Tobacco giants respond to smoke signal from the East: New York: The two market leaders plan to start production in the old USSR, writes Larry Black

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The collapse of Communism is proving a bonanza for Western cigarette manufacturers. With smoking habits declining or barely stable in their traditional arenas, they have been handed a potential market of 675 billion cigarettes a year.

Marlboros, Camels and Winstons, it seems, are to be at the leading edge of capitalist investment in the former republics and satellites of the Soviet Union.

Prompted by the prospect of huge shortages of cigarettes there next year, the two largest US tobacco companies - Philip Morris and RJ Reynolds - announced important production plans for Russia and the Ukraine earlier this month. The moves followed acquisitions in Czechoslovakia and Hungary.

The shortfall in supply this year is expected to be almost 100 billion cigarettes. This has been aggravated by a year-long suspension of imports because of foreign exchange shortages. Demand for the best-selling Marlboros alone outstrips supply by five to one.

Furthermore, this market - a third larger than the US - does not have the strict health or advertising restrictions applied in the West.

'I can see why they're falling all over each other,' said Nick Morriss, a partner at the accountants Coopers & Lybrand who advised Eastern European governments on their privatisations earlier this year. While the cigarette industry may be shrinking in Western markets, 'in the East it's still a cash cow'.

With only a billion 'American blend' cigarettes currently manufactured in the former Soviet Union, the short-term solution has been to ramp up production at the recently acquired factories in Eastern Europe. Shipping rights to Russia, analysts say, were one of the principal reasons behind the stiff bidding earlier this year for control of Tabak, the Czech cigarette monopoly. Companies such as BAT Industries, France's Seita and Germany's Reemtsma joined the Americans in the contest, in which Philip Morris ended up paying dollars 413m for a 60 per cent stake.

In the longer term - the next 12 months - both big US companies recognise that they will have to scramble to manufacture across the former Soviet Union. So far, they have announced plans to add capacity for 80 billion cigarettes a year to the existing supply of about 200 billion.

But they are taking radically different approaches.

Philip Morris, long the leading importer of Western cigarettes to the old Soviet Union, plans to produce up to 35 billion Marlboros a year at a new factory near St Petersburg and at Krasnodar, using imported tobacco. RJR, on the other hand, will make 44 billion traditional Russian cigarettes a year near St Petersburg and Lvov, using much darker local tobaccos. Only later will it introduce Camel and Winston.

Marlboros sell for 150 to 180 roubles a pack, local brands 30 to 45. Philip Morris hopes to build volumes of the brand most consumers will probably trade up to as their income improves; RJR is trying to grab market share in the products they are already used to.

Industry specialists say both strategies make sense. Premium brands 'are always more profitable, and the cachet of things Western is far from sated', Diane Temple, tobacco analyst with Salomon Brothers in New York, said. But RJR's plan is the logical tack for the number two producer, which does not enjoy the same pent-up demand as Marlboro.

The supply of tobacco leaves is likely to be a key element in both plans. While 'Virginia blend' tobaccos are available from countries such as India, Brazil and Zimbabwe, it will be some time before Philip Morris can expect to source blond leaf from Georgia and other southern republics, as RJR can for its brands.

The shaky state of the former Soviet economy could slow the penetration of the Western cigarette makers, but most analysts doubt it. 'Without meat, the average Russian will grumble,' said Emmanuel Goldman, tobacco specialist with the Oppenheimer & Co brokerage in New York. 'But he'll strike if he can't get cigarettes.'

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