Japanese swop on Gallaher likely to spark consolidation in tobacco

Japan Tobacco's swoop on Gallaher, the maker of Benson & Hedges and Silk Cut cigarettes, set alight shares across the tobacco sector yesterday, as investors sought out the next bid target in an industry that has long been ripe for consolidation.

Rumours have swept global markets for years about potential tie-ups between the six key players that together control the vast majority of the global market, which is worth more than $380bn.

The offer from Japan Tobacco, the world's third largest maker of cigarettes, sent shares in Gallaher up by 22 per cent to 1,190p. Analysts believe it could flush out a rival bid for the UK group from either the Spanish cigar maker Altadis or British American Tobacco, which sells Royals King Size Red in the UK.

In any event, analysts believe this could be the start of a wave of consolidation.

Tobacco companies are seeking to grow through acquisitions as a faster way of increasing market share than through introducing their own brands into new markets.

UBS said a deal could encourage Imperial Tobacco to make a move for Altadis. The Spanish group, which owns the Gauloises and Fortuna cigarette brands, has been linked with both Imps and Japan Tobacco.

Rogerio Fujimori, analyst at Credit Suisse, said: "The presence of too many players in Europe intensifies competition for market share and it is reasonable to assume that instead of the existing six big players, we should see possibly four in the medium term.

"The maturity of the Western European market, where demand is steadily declining due to increasing regulation, should also be a driver of sector consolidation over time. This latest news is consistent with this."

With the tobacco industry under attack in many of its major markets, the case for consolidation is compelling.

Andrew Darke, an analyst at the brokers Evolution, said companies are having to think of ways of tackling declining volumes in the West.

"Merging companies can achieve real cost economies in terms of marketing and administration," he said. "There are real benefits to shareholders from acquisition activity."

Imperial Tobacco's acquisition of Reemtsma, the German cigarette maker, in 2002 yielded synergies worth 12 per cent of sales, a cost saving that Credit Suisse describes as typical for tie-ups in the sector as sales forces and factories are rationalised.

The industry is under attack from all sides. Health campaigns and the move towards healthier living in the West has led to dwindling numbers of smokers, while higher taxation is sending consumers to seek out cheaper brands. Another factor is increasing regulation. More and more countries are adopting smoking restrictions in public places on top of advertising bans.

More than 20 European Union countries enacted bans on most forms of tobacco advertising and smoking bans in time to meet a 2005 deadline.

Until 2002, volumes in Western Europe were relatively stable but there has been a marked deterioration since then.

Analysts estimate that most Western markets will decline by 2 to 4 per cent a year over the medium term. This can only lead to intensifying competition among the large international players and a move to diversify sources of revenues through expansion into emerging markets and other tobacco products.

Emerging markets accounted for 75 per cent of world volumes in 2005. The outlook for GDP growth is solid and consumers brought up on state-owned products seek fashionable Western brands as a mark of their growing wealth, in the same way they would upgrade to a more expensive car.

Although several emerging markets are still dominated by local players - China National Tobacco Corp (CNTC) in China controls 99 per cent of the nation's market share and Indonesian firms capture 70 per cent of the market there - international players have made steady inroads. Russia is seen as a key growth country - a factor which makes Gallaher such an attractive bid target.

Mr Darke sees JT as the most likely candidate for a successful bid. Imperial Tobacco would control more than 90 per cent of the UK market if it were to merge with Gallaher, completely ruling it out. BAT would also face anti-trust issues. "These would not be insurmountable, however," Mr Darke said.

In recent years, Japan Tobacco has increasingly seen the need to expand away from its home market. Michael Smith of JPMorgan said: "The strategic advantage we see for a JT purchase of Gallaher would be a strong emerging market volume base, a strong management team and limited West European overlap."

Japan Tobacco controls more than 70 per cent of its domestic market and sells Camel, Salem and Winston brands outside the US. At first glance, JT looks in an enviable position. Half of the male population smokes in Japan while the average smoker burns through a pack a day and JT makes nine of the nation's top 10 brands, including Mild Seven, Caster and Seven Stars.

However, the Japanese government is understood to be looking to halve the number of smokers in Japan by 2010 in the hope of reining in medical costs. The latest market data suggests that smoking is fast declining in Japan.

The purchase of Gallaher would give it access to seven markets where it is not currently active - in four of which Gallaher already enjoys the number one position in terms of market share.

Gallaher's expansion into the emerging markets of Russia, where it owns Liggett-Ducat and makes Golden Deer cigarettes, and Ukraine and Kazakhstan, where earnings have risen sharply - up 17.4 per cent in 2005 - makes it a good fit for Japan Tobacco.

Analysts estimate a combined group with its improved scale in Europe and a jump to number one market position in the key growth market of Russia could achieve cost savings of 5 per cent a year.

And Gallaher is looking increasingly receptive to an approach. In the UK, where it gets 50 per cent of profits, it faces falling volumes as smokers move to cheaper alternatives. Although Gallaher has introduced lower-priced brands to meet this demand, the situation is expected to become more challenging as the smoking ban, already in force in Scotland, is extended into England and Wales next year.

And as Gallaher remains one of the smaller players in the industry, it is only a matter of time before it is gobbled up.