Philip Morris, Japan Tobacco seek Russia advantage with $1.5 bln deal

Reuters

* Firms buy into distributor Megapolis for $750 mln each

* To support expansion in world No.2 market by volume

* Megapolis may still pursue IPO

* Russia cracking down on tobacco consumption

By Maria Kiselyova and Martinne Geller

MOSCOW/LONDON, Dec 4 (Reuters) - Philip Morris InternationalInc and Japan Tobacco Inc are buying 20 percentstakes in their Russian distributor Megapolis for $750 millioneach, strengthening their grip on the world's No.2 cigarettemarket by volume after China.

Russia, where 40 percent of the adult population smoke, is akey battleground for foreign tobacco companies grappling withdwindling sales in many developed markets where governmentregulation is becoming stricter and smokers fewer.

Foreign players - British American Tobacco,Imperial Tobacco, Japan Tobacco and Philip Morris -supply more than 90 percent of the Russian market, worth about$20 billion a year.

However, distribution has stayed mostly in Russian handswith Megapolis - majority owned by Igor Kesayev, who alsocontrols the Degtyarev arms factory and food retailer Dixy - controlling about 70 percent.

"This is a milestone deal," said an analyst who declined tobe named. "Tobacco producers have dreamed of breaking thismonopoly."

By partly owning Megapolis, Marlboro cigarettes-maker PhilipMorris and Japan Tobacco, home of the Winston brand, may behoping to reduce their distribution costs and raise theirprofile compared with Imperial Tobacco, whose Davidoff andGauloises brands are also distributed by Megapolis.

Imperial was not immediately available for comment.

Philip Morris said it expected the deal to lift its earningsas of the first quarter of 2014, without detailing how.

Tougher regulation is lifting cigarette prices in Russia,crimping sales and limiting product availability as PresidentVladimir Putin's Kremlin strives to improve public health andstem a population decline that began after the Soviet Unioncollapsed in 1991.

Morningstar analyst Thomas Mullarkey predicted Russiancigarette sales volumes would fall nearly 10 percent next yeardue to an increase in excise taxes, but said the price of a packwas still cheap.

"It's still an affordable habit, and the excise taxes arestill going to be low compared to U.S. and UK standards, evenafter the increase," he said. "In the long run, the Russianmarket has ample opportunity to continue its trend of going fromlow-level brands to higher-margin and higher-priced brands."

STEP TOWARD OPENNESS

Megapolis said the deal was the first time that the world'sleading cigarette makers had access to local distributors andthat the cash inflow did not mean the company would notresurrect plans for a flotation, pulled in 2011.

"This deal is for Megapolis a step toward being more open;we are not giving up the idea of holding an IPO," a spokesmanfor the Mercury Group, Kesayev's holding company, said.

The deal includes possible additional payments by each stakebuyer of up to $100 million based on Megapolis' performance overthe four years following the closing of the transaction,expected this month.

Japan Tobacco has a 36 percent share of the Russian marketand runs factories in St Petersburg, Moscow, Leningrad Regionand Yelets. Philip Morris has 26 percent and has facilities inKrasnodar and near St Petersburg.

Megapolis delivered more than 260 billion cigarettes in 2012to 150,000 outlets and had revenue of around $12 billion.

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