soon shattered as regulations hindered meaningful business advantages for the foreign JV partner.
The three JVs that eventually took place all delivered unsatisfactory results over the years and eventually were exited by the foreign JV partners.

Nevertheless, China's admission to WTO has at least helped to ease national restrictions on the sale of imported cigarettes and
to bring down import tariffs.
Moreover, as The Economist put it;" WTO still provides the best means to discipline and cajole".[17]
Which is, in my view, much better than threatening China with political ultimatums or sanctions.

However, in 2005 the Chinese government made it clear that it would not allow foreign cigarette companies to build production plants or to form new JVs in China. The reason stated was the effort to reduce smoking in China, in line with China's ratification of the WHO anti smoking agreements.

In my opinion, the Chinese state is exploiting such initiatives to protect a highly profitable industry, one that contributes significantly to tax revenue.
The importance of tobacco tax should not be underestimated if one is to understand China's reason for vigorously guarding its cigarette market.

As since 2005 there are not many domestic manufacturing options left to TTCs, Philip Morris International has resorted to an agreement with CNTC for license manufacturing of Marlboro at two of CNTC's factories, giving the company a competitive edge over its foreign rivals.
However, TTC's combined market share is still minimal; I would say at best half a percentage point of 2.4 trillion cigarettes.

Subsequently, the revenue generated by TTCs in China reflect this.

It is my conviction that the future of China's cigarette market looks very promising for CNTC and the Chinese state as ultimate recipient of profit and taxes, yet bleak for investors in foreign cigarette companies. To any investor in PMI, BAT, or Japan Tobacco who might expect China to be the next big profit driver the key conclusion of this article is: It just won't happen anytime soon.
For over 35 years the Chinese have been very efficiently resisting the market entry of TTCs and I see no reason why they should not continue doing so.
Notably, The Economist writes; "Many foreign companies feel they must compete not with Chinese firms but with the Chinese state"[18]

If for whatever reason the Chinese state should stop guarding the cigarette industry resulting in equal competition, then I am convinced that TTCs will capture a good portion of the market in the long run. Drawing on analogies from other markets, I would say we are looking at a time period of an unknown time variable "x" + two decades. In other words, China will certainly not contribute to TTCs earnings in the short to medium term but definitely has the potential to do so in the very long run.

In the meanwhile, the Chinese state keeps several hundred millions of smokers happy with an array of cheap and affordable
cigarettes.
An important aspect that must not be underestimated as TTCs might profit from Chinese smoker's nicotine dependency in the future.

In my opinion, PMI is positioned best to conquer this market and will be first out of the starting blocks. Not due to the current license manufacturing and the quantities PMI sells in China but more so to their strong and established business partnership with CNTC. Being a preferred business partner places PMI in a good position to negotiate brand buyouts, factory takeovers, and opens up the possiblity of future projects. As an anti tobacco NGO spokesperson in China put it:" The industry and the government are one family." [19] PMI, I imagine, is at least regarded as a distant relative by now.

Disclaimer: This article is for informational purpose only and shall not be construed to constitute investment advice. Nothing contained herein shall constitute a solicitation, recommendation or endorsement to buy or sell any security.
Disclosure: I am long Philip Morris International and Altria Group.

References:

[1] The Economist, 1/28/ 2012, page 28, Poisonous Gift

[2] The Chinese Tobacco Market and Industry Profile, page 17

[3] South China Morning Post, dated 2/14/2011

[4] ibid

[5] China's Tobacco Industry Ups Taxes And Profits

[6] Breaking and re-entering: British American Tobacco in China 1979-2000, page ii88

[7] Eyes on the Prize: Transnational Tobacco Companies in China 1976-1997,page 293

[8] Breaking and re-entering: British American Tobacco in China 1979-2000, page ii90

[9] Eyes on the Prize: Transnational Tobacco Companies in China 1976-1997,page 293

[10] American Threats and U.S.-China Negotiations Over MFN Status and Market Access, page 94ff

[11] Eyes on the Prize: Transnational Tobacco Companies in China 1976-1997,page 295

[12] ibid, page 301.

[13] Breaking and re-entering: British American Tobacco in China 1979-2000, page ii90

[14] Analysis of a Tobacco Vector and its Actions in China: The Activities of Japan Tobacco, section: CNTC and other TTCs

[15] Japan Tobacco Annual Report 2011, page 125.

[16] Japan Tobacco Annual Report 2011, page 60.

[17] The Economist 12/10/ 2011, page 16, Ten Years of China in the WTO

[18] ibid

[19] The Economist, 1/28/ 2012, page 28, Poisonous Gift

Disclosure: I am long PM, MO.