Where There's Smoke, There's Profit--for Beijing

Foreign cigarette makers can't get past the state monopoly

With 350 million smokers and sales of 1.7 trillion cigarettes a year, China looks like El Dorado to global tobacco companies. Heavyweights such as Philip Morris, Japan Tobacco, and British American Tobacco are all pursuing cooperation agreements and joint ventures with local manufacturers while flooding China with promotions for the tiny quantities of cigarettes that are legally imported into the country. But the real--and, so far, elusive--prize would be an agreement to manufacture and sell smokes in China. In early September, it seemed for a moment that the dam had been broken: Britain's Gallaher Group PLC, maker of Benson & Hedges, announced an agreement to manufacture and market cigarettes in the mainland while helping a Chinese company sell its cigarettes in Russia.

The multinationals, however, had better learn patience. Gallaher's shares jumped 6% on news of its deal--but it turned out to be only a letter of intent, a document that in China often takes years to translate into an actual contract. In the same vein, British American Tobacco PLC announced in July it was close to signing an agreement to make cigarettes in Sichuan province. But China's State Tobacco Monopoly Administration, the agency that regulates the industry, denied there was any deal in the works. Says Ann Tradigo, a spokeswoman for BAT in London: "We are optimistic, but it's taking time."

Sure, Beijing has pledged to lower tariff barriers on cigarettes as a condition of membership in the World Trade Organization. But tobacco may be one of the last industries in China to fully open to foreign investment. The reason? Foreign competition could well swamp China's 185 inefficient cigarette makers and 600,000 tobacco growers. And China's government is addicted to nicotine: Profits from companies controlled by the state tobacco monopoly plus taxes on cigarette sales will likely reach $15 billion this year--7% of total government revenues.

Beijing's game plan is clear: hold back virtually all large-scale foreign investment until officials can begin merging many of the smaller cigarette makers into a few regional giants. "There is no plan to approve any joint ventures with foreign companies," confirms an official at the State Tobacco Monopoly Administration. "Our work is focused on restructuring the [local] tobacco industry."

That leaves foreign tobacco companies scrambling to boost their visibility in anticipation of an uncertain future. Japan Tobacco Inc. sponsors the Mild Seven Outdoor Quest--an extreme sports competition. Philip Morris Cos. sells Western-themed clothing in Marlboro Classics shops. BAT works with tobacco growers to improve leaf quality. And all three spend millions each year dispatching young women in skimpy outfits with cigarette logos to bars, where they hand out free smokes.

So far, the only manufacturing ventures are small. Japan Tobacco has a $31.5 million joint venture producing 1.5 million cartons of Camel cigarettes annually in Fujian province. And BAT makes 2 million cartons of cigarettes yearly in a factory in Shandong province. All told, foreign brands account for less than 10% of cigarettes sold in China--and most of those are smuggled in.

The multinationals may face another barrier: a growing health awareness that is leading to new restrictions on cigarette marketing. Billboard advertising was recently banned, and most sports sponsorships are being called off. Tobacco companies "are already feeling the pressure" of new regulations, says Jin Shuigao, a professor at the Chinese Center for Disease Control & Prevention in Beijing.

Still, it's not clear how quickly these measures will impact an entrenched national habit. And provincial officials--at least those without a local cigarette factory to protect--are as eager as the foreigners to seal a deal. "We are very ready to welcome BAT," says an official from Sichuan province, where BAT's proposed factory would be built. "This is a big investment and can only help the local economy." As foreign companies continue to pound on the door of China's tobacco industry, they are counting on more officials to start sharing that sentiment.

By Dexter Roberts in Beijing, with Mark L. Clifford in Hong Kong

Before it's here, it's on the Bloomberg Terminal.