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. Last Updated: 07/27/2016

Cigarettes for Russia: The Last Great Rush

Tobacco industry growth is flat both in America and in Europe. With anti-smoking campaigns and anti-tobacco litigation at high pitch in the West, selling cigarettes there is only getting more difficult.

With Western markets looking less favorable, a country such as Russia looks like one of the last, best hopes for multinational tobacco giants such as Philip Morris, British-American Tobacco, RJ Reynolds Tobacco and Rothmans.

Cigarette manufacturers "are tending to see the Third World, plus Russia, as in some sense freedom from the drumbeat of regulatory proposals, litigation and bad publicity" in the West, said Richard Daynard, a lawyer with the Tobacco Products Liability Project at Boston's Northeastern University.

The world's tobacco majors have come to Russia with marketing tricks well tested in the West: car giveaways, sports sponsorships, beach pavties and free samples of the company's wares around city cafes and nightspots.

Western manufacturers have invested hundreds of millions of dollars in privatizing and modernizing state factories to produce domestic and international brands. Meanwhile, they continue to import their flagship international brands and shell out millions of dollars to market their products and wrestle more market share from each other.

In just five years since the Soviet Union collapsed, Western cigarettes have lured millions of Russians away from the acrid-smelling papirosy -- the stubby, cardboard filter Soviet-era cigarettes that were as cheap as they tasted.

In just the past six months, tobacco manufacturers have spent over $4 million on press advertising alone in Russia, according to The Monitoring Co., a Moscow firm that tracks consumer advertising.

"The irony of this strategy is immense, given that people in Western nations are quitting in droves," said Daynard. "It's analogous to saying, 'You've come a long way, Russia. Now you're ready to smoke our Western cigarettes.'"

But for now, it's perhaps less important how they get a piece of the market. They just need to get a piece -- and get it fast.

According to tobacco analyst Roy Burry of the New York investment brokerage Oppenheimer & Co., multinational tobacco companies "have to be there" in Russia. "Increasingly, future profits will hinge on overseas markets," he said in a recent research report.

Much like a land-grab, "the goal is to capture as much as possible, beat out the competitors, control that volume and tinker with the price structure" by charging low prices, ratcheting them up later and experimenting with the maximum price each brand can support, said Gary Black, an analyst for Sanford & Bernstein, a U.S. investment firm.

"If you don't control the market, then it might be too late," said Black.

According to government and industry sources, the Russian market represents an estimated consumption of close to 240 billion cigarettes a year -- or 1,600 for every man, woman and child in the country. By comparison, the U.S. market is still more than double that figure at 500 billion, or over 2,000 cigarettes per head in 1995, and the Poles smoke 2,700 cigarettes a year.

But economically ailing Russian producers can't feed Russia's habit. Only 140 billion cigarettes were produced in Russia in 1995, sliding down from 150 billion in 1990 and just over 180 billion in 1985.

Of that 140 billion produced here in 1995, foreign joint tobacco plants turned out 61 billion cigarettes, or 44 percent of Russia's total domestic production, in eight of Russia's 26 cigarette plants. That's 44 percent more than five years ago.

The Western tobacco multinationals are also aggressively importing: According to official figures, in 1995, Russia imported $483.4 million worth of tobacco goods, including $451.1 million from outside the CIS; Chinese and Bulgarian cigarettes have seized a sizable share of the 100-billion-stick import market, but foreign multinational importers snared a 29 percent share of the total market.

Although they still control half of local production, purely Russian factories are lagging further behind. Domestic producers were caught completely off guard by the Western blitz, and catching up looks unlikely.

Even with their solid foothold in Russia's vast market, profitability for multinational producers in Russia has been spotty. But they are poised for what they hope will be explosive growth here.

Since 1994, foreign tobacco companies have announced planned investments of $366 million for modernization programs through 1997.

British-American Tobacco, a unit of BAT Industries, so far has the largest declared investment in Russia at $150 million. U.K.-based Rothmans is a close second at $80 million, and Philip Morris has sunk $70 million in the country so far. RJ Reynolds, a subsidiary of U.S.-based RJR Nabisco Holdings, stands last among the big names at $66 million, but is considering further investment.

As has been their strategy in many emerging markets, foreign tobacco firms bought big stakes in choice domestic factories in order to produce more cheaply and efficiently, buy up well-known and potentially valuable local trademarks, barrage the consumer with as many choices as possible and ultimately control who enters the market, industry analysts said.

"These companies don't want to lose any part of the market, even to local Russian brands," said Daynard of the Tobacco Project. "That keeps competition out, and whatever brands [foreign makers] want to move into, they can. They can't be undercut if they own all the brands out there."

During Russia's privatization program, Western tobacco firms were among the most serious bidders. Eight of former Soviet tobacco monopoly Tabakprom's 26 tobacco factories are now foreign joint ventures with the industry's giants. RJR-Petro in St. Petersburg, Yava Tabak and Saratov Tobacco with British-American Tobacco in Moscow, Rothmans with Nevo Tabak in St. Petersburg and Philip Morris with Krasnodartabakprom in southern Russia have attracted the most significant chunks of investment money.

BAT has said it intends to invest more than $100 million in Yava-Tabak and more than $50 million in Saratov through 1997 in order to raise their combined production from 17 billion cigarettes to 30 billion annually.

Among other tobacco leviathans, RJR Nabisco Holdings' top official has said RJR still has plans to sell 24 billion cigarettes in Russia this year, up from 14 billion sold last year.

"One of the reasons I'm here," RJR chief Steven Goldstone said during a visit to Russia earlier this month, "is that our business is developing very quickly. As you can see, we have explosive growth [and] the tobacco business ... exceeds our expectations. Now we're considering the question of improving investment in Russia" and committing a further $100 million to expansion in the market, he said in an interview with Kommersant Daily.

Not surprisingly, though, with investment costs high, some Western stakeout operations are still losing money here. Philip Morris' Krasnodar plant has been in the red for the past two years. But Andreas Gembler, president of Philip Morris' operations in Eastern Europe, the Middle East and Africa, said he hoped the plant would turn a profit by next year, particularly because Krasnodar factory officials projected production of as much as 7 billion cigarettes in 1997, up from about 4 billion in 1996.

Russia right now probably accounts for only 2 percent to 3 percent of Philip Morris' international profits, estimated by Black for 1996 at $4.1 billion, up from $3.45 billion in 1995.

Because significant profits from producing cigarettes in Russia are likely still years away, imports are nevertheless crucial for foreign manufacturers' bottom lines in Russia. And because the Russian market has been flooded with dozens of foreign brands, the battle for market share -- the use of taste and price to win customers and keep them within a brand family for a lifetime -- is getting fiercer.

"The market has turned around completely and is now very much consumer-driven rather than production-driven," Hans Fluri, Philip Morris' vice president for Eastern Europe, said earlier this month at the company's Krasnodar factory opening. "You want to reach as many consumers as possible -- be present in all price ranges, in all segments of taste. ... We have to really tailor-make brands more in Russia."

"Once you start seeing segmenting of the market into subgroups, that usually gives the market another kick," said Sanford & Bernstein's Black. "That indicates a new wave of growth ahead once you start tailoring to a group of consumers."

Western tobacco firms are still spending heavily to position their brands among increasingly sophisticated Russian smokers. In September alone, Philip Morris spent $561,600 on press advertising, Rothmans spent $299,520 and BAT spent $149,500. Each company spent roughly half as much six months earlier, according to The Monitoring Co.

In the battle for market share, the once-ubiquitous, red-boxed Marlboros -- at one time practically a currency in Russia -- are being crowded on kiosk shelves by light and ultra-light brands, low-tar and low-nicotine cigarettes, king-size and especially womens' brands.

The young, blond, all-American Lucky Strike guy is muscling aside the craggy-faced Marlboro Man on billboards around Russia, and the marketing recipes that snared Western smokers are cropping up in similar guises around Russia.

Tobacco companies know price is crucial for Russian smokers, many of whom can't afford the switch to American-brand smokes from affordable Russian Belomorkanal or Kazbek brands. But Western manufacturers are introducing brands that will fight it out in the low-cost trenches -- with products retailing for between 900 rubles and 2,000 rubles (16 cents to 38 cents) per pack -- hoping to woo consumers from Russian smokes over to joint-produced brands.

BAT's strategy in Russia, in part, has been to resurrect low-cost nostalgia brands, such as the relaunched Kosmos brought back earlier this year and a repackaged, jubilee edition of Yava. But BAT is also competing on price with its low-end Astra brand, produced at the Saratov factory.

More worrying to the multinationals than domestic producers in the low end are cheap Bulgarian and Chinese imports. "Low-cost imports from Bulgaria and China ... may present the greatest threat to domestic producers via price," a recent Deloitte & Touche report said, explaining that Chinese manufacturers that use American-style tobacco are the biggest threat.

Philip Morris also competes in this "value segment" with its own Apollo Soyuz brand as well as Bond Street, an international brand that targets crossover smokers the company hopes will "trade up" for a higher-priced brand down the road.

In the mid-price or "sub-premium" segment, Rothmans is pitting its sleekly artsy Hermitage against Philip Morris' Peter I, a unique brand for the Russian market, as well as L&M and Chesterfield brands.

For the mid-price sector, Philip Morris had a test run of Bond Street at its Krasnodar factory and also plans to produce Chesterfields there soon. BAT fields its Pall Mall, Barclay and sophisticated Hollywood brands; German importer Reemstma weighs in with the straightforward West and West Light brands.

RJR hasn't ventured far out of the premium segment and relies on its old standards -- Winston, Winston Lights and Camel -- while Lucky Strike competes for BAT. The Rothmans house brand and the Davidoff family from Reemstma are also up against the powerhouse in this high-end segment -- Philip Morris' Marlboro.

This saturation and segmentation of the market is a tried-and-true method. "You have to seize control first, then move the pricing up," said Black.

And when Russians finally figure out their favorite brand, "the next move for the companies is to begin moving prices up, to get people to pay as much as they're going to be able to," said Daynard.

Social strata can't be overlooked in marketing to a country still uncomfortable with its new class consciousness.

"West is more democratic, it's not for New Russians or people like that," said Reemstma marketing manager Mikhail Kondratyev.

"Yava is for the middle class, older people," stresses BAT's manager of public relations.

Meanwhile, light and menthol segments are booming, Kondratyev said, "for women, of course."

"Early on, each smoker is trying to associate or disassociate themselves with a brand, thinking 'I'm that kind of person -- I smoke this. I'm not that kind of person -- I don't smoke that," said Daynard.

By creating products that can fill as many demographic niches as possible, cigarette companies attempt to appeal to the largest range of customers -- before their competitors do.

As they're busy competing among themselves, one thing Western tobacco giants do not have to worry about much is a threat from Russia's own cigarette industry.

"In many ways, we are the local industry," said Andrew White, corporate affairs director for Philip Morris in Russia. "There's a huge demand for filter cigarettes, for instance, that simply cannot be met by local brands."

Opponents of the foreign cigarette industry are upset that Western manufacturers have been able to launch "such a serious attack on the Russian market," wrote Viktor Buksim in Financial Izvestia in March.

Foreign manufacturers counter that without their help, the Russian cigarette industry would have been nearly snuffed out anyway.

Now that they are local producers, Western tobacco companies are also of two minds about protectionist measures such as import taxes. On one hand, they resent cigarette smugglers and the few shady importers such as the National Sports Fund, which have had government-sanctioned permits to import duty-free.

On the other hand, they have used their multimillion-dollar investments as a lever to lobby against protectionist measures on imports. They say that until the current wave of investment bears fruit, imports are needed to fill demand.

A report by Deloitte & Touche agrees that this is the right policy. "The current tax levels are overall in a very good state; current rates are not promoting smuggling and are reasonable in comparison to other European and CIS countries. However, privileges [for veterans and sports organizations] should be removed, and customs import tax reduced ... to remove the barrier to domestic producers," the Deloitte & Touche report said.

The same report contended that the Russian government could nearly double its tobacco industry tax revenues by the year 2000 -- if the industry is allowed to develop without further tax law changes and import restrictions and with better collection of existing taxes.

A lobby group for foreign cigarette manufacturers, the National Association of Cigarette Importers, has lumped the Sports Fund -- which has now lost its cigarette import privileges -- together with smugglers and other entities with tax concessions as the culprits behind the loss of roughly $800 million in 1995 to the state budget.

"Passing new measures to further protect domestic producers will result in new privileges to various organizations, either importers or others, and ... further damage the current situation," the Deloitte & Touche report said. Moreover, "the higher the taxes imposed on imported goods, the greater the motivation to evade them."

Meanwhile, the import tax situation is in flux. The State Duma, Russia's lower house of parliament, is considering several versions of draft legislation establishing a new excise tax regime. Russia is applying for World Trade Organization membership, and Russia's complex system of different excise taxes on imported tobacco and domestic tobacco products violates WTO membership requirements.

Currently, the excise tax is a flat 20 percent on domestically produced cigarettes and papirosi. For imports, the rate is 2 ecus ($2.50) per 1,000 cigarettes (about 50 packs).

Tabakprom, the old state monopoly, is plugging to keep the 20 percent rate -- but not more than 7,500 rubles -- for every 1,000 cigarettes, either domestic or imported filter cigarettes. Tabakprom contends a pack of locally produced Prima cigarettes should not be subject to the same excise tax as a pack of Marlboros.

Foreign importers say the two segments do not compete, and favor extending the 2-ecu rate to domestic brands. A percentage rate, they argue, only hurts higher-priced, higher-quality brands; some manufacturers even support a different draft circulating that would create a tiered system specific to price per pack.

The flat 20 percent rate "ends up penalizing the more expensive brands, which aren't competing with low-end products like papirosi," said one multinational tobacco company official who requested anonymity.

Even more curiously, the politics of excise taxation is making for some strange bedfellows. Multinational giant BAT, which produces low-end, widely sold brands such as Yava, has sided with the Tabakprom proposal. "As a local producer ... we have to see a stable market," said Richard Howe, managing director for BAT in Russia.

"Give local producers an incentive to continue production in Russia," he said, adding that an excise tax unfavorable to manufacturers here "will kill local production, and could even create social unrest in the regions."