[Intl-tobacco] China: Gallaher, Shanghai Tobacco Sign Reciprocal License Pacts/Analysis

[Robert Weissman]

November 3, 2003
Gallaher, Shanghai Tobacco Sign Reciprocal License Pacts
Wall Street Journal

LONDON -- Gallaher Group PLC and Shanghai Tobacco Corp. said Monday they have
signed reciprocal trademark license agreements to manufacture,
distribute and sell
one of each other's brands in China and Russia.
The deal follows last year's signing of a cooperative letter of intent
with the
China National Tobacco Corporation, together with the State Tobacco Monopoly
Administration.
Under the license agreements, STG has nominated one of its key brands,
Golden Deer,
to be manufactured, distributed and sold in Russia by Gallaher, through its
Liggett-Ducat operation, and Gallaher has nominated one of its key
brands, Memphis,
to be manufactured, distributed and sold by STG in China.
The products are planned to be launched in the first half of 2004, and initially
will be distributed and sold in the Shanghai and Moscow municipalities. Thereafter
they may be rolled out to other cities and provinces across China and Russia.
A business coordination committee has been established to prepare the
brands for
launch in each company's respective markets, and to coordinate
cooperation and
communication between the parties for the development of the business.


November 3, 2003
THE SKEPTIC: Gallaher, China's Baby Steps - What's Next?
BRIAN TRUSCOTT
Wall Street Journal

LONDON -- "Memphis" - one of the more pronounceable English words out there.
And it's a good bet this is one of the reasons why Gallaher (GLH)
decided to pick
this particular mid-priced cigarette brand to manufacture and distribute
in China
via Monday's highly-symbolic trademark license agreement with Shanghai
Tobacco. The
fact that Memphis is also a good, old-fashioned American-type name is probably
another reason.

The deal - in the works for more than a year - means Shanghai Tobacco will
manufacture and distribute Memphis cigarettes in China while Gallaher
will do the
same for the China tobacco company's Golden Deer brand in Russia via its
Liggett-Ducat operation.
Yes, Gallaher shares got a nice little pop from the announcement Monday,
which was
accompanied by a formal signing ceremony in Shanghai. Shares moved as
much as 1.8%
higher to 601 pence each in early trade.

Of course, investors shouldn't get overly excited about this relatively
small deal.
Annual production of Memphis cigarettes in China will likely amount to
volumes in
the tens to hundreds of millions, not billions - an amount that pales in comparison
to Shanghai Tobacco's annual production of 70 billion cigarettes. The
reason for
this is simple enough: Memphis is a mid-priced smoke . Yes, it should
make inroads
in urban markets, such as Shanghai, where mid-priced cigarettes account
for about
80% of volumes. But mid-priced cigarettes only make up about 20% of the market
outside the cityscape, so growth should be tough to come by - unless, of course,
the appetite for foreign brands takes off.

The deal complements Gallaher's license to import a certain amount of its
Sobranie-brand cigarettes into China - a quota system that has already
led to
Gallaher grabbing 3.5% of that particular premium-priced market. The
first Memphis
cigarettes - which account for 4.5% of Gallaher total volumes - should start
arriving in Shanghai corner shops in the first half of next year. Just
don't expect
the cigarettes to taste like the ones people smoke in, say, Austria,
where Memphis
has 27.5% share of that particular market. Why? Well, commercial sensitivities
about American blend ratios aside, Shanghai Tobacco will provide some of what's
called the "rag," the cut tobacco that will be going into Memphis
cigarettes. This
will make the taste different, in much the same way U.S. consumers say McDonald's
hamburgers taste different in foreign countries.

Gallaher will be doing exactly the same for Shanghai Tobacco's Golden
Deer brand,
which is one of the company's top five brands, costs a bit less than
ST's popular
Double Happiness brand, and will sit well in Russia's mid-priced market. Monday's
agreement was finalized with both China National Tobacco Corporation and State
Tobacco Monopoly Administration officials in attendance. This is a good
sign and
further cements Gallaher's China relations, following an earlier
decision to
distribute ST's premium Chunghwa brand in London. So, baby steps, then,
for both
sides. What's next?

The obvious rationale comes from the China side. After all, it's likely
that within
two or three years, most of the big global tobacco players will have
some sort of
trade agreement with the government or Chinese tobacco companies - a
move that
comes part-and-parcel with WTO entry.
Chinese politicians know that opening up a state-controlled market means
a big dent
in government sales as foreign competitors eat away at market share. So, Chunghwa
and Golden Deer should be seen as the first obvious steps to plug that domestic
loss of revenue with a fledgling effort to ramp up export sales of homegrown
tobacco .

That's why it's reasonable to assume that if this small Memphis belle of
a deal
goes well, Gallaher will be able to manufacture and distribute
additional brands in
China, in return for opening up some of its key markets abroad for
Chinese brand
distribution. It's also interesting that the CNTC chose this deal to
start things
off. After all, British American Tobacco (BTI) has been pressing for a
deal to
complement a land deal signed in May, 2001, which was supposed to pave
the way for
setting up a JV and building a cigarette factory in Sichuan Province's Mianyang.
Unfortunately, it's no secret the CNTC only has rationalization on its
mind these
days, as it has so far reduced the number of domestic factories to 180
from 220.
Perhaps that's one reason why BAT's negotiations remain in limbo and Gallaher's
readiness to let a domestic factory in on the production side of things
has opened
the door to China just that tiny bit more.