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Please see General Disclaimers on the last page of this report.

Current Environment ............................................................................................ 1

Industry Profile .................................................................................................... 14

Industry Trends ................................................................................................... 20

How the Industry Operates ............................................................................... 37

Key Industry Ratios and Statistics ................................................................... 44

How to Analyze an Alcoholic Beverage or Tobacco Company ................. 46

Industry References ........................................................................................... 50

Comparative Company Analysis ...................................................................... 52

This issue updates the one dated May 2014.

Industry Surveys Alcoholic Beverages & Tobacco Joseph Agnese, Consumer Staples Sector Equity Analyst

NOVEMBER 2014

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S&P CAPITAL IQ INDUSTRY SURVEYS (ISSN 0196-4666) is published weekly. Redistribution or reproduction in whole or in part (including inputting into a computer) is prohibited without written permission. To learn more about Industry Surveys and the S&P Capital IQ product offering, please contact our Product Specialist team at 1-877-219-1247 or visit getmarketscope.com. Executive and Editorial Office: S&P Capital IQ, 55 Water Street, New York, NY 10041. Officers of McGraw Hill Financial: Douglas L. Peterson, President, and CEO; Jack F. Callahan, Jr., Executive Vice President, Chief Financial Officer; John Berisford, Executive Vice President, Human Resources; D. Edward Smyth, Executive Vice President, Corporate Affairs; and Lucy Fato, Executive Vice President and General Counsel. Information has been obtained by S&P Capital IQ INDUSTRY SURVEYS from sources believed to be reliable. However, because of the possibility of human or mechanical error by our sources, INDUSTRY SURVEYS, or others, INDUSTRY SURVEYS does not guarantee the accuracy, adequacy, or completeness of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. Copyright © 2014 Standard & Poor's Financial Services LLC, a part of McGraw Hill Financial. All rights reserved. STANDARD & POOR’S, S&P, S&P 500, S&P MIDCAP 400, S&P SMALLCAP 600, and S&P EUROPE 350 are registered trademarks of Standard & Poor’s Financial Services LLC. S&P CAPITAL IQ is a trademark of Standard & Poor’s Financial Services LLC.

INDUSTRY SURVEYS ALCOHOLIC BEVERAGES & TOBACCO / NOVEMBER 2014 1

CURRENT ENVIRONMENT

Beer consolidation on tap

Large-scale acquisitions are brewing for the top three players in the global beer industry. On September 14, 2014, Heineken Holding NV (the third-largest brewer in the world) rejected the takeover proposal from SABMiller plc (the world’s second-largest brewing company)—a deal that could have strengthened SABMiller against a potential bid by Anheuser-Busch InBev NV (AB InBev), the leading global brewer. The deal would have contributed more than $25 billion in sales, enhanced SABMiller’s presence in emerging markets, including Africa and Mexico, and boosted its portfolio of global beer brands. To date, Heineken has four brands in the global top 10 of premium beers.

Within 20 years, SABMiller has grown from being mainly a South African brewer to the second largest global beer brewer from its acquisitions of Colombia’s Bavaria Brewery in 2005 and Australia’s Foster’s Group in 2011. According to a Bloomberg article published on September 15, 2014, SABMiller is assessing its next move after Heineken’s rejection.

Meanwhile, a consolidation of the world’s two largest brewing companies has been rumored for years, and with the revival of global merger activities this year, speculation has been renewed. According to an article published in The Wall Street Journal on September 15, 2014, AB InBev is exploring financing that could amount to $122 billion, to buy SABMiller. The

purchase price would exceed InBev’s $52 billion acquisition of Anheuser-Busch in 2008, the largest deal in the global beer industry.

In developed countries, beer consumption has stopped rising, while the number of American breweries has jumped from fewer than 100 two decades ago, to more than 3,000 as of September 2014. Because of these factors, AB InBev has few other ways to grow apart from acquiring—and SABMiller is a tempting target. Aside from being the second-largest brewer, with more than a 9% share in the global beer market, 70% of SABMiller’s sales are in emerging markets—countries that are still developing a taste for beer.

AB InBev itself is a product of large consolidations. In 2004, Brazil’s AmBev SA and Belgium’s Interbrew merged to form the global number one brewer by volume. In 2008, the consolidated company bought Anheuser-Busch, and was renamed AB InBev.

According to Euromonitor International, an international consumer market research firm, AB InBev had an almost 20% share of the global beer market in 2013, followed by SABMiller, with a 9.6% share, and Heineken, with a 9.3% share. A consolidation of AB InBev and SABMiller would be a megadeal in the industry, since these two companies would jointly take one-third of the global beer brewer market, while a consolidation of SABMiller and Heineken would create a company of roughly the same size as AB InBev, making it more difficult for AB InBev to purchase SABMiller.

If the consolidation of the top two industry players were to proceed, the combined entity would likely be required to divest MillerCoors—of which SABMiller owns a 58% stake—on antitrust grounds. Molson

B01: US Sales of leading brewers

US SALES OF LEADING BREWERS(Ranked by 2013 sales, in millions of 31-gallon barrels)

MARKET

- - - - - - SHIPMENTS - - - - - - - - SHARE (%) - -

COMPANY 2012 2013 % CHG. 2012 2013

Anheuser-Busch 99.2 96.7 (2.5) 46.3 45.7MillerCoors 59.0 57.2 (3.0) 27.5 27.0Crow n Imports 12.3 13.0 5.7 5.7 6.1Heineken USA 8.5 8.3 (1.9) 4.0 3.9Pabst 6.0 5.8 (2.7) 2.8 2.7Boston Beer 2.7 2.9 7.5 1.2 1.3D.G. Yuengling 2.8 2.7 (2.3) 1.3 1.3North American Brew eries 2.7 2.6 (4.6) 1.3 1.2Diageo/Guinness USA 2.6 2.4 (7.9) 1.2 1.1Mark Anthony (Mike's) 1.4 1.5 6.0 0.7 0.7Others 17.1 18.4 7.7 8.0 8.7

Total 214.1 211.5 (1.2) 100.0 100.0

Source: Beer Marketer's Insights.

2 ALCOHOLIC BEVERAGES & TOBACCO / NOVEMBER 2014 INDUSTRY SURVEYS

Coors Brewing Co., the seventh-largest global brewer by volume last year, according to Euromonitor, is the likeliest buyer of SABMiller’s stake. According to an article published in The Wall Street Journal on June 27, 2014, Molson Coors’s Chief Executive, Peter Swinburn, said that he would not rule out buying SABMiller’s stake should the opportunity arise.

BEER SALES FELL AGAIN IN 2013 AFTER UPTURN IN 2012 According to Beer Marketer’s Insights, beer shipments in 2013 (latest available) declined, following the same trend in 2009 to 2011. The US beer industry experienced a 1.2% decline in beer shipments in 2013—as opposed to the 1.7% increase in 2012—which is consistent with the fall in shipments recorded in 2011

(1.4%), 2010, and 2009 (both 1.3%). Anheuser-Busch InBev noted in its 2013 Annual Report that volumes in the US declined mainly due to pressure on consumer disposable income.

According to the trade group, Distilled Spirits Council of the United States (DISCUS), beer’s market share of gross dollars for suppliers declined to 48.3% in 2013 (latest available) from 56% in 1999. Research and consulting firm Information Resources Inc. (IRI) attributed the decline to increased competition, particularly from the liquor segment. Further, the growth of craft beers is taking away share from the leading US beer brands. In 2013, sales of craft beers

grew 16% in volume, versus a 1.7% decline for the biggest US beer brands, according to IRI data quoted in a Bloomberg article dated January 23, 2014. Bud Light, which stood at No. 1 on the list, reported a 1.3% sales decline in 2013, while Miller Lite reported a sales decline of 4.4%.

In 2014, we expect overall industry beer volumes to continue to fall; in addition to increased competition, consumers remain cautious, as the labor-force participation rate remains low by historical standards. While some import brands improved in 2013, premium light beers declined at a much steeper rate than the beer industry overall, dragging down the entire category’s growth. In addition, we expect spirits and wine to continue to gain share.

Megabrands continue to lose share, but innovation thrives Estimates from Beer Marketer’s Insights show that only four of the top 10 suppliers reported shipment gains in 2013 (latest available), versus eight in 2012. Anheuser-Busch continued to hold the top position in 2013, with a 2.5% decline in shipments (versus a 0.6% increase in 2012). MillerCoors retained second place with a 3.0% decline in shipments in 2013 (versus a 1.8% decline in 2012). Crown Imports stayed at No. 3, with a 5.7% rise in shipments in 2013, following a 3.5% gain in 2012. Heineken USA remained in fourth place, reporting a 1.9% decline in 2013 versus a 5.0% gain in 2012. Pabst continued to hold the fifth position, with a 2.7% decline in 2013 versus a 4.4% increase in 2012. The market share of most suppliers fell during the year. Anheuser-Busch’s market share dropped to 45.7% in 2013 from 46.3% in 2012, while MillerCoors’ share dropped to 27.0% in 2013 from 27.5% in the prior year.

In terms of the top three brands by sales, results in 2013 were similar to results in 2012. For the third consecutive year (after nearly 20 years in the lead), Anheuser-Busch did not control the two top-selling brands in the US in 2013. Bud Light (owned by Anheuser-Busch) remained in the top position, though the brewery dropped 3.8% (after a moderate 0.5% drop in 2012), continuing to fall after its first-ever decline in 2009. Coors Light (owned by Molson Coors and distributed by MillerCoors) remained at the No. 2 position for the third year in a row, on a 2.3% volume decline (to 18.2 million 31-gallon barrels), following a gain of 2.4% in

B02: TOP 10 BEER BRANDS

TOP 10 BEER BRANDS(Ranked by 2013 sales, in millions of 31-gallon barrels)

- - - - - - - - - - SALES - - - - - - - - - -

BRAND BREWER 2012 2013 % CHG.

1. Bud Light Anheuser-Busch Inc. 39.7 38.2 (3.8)2. Coors Light Molson Coors Brew ing 18.7 18.2 (2.3)3. Budweiser Anheuser-Busch Inc. 16.8 16.0 (4.8)4. Miller Lite Miller Brew ing Co. 14.7 13.7 (7.1)5. Corona Extra Grupo Modelo 7.2 7.4 (6.3)6. Natural Light Anheuser-Busch Inc. 7.9 7.4 1.47. Busch Light Anheuser-Busch Inc. 6.7 6.7 0.88. Busch Anheuser-Busch Inc. 5.7 5.3 (5.8)9. Michelop Ultra Anheuser-Busch Inc. 3.8 4.1 7.2

10. Miller High Life Miller Brew ing Co. 4.5 4.0 (10.1)Total, top 10 125.6 121.0 (3.7)

Source: Beer Marketer's Insights.


2012. Budweiser (also owned by AB InBev), in third place for the third year, saw sales decline 4.8% to 16.0 million barrels in 2013, following a sales decline of 5.6% in 2012.

Meanwhile, performance of the sub-premium category was mixed in 2013 (latest available). Natural Light and Busch Light were up 1.4% and 0.8%, respectively, following a 4.8% decline for Natural Light and a 0.8% increase for Busch Light in 2012. Miller High Life fell 10.1%, following a 5.3% decline in 2012.

In order to counter the declining sales of their flagship brands, both AB InBev (parent of Anheuser-Busch) and MillerCoors have been developing innovative products since 2012. In 2014, flavored malt beverages (FMBs)—beers that are either mixed with another alcoholic drink or with some flavoring or mixer, like lemonade—are becoming a growth segment for the industry. AB InBev and MillerCoors are stocking their shelves with their latest apple-flavored line extensions of their flavored malt beverages, called Apple-Ahhh-Rita and Redd’sWicked Apple, respectively. These breweries aim to tap this growing segment of the beer market in the US. FMBs represent 4% of the overall malt-based beverage volume in the US, but contribute 31% of volume growth based on the total of all segments that are posting growth.

We hold a favorable view toward the recent launches of innovative products by AB InBev and MillerCoors, and the efforts of most brewers to widen their target markets. Brewers in the US are developing more inclusive general-market advertising targeted at a bigger and more diverse drinking audience, especially Hispanics and African-Americans. According to industry estimates by Heineken USA, Hispanics and African-Americans are expected to drive 70% of beer growth from 2000 to 2020. In October 2014, Nielsen, a market research and advertising-ratings firm, reported that beer represents half of Hispanics’ beverage alcohol volume sales. Hispanics are expected to make up 27% of the population in the US by 2040.

Both AB InBev and MillerCoors are focusing on an ethnic multicultural advertising strategy. While MillerCoors, in collaboration with Commonground (a multicultural advertising agency), is testing general-market advertisements that include Hispanics and African-Americans, AB InBev is making music a bigger part of its advertising strategy. With the help of advertising agency Translation, AB InBev organized a 2012 Labor Day weekend music festival in Philadelphia, called Budweiser “Made in America,” which featured rock, hip-hop, and rhythm and blues bands, as well as Latin dance acts. In August 2014, AB InBev, through its Budweiser brand, launched a new limited edition packaging for its MADE for Music platform featuring Jay Z. The new packs will be available in key UK retailers and convenience stores.

Trading up accelerates Beer volumes increased by 0.1% for the year through December 29, 2013 (latest available), according to data from Nielsen, as cited in industry magazine Beverage Industry. Sales (in dollar terms) increased by 3.1%, mainly due to acceleration in trading up by consumers along with some price hikes by suppliers. The above-premium segment reported a gain of 2% in sales (by volume) in 2013. The sub-premium price segment as a whole was down 4% in 2013. The Craft and Hard Cider categories also witnessed increases in dollar sales, rising 18% and 100%, year over year, respectively.

Beer Marketer’s Insights noted that most brands lost market share in 2013, though volumes were up for big brands. While the share of sales (in dollars) in 2013 fell 0.6%for AB InBev and 0.5% for MillerCoors, year on year, the share for players like Crown and Boston Beer rose.

Imports gain According to Euromonitor, import beer shipments rose 4.0%, while their dollar value increased by 7.0% in 2013 (latest available). While imported beers are priced higher than domestic beers, consumers are willing to pay extra to experience different beers, according to the report. However, the price gap between imported beers and the rest of the category is shrinking, according to Nielsen. The research firm noted that the pricing per case for imports increased 0.7% in 2013, compared with the category average, which was up 3%.

Mexican beers, representing four of the top six brands, dominate the import category. We think that the rising Hispanic population in the US, particularly in California, has aided Modelo’s growth and, in turn, total import growth. With the Hispanic population expected to rise at a faster rate than any other US demographic segment for the next several years, we expect imported beers to continue to rise, and Mexican


beers to continue to dominate the category. Mexico’s Grupo Modelo SA de CV has dominated the import category for several years. Three of its brands (Corona Extra, Modelo Especial, and Corona Light) were on the top 10 imports list in 2013.

The continued growth in imports from 2010 through 2013 marks a rebound in beer imports from the double-digit declines recorded in 2009 and 2008. According to market research firm IBISWorld, Mexican beers account for 48% of imports, Dutch beers 24%, while Belgian beers and Canadian beers each make up 7%. According to Nielson, Mexican imports grew 11.1% in 2013, while Canadian and European imports were down 6.5% and 2.1%, respectively.

The imported beer category has posted double-digit annual growth since 1992, significantly outpacing the overall domestic category. Furthermore, imports steadily gained market share, moving from 9% in 1999 to approximately 14% at the end of 2007. However, in 2008, import shipments fell 4.1%, according to Beer Marketer’s Insights. Imports had not recorded a decline since 1991, when the implementation of an excise tax hike drove shipments down 10%. Imports lost approximately 0.6 share point in the US market in 2008, due to economic weakness and super-premium category success.

Craft beers continue to lead; big brewers get in on the action Consumers continue to pay a premium for craft brands. According to the Brewers Association, the craft brewing industry grew 18% by volume and 20% by dollars in 2013 (latest available), for a beer industry share of 7.8% and 14.3%, respectively. In 2013, 2,768 craft breweries operated in the US for some or all of the year, comprising 1,237 brewpubs, 1,412 microbreweries, and 119 regional craft breweries.

Craft beer growth has accelerated in recent years, despite difficult economic times and the increase in the segment’s base, according to Beer Marketer’s Insights. Insights estimated that volume grew 5% in 2008, 6% in 2009, 10% in 2010, over 14% in 2011, 12% in 2012 and 15% in 2013 (latest available), while dollar sales for the year increased 18% according to IRI. As shown in the accompanying table, all of the top 10 (except one) saw shipment growth in 2013; because the smaller craft brewers grew more strongly, however, most of the leaders lost share in the craft segment.

Regardless of how they get into the segment, big beer companies have kept their craft operations separate from their primary beer operations. For instance, MillerCoors has a

separate craft division named Tenth and Blake Beer Company, which markets its craft beer under the name Blue Moon Brewing Co. This could be because consumers are becoming increasingly selective about how and where the products they consume are produced. According to the Brewers Association, a craft brewery is small and produces less than six million barrels annually, or approximately 3% of annual sales in the US. The Boston Beer Co., the largest craft brewery by far and the seller of Samuel Adams, sold 1.9 million barrels in the first half of 2014, while players such as AB InBev sold 191.7 billion barrels in the first half of 2014.

According to the Brewers Association, aside from the growth of the craft beer industry in the US, the industry has seen expansion of its exports to other countries, including Canada, Sweden, and United Kingdom. Based on data from the Brewers Association, US craft beer exports in 2013 totaled $73.6 million, an increase of almost 50% compared with 2012. Exports to Western Europe rose 45.5%.

S&P Capital IQ (S&P) attributes the success of craft beers to several factors. One is their uniqueness. Innovation in the category is also strong, with the introduction of seasonal brews, products aged in whiskey

TobacB03: MICROBREWERY SALES

MICROBREWERY SALES(Ranked by 2013 sales, in thousands of 31-gallon barrels)

MARKET

- - - - - - SHIPMENTS - - - - - - - - SHARE (%) - -

COMPANY 2012 2013 % CHG. 2012 2013

Boston Beer 2,150 2,325 8.1 15.5 14.8Sierra Nevada 960 980 2.1 6.9 6.2New Belgium 765 792 3.5 5.5 5.0Craft Brew ers 675 735 8.9 4.9 4.7Spoetzl 524 568 8.4 3.8 3.6Lagunitas 235 400 70.2 1.7 2.5Magic Hat/Pyramid 337 298 (11.6) 2.4 1.9Deschutes 253 286 13.0 1.8 1.8Bell's 216 248 14.8 1.6 1.6Brooklyn 176 216 22.7 1.3 1.4Others 7,609 8,902 17.0 54.7 56.5

Total 13,900 15,750 13.3 100.0 100.0

Source: Beer Marketer's Insights .


and wine barrels, and vintage-dated beer. In a time of slowing introductions, new products stand out. Retailers have been devoting more shelf space to craft beers and suggesting beer and food pairings in their displays, driven by craft beers’ unique flavorings and aromas. Additionally, many craft beers are produced locally; as such, they help support local economies and play well into the trends of eating at home and locally.

OUTLOOK FOR ALCOHOLIC BEVERAGE INDUSTRY REMAINS GENERALLY POSITIVE

Despite weak growth in gross domestic product (GDP) and employment, and the likely near-term effect of these two factors on disposable income, we remain generally positive on the US alcoholic beverage industry, given the attractiveness of craft brews as an affordable luxury, new product activity, and penetration into developing regions abroad.

Spirits. The spirits industry saw good growth in 2013, driven by targeted marketing to demographic “sweet spots” (specific age and ethnic groups), increased attention to the off-premise trade (such as warehouse clubs and supermarkets), stabilization of the on-premise business, and continued brand innovation. We expect prospects to remain bright for 2014, as we see drinkers favoring wine and spirits over beer. S&P expects that trading-up activity (where individuals switch from lower-end products to premium products) will remain on an uptrend over the near term as the economy recovers and will continue to characterize demand over the long term. With volumes recovered in 2010 to 2013, revenue climbed at a faster pace on a return to premiumization. We expect continued growth in 2014, with pricing power retained by producers.

Wine. The wine industry’s outlook is positive. Despite continued competitive pressures on wine prices, we expect wine volumes to rise moderately, driven by off-premise consumption. As demand for premium beverages rises, we think that companies offering high-end products and a selection of imported wines will benefit, by capturing market share from domestic brewers.

Beer. S&P is neutral on the domestic brewing industry, reflecting our view of modest profit growth driven by higher pricing and continued cost cuts, but only flat to slightly higher volumes as consumers increasingly migrate to wine and spirits. S&P thinks that sales of import beers and craft beers will benefit from consumers trading up to higher quality beers. In response, major domestic brewers have recently taken steps by participating with import breweries, and increasing product and packaging innovation.

Year to date through September 19, the S&P Distillers and Vintners Index rose 26.3%, while the S&P Brewer’s Index increased 27.7% compared with the S&P 1500’s increase of 8.2%. In 2013, the Distillers & Vintners and Brewers indices gained 33.8% and 38.1%, respectively, versus a 30.1% advance for the S&P 1500.

Tobacco industry looks to consolidate

US sales of cigarettes have declined in recent years, and industry players are looking to consolidate. On July 15, 2014, Reynolds American Inc., the parent company of R.J Reynolds Tobacco Co., and Lorillard, Inc., the third-largest tobacco company in the US, announced that they have entered into a definitive agreement in which Reynolds will acquire Lorillard in a cash-and-stock transaction that will total $27.4 billion, including the assumption of net debt. Following the transaction, Reynolds is expected to have over $11 billion in revenues, approximately $5 billion in operating income, and its operating companies will have a vast portfolio, including Newport, Camel, Pall Mall, and Natural American Spirit in combustible cigarettes, Grizzly in smokeless tobacco, and VUSE in the growing e-cigarette market. The merger would create a stronger competitor to industry leader Altria Group Inc.

British American Tobacco (BAT), which has a 42% stake in Reynolds, has reiterated its strong confidence in the company and the transaction.


E-CIGARETTES: TOBACCO COMPANIES LOOKING FOR GROWTH

A Fortune article published on June 10, 2014 reported data from Euromonitor showing that the number of traditional cigarettes sold has fallen 29.6% since 2004. The drop can largely be attributed to education campaigns and bans on smoking in public places. One such alternative, which is experiencing considerable growth, is the e-cigarette, an electronic inhaler containing nicotine-based water that can be inhaled as vapor. The sale of e-cigarettes is estimated to be a $1.5 billion market, and is expected to grow 24.2% per year through 2018, according to December 2013 projections from Research and Markets, a leading source for international market research reports and market data.

Many independent startups, such as NJOY, Logic, and Vapor, have launched e-cigarettes. April 2014 data from the US Centers for Disease Control and Prevention (CDC) show that 8% of US adults used e-cigarettes in 2012, up from 3% in 2010. According to a September 2013 study by CDC, the percentage of high-school students who used e-cigarettes more than doubled from 4.7% in 2011 to 10% in 2012.

The growing e-cigarettes market has also attracted big tobacco players, which are taking steps to enter this small yet promising segment. For instance, in April 2012, Lorillard acquired blu Cigs, an e-cigarette company, for $135 million, as part of its effort to diversify from cigarettes and gain a foothold in the smokeless products market. In 2013, the company reported e-cigarette sales of $230 million, compared with $61 million in 2012. The company’s blu eCigs brand is available through more than 110,000 retail outlets. In October 2013, Lorillard acquired British e-cigarette manufacturer SKYCIG for approximately £30 million and an additional contingent consideration of up to £30 million to be paid in 2016 based on the achievement of certain financial targets. Altria, the largest US tobacco company, launched its electronic cigarette, MarkTen, in Indiana to leverage the growing segment. Following suit, Reynolds, the second-largest US tobacco company, introduced its electronic cigarette, VUSE, in Colorado, and is making a nationwide rollout in 2014. As of June 2014, Altria was preparing for a national rollout of its MarkTen e-cigarette product.

Another alternative to e-cigarettes is more specialized devices knows as “vapors,” “tanks,” and “mods”, which currently account for more than a third of the total $2.2 billion market for electronic vapor products. These e-vapor products are said to be less addictive than combustible cigarettes, have a stronger battery, and are more affordable than combustible cigarettes and rechargeable e-cigarettes.

The e-cigarettes category, unlike the traditional cigarette segment, is not governed by strict rules and regulations, or subject to heavy taxes. Manufacturers claim that e-cigarettes cause less harm than traditional ones. However, regulators are still assessing the impact of e-cigarette smoking on consumers’ health and are considering whether to impose restrictions. Italy is considering banning the product from schools, while France is planning to ban them from public spaces. The UK government is planning to treat e-cigarettes as medicines, while Mexico, Brazil, and some Asian countries have imposed sales restrictions. In the US, the Food and Drug Administration (FDA) proposed federal rules to prohibit the sale of e-cigarettes to anyone under 18. Manufacturers are required to submit their products subject to FDA approval, disclose the ingredients, and warn consumers that nicotine is addictive.

Currently, e-cigarettes cost about half as much as traditional cigarettes, another factor encouraging consumers to try them. However, all the growth estimates could change if regulators decide to impose regulations and taxes similar to traditional cigarettes.

Providing some lift to the advertising industry With the three big players—Altria, Reynolds, and Lorillard—set to join the e-cigarette industry, the advertising industry is hoping for a fillip. The industry has been on a decline ever since traditional cigarettes’ sales started decreasing amid strict regulations. But with increasing demand for e-cigarettes, the advertising sector is looking forward to increased spending by companies as they explore print, TV, and direct mail, among other marketing avenues.

On April 2014, Senator Dick Durbin, together with other Democratic members of Congress, submitted a report including a review of marketing strategies, urging the FDA to regulate the e-cigarette industry. According to the report, the largest e-cigarette makers spent nearly $60 million on advertising and


promotion in 2013, while marketing spending grew more than 100% year on year. Five companies provided advertising expenditure information for 2013. The report indicated that the marketing expenses of these companies increased 164% from 2012. Worth noting is that one of the companies increased its marketing expenses by 300%, while another company increased its marketing expenses by 352%.

Eight e-cigarette companies were identified as using various practices that appeal to youth. These companies promote their products through sponsored or sampling events—six of the surveyed companies sponsored or provided free samples at 348 events. Seven e-cigarette companies aired television and radio advertisements during events and programs, some of which had a large number of youth viewers. NJOY, for example, advertised during the Super Bowl, an event that reaches a considerable audience of youth under 18 years of age. Lastly, six e-cigarette companies market e-cigarettes in flavors appealing to children and teens, such as Cherry Crush, Chocolate Treat, Peachy Keen, and Grape Mint.

Lorillard launched two new TV ads for blu eCigs in December 2013, and plans to spend more on marketing in 2014 than in 2013, when it spent about $30 million. NJOY Inc. is planning to spend more than $30 million for US marketing in 2014, three times its spending in 2013. Both companies plan to spend most of their budgets on TV advertising.

After a gap of 43 years, Reynolds American Inc. is planning to return to TV ads to market its VUSE e-cigarette. Amid rising concerns over young people adopting smoking through this avenue, the company has planned to target late-night TV, when adults constitute about 85% of the viewership. In April 2014, the FDA proposed rules for e-cigarettes; however, these rules do not cover restrictions on advertising. According to a New York Times report dated August 29, 2013, the makers of e-cigarettes are using the same marketing tools employed by the tobacco industry during the middle of the 20th century.

E-cigarettes provide some benefits As concerns over e-cigarettes’ effects on the health of users soar, numerous studies are being conducted to assess whether they serve as a better alternative to traditional cigarettes or to government-approved tobacco abstinence products such as nicotine patches and lozenges. According to a study conducted by researchers at the University of Catania in Italy, quoted in a Wall Street Journal article dated June 25, 2013, 8.7% of the 300 local smokers who tried e-cigarettes between 2010 and 2012 stopped smoking traditional cigarettes after a year. While 4% of the people who were given e-cigarettes without nicotine quit smoking, 13% of the people who were provided e-cigarettes with the highest dose of nicotine managed to quit. The study further found that 73.1% of the respondents who quit smoking traditional cigarettes after a year also stopped using e-cigarettes. Another study conducted online by the University of East London in the UK, quoted in the same article, noted that 74% of the 1,347 e-cigarette users from 33 countries who participated in the survey quit smoking for a few weeks or more, while around 70% of the respondents reported a reduced urge to smoke.

The University of Auckland in New Zealand also conducted a trial on 657 smokers to compare the quit rates of e-cigarette users vis-à-vis users of nicotine patches. The study results showed that 57% of those who smoked e-cigarettes managed to cut their tobacco intake by half, while only 41% of those who used nicotine patches were able to do so. Further, 5% of those who used either of the tools were able to quit in a period of six months from the start of the study. The results, as reported in a Bloomberg article dated September 7, 2013, pointed toward the probable efficacy of e-cigarettes to lessen consumers’ tobacco intake. However, according to an April 2014 study by the CDC, roughly 75% of e-cigarette users surveyed said that they also smoke regular cigarettes, a figure that has not changed much over the course of the four years during which the survey was conducted. This finding raises questions about whether the product is really helping people to quit smoking.

The increasing scrutiny by various health professionals has also exposed the ill effects of using the device. According to 60 Millions de Consommateurs (60 Million Consumers), a French magazine, traces of heavy metals and chemicals like formaldehyde were found in many devices. The nicotine content in the e-cigarettes was also significantly higher than the amount mentioned on the labels, according to the magazine. While the side effects of e-cigs and nicotine patches are similar, no definite conclusions can be made as to which tobacco abstinence product is better, according to the New Zealand study.


Calls for regulation The growing use of the e-cigarettes has increased regulators’ concerns. While e-cigarette proponents claim that the product helps smokers to quit traditional cigarettes, health officials counter that it is serving as a new medium for smoking. Regulators believe that the availability of e-cigarettes online and their advertising on TV, which are banned for traditional cigarettes, are resulting in increasing adoption by minors.

According to an August 2014 report by the CDC, more than 263,000 youth who had never smoked a regular cigarette used e-cigarettes in 2013—a threefold increase from about 79,000 in 2011. Among youth who had used e-cigarettes, 43.9% said that they intended to smoke regular cigarettes within the next year, compared with 21.5% of those youth who had never used e-cigarettes.

According to a Wall Street Journal article dated September 24, 2013, the attorneys general of 40 states have sent a letter to the FDA urging restrictions on the advertising and sale of e-cigarettes to youth. They noted that the device is offered in a range of flavors like chocolate, cherry, and bubble gum that are more appealing to young people compared with the traditional cigarettes that are available only in tobacco and menthol flavors. Marketing strategies that use cartoons to flash the ads, a technique that is banned in the case of traditional cigarettes, is also appealing to youth. E-cigarette makers such as Lorillard and NJOY Inc. have stated that they screen the customer’s age before selling their product online and are in favor of restricting sales to minors. In August 2014, 29 attorneys general urged the FDA to impose stricter rules on e-cigarettes after the regulator released its proposed federal rules for the product, while some democrats submitted a report in April 2014, emphasizing the factors that needed to be addressed by the regulators, particularly on the advertising front.

TOBACCO REGULATORY ISSUES

Menthol awaiting FDA opinion; not likely to be banned The Family Smoking Prevention and Tobacco Control Act, signed into law in June 2009, gave the FDA authority to regulate tobacco products and made the sale of most flavored tobacco products illegal to prevent youth and young adults from smoking. The law, however, exempted menthol-flavored cigarettes. The exclusion of menthol flavoring from the list of banned products met with opposition from Joseph Califano and Louis Sullivan—both of whom formerly held the position of US Secretary of Health—who said in October 2010 that they strongly supported an FDA ban on menthol in cigarettes. Earlier in 2010, they had asked the Tobacco Products Scientific Advisory Committee (TPSAC), an FDA panel, to recommend that the FDA ban menthol in cigarettes.

In March 2011, the TPSAC issued its report and recommendation on menthol flavoring in cigarettes. It said the removal of menthol cigarettes from the US market would benefit public health, but did not call for an outright ban, which was viewed very positively by the cigarette manufacturers. Later, in July 2011, the FDA completed its own independent review on the impact of menthol cigarettes on the public and submitted its report to external scientists for a review.

However, in July 2013, the issue surfaced once again, as the FDA noted that regulatory action on menthol-flavored cigarettes is required because they represent a greater risk to public health than traditional cigarettes do. According to the FDA, the flavor of menthol cigarettes is milder than that of traditional ones; they are more addictive and thus are more difficult for smokers to quit, according to a Wall Street Journal article dated July 24, 2013. The article noted that the FDA is evaluating options ranging from restrictions on marketing to limiting the amount of menthol allowed per cigarette to imposing a complete ban on menthol cigarettes. The regulations will affect African-American smokers the most, as 80% of them smoke menthol versions, according to the results of a federal survey quoted in the article. Any such restriction could lead to a black market since, on average, 30% of adult smokers and 40% of youth smokers use menthol cigarettes.

S&P thinks that the uncertainty surrounding the potential for a menthol ban has been an overhang on the tobacco group, given its importance to the cigarette market. Menthol cigarettes accounted for just over 31.7% of the total cigarette market in the first half of 2014, up from 26% in 2003, according to Lorillard Inc. Menthol is particularly significant to Lorillard, which derives approximately 90% of its total revenue


from menthol cigarettes. Though we think that an outright ban on menthol cigarettes is unlikely, we do not rule out an eventual ban. It is not clear that the FDA is obligated to follow the committee’s recommendation or conclusions, as is the case for the FDA’s drug advisory committee, which could recommend the removal of an unsafe product or the addition of a warning. We would also note that the FDA has no timeline or deadline to act on menthol. In the meantime, there have been several developments that could present a challenge to an outright ban.

WTO challenge. In April 2012, the World Trade Organization (WTO) appeals court upheld an earlier decision that the ban on clove cigarettes by the Family Smoking Prevention and Tobacco Control Act discriminates against Indonesia, the world’s leading producer of clove cigarettes. Earlier, in April 2010, Indonesia had challenged the law citing that it unfairly favors US-based menthol cigarette makers, and the WTO had decided in favor of Indonesian government. According to a Wall Street Journal article dated April 4, 2012, the ban on clove cigarettes resulted in a trade loss of around $15 million per year for the Indonesian government.

Study finds lower lung cancer risk with menthol. Interestingly, in March 2011, Vanderbilt University released the results of a seven-year study of around 86,000 adults in 12 southern states, which found that menthol cigarettes might pose a lower risk for lung cancer than unflavored versions. The study, funded by the National Cancer Institute, the federal government’s principal agency for cancer research, found that menthol smokers consume fewer cigarettes a day than non-menthol smokers do, with some race-based differences. Black menthol smokers used an average of 1.6 fewer cigarettes a day than non-menthol smokers did, while white menthol smokers used an average of 1.8 fewer cigarettes a day, according to the report. The study urged the FDA to include Vanderbilt’s findings in the agency’s analysis in weighing a ban.

Unintended consequences. The US tobacco industry is strongly opposing the ban on menthol products on a number of grounds. In addition to not accepting the TPSAC’s claim that menthol cigarettes make people likely to take up smoking, the industry is suggesting that a ban on menthol cigarettes would give rise to illicit trade and counterfeit products. We think that a ban on menthol cigarettes would result in a significant loss of tax revenues in the billions of dollars for the US government, as well as the potential for job losses.

Industry players also argue that if smokers cannot find preferred menthol products through legitimate retail channels, they are likely to seek them through illicit channels, which would probably be either contraband menthol from other countries or altogether new menthol products. According to Euromonitor International, this argument was given serious thought by TPSAC. Committee chairman Jonathan Samet, a professor at the University of California’s Keck School of Medicine in Los Angeles, said, “Depending on what directions or actions the FDA may choose to take, then they would need to consider the potential for contraband under those scenarios.”

Age limit on tobacco sales raised in NY and NJ The UK has had success in reducing youth smoking by 30%, after increasing the legal age for purchasing cigarettes to 18 (from 16) in 2007. New York City is following suit and increased its minimum age to purchase tobacco products to 21 (from 18). The bill was adopted in October 2013 and took effect in March 2014. According to New York City estimates, 20,000 high-school students in the city smoke and some 80% of all smokers in the city began smoking before the age of 21. The lawmakers also approved other legislation, such as increased penalties for retailers that evade tobacco taxes, prohibition on discounts for tobacco products, and a minimum price of $10.50 a pack for cigarettes and little cigars.

According to a CBS news article published in February 2014, similar bills to raise the age to buy tobacco products to 21 are also pending in-state legislatures in Hawaii, Massachusetts, and New Jersey. Colorado and Utah voted favorably on proposals to treat tobacco like alcohol by increasing the minimum age to purchase to 21. Retailers say that these changes will hurt both their business and state tax revenues, but without any corresponding benefit, as those in the restricted age group could resort to the black market to procure these products.

Government looks to tobacco for another revenue grab As the government faces challenges in trimming the deficit and funding initiatives, it is looking for ways to increase tax revenues, according to a Wall Street Journal article dated April 5, 2013. One such avenue


would be increased taxes on cigarettes and tobacco products, the proceeds of which would be earmarked to fund pre-kindergarten education for children from lower-income families.

In March 2014, President Obama proposed an increase of 94 cents per pack in the federal cigarette tax rate and a proportionate 93% increase in all other tobacco tax rates. The tax rates would be adjusted annually by an inflation index. The additional tax revenue would be used to fund pre-school education for four-year olds in low-income families. According to the White House Office of Management and Budget (OMB), the proposed increase in taxes would raise $78 billion from 2014 through 2024. The OMB estimates the cost of expanding pre-school education to four-year olds from low-income families at $76 billion over this period.

Any increase in federal tax affects the sales of cigarettes, as evidenced in the past. In 2009, when the federal tax on cigarettes was increased from 39 cents to $1.01 for each pack, cigarette sales dropped 10%. Anti-smoking groups have always come out in support of such moves, as they believe that an increase in prices makes the product out of reach for kids and lower-income people, forcing them to quit.

In February 2014, New Jersey Governor Chris Christie and a New Jersey legislator proposed a 75% wholesale tax on e-cigarettes. The proposal was met with strong opposition, as nearly 50 independent e-cigarette retailers banded together to fight the proposed tax. According to Governor Christie, the tax could bring in $35 million a year. On June 30, 2014, Governor Christie signed the fiscal year 2015 budget, which does not include the proposed e-cigarette tax.

Australia’s plain-packaging rules implemented In August 2012, the Australian high court upheld the new plain-packaging tobacco rules that were passed in November 2011. Four global tobacco companies—British America Tobacco (BAT), Phillip Morris International (PMI), Imperial Tobacco, and Japan Tobacco (JTI)—had challenged the rules on constitutional grounds, claiming they extinguished the companies’ intellectual property rights. The new plain-packaging rules, which were implemented on December 1, 2012, require tobacco companies to sell their products in packets without logos and with only the brand name in standard font on the front of every packet. In addition to the name, the packets include graphics of smoking-related diseases.

Despite the ruling, PMI has not given up hope. According to an article dated August 18, 2012, in The Australian, a daily newspaper, Hong Kong–based Phillip Morris Asia (the parent company of Phillip Morris Australia) initiated international action by filing a case under the 1993 Australia-Hong Kong bilateral investment treaty (BIT). The article stated that the legal action is underway, and the arbitration process could take as long as three years for a resolution.

Meanwhile, several member countries at the WTO have taken Australia to International Court over the world’s toughest antismoking laws, stating that these laws violate international trade agreements. Ukraine started the legal proceedings against Australia in March 2012, and it was joined by Honduras and the Dominican Republic. Other countries, including Brazil, Canada, the European Union (EU), and Indonesia, have signed up for the legal complaint against Australia. According to a Financial Times article dated April 29, 2012, BAT and PMI are providing legal support and advising several countries that had complained about Australia’s plain-packaging laws. The article also specified that JTI has joined PMI and BAT in launching lawsuits against the Australian government.

Tobacco companies’ main concern, following the plain-packaging laws, is how to differentiate their products and charge a premium for their brands. The companies see decreased revenues as price wars would, according to an internal study by PMI, result in a 19% reduction in cigarette prices, if such laws are implemented. While tobacco companies are ready to support the regulations that result in clear benefit to the public health, they oppose such laws that do not assure any effective reduction in damage from smoking, according to a Bloomberg article dated August 22, 2013. PMI has incurred around $5.1 million so far this year in lobbying the government agencies for trade and other related matters. For 2012, such amount stood at $9.8 million, the article noted.

In addition, Australia’s new plain-packaging rules could act as a precedent and spread to other countries, including the $161 billion European market, which is also considering adopting plain-packaging rules. In


April 2012, the UK Department of Health (DOH) launched a countrywide consultation (which ended in August) to gather opinions on whether tobacco products should be sold in standardized packaging. New Zealand and Britain recently delayed new packaging rules, in part to see how Australia’s effort pans out.

Europe gets aggressive on tobacco Like the governments of other countries, the European Union (EU) is cracking down on tobacco products being sold in the region. The legislators of the EU parliament have sanctioned a ban on flavored cigarettes (including menthol) under a broad legislation and are mulling treating e-cigarettes as medicines, as stated in a Wall Street Journal report dated October 14, 2013. EU lawmakers believe that flavored cigarettes entice young people to start smoking. The parliament also approved a new rule that requires health warnings covering 65% of cigarette packs.

The regulations, apart from posing hurdles for tobacco companies (like Philip Morris International, British American Tobacco, and Imperial Tobacco Inc.), can further promote the black market, which has already made inroads in the region. While cigarette consumption in the EU declined 5.7%, year over year, to 593 billion cigarettes in 2012, counterfeit and illegal sales increased 0.4% to 65.5 billion during the same period, according to KPMG estimates quoted in the article.

E-cigarettes targeted, too In order to provide more effective and secure choices to people trying to decrease or cease smoking, the UK plans to license all products containing nicotine as medicines, according to the Medicines and Healthcare Products Regulatory Agency (MHRA). The step is a part of broad legislation expected to be adopted next year (and to be effective by 2016) that will include electronic cigarettes. The bourgeoning e-cigarette market is spurring legislators in many countries to look to tighten the regulations imposed on the industry.

The MHRA, as reported in a Bloomberg article dated June 12, 2013, is not looking to ban e-cigarettes, but rather to ensure that companies are selling products that are effective substitutes for traditional cigarettes and thus can help people reduce or quit smoking. Research findings, such as the one presented by the University of Athens that showed e-cigarette usage results in lung damage and others that have reported explosions causing second-degree burns to users, have generated immense regulatory scrutiny around the world. Further, since users inhale nicotine through this device, regulators believe this could also be addictive for users. E-cigarette consumers are opposing the proposed regulations, as they believe it will only push smokers to smoke unhealthier traditional cigarettes in addition to fueling the black market.

Russia cracks down Russia, the world’s second-largest tobacco market after China, has taken a stern measure against smoking by issuing anti-smoking rules. In February 2013, President Vladimir Putin signed a bill that included measures aimed to reduce consumption of cigarettes in the country. According to data from the World Health Organization, 40% of Russians smoke, of which 60% are men. According to an article in The Wall Street Journal dated October 15, 2012, nearly 50% of the 44 million smoking population of Russia smokes at least one pack a day. Every year, around 400,000 people in Russia die because of smoking-related diseases, which leads to an annual cost of around $48 billion for the country, the article noted.

The law, which took effect June 1, 2013, calls for a ban on smoking in public places such as offices, as well as in areas near schools and hospitals. Beginning June 1, 2014, smoking at places such as restaurants and train stations will be restricted. The law also includes a ban on cigarette sales at street kiosks by 2015 and calls for higher excise taxes. In addition to restrictions on advertising, the legislation sets a minimum price for cigarettes, which currently is as low as about one dollar per pack in Russia. President Putin has targeted a 10%–15% reduction in smoking by 2015.

The four global tobacco companies (PMI, BAT, JTI, and Imperial Tobacco) control more than 90% of the Russian tobacco market. They have seen the consequences of such government restrictions on their sales in other countries, and now that Russia is implementing such measures, they will certainly feel the pinch.


LITIGATION

An increase in the death toll due to tobacco consumption in the past few decades has increased the number of lawsuits filed against the tobacco companies. While the plaintiffs in some cases have received favorable judgments from the court, we have also seen many cases dismissed. According to a Reuters article dated August 21, 2012, the New Hampshire Supreme Court ruled against the class action lawsuit filed against Phillip Morris USA, the company owned by Altria Group. Its decision reversed the class action certification granted by a Merrimack County Superior Court judge in 2010 to a group of smokers, who claimed that the company had misled them by saying that its Marlboro cigarette has less tar and nicotine compared with other cigarettes. The court noted that this case could not be treated as class action as there were many “individual issues” and that it could not be assumed that consumers were unaware that light cigarettes were equally harmful as the regular ones, provided “substantial information” was available to the them between 1976 and 1995. Before this ruling, 15 other courts had rejected such claims on light cigarette cases, according to the article.

In early 2012, the Minnesota Supreme Court dismissed a class action against Phillip Morris USA by smokers that had purchased Marlboro Lights cigarettes in Minnesota between 1971 and 2004. The court noted that class action status was prohibited by the terms of the 1998 Master Settlement Agreement (MSA), according to a Reuters article dated May 30, 2012.

In December 2012, an Illinois judge denied the reopening of the class action lawsuit filed against Phillip Morris USA that involved a claim of $10.1 billion by the plaintiffs. The case was filed in 2000 and in 2003, Judge Nicholas Byron, now retired, found that the company violated Illinois law by marketing the cigarettes as light and low tar, portraying them as safer options. This became the first case in which a tobacco company lost a lawsuit filed by consumers. However, in 2005, the Illinois Supreme Court overturned the decision, noting that the Federal Trade Commission (FTC) had allowed the companies to use such descriptions for their products. In 2006, the case was dismissed. In late 2008, the high court ruled that consumers could file a lawsuit against the tobacco companies that market their products as light or low tar.

On July 18, 2014, Florida widow Cynthia Robinson won a $23.6 billion lawsuit against Reynolds, one of the largest recent judgments on the industry. Robinson’s husband died in 1996 from lung cancer, and 10 years later, she and her attorneys filed a lawsuit against Reynolds, arguing that the company was aware that cigarettes were addictive and caused lung cancer, but was negligent in telling smokers, like her husband, about those risks.

TOBACCO OUTLOOK POSITIVE

As of early October 2014, our fundamental outlook for the tobacco sub-industry for the next 12 months was positive, reflecting what we see as favorable pricing trends, healthy free cash flow growth, and a relatively benign litigation environment.

As had been widely expected, in April 2009, the federal excise tax on cigarettes jumped to $1.01 per pack from $0.39. In our view, tobacco is likely to be a continued target for additional state excise taxes, and we see attempts to raise rates as likely in the future. However, against a relatively benign litigation backdrop, major tobacco companies have begun to shift focus to battling excise tax hikes and other anti-smoking ballot initiatives.

In June 2009, President Obama signed the Family Smoking Prevention and Tobacco Control Act into law. The bill gives the FDA the power to regulate both the manufacture and marketing of tobacco products. We viewed the enactment as a slight overall negative for the industry, but we note that tobacco companies were well aware of lawmakers’ desire to enact this regulation and had ample time to prepare for compliance. With restrictions on advertising, marketing, and packaging, we think the law serves to solidify current market shares.

In the past few years, several events have been favorable for the industry. In March 2011, the Tobacco Products Scientific Advisory Committee (TPSAC) did not call for an outright ban on menthol cigarettes. In


November 2011, a federal judge blocked the government from requiring tobacco companies to display graphic warnings until the courts can review the constitutionality of the requirement under the provisions of the Family Smoking Prevention and Tobacco Control Act. In August 2012, the US Federal Circuit of Appeals affirmed the lower court’s ruling, saying the government failed to provide evidence that the labels would reduce smoking rates.

Despite our expectation for a low– to mid–single-digit percentage decline in domestic consumption, we expect industry operating profits to rise modestly, as cost-saving efforts and merger synergies should offset greater investment in focus brands. In 2009, we estimate that volumes declined at a high single-digit rate as the federal excise tax increase was absorbed and trade inventories were adjusted, while in 2010 and 2011, we think volumes dropped at a more moderate low to mid–single digit rate. We estimate volumes dropped about 3% in 2012 and fell 3.5% to 4% in 2013.

Year to date through September 19, the S&P Tobacco Index increased 6.4%, versus an 8.2% rise in the S&P 1500 Index. In 2013, the Tobacco Index rose 11.8%, compared with the S&P 1500’s 30.1% gain.


INDUSTRY PROFILE

Alcohol sees further growth; tobacco fundamentals changing

In the US, alcoholic beverage and tobacco products are big businesses. Alcoholic beverages, at their highest sales level to date, accounted for an estimated $207.1 billion of retail sales in 2013 (latest available), up 3.1% from 2012’s $200.8 billion. Beer accounted for just under half of alcoholic beverage revenues, with consumers downing about $101.3 billion worth of brew in 2013. Altria Group estimated that profits of US tobacco manufacturers in 2013 (latest available) totaled $14.5 billion, for a compound annual growth rate (CAGR) of 5.0% since 2008.

Excise taxes on alcohol and tobacco represent a tremendous revenue source for federal, state, and municipal governments. In January 2003, the Alcohol and Tobacco Tax and Trade Bureau (TTB) became the newest bureau in the Treasury Department. For fiscal 2013, according to the July 2014 TTB report to the US Senate Committee on Finance, the TTB collected taxes totaling approximately $23 billion—of which $9.0 billion came from taxation of alcoholic beverages and $14 billion came from taxation of tobacco.

ALCOHOLIC BEVERAGES

After growing steadily since 2001, the alcoholic beverage industry faltered in 2009, and then resumed its growth trajectory in 2010–13, according to Beverage Information Group’s Handbook Advance 2014, an annual report on alcoholic beverage sales and consumption. Wine and spirits volumes continued to grow in 2013, while beer volume increased for the second time, after three consecutive years of declines. Beer volumes were up 2.2% in 2013 and 0.5% in 2012, after falling 1.3% in 2011, 1.9% in 2010, and 2.1% in 2009. Previously, the beer industry had not posted such poor performance since 1991, when volumes fell 2.2% due to the doubling of the federal excise tax.

In 2013, consumers continued to drink at home, rather than at bars and restaurants. Off-premise (at home) consumption accounted for 52.6% of total alcoholic retail sales in 2013, the same percentage as in 2012, versus 52.0% in 2011 and 51.5% in 2010; the balance was on-premise (bar and restaurant) consumption.

Beer claimed the largest share of sales again, in terms of both dollars and volumes. The category, with an 84.0% share of volume in 2013, gained share as spirits volume was flat and wine lost share. The retail value of US beer shipments totaled approximately $101.3 billion in 2013, on a volume of about 6.3 billion gallons.

In 2013, the second-largest segment in terms of sales was spirits, with total sales of $75.8 billion on 500 million gallons. Total volume share for spirits stayed at about 6.5% in 2013. Wine made up the third group, racking up sales of $29.9 billion on 774 million gallons, with a volume share falling to 9.7% in 2013, from 10.0% in 2012. Spirits growth slowed to 4.2% after experiencing 6.3% growth in 2012, while wine consumption growth of 3.6% was down from 3.9% in 2012.

Two companies dominate US beer market In the US, two producers dominate the beer industry, accounting for about 72.8% of the nation’s beer supply in 2013, down from 73.9% in 2012. According to estimates by industry trade publication Beer Marketer’s Insights, Anheuser-Busch Companies Inc. led the pack with a 45.7% share of volume in 2013 (down from 46.3% in 2012), followed by MillerCoors with a 27.0% volume share (down from 27.5%). The No. 3 domestic supplier by volume, Crown Imports, held a 6.1% share, up from 5.7%.

Anheuser-Busch. US beer shipments for Anheuser-Busch totaled 51.57 million barrels in the first half of 2014, 0.8% less than the volume in the same period in 2013. For fiscal year 2013, beer shipments totaled 103.96 million barrels, down 2.6% from 106.52 million barrels in 2012. Anheuser-Busch brews its beer through a system of 13 breweries in the US and sells it through more than 600 independent wholesalers. It changed its name to Anheuser-Busch InBev.


MillerCoors. This company, a joint venture of the US operations of SABMiller PLC and Molson Coors Brewing, sold 31.4 million barrels as of the second quarter of 2014, 1.9% less than the 32.0 million barrels in the second quarter of 2013. In 2013, MillerCoors sold 63.3 million barrels of beer shipments, down 2.7% from 65.03 million barrels of beer in 2012. MillerCoors owns and operates eight US breweries. In early 2005, Adolph Coors Co. merged with Canada’s Molson Inc. to form Molson Coors Brewing, the world’s fifth-largest brewer. The joint venture with SABMiller was established in mid-2008.

B11: BRANDS

TOP ALCOHOLIC BEVERAGE PRODUCERS AND THEIR BRANDS(As of April 2014)

BEER SPIRITS & WINE Sazerac(PRINCIPAL BRANDS IN (PRINCIPAL PRODUCTS BY COMPANY) BartonCOMPANY- DEFINED SEGMENTS) Fleischman

Diageo PLC Mr. Boston

Anheuser-Busch Vodka Crystal PalacePremium Smirnoff Skol

Budw eiser family Ciroc CzarinaSuper-premium Ketel One Meukow cognacs

Michelob family GinSpecialty Beers Tanqueray London Dry Brown-Forman

Redbridge Gordon’s Gin WhiskeyRolling Rock Whiskey Jack DanielsRock Light Bushmills Gentleman Jack WhiskeyWild Blue Crow n Royal Canadian MistZiegenBock Johnnie Walker Woodford Reserve

Sub-premium Liqueur Don Eduardo TequilaBusch family Baileys Fetzer w inesNatural family Romana Sambuca Southern Comfort

Malt Beverages Tequila Finlandia vodkaHurricane family Jose Cuervo Korbel champagneKing Cobra Don Julio Chambord liqueur

Energy Drinks Champagne180 All Natural Dom Perignon Pernod RicardMonster Moet & Chandon Whiskey

Imports Beer JamesonBass Guinness The GlenlivetBecks Harp Lager Chivas RegalHoegaarden Hennessy cognac Ballentine'sLeffe Captain Morgan rums Malibu rumStella Artois Beefeater gin

Nonalcoholic brews Beam Global Spirits & Wine Absolut vodkaO'Doul's Bourbon Kahlua liqueurO'Doul's Amber Jim Beam Jacob's Creek w ine

Maker's Mark

Molson Coors Whiskey E&J Gallo Winery Premium Canadian Club Barefoot Cellars

Carling Laphroaig Carlo RossiCoors family Windsor Canadian Gallo family VineyardBlue Moon family Wolfschmidt VodkaMolson Canadian DeKuyper cordials Constellation BrandsRickards Sauza tequila Wines

Sub-premium Courvoisier cognac Clos du Bois w ineKeystone family Estancia

Bacardi Franciscan Estate

SABMiller Bacardi rum Robert Mondavi WineryPremium Grey Goose vodka Simi

Miller family Bombay gin Woodbridge by Robert MondaviHenry Weinhard's family Cazadores tequila SVEDKA VodkaLeinenkugel's family Martini sparkling w ine Black Velvet Canadian Whisky

Super-premium Martini vermouth Paul Masson Grande Amber BrandyPilsner Urquell Noilly Prat vermouthPeroni Dew ar's w hiskey The Wine Group

Below-premium Otard cognac AlmadenMilw aukee's Best family Bénédictine liqueur Franzia

Malt Liquor B&B liqueur InglenookOlde English 800 Captain Morgan rum Paul MassonMickey's Malt Liquor Ridgemont Reserve 1792 bourbon

Paul Masson VSOP brandy

Source: Company reports.


Spirits industry restructures According to Beverage Information Group’s Handbook Advance 2014, the US distilled spirits market grew again in 2013, for the 16th year in a row. Demand totaled 210.5 million cases, up 2.3% from 205.8 million in 2012. (A case contains nine liters of beverage product.) The total value of sales at retail in 2013 was $75.8 billion, up 5.2% from 2012’s $72.1 billion. The market is relatively concentrated, with the top five marketers

accounting for 50.3% of volume, and the top 10 accounting for some 71.2%.

Diageo. Following its purchase of Seagram in December 2001, UK-based Diageo PLC has strengthened its position as the US market leader. According to Beverage Information Group’s Handbook Advance 2014, Diageo now holds 18.5% of the US distilled spirits market by volume, selling 39.1 million cases of distilled spirits in 2013.

Beam Global. In 2005, Jim Beam Brands (owned by Fortune Brands) acquired more than 25 wine and spirits brands from Allied Domecq Spirits USA, moving it into the No. 2 spot. In 2005, it accounted for about 10.5% of the market, with sales of more than 17.8 million cases. In 2013, it remained at No. 2

with a 10.9% share on 22.9 million cases. In January 2014, the company agreed to be acquired by Suntory Holdings Ltd. for $16 billion, including the assumption of debt.

Sazerac. The purchase of Constellation Brands’ entire portfolio of value spirits brands in early 2009 catapulted Sazerac Co. to No. 4 from No. 15, with an 8.1% share on sales of 15.3 million cases. The more than 40 brands acquired included Barton, Skol, Mr. Boston, Fleischmann’s, and Montezuma tequila. It climbed to No. 3 in 2013, with a 9.2% share on 19.4 million cases.

Bacardi. Bacardi USA became the No. 2 player in 2004 after acquiring the Grey Goose brand during the year. In 2013, it fell to No. 4 with an 8.3% share on about 17.5 million cases.

Pernod Ricard. After acquiring the remaining Allied Domecq brands in 2005, Pernod Ricard commanded an 8.0% share of the spirits market, selling 13.6 million cases that year. Its share slid to 7.6% in 2006 (on volume of 12.5 million cases), dropping it to fifth place in 2006; it maintained a 7.2% share on 15.1 million cases (in 2013).

In recent years, there has been resurgence in demand in the distilled spirits industry. Reasons for this resurgence include changes in regulations (which have led to increased marketing activity and aggressive media campaigns), trading-up activity (when individuals switch from lower-end products to premium products), increased popularity with younger drinkers, and the growing numbers of those aged 50 and older.

Before this, the distilled spirits industry was beset by consolidations and reorganizations, the moderating drinking habits of a generally mature customer base, and a heightened social consciousness about drunk driving and alcohol abuse. This caused a significant contraction of spirits consumption from a peak of over

B04: TOP 20 PREMIUM DISTILLED SPIRIT BRANDS

TOP 20 PREMIUM DISTILLED SPIRIT BRANDS(Ranked by 2013 sales, in thousands of nine-liter cases)

- - - CASE SALES - - -

BRAND MARKETER TYPE 2012 2013

1. Smirnoff* Diageo Vodka 9,850 9,9302. Bacardi** Bacardi USA Rum 9,323 9,2283. Captain Morgan Diageo Rum 5,675 5,7154. Jack Daniels Brow n-Forman Beverages Whiskey 4,821 4,7925. Absolut* Pernod Ricard USA Vodka 4,646 4,4406. Crown Royal Diageo Whiskey 4,160 4,3107. Svedka Constellation Brands Vodka 3,825 3,9508. Jim Beam Beam Inc. Whiskey 3,153 3,4929. Grey Goose Bacardi USA Vodka 3,451 3,382

10. E&J E & J Gallo Winery Brandy 3,120 3,15011. José Cuervo Diageo Tequila 3,165 3,03012. Skyy Campari America Vodka 2,806 2,85013. Pinnacle Vodka Beam Inc. Vodka 2,550 2,77014. Hennesey Moet Hennessy USA Cognac 2,270 2,42015. Jagermeister Sidney Frank Importing Liqueur 2,445 2,35016. Burnett's Heaven Hill Distilleries Vodka 2,039 2,35017. DeKuyper Beam Inc. Cordial 2,365 2,25118. Ketel One Diageo/Nolet Spirits Vodka 2,100 2,13519. Seagram's 7 Crown Diageo Whiskey 2,170 2,12520. Seagram's Gin Pernod Ricard USA Gin 2,203 2,098

*Includes all f lavors. **Includes full line.Source: Beverage Information Group’s Handbook Advance.


3.0 gallons per capita in the 1970s to a 1998 low of 1.75 gallons. However, per capita consumption has since risen to over 1.8 gallons.

Wine market remains fragmented, but continues to consolidate The US wine industry’s sales rose 3.6% in 2013 to about $29.9 billion at retail, from $28.9 billion in 2012, according to Beverage Information Group’s Handbook Advance 2014. Compared with many other

consumer product categories, the US wine market is fairly concentrated, though to a lesser degree than the beer or distilled spirits industries.

Much like spirits, wine has been enjoying a multi-year rebound in per capita consumption following a precipitous decline. Per capita consumption in 1970 was 1.05 gallons, but consumption peaked in the mid-1980s after taking share from spirits. Consumption then fell sharply until 1994, before beginning its long rally to 2.96 gallons in 2008, according to the Wine Market Council, a wine-industry trade association. In 2013, wine consumption reached 3.08 gallons per capita.

According to Beverage Information Group, the top six US wine marketers in 2013 accounted for about 78% of

volume. They were E.&J. Gallo Winery, The Wine Group Inc., Constellation Brands, Trinchero Family Estates, Bronco Wine Co., and Treasury Wine Estates (formerly Foster’s Wine Estates Americas).

In 2013, E.&J. Gallo Winery maintained its lead supplier position, accounting for 29.3% of the domestic table wine unit case sales. (A case contains nine liters of wine.) The No. 2 producer—The Wine Group, with about 18.0% of the industry’s shipments—retained its position; it had moved up in 2009 from No. 3 on the purchase of some value-priced brands from Constellation Brands in 2008, including Almaden, Inglenook, and Paul Masson. In 2013, Constellation Wines retained the No. 3 position, with a 15.5% share, after falling from No. 2 with the sale of its value brands in 2008. It had moved to No. 2 after it acquired Robert Mondavi Winery Ltd. in the fourth quarter of 2004.

Treasury Wine Estates, Gallo, and Constellation also had a significant share of imported table wine sales in 2013. The leading importer of table wine in 2013 was Deutsch Family Wine & Spirits, with a 14.2% share of the import market, benefiting from the continued rapid growth of its Yellow Tail brand.

TOBACCO

Total domestic tobacco production increased 27.4% to 762.4 million pounds in 2012, but declined 5.1% to 724.1 million pounds in 2013, according to the Economic Research Service of the US Department of Agriculture (USDA), a provider of data and research related to agriculture, food, natural resources, and rural development. In 2014, tobacco production is forecast to reach 809 million pounds, up 12% from 2013.

B05: TOP 20 US WINE BRANDS

TOP 20 US WINE BRANDS(Ranked by 2013 sales, in thousands of nine-liter cases)

- - - - - - - DEPLETIONS - - - - - - -

COMPANY 2012 2013 % CHG.

1. Franzia Winetaps The Wine Group 23,200 25,000 7.82. Barefoot Cellars E & J Gallo Winery 14,400 15,870 10.23. Carlo Rossi E & J Gallo Winery 12,300 12,120 (1.5)4. Sutter Home Trinchero Family Estates 10,788 10,750 (0.4)5. Twin Valley E & J Gallo Winery 9,100 9,100 0.06. Woodbridge Constellation Brands 8,450 8,970 6.27. Peter Vella E & J Gallo Winery 7,135 7,050 (1.2)8. Livingston Cellars E & J Gallo Winery 5,700 5,520 (3.2)9. Beringer Treasury Wine Estates 5,392 5,328 (1.2)

10. Charles Shaw Bronco Wine Co. 5,388 4,983 (7.5)11. Almaden The Wine Group 4,650 4,000 (14.0)12. Black Box Constellation Brands 2,695 3,410 26.513. Arbor Mist Constellation Brands 3,470 3,260 (6.1)14. Inglenook Francis Ford Coppola 3,200 3,200 0.015. Kendall-Jackson Jackson Family Wines 3,084 3,200 3.816. Cupcake Vineyards The Wine Group 3,000 3,150 5.017. Rex Goliath Constellation Brands 2,857 3,060 7.118. Vendange Constellation Brands 2,327 2,800 20.319. Bota Box Ste. Michelle Wine Estates 2,780 2,753 (1.0)20. Chateau Ste. Michelle DVF Wines 2,050 2,579 25.8

Total, top 20 131,966 136,103 3.1Source: Beverage Information Group’s Handbook Advance.


Total US shipments by the three largest domestic cigarette companies dropped around 1.9% in 2013 after falling 2% in 2012, 3% in 2011, 3.8% in 2010, and 10.1% in 2009 (the last attributable to the significant increase in the federal cigarette excise tax).

The longer-term downward trend in cigarette shipments primarily reflects reduced consumption due to higher retail prices (largely because of state excise tax increases) and declining demand. In our view, demand has been dampened by heightened health concerns, anti-smoking advertising campaigns, and restrictions on smoking in public places. Regarding tobacco leaf production, acreage was 355,700 in 2013, and it is

expected to increase to 358,880 acres in 2014, 1% above 2013. Cigarette leaf accounts for over 90% of leaf production.

The global market for cigarettes is more than 10 times that of the US market, based on volume. S&P Capital IQ estimates that worldwide cigarette consumption was flat to up 1% in 2013, on a base of approximately 5.6 trillion units. Philip Morris International is the largest producer of American-style cigarettes for foreign markets. The company shipped 880.2 billion units outside the US in 2013, down 5.0% from the previous year, and far greater than Philip Morris USA’s total of 135.1 billion units, which was up 0.1%.

Three companies control US cigarette market The US cigarette industry is an oligopoly. The three leading cigarette producers control approximately 91.5% of domestic sales. Philip Morris USA Inc. (a division of Altria) accounted for approximately 50.6% of US shipments in 2013, Reynolds American Inc. controlled about 26.0%, and Lorillard Inc. (formerly Carolina Group) controlled around 14.9%.

Philip Morris USA. Philip Morris USA has been the nation’s largest tobacco company since 1983. In 2013, its US cigarette shipments totaled 135.1 billion units, up 0.2% from 2012, giving it an estimated 50.6% domestic market share. Philip Morris USA sells Marlboro, Virginia Slims, and Parliament as its major premium brands. Its principal discount brand is Basic.

H01: Tobacco market share

Altria28.9%

Reynolds American

26.6%

Lorillard15.1%

Others29.5%

US TOBACCO MARKET SHARE—FIRST HALF, 2014

Source: Company reports.

TobacH02: US TAXABLE REMOVALS OF SELECTED TOBACCO PRODUCTS

40

55

70

85

100

115

130

3,000

4,500

6,000

7,500

9,000

10,500

12,000

2002 04 06 08 10 12 2014†

Cigars Snuff Other tobacco products*

US TAXABLE REMOVALS OF TOBACCO PRODUCTS

*Chewing, pipe, and roll-your-own tobaccos. †Estimated based on January to July annualized values.Source: US Alcohol and Tobacco Tax and Trade Bureau.

Cigars, million unitsSnuff, & Other products,

million pounds

240

280

320

360

400

440

480

2002 04 06 08 10 12 2014†

Cigarettes, billion units


Philip Morris USA’s Marlboro family is the largest-selling cigarette brand in the US. In 2013, shipments totaled 117.2 billion units, down 0.7% from 2012.

In early 2009, Altria became the largest manufacturer and marketer of smokeless tobacco products with the completion of its acquisition of UST Inc. Its brands include premium brands Copenhagen and Skoal, and value brands Red Seal and Husky.

Reynolds American. This company was formed in 2004 with the merger of R.J. Reynolds Tobacco Co. (the No. 2 player in 2003) and Brown & Williamson Tobacco Corp. (No. 3 in 2003). The company’s combined portfolio includes premium cigarette brand, Camel, and discount brands such as Doral and Capri. In 2013, Reynolds American’s share of the US cigarette market was 26.0%, down fractionally from 26.5% in 2012. The company is exiting its private-label cigarette business. With its acquisition in 2006 of Conwood LLC, Reynolds American became the second-largest manufacturer of moist smokeless tobacco behind market leader UST. Its brands include premium brand Kodiak and discount brand Grizzly.

Lorillard Inc. Lorillard Inc. (spun off from Loews Corp. in mid-2008) is the third-largest US cigarette company. Its flagship Newport brand is the No. 1 menthol-flavored cigarette brand in the US and the No. 2 premium cigarette brand behind Marlboro. Newport’s total US retail share in 2013 was 14.9%, up from 14.4% in 2012. Despite the overall industry decline, domestic sales of menthol cigarettes have outperformed the industry, disproportionately benefiting Lorillard.

Smokeless and other tobacco products become growth drivers In contrast to cigarettes, sales of both cigars and smokeless tobacco products continue to rise, partially offsetting declines in tobacco consumption through cigarette smoking. A study from the Harvard School of Public Health found that while US cigarette sales declined 18% between 2000 and 2007, from 21.1 billion packs to 17.4 billion, sales of other tobacco products (such as moist snuff, roll-your-own tobacco, and small cigars) increased by 1.1 billion cigarette pack equivalents, offsetting about 30% of the decline in cigarette units. Cigarette sales dropped 4.2% year over year in 2008, followed by declines of 10%, 3%, and 2% in 2009, 2010, and 2011, respectively, according to the latest available data from the Federal Trade Commission (FTC).

We see demand for other tobacco products driven by increased taxation on cigarettes and smoking bans. Other tobacco products typically were taxed at lower rates and, as a result, were cheaper than cigarettes, with small cigars and roll-your-own taxed at 5% to 10% the rate of cigarettes. However, effective April 1, 2009, federal excise taxes on little cigars were increased by $0.97 to $1.01 per pack of 20, essentially bringing the tax rate in line with cigarettes. The tax rate on large cigars and cigarillos rose from 20.719% of the manufacturer’s price per cigar (with a cap of $0.05) to 52.75% (with a $0.40 cap).

Cigars. Large cigar sales increased 37% between 2000 and 2007, but fell approximately 3% to 4.784 billion units in 2007 from a recent peak of 4.93 billion in 2004, according to the USDA. However, demand for small cigars rose 47% in that period. In our view, the dramatic increase can be attributed to lower taxes and fewer marketing restrictions relative to cigarettes. The consumption of large cigars rose to 12.9 billion units in 2011, up 126.3% from 5.7 billion in 2008, while small cigar consumption declined to 0.8 billion units, down 86.4% from 5.9 billion during the same period, according to data from the Centers for Disease Control and Prevention.

Small cigars can be sold in packs of 20, in packages similar to cigarettes, but they are priced significantly lower than cigarettes. In addition, manufacturers had marketed various flavors, such as candy, mint, and fruit flavors, which appealed to younger and starter smokers, until the FDA banned the practice in 2009. Typically, smokers do not inhale cigars, which make them seem to be less harmful than cigarettes; however, they are often perceived as a substitute for cigarettes and are inhaled.

Smokeless tobacco. With annual revenues of over $5 billion, according to S&P Capital IQ’s estimates, the smokeless category is worth just a small fraction of the cigarette market. Although small, the smokeless category is growing versus the decline in the cigarettes. However, it has the benefit of both lower taxation and not producing second-hand smoke. We project the compound annual growth rate (CAGR) in the


smokeless category in the mid-single-digits, as consumers learn more about smokeless products and seek an alternative to cigarettes.

According to the USDA, snuff production in 2011 (latest available) totaled 106.2 million pounds, up 6.5% from 99.7 million pounds in 2010. Use of dry snuff continues to decline, while consumption of moist snuff may be getting a boost from increased restrictions on smoking in public places. As the rate of cigarette consumption declines, we project that the use of smokeless tobacco, such as snuff and leaf chewing tobacco, will continue to increase.

UST Inc. dominated the moist snuff category. With brands such as Copenhagen, Skoal, Red Seal, and Rooster, UST commanded about a 60% market share in 2008, according to industry estimates. However, the company had lost market share to rivals that introduced new, lower-priced products. In 2009, Altria Group acquired UST Inc. According to the latest available retail share data from SymphonyIRI Group, a leading provider of retail tracking data, Altria Group held a 55.4% share in 2012, up from 55.1% in 2011.

INDUSTRY TRENDS

The major companies in the US tobacco and alcoholic beverage industries currently face uninspiring domestic growth prospects. As a result, they have pursued two primary strategies in recent years: reorganizing their business structures via acquisitions and/or restructurings, and aggressively pursuing growth by targeting international markets and developing new products.

Although the US alcoholic beverage and tobacco industries are mature, they remain very profitable. This is particularly noteworthy because consumption has been growing slowly—or even declining, as in the case of cigarettes. Along with rising health consciousness among consumers, greater legal and regulatory restrictions also have stymied growth.

HARD CIDER IS MAKING A COMEBACK…

Hard cider, a fermented apple drink, has been growing in popularity among women who prefer a slight sweetness in their drink. Cider appeals more to women because, according to the results of a survey released in January 2011 by Mintel, a market research firm, nearly 20% of respondents believe it is less gassy than beer, a quality that women prefer. Mintel also stated that men, women, and young consumers new to drinking prefer cider because its taste is less alcoholic than beer.

Hard cider was popular until the mid-1800s but began declining in the second half of the 19th century as people shifted to beer. Cider’s market share dropped further after Prohibition ended in 1933. The category now accounts for a small share of US beer consumption (cider is included with beer in consumption statistics). Over the past three years, however, the industry has witnessed a general decline in beer shipments and, hence, the hard cider category is being targeted as a new source of revenue growth for brewers.

In 2011, retail sales of hard cider surged to $448.8 million, up 23% from 2010, the fourth consecutive year of double-digit growth. According to the Beverage Information Group, a market research firm, cider volume growth accelerated to 54.7% in 2012 from 21% in 2011. In 2012, cider sales at US stores increased 65%, according to estimates by Nielsen. For the 52 weeks ending December 29, 2013, hard cider sales grew 100% in dollars and 101% in cases, according to IRI.

In order to take advantage of this growth, several beer companies are moving into this category. In February 2012, MillerCoors paid $40 million to acquire Minneapolis-based Crispin Cider Co., which produces European-style natural hard apple ciders using fermented unpasteurized fresh-pressed apple juice. In April 2012, Boston Beer rolled out its Angry Orchard cider brand nationally, following its introduction in New England, New York, Maryland, and Colorado in 2011. In May 2012, AB InBev launched Michelob Ultra-Light Cider, the first cider produced and distilled by the company in the US. It has 4% alcohol by content and carries 67% of the calories of traditional ciders.


In August 2012, Heineken NV, which has about 20% of hard cider’s global market share, acquired US importation rights to the Strongbow cider brand from Vermont Hard Cider Co. In December 2012, Vermont Hard Cider was itself acquired by the Irish cider company C&C Group for $305 million. The deal will give C&C Group about a 50% share of the US cider market.

Brewers and cider growers are increasing their production as demand for cider is rising. In 2012, Vermont Hard Cider announced plans to set up a new 100,000-square-foot production facility in Middlebury, Vermont, in addition to its existing 62,000-square-foot facility. The new plant, expected to cost more than $20 million, will increase annual production capacity to 10 million cases from four million cases. According to an article in The Wall Street Journal (October 14, 2012), more than two dozen cideries operate in New York’s Hudson Valley, versus only 11 five years earlier, and there were plans to open several more.

According to preliminary data published in Beverage Information Group’s Handbook Advance 2014, an annual report on alcoholic beverage sales and consumption, Boston Beer dominates the cider category, with a 34.6% market share in 2013, followed by Vermont Hard Cider Co., which had a 22.8% share.

…but is impeded by erratic tax rates Despite cider’s considerable growth, taxes are an issue. The tax levied on the drink is determined by its alcohol and carbonation, both of which can vary. Small changes in production processes or cultivating conditions lead to variability in the product’s alcohol content. When cider’s alcohol content is above 7%, the drink is treated as wine, and a tax of $1.07 per gallon is levied on producers manufacturing more than 100,000 gallons per year. When cider contains fizz or carbon dioxide exceeding 0.39%, the drink is treated as champagne and the total tax then levied is $3.40 per gallon. However, if the alcohol content in the drink is lower than 7%, it is treated as beer: a tax of 22 cents per gallon is levied for large producers, while small producers pay a tax of 17 cents per gallon.

The taxes presently levied are approximately 15 times greater than Congress intended when it set tax rules for wines and associated beverages. The inconstant tax regime is making it difficult for new cider makers to enter the industry. Cider makers and lawmakers are both pushing for a revision to make the tax structure similar to that of beer (which is fixed at 22 cents per gallon), thereby equalizing the tax rules. They also propose to extend the rules to pear hard cider and to increase the cap for cider’s alcohol content to 8.5%.

SPIRITS VOLUMES IMPROVE, PARTICULARY AT THE HIGH END

According to DISCUS, spirits volumes rose 1.9% in 2013, and revenues advanced 4.4%, as consumers continued trading up to premium spirits. Volumes in the high-end and super-premium segments rose 7.2% and 6.3%, respectively, in 2013, after rising 4.8% and 8.9% in 2012. Value spirits were down 1.2%, after an increase of 1.8% in 2012. In the value segment, the rate of growth for vodka, tequila, and rum were down 0.6%, 0.4%, and 2.8%, respectively, in 2013. High-end premium Irish whiskey volumes increased 20.2% in 2013, after a 13.0% rise in 2012.

Secular shift from beer to spirits For decades, beer has been Americans’ preferred alcoholic beverage, and it had captured more than 50% market share (by revenues) of the US alcohol industry. In 2000, beer commanded 55.5% market share by revenues, versus 28.7% for spirits and 15.7% for wine, according to DISCUS. However, the position of these segments has been changing, with beer losing market share to spirits and wine. By 2013, beer’s market share had fallen to 48.3%, while spirits climbed to 34.7% and wine to 17.0%. According to DISCUS, the share of distilled spirits grew in 2013 due to the global whiskey renaissance, as well as companies’ continuous modernization, product innovations, and “sophisticated line extensions.” It further noted that increased access and a convenient shipping environment also helped the sale of distilled spirits. According to data from DISCUS, the export value of distilled spirits from the US is three times that of beer, as consumers’ demand for American whiskey is growing around the globe.

Gallup, a consulting firm that provides data-driven news based on US and world polls, conducts an annual survey to assess shifts in beverage preferences in the US. In its latest survey, conducted in July 2013, Gallup found similar preferences for beer and wine: 36% of the respondents preferred beer and 35% preferred


wine. Spirits, at 23%, placed third. Gallup found that the preference for beer fell across most age groups, with a significant drop observed in the young-adult group aged 18 to 29 (41% in 2012–13, from 71% in 1992–94), followed by middle-age adults aged 30 to 49 (43%, down from 48%). There was a slight increase among those considered old-age adults aged 50+ (29%, from 28%).

Meanwhile, preference for spirits among young adults grew significantly: 28% of young adults now prefer spirits, versus 13% in the early 1990s. On a gender basis, Gallup found that 53% of males showed a preference for beer, followed by 22% for liquor and 20% for wine; however, 52% of females preferred wine, followed by 24% who preferred liquor and 20% who preferred beer. Although the percentage of Americans who drink alcohol has stayed fairly steady in the 60% range since the early 1990s, US drinkers’ preferences have shifted to the point that young drinkers are now just as likely to say they drink wine most often as to say beer, according to Gallup.

Gallup also pointed out the difference in drinking preferences for whites and non-whites. According to Gallup, 38% of whites preferred beer (versus 34% for non-whites), 36% preferred wine (versus 34% for non-whites), and 22% preferred spirits (versus 26% for non-whites).

Spirits makers innovate to expand market The spirits industry is burgeoning with innovation as beverage companies are experimenting with different ideas to increase their sales figures, according to a Wall Street Journal article dated September 18, 2013. Industry analysts told the newspaper that even in a fragile economy, US consumers are trading up, with ultra- and super-premium spirits growing at volumes well above the market rate. The article cited how the addition of cotton candy and whipped cream flavors of Pinnacle vodka contributed to a 13% increase in Beam Inc.’s first half 2013 sales. In 2009, the company had introduced black cherry–flavored Red Stag bourbon whose success was in doubt before the launch. However, ever since its debut, Red Stag sales have risen in double-digit percentages every year, the company’s general manager told The New York Times in an article published on June 24, 2013.

Other distillers followed the success of Red Stag. In October 2011, Brown-Forman introduced Southern Comfort Fiery Pepper. Kissed caramel and iced-cake versions of Smirnoff helped Diageo’s North American operating profit to rise 9% in the year ended in June 2013, according to The Wall Street Journal article.

Around the world, flavored liquor is also making a splash, according to the September 2013 Wall Street Journal article. Diageo introduced products such as Snapp, a champagne-inspired apple drink marketed to women in Kenya and Nigeria, as well as rum brand Shark Tooth, which is sold in Russia. The company launched Baileys Chocolat Luxe, a flavored Irish cream liqueur, globally in 2013.

Spirits makers have set up innovation centers to carry out the trials of new products, as they believe demand for new products or varieties would drive sales and enable them to increase prices. Makers of these flavored spirits want to direct their focus toward new markets but also need to ensure that they do not alienate their core whiskey drinkers.

Further, whiskey makers such as Beam are accelerating efforts to cater to female consumers, which are the most under-represented group, according to Beam. The company acquired 2 Gingers Irish whiskey from Kiernan Folliard in December 2012 and, since that time, has rapidly expanded distribution. The whiskey is gaining popularity among female drinkers, mainly due to its mild, non-burning flavor. In 2011, the company acquired the Skinnygirl brand, a low-calorie margarita, in a move to expand its offering to weight-conscious women. Beam expanded the brand to include a variety of vodkas and wines. While regular vodkas have around 100 calories per each 1.5-ounce serving, Skinnygirl vodkas have only 77 calories, as they have less alcohol content.

The concept has gained huge popularity, driving other spirit makers to launch similar versions. Restaurants, too, have followed suit by attaching phrases like “skinny” and “slender” to their menus, as stated in trade publication Advertising Age’s report dated May 21, 2013. Restaurants such as Red Lobster and The Kona Grill are using low-calorie mixers to reduce the calorie count of regular liquor brands. In the article,


Technomic, a food industry research and consulting firm, pointed out that the mention of words such as “skinny” in restaurant menus jumped 44%, year on year, in the first quarter of 2013.

Whiskey/bourbon boom US whiskey, which had only a small presence abroad until about 25 years ago, has been increasing its footprint outside the US. Bourbon (also known as “America’s native spirit”), which has been a staple bar product in the US for many years, is now seeing demand growth in different parts of the globe. According to DISCUS, in 2013, US exports of American distilled spirits touched a record high of nearly $1.51 billion, driven by premium bourbon and Tennessee whiskey, which exceeded the $1 billion mark for the first time.

Brown-Forman Corp. says its Jack Daniel’s brand, a leading US whiskey, is available in more than 135 countries and generates more than half of its sales outside the US. According to the latest available data from Drinks International, a monthly trade magazine covering the global spirits, wine, and beer markets, Jack Daniel’s ranked eighth among whiskeys in 2012 (as measured by year-on-year volume sales performance of spirits brands with worldwide sales exceeding 1 million nine-liter cases). Another well-known brand, Jim Beam bourbon, owned by Beam Inc., is sold in more than 110 countries and ranked 11th by Drinks International; it also generates a majority of its sales outside the US. Along with these established brands, smaller brands such as Maker’s Mark bourbon (owned by Beam Inc.) are also moving abroad. According to a forecast from Euromonitor International, by 2016, 70% of annual US whiskey growth will come from outside the US.

Companies have been devising plans to meet the anticipated surge in demand for their products. For instance, Brown-Forman, in its fiscal 2013 fourth-quarter earnings call in June 2013, announced that it spent $100 million in fiscal 2013, including funds allocated for distillery expansion in Lynchburg and a cooperage in Alabama. In its second-quarter 2013 earnings report, Beam Inc. noted that it has accelerated advertising outlays for Jim Beam in key markets such as the US, Australia, and Germany.

Although US whiskey brands are starting to gain attention abroad, they still have a long way to go. According to Euromonitor International, US whiskey currently holds only around 1% of the global spirits market and only 10% of the global whiskey market (both by volume). Although companies are concerned about a decline in European sales due to a weakly growing economic environment, Germany’s desire for American bourbon has provided some relief for US spirits companies. In fact, Germany is the second-largest export market for Beam Inc., which says Germany is the world’s third-largest bourbon market after the US and Australia. Brown-Forman derives 27% of its sales from Europe. Euromonitor estimates that global volumes of bourbon and other US whiskeys will grow at a CAGR of 1.6% from 2007 to 2016.

US whiskey’s main competitor is Scotch whiskey, which has seen a surge in demand from emerging markets. The Scotch Whiskey Association, an industry trade group, says that while the US and France remain the world’s biggest markets for Scotch, exports to emerging countries such as Singapore, Taiwan, South Korea, and Brazil increased significantly in 2011. According to estimates from Euromonitor, demand for single malt Scotch is expected to grow at a 16% rate in China and 19% in India between 2010 and 2015. For the year ended June 2012 (latest available), exports from Scotland grew 12% to £4.3 billion, according to data from the Scotch Whiskey Association quoted in an article in the Financial Times dated January 25, 2013. The association estimates that over the next four years, around £2 billion will be invested in the sector to build new distilleries. Although a large part of this investment is expected to come from giants such as Diageo, which dominates the market, several smaller players will also contribute to the expansion, the article noted.

Beam Inc. agrees to be acquired by Suntory Holdings Limited In May 2014, Beam Inc. was acquired by Suntory Holdings Ltd. for $16 billion, including the assumption of debt. The transaction joins Beam’s leading brands in bourbon and whiskey with Suntory’s Japanese whiskies.

Tariff reductions aid US spirits sales abroad Preference for US whiskey around the world is evidenced by exports of US distilled spirits, which grew 1.7% in 2013 and 11.9% in 2012, following an increase of 16.5% in 2011. Growth in US spirits exports should receive a significant boost in the near term, following the passage of free trade agreements (FTA)


with Panama, Columbia, and South Korea. An FTA with South Korea took effect on March 15, 2012, when the country eliminated the 20% import duty on bourbon and Tennessee whiskey. The country will also phase out import duties on other US spirits (currently 20%) over a period of five years. Although South Korea entered into an FTA with the European Union (EU) on July 1, 2011, the duty on imported Scotch and Irish whiskies is currently 15%, thereby giving a competitive advantage to US products. The EU is also in talks for an FTA with India, which would lower import duties (currently at 150%) on high-end alcohol products from the EU.

China also plans to cut import taxes on a number of luxury goods, including alcohol. The country became the fifth-largest consumer of wine in the world in 2013 by volume, according to Vinexpo/IWSR (International Wine and Spirit Record). China expects a significant increase in the import of alcoholic products following a reduction in import duties, which are currently as high as 50% on liquor. Current import tariffs on luxury goods are in the range of 15%–50%; a cut of around 2%–15% is expected. (Vinexpo conducts exhibitions every other year in Bordeaux for international wine and spirits participants, and it is owned by the Bordeaux Chamber of Commerce and major companies in the industry. IWSR is a market research firm that publishes a monthly trade magazine.)

WINE CONSUMPTION, SALES ROSE IN 2013

Wine consumption rose 2.1% in 2013, after gains of 1.9% in 2012 and 3.1% in 2011; retail sales advanced 3.6%. The on-premise segment rose 2.1%, after a 0.6% gain in 2012. Off-premise declined 6.7% in 2013 after growth of 2.3% in 2012 and 3.4% 2011, according to Beverage Information Group’s Handbook Advance 2014. On-premise sales accounted for 43.6% of total retail wine sales in 2013, compared with 47.4% in 2012. Off-premise sales accounted for 56.4% of total retail sales in 2013, slightly up from 52.6% in 2012.

Following a significant decline in 2008 and 2009, the champagne industry rebounded in 2010 and continued to recover in 2011. According to Le Comité Interprofessionnel du Vin de Champagne (CIVC), the trade association that represents all the grape growers and houses of Champagne in France, following the downturn of 2009, when fewer than 300 million bottles of champagne were shipped, the industry rebounded in 2010 (320 million bottles shipped), and improved further in 2011 (323 million bottles). In 2012, CIVC reported a 4.4% drop in shipments to 308.8 million bottles. Shipments fell a further 1.5% in 2013 to 304 million bottles.

Lower-priced domestic wines continued to outpace imports, rising 3.2% in 2012, according to the latest available full-year information, while imports fell 2%. Among imports, Italy continued to lead with a 25% share of total imports (by dollars) in the nine months ended September 2013, followed closely by France (24%) and Australia (9.9%). Volumes from Italy rose 5.1% in the year ended September 2012 compared with the 12 months ended December 2011, while volume from France and Australia increased 14.2% and 9.9%, respectively, during the same period. Top volume gainers for the year ended September 2012 included Spain (up 45.9%), Chile (+38.2%), and Argentina (+37.5%), while Portugal and Germany fell 15.7% and 5.9%, respectively.

Wine industry changes tactics for Millennials According to a survey published by the Wine Market Council in January 2014 and reported in Wine Enthusiast magazine, Millennials are well represented in the category of “high-end wine buyers” (buyers who purchase wine bottles that cost more than $20 at least once a month). The survey noted that, compared with people in other demographic groups, Millennials experiment more with newer wines or wines with which they are not familiar. The survey results also indicate that wine consumption patterns are evolving. People want newer varieties, in addition to old standbys like Chardonnay and Merlot, and are willing to pay a higher price.

The group’s consumption is also high. According to data from the Wine Market Council, as quoted in a New York Times article dated December 25, 2012, around 51% of Millennials consume wine at least once a week. These young buyers have become the new target for wine companies, which are switching up their offerings to suit these consumers. Wine companies believe that this group looks for convenience and flexibility in any


offering and, therefore, new packaging offers companies a way to gain acceptance for their products. Companies are packaging wine in plastic containers, boxes, and aluminum cans to break the age-old convention of “wine in a glass bottle.” New brands such as Stacked Wines offers wine in plastic cups stacked in a box, while Bonfire Wines offers wine in a pouch. These companies also believe that the packaging should be attractive. To address this, Bonfire Wines designed its pouch covers in florescent colors. Companies are also targeting this demographic by advertising their products through social media platforms.

Amazon tries again in wine Before the 2012 holiday shopping season, Amazon announced the launch of its online marketplace— Amazon Wine—through which the company would sell wine in the US. As of May 2014, the marketplace featured over 5,000 wines and ships six bottles of wine for $9.99 to 22 states and Washington, D.C. Amazon charges wineries $40 a month to join Amazon Wine, plus a 15% fee on each sale. The wineries ship their products directly to buyers. In 2009, Amazon pulled back from an effort to sell and ship wine after its partner, New Vine Logistics, suspended operations and went bankrupt.

According to data from Wine.com, a San Francisco–based online wine retailer, online sales account for only 1.5% of total wine sales in the US. Amazon’s foray into this segment could help it to capture some of that online share, but the company also has to deal with varying state regulations governing the sale of alcoholic beverages. According to a Wall Street Journal article dated October 26, 2012, while some states such as California and Washington do not impose any annual limits on the quantity of wine that can be shipped directly to buyers, other states such as Utah and Kentucky treat shipping directly to customers as a felony. Texas requires someone at least 21 years old to take delivery of wine.

According to the article, New York State fined Wine.com for shipping food products in a gift basket along with the wine. According to New York State law, alcoholic beverages and food cannot be shipped together. The article noted that the company incurs regulatory compliance costs of around $2 million annually.

DRINKING IN MODERATION MAKES WAY FOR TRADING UP

A trend toward moderation in alcohol consumption has colored the national mood for a generation. In the 1960s, sales for the US alcoholic beverage industry grew at a solid rate of approximately 5% annually. In the 1970s, sales slowed a bit, particularly for bourbons, which were the first major casualty of the move toward white spirits and lighter alcoholic beverages in general.

The 1980s were a mixed bag. The early part of the decade benefited from good growth in white spirits, and light beer’s increased popularity attracted new beer drinkers. In the mid-1980s, however, the nation’s move toward alcohol moderation accelerated. Many states changed their laws to raise the minimum drinking age. Federal excise taxes on alcoholic beverages were increased sharply in 1985 and then again in 1991.

In the early 1990s, these factors, combined with the onset of a national recession, took a toll on the industry’s unit sales growth, which came to a virtual stop. However, the late 1990s saw a surge in consumption due to favorable demographic trends and rising levels of disposable income.

Despite the burst of the dot-com bubble in 2001 and the ensuing economic recession, consumption continued to grow. Several factors—including product innovations, aggressive marketing, falling input costs, and increased availability of affordable imports—have helped to sustain modest growth since 2000.

DEMOGRAPHIC “SWEET SPOTS”

The number of consumers reaching legal drinking age has risen steadily in recent years, according to the US Census Bureau. This demographic “sweet spot” has become a growth driver for wine and spirits. Recent trends indicate that these categories are gaining favor over beer and pose a threat to the potential growth in beer volumes. S&P Capital IQ (S&P) attributes this, in part, to an aggressive marketing push by wine and spirits companies in recent years, new products and line extensions, and the claims that these products are healthier than beer.


According to a survey conducted in July 2014 by Gallup, a market research firm, 41% of Americans prefer beer over wine and liquor—one of the highest rates recorded since beer tumbled in 2005. Around 31% of US

drinkers prefer wine, while 23% prefer liquor. The percentage of drinkers preferring wine grew significantly from the 32% in 2010, while the percentage for beer was near the lowest in this survey since 1992. According to the survey, beer preference has declined most among the 18-to-29 age group, where it dropped from 71% in the early 1990s to 41% in 2012–13. The preference for beer among consumers in the over-50 age group increased slightly, from 28% in 1992–94 to 29% in 2012–13, while the preference for wine grew to 46% from 37% during the same period.

As per a study published in January 2011 by Nielsen, a research and ratings firm, these young consumers (aged 21–34) will grow to 40% of the total drinking population of the US in the next 10 years. According to the same study, although a majority of these young consumers still preferred beer, they purchased more wine and spirits than the older generation did at the same age. In addition, premium wine sales

should benefit from increasing numbers of consumers in the over-55 age group, who tend to consume more wine (especially premium wine) than beer. Growth in this choice demographic should also lead to growth in spirits, which older consumers tend to prefer as such beverages have an aura of greater sophistication.

Preference of alcoholic beverages is also different among white and non-white populations in the US. As per a study by UK-based Diageo PLC published November 2011, the non-white population, which is growing at a faster rate than whites and thus is increasing its share of the total population, prefers spirits more than whites do. According to Diageo, 33% of non-whites prefer spirits compared with just 20% of whites. The US Census Bureau projects non-Hispanic whites to be only 46% of the total US population by 2050 (versus 64% in 2010) and, consequently, Diageo sees a rise in spirit preference among US drinkers.

BEER WEAKNESS

In both 2010 and 2011, total beer consumption fell, slipping 1.9% in 2010 to 6.4 billion gallons and 1.5% in 2011 to 6.27 billion gallons. Consumption increased 0.5% to 6.3 billion gallons in 2012, and then decreased 1.6% to 6.3 billion gallons in 2013.

S&P thinks that the muted beer demand is a result of strong competition from the wine and spirits categories, a move toward healthier living, a lack of innovation and creativity in the beer market, and to a lesser extent low wage growth among beer’s core male legal drinking age audience.

USPOP-1: US RESIDENT POPULATION PROJECTIONS

US RESIDENT POPULATION PROJECTIONS(In thousands)

- - - - % CHANGE - - - -

AGE GROUP 2015 2020 2060 2015- 2020 2015- 2060

Under 5 yrs. 21,051 21,808 24,748 3.6 17.6% of total 6.6 6.5 5.9

5 to 13 yrs. 36,772 37,769 44,758 2.7 21.7% of total 11.4 11.3 10.6

14 to 17 yrs. 16,695 16,582 19,782 (0.7) 18.5% of total 5.2 5.0 4.7

18 to 24 yrs. 30,983 30,028 35,239 (3.1) 13.7% of total 9.6 9.0 8.4

25 to 44 yrs. 84,327 88,501 106,303 4.9 26.1% of total 26.2 26.5 25.3

45 to 64 yrs. 83,839 83,238 97,404 (0.7) 16.2% of total 26.1 24.9 23.2

65 yrs. & over 47,695 55,969 92,033 17.3 93.0% of total 14.8 16.8 21.9

Total population 321,363 333,896 420,268 3.9 30.8

Racial composition (%):

Black 13.2 13.4 14.7AIAN 1.3 1.3 1.5Asian 5.3 5.7 8.2NHPI 0.2 0.2 0.3Tw o or more races 2.6 2.9 6.4

Note: Totals may not add due to rounding.

Black refers to African American; AIAN American Indian and Alaska Native; NHPI = Native Haw aiian and Other Pacif ic Islander.Source: US Census Bureau.


With healthier living determining beer-drinking habits, light beer consumption continued to dominate the US market in 2013, with a 49.1% share of all beer consumption (down 4.1%), but this segment lost share slightly after claiming a 50.4% share in 2012. Still, Bud Light, a light beer, is now the leading brand in the world; it surpassed its stable-mate Budweiser in 2003. In fact, four of the top six selling domestic brands in 2013 were light beers.

STREAMLINING, GLOBALIZATION BOOST PROFITS

Despite maturing growth trends, the US alcoholic beverage industry remains a highly profitable business. Although net sales growth in recent years has been relatively slow (about 2%–4% a year), profitability as measured by operating margins is high relative to most other consumer goods. S&P estimates that operating margins for US alcoholic beverage companies are above 20% on average, well above the mid-teens percentage range typical of packaged food companies.

In order to shore up profits during a period of slowing growth rates, the multinational corporations that dominate the alcoholic beverage industry have reorganized in recent years. At least a half-dozen major companies—including Constellation Brands Inc., InBev SA, Diageo, Beam Inc. (formerly part of Fortune Brands Inc.), Allied Domecq PLC, Anheuser-Busch Companies Inc., and Molson Coors Brewing Co.—have realigned their businesses by selling some divisions, selling themselves, and/or buying others. Corporate structures have been streamlined, and globalization and consolidation have helped the industry to maintain its above-average profit margins.

Consolidating global beer market In 2008, the US market underwent major consolidation with InBev’s buyout of Anheuser-Busch at the end of the year and the merger of the US and Puerto Rican operations of Molson Coors Brewing Co. and SABMiller plc in mid-2008. Prior to 2008, US brewers and alcoholic-beverage makers rushed to establish a presence in the potentially lucrative developing markets of Asia, Eastern Europe, and Latin America. Domestic brewers have extended their reach abroad in a variety of ways: through exports, joint ventures with local brewers and distributors, and purchases of equity interests in local brewers.

US companies hardly are going unchallenged in this race. Foreign brewers, confronting similar issues in their home markets, also are expanding beyond their borders. One result has been a rising concentration in global sales. In 1980, the world’s top 10 brewers produced less than a quarter of the total international sales volume; by 2005, they accounted for just over 60%, according to Impact, a trade publication covering the alcoholic beverage industry. More interestingly, the top four—Anheuser-Busch InBev, SABMiller, Heineken NV (pro forma for its buyout of Mexico’s FEMSA in 2010), and Carlsberg Breweries A/S—held just over 50% share of the global beer market in 2009, according to beer consultancy Plato Logic.

Anheuser-Busch. In terms of market expansion, the most aggressive US brewer in recent years has been Anheuser-Busch, the world’s largest beer maker. Since 1993, the company has made deals in China, Japan, Brazil, India, Italy, France, Switzerland, and Spain. A-B also has established joint ventures in South America with Compañía Cervecerías Unidas SA (Chile) and Buenos Aires Embotelladora SA (BAESA, Argentina). These investments augment Anheuser-Busch’s already strong positions in its main export markets (Canada, the United Kingdom, and Japan) and complement its activities in numerous other markets.

In June 2013, Anheuser-Busch InBev acquired the remaining 50% share in Mexico’s Grupo Modelo SA de CV for $20.1 billion (it had obtained the first 50% interest in the acquisition of Anheuser-Busch in 2008). Modelo is the brewer of the Corona Extra, Modelo, and Pacífico brands. Consumption of Corona has grown very rapidly in recent years: in 2012, it was the sixth most popular beer in the US. In September 2014, speculation that AB InBev may put in a bid to acquire SABMiller resurfaced.

SABMiller. In July 2002, South African Breweries PLC acquired Miller Brewing (then a subsidiary of Philip Morris Cos. Inc.) for $5.4 billion and renamed itself SABMiller plc. Before its acquisition, Miller Brewing formed a number of alliances with brewers and other beverage companies in Japan, Brazil, China, and the UK. In mid-2005, SABMiller acquired Columbian brewery Grupo Empresarial Bavaria, displacing Anheuser-Busch as the world’s second-largest brewer. SABMiller remained in second place after the


purchase of Anheuser-Busch by InBev SA in 2008. SABMiller attempted to acquire Heineken in September 2014, but the initial offer was rejected.

Molson Coors. In early 2005, Adolph Coors Co. completed a merger of equals with Canada’s No. 1 brewer, Molson Inc., making it the fifth-largest brewer in the world at the time. In 2001, foreign sales accounted for just 4% of Coors’ total sales. Since then, Coors has aggressively expanded its international presence. In February 2002, the company completed its acquisition of the Carling business of UK-based Bass Brewers from Bass parent Interbrew SA International—sales that represented 40% of total Coors sales. This deal made Coors the second-largest brewer in the United Kingdom, behind UK-based Scottish & Newcastle PLC, and gave it nearly 19% of the UK beer market. In June 2012, the company acquired the Central and Eastern European brewer StarBev LP for $3.5 billion, thereby expanding its presence in emerging markets. Should AB InBev ever be successful in acquiring SABMiller, the joint firm would probably be required to divest MillerCoors on antitrust grounds, and Molson Coors appears to be the likeliest buyer.

For many years, Coors has exported its products to numerous countries, including Australia, Holland, Ireland, Japan, and the Caribbean islands. The company, which has US and foreign production facilities, has stepped up its international activities in recent years by establishing licensing agreements with foreign brewers.

BEER CONSOLIDATION DRAMA FROTHS UP

In recent years, the slowing demand for beer in developed markets such as the US, the UK, and Canada has spurred consolidation in the industry. Most industry players have been seeking inorganic methods for growth amid the decline in shipments. As a result, the industry has witnessed several big-ticket deals. In 2008, Belgium/Brazil–based InBev SA acquired US-based Anheuser-Busch for $52 billion; the company then changed its name to Anheuser-Busch InBev. In 2011, London-based SABMiller acquired Australia-based Foster’s Group Ltd. for $10 billion. In 2010, Dutch brewer Heineken NV acquired Mexico’s FEMSA Cerveza for $7 billion.

Consolidation has also enabled industry players to expand their footprints in emerging markets, thereby reducing their exposure to declining demand in the developed markets. An example of this strategy is the $3.5 billion acquisition of StarBev LP by Denver-based Molson Coors Brewing Co., completed in June 2012. The acquisition of StarBev will provide Molson Coors with access to the emerging markets of Central and Eastern Europe (CEE), where StarBev operates nine breweries and generated $1 billion in sales in 2011. In 2011, approximately 97% of Molson Coors’ sales came from the UK and Canada; in 2012, this percentage declined to 84%. According to Molson Coors, although the CEE region is facing an economic slowdown, the historical trend of that region’s beer market suggests strong upside potential. The company also stated that the acquisition provides a platform on which to grow its key brands Staropramen and Carling and gives it access to StarBev’s portfolio of more than 20 brands. The company expects to generate approximately $50 million in pretax operational synergies by 2015.

AB InBev/Modelo transaction completed In June 2012, Anheuser-Busch InBev (AB InBev), in a move to further consolidate its position, entered into an agreement to acquire the remaining 50% share in Mexico’s Grupo Modelo SA de CV that it did not already own for $20.1 billion (the first 50% interest was obtained through InBev’s acquisition of Anheuser-Busch in 2008). The transaction, which faced regulatory hurdles, finally closed on June 4, 2013, giving AB InBev control of more than 50% of US beer industry market share (by volume); in 2012, its market share was 46.3% and Modelo had 5.7%, according to Beer Marketer’s Insights, a brewing industry trade publication. With the completion of the merger, the company also expands its presence in another emerging market of Latin America (Mexico), complementing its strong position in Brazil.

According to the company, beer accounts for a 70% share of the alcoholic beverage market (by dollar value) in Mexico, and such share is expected to increase going forward. According to Euromonitor International, volume in the Mexican beer market is expected to grow at a compound annual growth rate (CAGR) of around 3% between 2011 and 2016. Furthermore, AB InBev, which owns brands such as


Budweiser, Stella Artois, and Beck’s, will control Modelo’s main brand, Corona Extra, which is exported to more than 180 countries.

To assuage antitrust concerns, Modelo entered into an agreement to sell its 50% joint venture interest in Crown Imports to Constellation Brands Inc., the other joint venture partner, for $1.85 billion. Crown Imports is responsible for the distribution, marketing, promotion, and pricing of the Modelo brands in the US. With 100% control of this venture, we think prospects for Constellation have improved dramatically from an earnings and cash flow perspective, and we think its longer-term growth opportunities are bright. The agreement allows Constellation to add other brands to its distribution portfolio, including the faster-growing categories of imports (albeit only non-Mexican brands) and craft brands.

According to a November 2012 article in Reuters, the number of craft brewers in the US had increased to more than 1,600 in 2010 from 537 in 1990 and only eight in 1980. The article noted that craft beers account for around 6% of the US beer market share (by volume), according to data from the Brewers Association, a trade group for small independent brewers. Since brewers are banned from distributing beer directly to retailers in 38 states, they must rely on independent wholesalers to act as intermediaries. The merger talks raised concerns among the craft brewers who noted that AB InBev’s increased market power could be used to inhibit wholesalers from delivering craft beers to the market.

On January 31, 2013, the US Department of Justice (DOJ) filed a lawsuit in US District Court (District of Columbia) to block AB InBev’s acquisition of Modelo, stating that it would hamper competition in the US beer market, which would result in consumers paying more for beer and having fewer choices.

To further ease antitrust concerns over the acquisition, AB InBev sold another $2.9 billion worth of Modelo’s assets to Constellation, bringing the total deal value to $4.75 billion, including the $1.85 billion deal discussed above. AB InBev agreed to divest Modelo’s Piedras Negras brewery in Mexico to Constellation, including licensing rights to Modelo’s five brands.

On April 19, 2013, the DOJ announced that it had reached a settlement with AB InBev and Modelo that requires the companies to divest Modelo’s entire US business (including licenses of Modelo brand beers, its Piedras Negras brewery, its interest in Crown Imports, and other assets) to Constellation Brands.

THE APPEAL OF EMERGING MARKETS

Consolidation in the global beer industry has accelerated in recent years. At the beginning of the new millennium, brewers focused primarily on Europe; their attention since has swung to China. Merger and acquisition opportunities continue to attract brewers eager to improve distribution capabilities, realize cost savings, increase diversification, enhance growth prospects, and reduce competition. In the last few years, as developed market growth has plateaued, brewers have been relying on emerging market acquisitions to bolster results. Below, we review important target markets.

China. With a population of 1.3 billion and a rapidly growing economy, China has become an attractive place for brewers to do business. According to a December 2012 report published by the Kirin Institute of Food and Lifestyle, the research arm of Kirin Holdings Company Ltd., per capita beer consumption was 33.3 liters in 2011, which is low versus other countries (76.6 liters in the US, 71.6 liters in the UK, and 107.6 liters in Germany). Nevertheless, consumption continues to grow strongly, with the 2011 (latest available) total up around 90% from 2000.

China surpassed the US to become the biggest consumer of beer in 2003, and held the No. 1 position in 2004 with the consumption of 28.6 billion liters, or 19% of the world market. In 2011, China’s share rose to 25.9% of the world market to 48.98 billion liters, from 22% in 2008. The US market remained a distant second with 12.6% of the market at 23.86 billion liters. Impact projects that China’s beer market will expand at least 5% annually for the next five years, with per capita consumption potentially doubling in the next decade.


In the past few years, China has witnessed numerous business transactions. In order for investments in China to provide the significant growth potential that companies seek they must overcome the major problems of unfavorable pricing and fragmented distribution.

In 2004, Interbrew purchased a controlling interest in Malaysian Lion Group’s Chinese beer business. Added to its 24% stake in Zhujiang (another Chinese brewer), Interbrew is now the No. 3 brewer in China. Of China’s top three brewers, only Beijing Yanjing Beer Group did not have a foreign partner. China Resources Snow Breweries is 49% owned by SABMiller, and Tsingtao is 19.9% held by Asahi Breweries.

Eastern Europe. With uninspiring growth prospects in mature Western European markets, the brewing multinationals viewed Eastern Europe as fertile ground. Unlike other developing regions, Eastern Europe is already an established beer-drinking stronghold, adding to its attractiveness. Eight Eastern European markets placed among the top 20 global markets in terms of per capita consumption in 2004. The Czech Republic has the highest per capita consumption in the world, according to the World Health Organization’s (WHO) “Global Status report on alcohol and health 2014”, at 12.5 liters per person over the age of 15.

Of the top five beer markets, Russia experienced the highest growth rates in recent years. However, the Russian market contracted by 8% in 2013 due to slower economic growth and outlet restrictions there.

The declining beer consumption in Europe is evidenced by decreasing per capita beer consumption across a majority of the European countries. According to a September 30, 2011, article in just-drinks, a web-based global industry research firm, per capital beer consumption increased in only four countries—Estonia, Norway, Sweden, and Malta—between 2008 and 2010, while the UK and the Netherlands registered major declines in beer consumption. According to a report by Ernst & Young, consumption of beer in Europe fell 8% between 2008 and 2010, and nearly 260,000 brewing-related jobs were lost during that period.

We think the outlook for this region in the next few years could be challenging, particularly on significant boosts in excise taxes for cigarettes and alcohol as governments seek to bolster struggling finances. Effective January 2010, Bulgaria hiked its cigarette excise tax 43%, while the Czech Republic raised excise taxes on beer 33% and had plans to raise its tax on spirits 8% next year. In Russia, beer taxes rose 200% on January 1, 2010, with some observers estimating a rise of 20% in prices due to higher taxes and raw materials costs.

Mexico and Latin America. Benefiting from favorable demographics and a temperate climate, Latin America is viewed by the large global brewers as a promising region. Beer consumption has been rising, helped principally by improved economic activity in some key markets. While pockets of economic weakness remain in several Latin American countries, market reforms and rising levels of prosperity could make the region even more attractive over the long term. According to SABMiller, beer sales volume grew by 8% in Latin America in 2011, mainly due to impressive growth recorded in Peru, Argentina, and Chile. According to the company, lager sales volume was up 3.0% in 2013. Many markets within Latin America have only a few local brands, so this could be an opportunity for beer imports.

Accordingly, Interbrew combined with Brazilian brewer AmBev in 2004, creating InBev SA, the world’s largest brewer. A similar scenario in 2005 saw SABMiller acquire leading Columbian brewer, Grupo Empresarial Bavaria, to become the second-largest brewer globally.

In January 2010, Heineken agreed to buy the beer operations of FEMSA, the second-largest brewer in Mexico with a 43% share, in an all-stock transaction for $7.6 billion, after SABMiller dropped out of the bidding. FEMSA’s brands include Tecate and Dos Equis. The transaction increased Heineken’s exposure to Brazil, where FEMSA had a 9% share, and its overall exposure to emerging markets to about 40% of its operating profits, up from over 30%.

In August 2011, Kirin Holdings, agreed to pay $2.6 billion to acquire a 50.45% stake in Schincariol, one of the largest beer and soft drink manufacturers in Brazil; the acquisition was completed in November. Schincariol’s brands include Nova Schin and Devassa beers and the company owns 13 production facilities.


Running against this trend is Molson Coors, which sold its Brazil-based Kaiser brewery in late 2006. The brewery had been losing market share since it was acquired in 2002.

More recently, given the slowing growth in developed economies, some brewers, like SABMiller, are opting to build scale in slowing markets in order to harvest efficiencies and cost cuts. In December 2011, SABMiller purchased Australian brewer Foster’s Group Ltd.

Promise for wines Not only is China a major attraction for brewers, but it holds promise for wine makers as well. According to a study by Vinexpo/IWSR (International Wine and Spirit Research), wine consumption in China grew at an annual rate of 7% per year from 2002 to 2006, and was expected to accelerate to 13% per year from 2006 to 2011. According to the latest figures by Vinexpo/IWSR, China became the fifth-largest wine consumer in the world in 2011 (supplanting the UK), and was projected to show additional growth of more than 50% between 2011 and 2015. According to Vinexpo/IWSR, by the end of 2015, per capita wine consumption in China will be in the range of 1.9 liters–2.0 liters, up from 1.15 liter per person in 2009 as reported earlier by the Wine Institute. (Vinexpo conducts exhibitions every other year in Bordeaux for international wine and spirits participants, and it is owned by the Bordeaux Chamber of Commerce and major companies in the industry. IWSR is a market research firm that publishes a monthly trade magazine.)

Given its potential for higher per capita consumption, China is becoming an important investment market for international wine makers. Les Grands Chais de France (one of the largest producers in France), Macro-Link Holdings Ltd., and CITIC Guoan Group are among the few major wine companies to invest in this market.

Although Mexico is not a major export market at present, it holds much future promise for US wine companies, due to the country’s rising per capita income. In addition, the elimination of the 20% tariff on US wine imports at the beginning of 2004, under terms of the North American Free Trade Agreement (NAFTA), has boosted Mexico’s potential.

TOBACCO SEES DECLINING DEMAND

From 1994 through 2003, cigarette consumption declined an average of approximately 1.9% annually; in 2004, volume fell an estimated 2.5%. The rate of decline then slowed, with a 1.1% drop in 2005 and a 1.3% decrease in 2006, but then accelerated again, falling about 4% in 2007 and 2008, after a step-up in the Master Settlement Agreement (MSA) payment and a significant increase in excise taxes. Following the significant increase in the federal excise tax on cigarettes (to $1.01 per pack from $0.39) in April 2009, volumes dropped at a high-single-digit rate, but then moderated to a low to mid-single-digit decline in the following years as consumers adjusted to higher prices.

The reduction over time is attributed to higher retail prices to cover higher excise taxes, increased awareness of the health risks of smoking, and restrictions on where people can smoke. For cigarettes, unit volumes are dropping, while prices are going up. While this situation is leading to net revenue gains, the growth rate is generally below that of a decade ago.

Regulation impedes tobacco discounters S&P thinks that legislative actions have raised cigarette production costs and narrowed the price gap between premium cigarettes and their deep-discount alternatives. The Model Statutes, passed by MSA signatory states, require nonparticipating manufacturers (NPMs) to either join the MSA or make refundable deposits to the states. Subsequent “allocable share” legislation passed by nearly all of the MSA states no longer allows smaller manufacturers to receive a refund of their payment, forcing them to raise prices. (The MSA is discussed in further detail later in this section.)

Since several NPMs were not in compliance with the Model Statutes, the National Association of Attorneys General had drafted legislation that would allow states to enforce the escrow payments. This legislation would ensure that rules are consistent from state to state. As steps are taken to ensure compliance with legislation, S&P thinks that cigarette production costs have risen, especially for deep-discount manufacturers. This model legislation has been adopted in full or in part by virtually all of the 46 MSA states.


Menthol provides domestic growth opportunities We see an opportunity for growth in the US market, despite its mature nature and persistent decline in overall demand. In our view, manufacturers can take advantage of recent growth in the menthol category, which likely will aid top-line expansion.

The menthol cigarette category has experienced growth in domestic market share, moving from about 26% of cigarettes sold in 2003 to 31.7% in the first half of 2014, according to Lorillard Inc., maker of the No. 1 menthol brand, Newport. With the menthol market steadily gaining share of the domestic tobacco industry, tobacco companies have positioned themselves to take advantage of premium pricing in the menthol segment. Reynolds markets two leading menthol brands: Kool, the first menthol brand, was introduced in 1933; Salem, the first filtered menthol brand, was introduced in 1956. Reynolds has since extended its flagship Camel line to include menthol and has de-emphasized its Kool brand. In 2009, it introduced Camel Crush, a regular cigarette with a menthol capsule smokers squeeze to release the flavor.

Also taking advantage of this potential growth opportunity, Philip Morris USA introduced a line extension of its Marlboro brand, Marlboro Menthol, which it had hoped would compete effectively in the premium segment against Newport. With aggressive promotional activity on this brand, we think that Menthol has accounted for about half of the total Marlboro brand growth in recent years.

FDA regulation of tobacco passed in 2009 More than 10 years after the first efforts to grant authority to the US Food and Drug Administration (FDA) to regulate tobacco products, President Obama signed the Family Smoking Prevention and Tobacco Control Act into law on June 22, 2009. This law gives the FDA the authority to regulate the manufacture and marketing of tobacco products, including the power to reduce nicotine content and regulate chemicals in cigarettes.

The law has banned most tobacco flavorings, which are considered appealing to first-time smokers, particularly children. Menthol is excluded for now, but the FDA was required to set up an advisory panel to study and report back in a year as to whether menthol should be included in the ban. This exception has been highly criticized, with opponents pointing out that menthol cigarettes are disproportionately sold to African-Americans. The new advisory board met for the first time in the beginning of April 2010 and menthol was the first matter tackled by the members. Given the importance of menthol to the industry, the industry’s nonvoting representative is Dr. J. Daniel Heck, principal scientist at Lorillard Inc., the leading manufacturer and marketer of menthol cigarettes. (For a more detailed discussion on the regulation of menthol cigarettes, see “Tobacco Regulatory Issues” in the “Current Environment” section of this Survey.)

The law also tightens regulations on advertising and marketing of tobacco products. Color advertisements and store displays are to be replaced by black-and-white-only text, except in publications with an adult readership of 85% or more. Cigarette makers were required to stop using words such as “light,” “mild,” and “low” on packages and advertising by June 2010. All outdoor advertising of tobacco within 1,000 feet of schools and playgrounds is banned. Companies are also prohibited from sponsoring sporting or cultural events and using giveaway promotions. New products, such as smokeless tobacco and other products purported to have lower health risks, have to undergo approval processes that require a demonstration of their health benefits.

Altria poised to benefit We see Altria Group Inc., the market-share leader, as a beneficiary of these regulations, since competitors’ efforts to take share either through novel advertising and marketing, or new product development, will now be hampered. We think more innovative, leading-edge marketers, such as Reynolds American Inc., which has come up with alternative tobacco products such as dissolvable tobacco pellets and strips, will have fewer and less effective tools to compete with Altria. We are not surprised that Altria has long been a proponent of FDA regulation.

We also think passage is incrementally positive for large manufacturers versus small, niche ones. It will be easier for larger companies to comply with the provisions since they already have extensive infrastructure to deal with current regulations. This bill has been discussed for many years now and, set against the backdrop of a declining demand environment, we think that the fees to pay for the creation and administration of a


new FDA tobacco oversight department and the additional costs of compliance will be passed on to consumers. We think smaller manufacturers will struggle, as their costs to comply with the new regulatory environment will increase disproportionately due to their small size. Some may even have to close.

TOBACCO LITIGATION ENVIRONMENT

In the past decade, the tobacco industry has faced numerous liability claims for health problems related to smoking. Notably, the 1998 Master Settlement Agreement (MSA)—between the tobacco industry and attorneys general of 46 states, Washington, D.C., and five US territories—resolved a class action suit brought by the states. Under the MSA, the tobacco industry must pay $250 billion over 25 years to reimburse states for healthcare costs related to smoking. The industry has recently won several of the largest class action suits in US history, but continues to face numerous legal challenges from individuals.

The number of claims filed against the US tobacco industry numbers in the thousands. Nonetheless, the industry has been, and likely will continue to be, largely successful in defending itself against the claims of individuals. In general, although the litigious environment persists, it appears to be less threatening to industry cash flow than in previous years, as new and innovative legal strategies by prosecutors have largely dissipated.

Graphic warning labels blocked on First Amendment grounds In November 2010, the US Food and Drug Administration (FDA) introduced 36 new graphic warning labels designed to cover half of a cigarette pack’s surface area. (At the time, all packages had only small text warnings.) These new labels are required under the provisions of the Family Smoking Prevention and Tobacco Control Act, which authorized the FDA to regulate the tobacco industry, and are intended to remind smokers of the detrimental health impact from smoking. The FDA accepted public comment on the 36 proposed labels, and in June 2011 it chose nine. All manufacturers were expected to display the new graphic warnings for packages produced after September 2012.

However, in February 2012, US District Court (District of Columbia) Judge Richard Leon ruled in favor of the tobacco companies—Lorillard Inc., R.J. Reynolds (Reynolds American Inc.), Commonwealth Brands (Imperial Tobacco Group PLC), and Liggett (Vector Group Ltd.)—that had filed a lawsuit against the FDA’s labeling requirement, citing infringement of free speech. The judge ruled that the government-imposed actions to print large graphic warnings on cigarette packs would violate the constitutional right of free speech. The government appealed this decision, and a hearing was held at the US Court of Appeals (District of Columbia) in April 2012, in which the FDA asked the appeals court to undo the ruling of the lower court. According to a Wall Street Journal article dated April 10, 2012, although the court could not arrive at a final decision during the hearing, it suggested that the lower court might not have properly ruled on the matter.

In August 2012, the US Court of Appeals (District of Columbia) ruled that cigarette companies do not need to comply with the federal rules requiring their products to show graphic warning images. Judge Janice Rogers Brown wrote that the FDA “failed to present any data showing that enacting their proposed graphic warnings will accomplish the agency’s stated objective of reducing smoking rates.” According to the court, the warning labels violated the tobacco companies’ rights to free speech under the First Amendment. This is because the labels not only warn the consumers of the bad effects of smoking, but also advise them to stop buying these products.

In December 2012, this court refused the federal government’s appeal to reconsider the ruling to strike down the warnings label requirement. However, in April 2013, the US Supreme Court ruled against the tobacco companies, allowing the FDA to continue to implement the tobacco law, according to a Wall Street Journal article dated April 22, 2013. The FDA is now working on proposing a new set of labels to discourage smoking, though this could take years, as it will have to go through the federal rulemaking process.

Slow FDA approval process solidifies shares of Big Tobacco Over 4,000 applications filed with the FDA since 2009 are still awaiting approvals from the agency, of which 3,500 belong to products that are already being sold in the market and the remaining 500 are requests for approvals of new products.


The FDA has justified the delay in approving new products by claiming that the application review is time consuming, as it needs to assess whether the new product poses more health risks compared with current tobacco products and whether it will increase tobacco consumption.

During the period between February 2007 and March 2011, the law allowed the sale of new products while still under review, but noted that the agency could order their removal at any time. Under the law, the agency is required to give its ruling no later than 180 days after the new product’s application is submitted. Starting in March 2011, new tobacco products had to get approval from the FDA before being introduced to the market. The FDA had not approved a single product until June 2013, when it cleared two of Lorillard Inc.’s products, Newport Non-Menthol Gold Box 100s and Newport Non-Menthol Gold Box.

In the meantime, the delay in new product approvals is helping the big tobacco players by keeping the small players from entering the market. According to the article, Philip Morris, which controls about 50% of the tobacco market in the US, formed a coalition with the Campaign for Tobacco-Free Kids, a nonprofit group, to negotiate a bill in support of the FDA. The move was opposed by small tobacco players, who believed that it could bolster the market shares of the big tobacco companies and could make it difficult for them stay in the market.

MSA deal reached, boost to cigarette manufacturers In December 2012, the three major US tobacco companies (Altria Group Inc., Lorillard Inc., and Reynolds American Inc.) announced that they had reached an agreement with 17 states, the District of Columbia, and Puerto Rico, under which they will receive about $1.5 billion worth of credits against future MSA payments related to the 1998 Master Settlement Agreement (MSA). The tobacco companies were required to pay around $206 billion to 46 states to compensate for the health costs they incurred due to smoking. Tobacco companies had held back the payment of around $7 billion for the period between 2003 and 2012, stating that the erosion in their market shares set off their obligation.

Chart H05: THE NEW CIGARETTE HEALTH WARNINGS

THE NEW CIGARETTE HEALTH WARNINGS

Source: US Food and Drug Administration.


The tobacco companies have announced that they will release funds worth $4 billion in escrow accounts and will receive credits against the payment made over the next five years, under the terms of the MSA, according to an article in The Wall Street Journal dated December 18, 2012. Reynolds, the article noted, has paid more than $3 billion into escrow accounts and expects to receive over $1 billion in credits. Altria’s Philip Morris expects to receive credits worth $450 million and Lorillard $198 million. The companies expect more states to join in.

DOJ trial: Big Tobacco wins, by losing The US Department of Justice’s legal action against domestic cigarette manufacturers—i.e., United States of America v. Philip Morris Inc., et al.—began in 1999. When the case was initially filed against Altria Group Inc., British American Tobacco PLC, Brown & Williamson Tobacco Corp., Liggett Group Inc., Lorillard Tobacco Co., and R.J. Reynolds Tobacco Co., the DOJ asserted four claims under three federal statutes: Count I under the Medical Care Recovery Act; Count II under the Medicare Secondary Payer provisions of the Social Security Act; and Counts III and IV under the Racketeer Influenced and Corrupt Organizations Act (RICO).

The government’s case was severely weakened in late 2000 when US District Judge Gladys Kessler dismissed two of its claims against the industry. Judge Kessler ruled that the government could not seek reimbursement for medical expenses paid out under Medicare and the Federal Employees and Health Benefits Act because it had long ignored that avenue for refunds. However, the suit could proceed under RICO.

According to Judge Kessler, the government’s allegations that the industry had concealed and deceived the public about the dangers of smoking met the threshold of a RICO claim. Thus, the case was tried only on Counts III and IV, alleging that the defendants violated the civil provisions of RICO.

In August 2006, the court ruled that cigarette companies violated civil provisions of RICO, but refused to order the companies to pay $10 billion for a smoking-cessation program or $4 billion for a “counter-marketing” youth advertising program sought by the government. The court did find, among other things, that the companies must remove terms such as light or ultra-light from cigarette packages and publish statements indicating that smoking is addictive and is not safe. While the ruling was technically a loss for cigarette manufacturers, the lack of financial penalties made the ruling a victory for the industry overall in terms of immediate risk to cash flows.

One of the main allegations is that the tobacco companies marketed light and low tar cigarette brands as being less dangerous to smokers’ health than regular cigarettes, while knowing that was false. Cigarette manufacturers contend their actions were not only legal and non-fraudulent, but also to a certain extent mandated by the government. For example, the Federal Trade Commission (FTC) regulates how tar and nicotine levels in cigarette smoke are measured, while Congress mandates exactly what warnings must appear on cigarette cartons.

The ruling was appealed on the grounds that the remedies are constitutionally impermissible because they essentially constitute regulation of the industry, a right reserved solely by Congress. In October 2006, the US Circuit Court of Appeals for the District of Columbia issued a stay of all remedies in the case pending final appeal. In June 2010, the US Supreme Court dismissed all appeals, which we see as a large victory for tobacco companies, as it removed uncertainty about the potential disgorgement of approximately $280 billion in past industry profits. It was expected that the case would be returned to Judge Kessler for action on other remedies pertaining to corrective advertising.

Engle’s new angle The Engle case was filed in 1994 on behalf of all smokers in the US, but the breadth was reduced to the state of Florida in 1996. In July 1999, the jury returned a verdict in favor of the plaintiffs; by July 2000, the court awarded punitive damages of $145 billion. The defendants posted bond exceeding $2 billion in order to appeal.

In May 2003, Florida’s Third District Court of Appeals set aside the circuit court jury’s decision in the Engle case, overturning the punitive damages award. Plaintiffs asked for a review, and in May 2004, Florida’s


Supreme Court agreed to review the Engle verdict. Finally, on July 6, 2006, the Florida Supreme Court decertified the Engle class and reversed the state court jury’s award of $145 billion in punitive damages. Former class members were allowed to file individual lawsuits by January 11, 2008; the State Supreme Court estimated that there are 700,000 members. However, according to Altria, as of December 31, 2013, Philip Morris USA faced 3,200 cases in-state courts and 1,200 cases in federal courts.

In our opinion, the Engle class action case was a significant victory for the tobacco industry. Not only was the $145 billion verdict reversed, but the class was also decertified due to the lack of commonalities in the class members’ claims. This set a favorable precedent for the tobacco industry, because the Florida Supreme Court concluded that certain issues decided in the case might be considered to be resolved for any potential future cases. We think that the ruling implied an easing of the legal risks for the industry, a lessening threat to cash flows, and a likely reduction in the exposure to class action suits.

At what Price? The Sharon A. Price, et al. v. Philip Morris Inc., et al. class action case, filed in the Madison County Circuit Court in Illinois, had a unique approach. Rather than claiming that smoking made them sick, plaintiffs had in essence sued Philip Morris Inc. for false advertising, alleging that Altria defrauded them by suggesting that Marlboro Lights cigarettes were less hazardous to smokers’ health. While the judge ruled against Philip Morris, that decision was later overturned on the grounds that Altria was specifically authorized to use descriptive names such as light and low tar by the Federal Trade Commission. We think that the resolution of the Price case sets an additional favorable precedent for the major tobacco companies, further lowering the risk to industry cash flows.

Schwab case dampens prospects for plaintiffs On September 25, 2006, a federal district court granted class certification to a lawsuit seeking up to $200 billion in damages. The case—Barbara Schwab, et al. v. Philip Morris USA Inc., et al.—appears to be a hybrid of recent legal actions against cigarette manufacturers. The suit was filed under RICO statutes, alleging that companies defrauded consumers who believed light cigarettes were safer than other brands. Plaintiffs are not seeking compensation for injury; rather, they are seeking reimbursement for a part of the cost of cigarettes purchased.

Although the trial was set to begin January 22, 2007, the US Circuit Court of Appeals granted a review of the class in November 2006 and issued a permanent stay of all trial activities. (Defendants’ appeal of the class certification is based on claims that the plaintiffs not only lack commonality across the class, but that the ruling runs counter to precedent set in federal and state court decisions.) As had been widely expected, in April 2008, the US Circuit Court of Appeals reversed the certification. The court ruled the group could not be treated as a class given that it was likely that each smoker had a different reason for choosing light cigarettes over regular ones. Thus, those smokers will have to file their own separate lawsuits. Given the probable expense, however, we think it is not financially viable for plaintiffs’ lawyers to proceed further.

Lights class actions The vast majority of these class actions had been not active, with more and more courts denying class certification or rejecting claims. The US Supreme Court reviewed the Good case to resolve whether federal law preempts state lawsuits arising from claims that light cigarettes make misleading health claims. In December 2008, it found that federal labeling laws do not protect companies marketing light cigarettes from being sued in-state lawsuits for false advertising. While this ruling was a surprise, given recent trends that favored federal over state regulation, we think that the financial implications are limited, since money is sought not for physical harm, but for “overpayment” by consumers. Additionally, fraud claims are generally not well suited for class action treatment. (See the litigation discussion in the “Current Environment” section of this Survey for recent updates.)

Florida widow wins $23.6 billion lawsuit against Reynolds On July 18, 2014, Florida widow Cynthia Robinson won a $23.6 billion lawsuit against Reynolds, one of the largest recent judgments on the industry. In 2006, Robinson and her attorneys filed a lawsuit against


Reynolds, arguing that the company was aware that cigarettes were addictive and caused lung cancer, but was negligent in telling smokers about those risks.

HOW THE INDUSTRY OPERATES

In addition to being highly regulated and heavily taxed, both the US alcoholic beverage and tobacco industries are far-reaching, mature, and consolidated. Still, there are many differences between the two. For this reason, we will consider the operations of each industry separately.

ALCOHOLIC BEVERAGES: AN OVERVIEW

Beer, wine, and distilled spirits compete in the highly regulated alcoholic beverage marketplace. Each category of beverage has its own unique characteristics, which we consider briefly here.

US beer industry Crude versions of beer have been in existence almost as long as recorded civilization. It has long been a popular drink in many countries, partly because it is relatively easy to make. Beer consists chiefly of malted barley, and/or other grains including rice, corn, wheat, flavored with hops (a cone-like flower), yeast as a fermenting agent, and, sometimes, other ingredients.

The domestic brewing industry once consisted of hundreds of small breweries located in towns throughout the country. After the passage of prohibition, most of these breweries went out of business, resulting in a major consolidation of the industry. Those that remained in operation produced beer for export, or switched to manufacturing soft drinks. Advances in refrigeration allowed beer to be produced year-round, while advances in trucking allowed the remaining breweries to dominate the industry once prohibition was repealed.

Grains in the brewing process are typically sourced domestically, while hops used are often a blend of domestic and European grown. The most popular beers, such as Budweiser and Bud Light, are brewed with rice to produce a crisper lighter taste. Anheuser-Bush Companies is the largest purchaser of rice in the US.

Given the large number of brewed beverages produced over the years, “beer” today is an umbrella term covering a wide range of related drinks distinguished by the type of yeast used, among other factors. Beer varieties include bitter (a beer brewed with more hops and a lighter malt than mild beer), lager (a light beer that matures for a longer time at a low temperature), ale (similar to, but heavier than, lager), and stout or porter (dark ales produced from the brewing of roasted malt).

In the US, beer drinkers long have preferred lagers because of their lighter taste until recently. Since the health-conscious 1980s, reduced-calorie or “light” beers have grown in popularity, mostly at the expense of fuller flavored brews. Accordingly, four of the top five most popular brands in the US are light beers, and now account for more than 50% of US sales volume.

In the past few years, however, beer drinkers have become increasingly fickle in their tastes. Perhaps tiring of mass-produced US style lagers, they have thirsted for variety in the form of imported and “craft” beers. Industry observers define craft beers as brews produced by small breweries (called microbreweries) that typically specialize in beer brewed with 100% malted barley instead of less expensive grains.

The brewing process is generally uniform among beer companies. However, the level of vertical integration among the largest US brewers varies by company. The most vertically integrated is Anheuser-Busch, the nation’s leading brewer in terms of both volume and revenue. Through its ownership of subsidiaries that perform many tasks other than brewing, Anheuser-Busch minimizes the impact of raw material supply shortages and helps the company’s brewing activities to operate at optimal efficiency levels.

For example, Anheuser-Busch obtains its raw materials both internally and from independent sources. Through its Busch Agricultural Resources subsidiary, Anheuser-Busch conducts rice drying and milling (along with research activities), operates numerous grain elevators throughout the country, and conducts


farming activities for important grain ingredients in various parts of the country. Its Metal Container Corp. subsidiary manufactures beverage cans for use by Anheuser-Busch and others, while its Eagle Packaging Inc. subsidiary supplies 100% of the company’s requirements for liner materials used in certain parts of its beer packages. Another wholly owned subsidiary, Anheuser-Busch Recycling Corp., is one of the world’s largest recyclers of aluminum beverage containers. However, with the company’s acquisition by InBev in 2008, some of these divisions have been sold, resulting in less vertical integration.

Wine Wine, like beer, has been enjoyed by humankind for millennia. Wines are produced around the world, with types differing by the variety of grapes used. Other factors that can differentiate wines include the topography of the vineyard, the climate in a particular vintage year, and methods used in the fermenting process (such as fermenting in oak casks or in stainless steel vessels).

White wines, often made from light-colored grapes, but also made from darker grapes if the juice is extracted with minimal contact with the grape skins, are generally lighter in taste than red and blush wines. Red wines typically are produced with darker grapes, and the skins are allowed to stay with the juice, often through the fermentation process, providing color and flavor. Blush wines also are made from darker grapes, but the juice is only allowed to stay with the grape skins long enough to draw partial coloration.

Today, industry observers categorize wines as follows: table wine (about 92% of US consumption), champagne and sparkling wine (5%), dessert and fortified wine (3%), vermouth and aperitifs (less than 1%), and wine coolers (less than 1%).

Table wines are the most popular and fastest-growing type of wine in the US. They contain 7% to 14% alcohol by volume, and they are traditionally consumed with food. Domestically produced table wines, which account for just under three-fourths of all US consumption, comprise varietals (made from a single variety of grape) and nonvarietals (made from a blend of two or more kinds of grapes). Varietals constitute the bulk of US consumption, with chardonnay being the most popular of the white wines. Of the reds, cabernet sauvignon is the most popular variety; white zinfandel is the most popular of the blush wines.

Table wines that retail at less than $6.00 per 750-milliliter (ml) bottle are generally considered to be generic or “jug” wines, so called because they are often packaged in large jugs or boxes, while those that retail at $6.00 or more per bottle are considered premium wines. The premium wine category is generally divided into three segments: popular premium ($6.00 to $12.00 per bottle at retail), super-premium ($12.01 to $15.00), and ultra-premium (more than $15.00).

For 2014, the US Department of Agriculture (USDA) forecast a grape crop of 7.94 million tons, an 8% drop from the prior year. Approximately 89% of all US grapes used for making wine are from California, with about 6% from Washington. In California, winegrowers project that some 3.90 million tons will be crushed in 2014, down 8% from 2013. In 2012, production was estimated at 4.39 million tons of grapes, up 13% from 2011’s 3.87 million tons. The 2011 figure itself was down 3.0% from 3.99 million tons of grapes in 2010, which in turn was down 2.7% from 4.1 million tons in 2009, according to the California Field Office of the National Agricultural Statistics Service.

In accordance with purchasing agreements, wine companies normally buy grapes from many different suppliers each year to minimize the impact of a poor harvest at any one supplier. Most of the grapes required for production by US wine companies are grown domestically, principally in California and New York. Sourcing from Chile (a significant grape producer) is common in times of grape shortages.

Once grown or obtained by the winery, grapes are crushed at company facilities and prepared for storage as wine. Normally, the wine is bottled and sold within 18 months after the grape crush. Wine inventories are usually at their highest levels in November and December, immediately after the crush of each year’s grape harvest.

To have a vintage date, a table wine must be made at least 95% from grapes harvested, crushed, and fermented in the calendar year shown on the label, and the wine must be labeled with an appellation of origin. For an appellation of origin (such as California’s Napa Valley) to appear on the label, at least 75%


of the wine must be derived from grapes grown in the appellation area indicated. Wine is normally distributed through wholesalers or state-level alcoholic beverage control agencies.

US spirits industry Distilled spirits manufacturers normally obtain their raw materials—principally grains—through purchases from various sources via contractual arrangements. They also make purchases in the open market. Grains are mashed at company distilleries, and the finished products—such as Jim Beam bourbons and Jack Daniel’s whiskeys—are aged for varying amounts of time, depending on the product. Like wine, distilled spirits are normally distributed through wholesalers or state-level alcoholic beverage control agencies. Distilled spirits products generally are classified as white goods, brown goods, and specialties.

White goods. Named for their clear or nearly clear color, white goods include vodka, gin, rum, and tequila. Vodka claims the majority of the US market for white goods, accounting for 32.0% of US distilled spirits consumption in 2013, slightly below the 32.3% in 2012, but up from 31.0% in 2009. Rum is the second-largest category (at about 12.4%), followed by tequila and gin.

Brown goods. Also named for their color, brown goods consist of Canadian, Scotch, Irish, and other whiskeys, bourbon, and blends. The majority of brown goods sold in the US consist of imported whiskeys (54% of the total for brown goods, and about 14% of all spirits), followed by domestic straight whiskey, primarily bourbon (about 34% of brown goods, and 9% of all spirits), and domestic blends.

Specialties. This catchall category includes both high-priced products, such as cognacs and imported liqueurs, and some of the industry’s least expensive offerings, such as domestic cordials, ready-made cocktails, and mixed drinks. The three major specialty categories are brandy & cognac, cordials & liqueurs, and cocktails & mixed drinks.

TOBACCO: A NATIVE AMERICAN CROP

Tobacco use has been traced to the indigenous peoples of North America, who were growing and using tobacco by the time Europeans began exploring the continent in the sixteenth century. Once immigrants began to settle on the continent’s eastern coast, they employed the land’s rich soil, temperate climate, and vast amounts of arable land in the cultivation of crops, including tobacco. By the mid-1800s, the US had become the world’s heaviest per capita grower and user of tobacco.

Although tobacco was a big trading product in the 1800s, Americans who used it either chewed it or smoked it in a pipe. A domestic commercial industry for tobacco products did not evolve for many years; brand-name goods had not yet been created.

In the early 1900s, cigarette smoking gradually became the preferred way to enjoy tobacco, while cigar smoking and tobacco chewing became socially unacceptable in many places. The growing popularity of mass-produced branded consumer goods also helped the cigarette industry. In addition, the introduction of cigarette-making machines let manufacturers meet the nation’s growing demand for cigarettes.

Tobacco typology The two most common types of tobacco produced in the US today are flue-cured and burley. Together, they account for about 94% of total US production. Other types include dark air-cured, dark fire-cured, Maryland, and cigar filler.

Most of a cigarette’s tobacco taste comes from flue-cured tobacco. This tobacco is made from a relatively light species of tobacco leaf, which is prepared for use by being aired over heat. It is produced in North Carolina (the largest producing state), as well as in Virginia, South Carolina, Georgia, and Florida.

Burley tobacco is a relatively dark species of tobacco leaf, which requires very little preparation before use. Kentucky is the largest producer of burley; it is also grown in Tennessee, Virginia, North Carolina, Ohio, Indiana, West Virginia, and Missouri.


Production and distribution Three groups form the backbone of the US tobacco industry: farmers, dealers, and manufacturers.

Farmers. The nation’s crop of leaf is grown by tobacco farmers located mainly in the southeastern US, where the climate is favorable for this crop. Tobacco farmers generally sell their flue-cured and burley tobacco at public auction to the highest bidder.

Until October 2004, tobacco leaf prices were supported under an industry-funded federal program that originated with the Agricultural Adjustment Act of 1933. Although amended many times over the years, the program’s basic components have remained in place. Specifically, in exchange for limiting production via allotments and quotas, US tobacco growers were guaranteed minimum prices through price supports.

The price support system made US-grown tobacco more expensive than most non-US tobacco, resulting in a declining trend in exports. The American Jobs Creation Act of 2004, which was signed into law in October 2004 by President George W. Bush, contains Title VI (titled “Fair and Equitable Tobacco Reform”) that provides for the buyout of US tobacco growers’ quotas, effectively eliminating the price support system. In the wake of this abrupt shift to market economics, production of tobacco dropped sharply, as did prices.

Dealers. Tobacco dealers act as the intermediaries between farmers and manufacturers. They select, buy, ship, process, pack, store, and finance leaf tobacco either for manufacturers’ accounts or for resale to them. Tobacco dealers generally are paid fees and commissions for their services.

Although tobacco product manufacturers occasionally purchase leaf tobacco at auction, dealers have increasingly taken over this function. Dealers let manufacturers withdraw capital from the labor-intensive tobacco leaf processing business and put it toward the more profitable business of marketing finished tobacco consumer products.

Manufacturers. Following a cigarette manufacturer’s purchase of tobacco leaf, the tobacco is graded, cleaned, stemmed, and re-dried. Then it is stored for aging for up to three years. Manufacturers maintain large inventories of leaf tobacco to support their production requirements, and because of the lengthy curing process. For leading producers, the manufacture of cigarettes is highly automated.

Finished products are sold principally to wholesalers (including distributors), large retail organizations, vending machine operators, the armed services, and others. International sales often are handled by either company subsidiaries or licensees, which market the products directly or through export sales organizations.

WHAT DRIVES DEMAND?

Although the alcoholic beverage and tobacco industries differ in many ways, they are similarly affected by the following consumer-related factors:

Price and value The quantity of alcoholic beverage and tobacco products that a nation consumes tends to remain steady through recession and prosperity. In contrast, the quality of the products purchased—as gauged by the comparative per-unit cost—is directly related to real disposable personal income. A decline in disposable income puts downward pressure on the prices of consumer products, as people shift away from buying premium-priced brand-name products in favor of lower-priced brands and private-label goods.

In the tobacco sector, discount cigarette brands had captured nearly one-third of the market by early 1993. Then, Philip Morris USA Inc. slashed the price of its popular Marlboro cigarette brand by 20%. (The day on which the cut took place was dubbed “Marlboro Friday.”) Following Philip Morris’s lead, most other branded cigarette producers instituted price cuts. Soon after these went into effect in mid-1993, discount cigarettes’ market share plummeted. Price hikes on premium brands in 2003 gave discount cigarettes a bump up in market share. However, this has steadily eroded until recently. Reynolds American estimates that deep-discount brands manufactured by companies that are not original participants in the Master Settlement Agreement (MAS) account for approximately 14% of US industry shipments. In the face of a


weak economy and significant federal and state excise tax hikes, we expect a reversal in market-share gains to continue as consumers seek cheaper alternatives. As an example, discount volumes at Lorillard jumped 3.5% in 2012 after rising approximately 16% in 2011 and around 30% in 2010 and 37% in 2009, compared with an overall company volume decline of nearly 1.4% in 2012. In 2013, Lorillard’s leading discount brand, Maverick, decreased 5.3% year on year. For the first half of 2014, Maverick’s domestic wholesale shipments decreased 6.3% compared with the first half of 2013.

The alcoholic beverage industry experienced a similar scenario in the early 1990s, as value-priced beer brands, such as Busch, had not established a significant presence in the brewing industry. Nevertheless, virtually all of the major brewers market beer products that target most price points. Although low-priced beers generally reap lower profit margins than high-priced brews, they help maintain production efficiency by keeping brewing capacity utilization at high levels.

As the US economy gradually improved in the early 1990s, the leading brewers successfully encouraged consumers to trade up by implementing wholesale price increases on the lower-priced beers. A decade later, consumers continued to trade up to premium brands, but brewers began to lose market share to wine and spirits due to changes in both demographics and tastes.

However, in the current environment, in the context of a slow economy, we have seen some evidence of trading down as sub-premium beers have strengthened and some on-premise consumption (i.e., at bars and restaurants) has shifted to off-premise consumption (i.e., at home), as we have seen in the past. Interestingly, in 2010, the major brewers took a different tack in raising pricing by narrowing the price gap between premium and sub-premium by focusing price increases on the sub-premium tier, which encouraged a return to trading up.

Additionally, while the trend toward off-premise consumption favors beer over spirits, over the past two years, spirits companies have been successfully launching new pre-mixed cocktail products targeting the off-premise market.

Foreign markets With the US population increasing at an annual rate of only about 1%, the domestic market for all alcoholic beverages has limited growth potential. However, fast-rising populations in developing markets outside the US offer attractive opportunities for growth.

According to US Department of Commerce projections, the world’s developing countries will expand much more rapidly in the future than developed countries. In 1950, approximately two-thirds of the world’s population was located in less-developed countries; now the figure is 80%. Future population growth is expected to occur almost entirely in Africa, Asia, and Latin America, according to the Census Bureau’s Global Population Profile. Accordingly, US alcoholic beverage and tobacco companies have expanded abroad rapidly in recent years.

US demographic trends and consumer attitudes Demographic changes affect the demand for consumer goods in general; alcoholic beverage and tobacco products are particularly sensitive. Principal among these changes in the US is the aging of the population. This is positive for wine and distilled spirits producers, whose customers tend to be older.

Beer and tobacco products, however, tend to be consumed in greater quantities by young adults. At the beginning of the current decade, the 21- to 27-year-old age group was experiencing strong growth, something that did not happen in the 1980s and 1990s. This increase in the number of individuals reaching legal drinking age was positive for producers of alcoholic beverages and tobacco.

America’s increased interest in healthy living, largely attributable to the baby boom generation (those born between 1946 and 1964), has hurt the consumption of alcoholic beverage and tobacco products in recent years. It also has encouraged the public to call for increased government regulation of these industries.


INDUSTRY TRAITS

The alcoholic beverage and tobacco industries are distinguished by their degree of concentration, strong profitability, and high barriers to national and international markets. In addition, they are subject to considerable taxes and regulation.

Concentrated and profitable The US alcoholic beverage and tobacco industries have undergone substantial consolidation over the years. Declining domestic consumption trends, a highly mature marketplace, and a steady rise in legal and regulatory burdens have spurred many manufacturers to join forces with competitors; others have perished. This market condition has bestowed upon these producers the benefits that oligopolists typically enjoy: cartel-like pricing practices and abnormally high profit margins, cash flows, and investment returns.

Ironically, government regulations imposed on the tobacco industry over the years have helped make the business more profitable. For example, all forms of electronic media advertising were banned in 1971; these restrictions have kept cigarette producers’ marketing costs well below the levels they otherwise would have been. At the same time, this has reduced competition by making it extremely difficult for new companies to grow brand awareness and capture market share.

Big barriers to large-scale success The initial barriers to entry into the US alcoholic beverage and tobacco industries are not that high, and many start-up companies can find a local or regional niche. Although microbreweries and small wine makers may achieve local success, such firms often have difficulty attaining profitability and may find it virtually impossible to go national. Economies of scale in manufacturing, distribution, and marketing create high barriers to the national and global markets.

The capital needed to build manufacturing facilities—and the costs associated with operating virtually any consumer packaged goods business on a national scale—are substantial. Large established brands also have a substantial advantage in marketing and advertising. In addition, the level of sales needed to justify the legal costs associated with these controversial industries has become increasingly prohibitive for newcomers.

Brand awareness The relatively saturated US market for alcoholic beverage and tobacco products acts to limit manufacturers’ pricing flexibility. As packaged consumer goods companies, they realize that one of the best ways to enhance their restrained pricing power is to develop customer loyalty through brand awareness. However, tightened advertising restrictions placed on these industries in recent years have forced companies to become more creative in their marketing campaigns.

The challenges have been especially great for tobacco companies. To build brand awareness without the use of electronic media advertising, as mandated by the federally imposed ban, tobacco manufacturers began to use incentive programs that allowed smokers to earn points toward merchandise bearing company or brand logos. However, under the more restrictive requirements of the November 1998 Master Settlement Agreement (MSA) between the tobacco companies and 46 states, manufacturers agreed to stop these incentive programs.

A long history of regulation The US government’s oversight of the alcoholic beverage industry goes back to the earliest days of the country’s formation. Faced with debts incurred during the Revolutionary War, Congress imposed the first federal tax on distilled spirits on March 3, 1791. This tax proved to be very unpopular, inciting the famous Whiskey Rebellion in 1794. To restore order, President George Washington mustered about 15,000 militiamen to establish the new federal government’s authority to levy such taxes. An unintended consequence of this action was to push producers of whiskey west into Tennessee and Kentucky, just outside the influence of federal control, where they remain concentrated today.

For the next six decades, taxes on distilled spirits were alternately enacted and repealed to meet federal revenue needs. In 1862, to finance the Civil War, Congress passed a law that imposed a tax on distilled


spirits. This legislation also created the Office of Internal Revenue (later the Internal Revenue Service, or IRS), which has become a permanent part of the federal revenue system.

In 1919, the Eighteenth Amendment to the US Constitution was ratified, banning alcohol and ushering in the Prohibition era. This amendment took effect in 1920. While demand for liquor declined, illicit markets sprang up to satisfy the remaining demand, spawning organized criminal activity, violence, and government corruption. One source estimates sales of bootlegged liquor at $3.5 billion in 1926. In 1933, the Twenty-first Amendment was passed, repealing the Eighteenth Amendment and ending Prohibition. The act also created the Alcohol Tax Unit (ATU) to collect alcohol-related taxes for the Internal Revenue Service.

In 1934, the National Firearms Act was passed, increasing the federal government’s role in regulating the firearms industry; regulatory responsibility was given to the ATU. In 1951, tobacco tax duties also were delegated to the ATU. Reflecting these new duties, the unit’s title was changed in 1952 to Alcohol and Tobacco Tax Division (ATTD) of the Internal Revenue Service. This division was responsible for enforcing the laws for alcohol, tobacco, and firearms.

With the call for greater regulation of firearms in the midst of increased crime rates in the 1960s, the ATTD was given even greater responsibilities in its regulatory role over the firearms business. It was again renamed; this time it was called the Alcohol, Tobacco, and Firearms Division (ATFD) of the Internal Revenue Service.

In July 1972, the ATFD was separated from the IRS and was given full bureau status in the Treasury Department, becoming the Bureau of Alcohol, Tobacco, and Firearms (ATF). Today the ATF, which is headquartered in Washington, D.C., regulates and enforces the collection of federal taxes on these industries, which collectively amount to more than $17 billion annually.

As part of the Homeland Security Act of 2002, ATF law enforcement and the regulatory responsibility relating to firearms and explosives transferred from the Treasury Department to the Department of Justice, effective January 24, 2003. The bureau’s name also was changed, to the Bureau of Alcohol, Tobacco, Firearms and Explosives, while responsibility for collecting taxes was handed to the newly created Alcohol and Tobacco Tax and Trade Bureau (TTB).

In April 1997, a federal court determined that the US Food and Drug Administration (FDA), which supervises the food and pharmaceutical product industries, also had the authority to oversee the US tobacco industry, due largely to the court’s interpretation of cigarettes as “nicotine-delivery devices.” However, the extent of the FDA’s power remained a subject of debate. In November 1998, a federal appeals court struck down FDA oversight of the US tobacco industry, and the Supreme Court has upheld this ruling. However, in June 2009, President Obama signed the Family Smoking Prevention and Tobacco Control Act into law, giving the FDA the authority to regulate the marketing and manufacture of tobacco products.

Heavy excise taxes Cigarettes are subject to substantial excise taxes in the US, and to similar taxes in most foreign markets. US federal excise taxes (FETs) amounted to $15.1 billion in 2011 (the most recent available data), up substantially from $11.5 billion in 2009 and $6.9 billion in 2008. On January 1, 2000, the FET on cigarettes increased to 34 cents per pack, from 24 cents in 1999. On January 1, 2002, the FET increased to 39 cents per pack, with other tobacco product taxes keeping pace. In February 2009,

B07: ALCOHOLIC BEVERAGE FEDERAL EXCISE TAX COLLECTIONS

ALCOHOLIC BEVERAGE FEDERAL EXCISE TAX COLLECTIONS(In millions of dollars)

CATEGORY 2006 2007 2008 2009 2010 2011 2012*

Distilled Spirits 4,630 4,728 4,840 4,800 4,924 5,183 5,419Domestic 3,395 3,444 3,559 3,564 3,667 3,780 4,004Imported 1,235 1,284 1,281 1,236 1,257 1,403 1,414

Wine 834 874 881 899 922 984 1,036Domestic 575 589 610 609 621 685 700Imported 259 285 271 290 300 299 336

Beer 3,713 3,745 3,779 3,742 3,651 3,652 3,664Domestic 3,213 3,198 3,252 3,250 3,186 3,126 3,148Imported 500 547 527 492 465 526 516

Total excise taxes 9,177 9,348 9,500 9,441 9,496 9,819 10,119

*Latest available.Source: Internal Revenue Service.


Congress approved implementing an additional increase to be effective April 1, 2009, which raised taxes per pack by $0.62 to $1.01 to finance children’s health insurance.

States and local governments also impose excise taxes, ranging from $0.17 to $4.35 per pack. Since 2002, 47 states, the District of Columbia, and several US territories have raised cigarette taxes more than 100 times. Overall, 29 states and the District of Columbia have cigarette excise taxes of $1.00 or more per pack; 14 states and the District of Columbia have taxes of $2.00 or more per pack; and five states have tax rates of $3.00 or more. The highest combined state and local tax is in New York City at $5.85 per pack and Chicago at $3.66. Proposals continue to be made to raise taxes at the federal, state, and local levels.

Alcoholic beverage products are likewise subject to high levels of taxation in the US. The federal excise tax on these products was increased last in January 1991, when the tax on beer doubled to $18.00 per barrel, or 32 cents per six-pack. The FET on wine increased more than fivefold that year, to $1.07 per gallon, or $0.21 per 750ml bottle, and the FET on distilled spirits increased by 8% to $13.50 per gallon, or $2.14 per 750ml bottle. In addition, all states impose excise taxes on alcoholic beverages.

KEY INDUSTRY RATIOS AND STATISTICS

Sales of alcoholic beverage and tobacco products are driven by consumer spending, which is influenced by the health of the overall economy. Although alcohol and tobacco are considered “staples,” which enjoy relatively stable sales regardless of economic conditions, trends in economic indicators such as disposable personal income directly influence buying patterns.

Real growth in gross domestic product (GDP). Reported quarterly by the US Department of Commerce, inflation-adjusted (or real) GDP growth is a measure of the health of the overall US economy. Most major economies are cyclical, advancing and contracting with the business cycle. The business cycle dating committee of the National Bureau of Economic Research establishes the official beginning and end of recessions.

In 2013, real GDP expanded at a 2.2% annual pace, slower than the 2.3% growth recorded in 2012. As of September 2014, Standard & Poor’s Economics (which operates separately from S&P Capital IQ) expected real GDP to increase 2.2% in 2014 and 3.0% in 2015. Consumer spending (as measured by real personal consumption expenditures) increased 2.4% in 2013, up from the 1.8% recorded in 2012. Standard & Poor’s Economics expects the unemployment rate to drop to 6.2% in 2014 and 5.7% in 2015 (from 7.4% in 2013), and it has projected consumer spending to increase 2.3% in 2014 and 2.8% in 2015. Residential fixed investment increased 12.0% in 2013, and is projected to grow 3.7% in 2014 and 14.1% in 2015. Nonresidential investment fell 0.5% in 2013, and is projected to advance 7.4% in 2014 and 1.2% in 2015.

Real disposable personal income. Reported each month by the US Department of Commerce, this statistic is a measure of inflation-adjusted income after taxes. Changes in disposable personal income influence how much consumers spend on alcoholic beverage and tobacco products. Although the quantity consumed tends to remain fairly steady during both good times and bad, during recessions, consumers may trade down by purchasing less expensive brands. During periods of rising disposable personal income, consumers are likely to trade up to premium-priced products.

In 2013, Americans’ real disposable personal income increased only 0.74%, following a 1.5% increase in 2012, a 1.3% increase in 2011, and a 1.8% increase in 2010. As of June 2014, Standard & Poor’s Economics was projecting that real disposable personal income would grow 2.48% in 2014 and 2.89% in 2015.

Producer price indexes (PPI). Compiled monthly by the Bureau of Labor Statistics (BLS), a division of the Department of Labor, PPIs track price inflation (or deflation) for the raw materials used by the US manufacturing sector (excluding excise taxes). These indices are helpful in assessing the cost pressures facing manufacturers, including those making alcoholic beverage and tobacco products.


A rise in the PPI can signal cost pressures that may hurt profit margins. Many firms cannot alter their selling prices quickly enough—if at all—to offset such pressures. This inflexibility may be caused by a high level of price competition or by contractual commitments with retailers.

Although individual components may be volatile, overall cost pressures facing US tobacco companies have been generally benign in recent years. The same cannot be said of alcoholic beverage manufacturers and, in particular, brewers. As is true for most other consumer products, rising energy prices in the last two years have increased pressures on margins. This has not only made manufacturing more costly, but has also raised the cost of transporting finished goods. In addition, the costs for other commodities, such as grain, glass, and aluminum, also have gone up considerably in the past year.

As of September 2014, Standard & Poor’s Economics was forecasting an increase of 0.3% in the price per barrel for crude oil in 2014, after a 4.0% rise in 2013.

Consumer price index (CPI). Also compiled monthly by the BLS, the CPI tracks retail price inflation (or deflation) for a basket of goods and services sold to consumers. The rate of price inflation in the general economy directly influences pricing trends in the alcoholic beverage and tobacco markets. The CPI was up 1.5% in 2013, 2.1% in 2012, 3.1% in 2011, and 1.6% in 2010. As of September 2014, Standard & Poor’s Economics was forecasting that the CPI would rise 1.9% in 2014 and 1.4% in 2015.

In recent years, price increases for alcoholic beverages consumed away from home rose at a faster pace than that of alcohol consumed at home, but the CPI for alcoholic beverages has slowed to a rate below the overall CPI since 2004.

Tobacco prices have risen dramatically since 1998, fueled by higher retail cigarette pricing due to higher excise taxes. However, this was largely offset by the influx of deep-discount brands. Since then, price increases have generally been tempered, although they rose strongly in 2008, 2009, and 2010 (boosted by the significant increase in federal excise tax on cigarettes in 2009). With cigarette price increases affected almost yearly, we expect tobacco prices to continue to rise ahead of the overall CPI.

Interest rates. The level of interest rates influences how active a company will be in making acquisitions and introducing new products. It also affects the amount of funds spent on capital expenditures, dividends, and stock repurchases. High or rising interest rates increase the cost of borrowing; this, in turn, tends to reduce companies’ willingness to make big outlays, such as those needed to undertake a sizable facility expansion or a share repurchase program. The reverse is also true: low or falling interest rates decrease the cost of borrowing, thus making financing more affordable.

Due to turbulence in global financial markets and an economic slowdown driven by housing, the Federal Reserve (Fed) has aggressively cut the federal funds rate to near zero, or 0.25% to 0% in December 2008, and has kept it at that level since then.

Yields on 10-year Treasuries have fallen with short-term rates, with the 10-year plunging to a low of 2.39% in October 2010. Since then, the Fed bought an additional $600 billion of US Treasuries through June 2011 (yields rose to a high of 3.74% in February). However, weakening of US economic data and sovereign debt turmoil in Europe drove yields down below 2% on an intraday basis in mid-March 2013, where they remained through early May.

Interest rates started to rise in May 2013 in anticipation of the Fed tapering its bond purchases, which it reduced beginning in January 2014. The 10-year Treasury note averaged 2.35% in 2013; as of September 2014, Standard & Poor’s Economics expected the yield on the 10-year Treasury note to settle at 2.6% in 2014 and at 3.4% in 2015.

Currency exchange rates. The exchange rates between the US dollar and foreign currencies are increasingly important in predicting a company’s profitability. This is due to the rising proportion of US alcoholic beverage and tobacco industry sales derived from markets outside the US.


For companies with significant operations in foreign markets, an increase in the value of the dollar compared with foreign currencies generally penalizes reported profits: after exchange translations, fewer dollars flow back to the US. The reverse is also true. When the dollar is weak, foreign operations’ profits and earnings are enhanced. Multinational companies often use currency hedging techniques to minimize this impact, but they usually are not sufficient to totally offset losses in periods of wide currency swings.

Many US alcoholic beverage and tobacco products companies have sizable operations abroad. Consequently, significant appreciation or devaluation in key currencies, such as the euro, pound, or yen, can influence reported profits materially in a given year.

HOW TO ANALYZE AN ALCOHOLIC BEVERAGE OR TOBACCO COMPANY

Key factors to consider when assessing an alcoholic beverage or tobacco company include brand strength, market position, and business mix. Attention should also be given to how these factors may interact with changing demographics and economic trends. Income statement, cash flow, and balance sheet data also should be scrutinized. In this section, we discuss these items.

BRANDS REIGN SUPREME

For alcoholic beverage and tobacco firms alike, a strong brand name is key to maintaining a competitive advantage. A strong brand fosters consumer loyalty, creating opportunities for market share growth and above-average pricing flexibility and profitability. It also opens the possibility of extending product lines. In some cases, a brand can be licensed to other firms for use on their products, yielding royalties for the brand’s owner.

Market position Market leadership is particularly important in the alcoholic beverage and tobacco industries, because advertising restrictions make it difficult to establish a new brand or to gain share from an existing leader. Once a firm attains market leadership, competitors, most often, will have a difficult time trying to unseat it.

Market leadership offers a company many benefits, including the potential to realize substantial economies of scale and advantages over its rivals. For example, Anheuser-Busch Companies Inc. has been able to leverage its dominant share of the US beer market—approximately 47.6% of the domestic market by volume in 2013 (latest available)—into superior profitability levels. It currently has a substantially higher net margin than its domestic peers do, in large part because of significant economies of scale.

LOOKING AT THE INCOME STATEMENT

With an alcoholic beverage or tobacco company, an income statement analysis starts with net sales, which are sales minus excise taxes. Because excise taxes tend to rise more sharply in some years than in others, eliminating them from the analysis gives a fairer picture of actual sales growth.

Sales growth Net sales growth is generally a sign of health for a business. However, one needs to look at how a company’s sales growth compares with that of its market, in general, and with those of its specific competitors. It is also important to determine what is behind any sales growth. Is it pricing? Unit volume gains? Acquisitions? Is the company gaining actual market share, or is it just benefiting from market growth?

For alcoholic beverage companies, it is important to look at sales growth over a full year. Many factors can influence comparisons of quarter-to-quarter shipments, including seasonality, weather, the timing of holidays, and pre-buying by distributors in anticipation of manufacturer price increases.

Profit margins A company’s gross profit margin normally depends on its product mix and operating efficiency. The gross profit margin (gross profit as a percentage of sales) usually can be enhanced by raising prices, shedding low-


margin businesses, increasing sales of higher-margin products (improving product mix), or by cutting costs (achieving operating efficiency).

The gross margin should be judged on both an absolute and a relative basis. Trends in a company’s gross profit margins on an absolute basis are important to observe; a number of factors—including acquisitions, dispositions, fluctuations in important raw materials costs, or pricing changes—can cause significant volatility. On a relative basis, if a company’s margin is high compared with that of its competitors, it probably has strong brand names or other competitive advantages that are keeping its rivals at bay.

It is also essential to look at the company’s operating margin performance, which reflects selling, general, and administrative expenses. The operating margin equals operating income (before deduction of items such as interest, and/or other nonoperating expenses) divided by sales. An increase in the operating margin usually indicates that management is using its assets more efficiently. Conversely, a prolonged narrowing of a company’s operating margin should raise warning signals.

Interest expense Interest expense is not normally a big line item for alcoholic beverage and tobacco companies. Capital requirements for these industries are relatively low, particularly for companies that are not building an international presence. Most of their interest charges relate to borrowing costs associated with mergers and acquisitions, share repurchases, dividends, and, to a lesser extent, refinancing.

A substantial increase in interest charges should prompt the analyst to ask its cause. If this is due to an investment in new manufacturing facilities, it could be a bullish sign that the company feels it needs to expand capacity because it predicts increased demand for its product. However, excessive debt leverage and the attendant interest charges can crimp near-term earnings while reducing the amount of funds available for other—and potentially more rewarding—purposes.

Net income The bottom line is, of course, net income. Since this income statement item represents the residual income (or deficit) after all expenses are accounted for, it can be manipulated. For this reason, be on the lookout for special items that can distort net income. For example, special (“extraordinary” or “nonrecurring”) credits might include a profit gain from an asset sale that will not be repeated in subsequent periods. A company also can derive special credits from favorable legal settlements or from a one-time change in accounting practices.

Special charges can result from business restructuring initiatives, losses derived from asset sales, unfavorable legal settlements, or a change in accounting practices. In recent years, many major US consumer products companies, including those in the alcoholic beverage and tobacco industries, have incurred such charges, mostly to restructure existing operations. These charges against retained earnings are often taken to consolidate facilities, reduce excess manufacturing capacity, dispose of underperforming or nonstrategic businesses, or lay off employees.

In recent years, tobacco companies have recorded substantial charges to cover litigation expenses and settlements. Given the number of tobacco cases pending and the recurring nature of litigation expenses, these charges should not be considered as extraordinary. More appropriately, they should be considered part of the cost of doing business in the US tobacco industry. However, it should be noted that the industry has achieved what we view as largely positive outcomes in defending itself from the more substantial cases, including the class action Price and Engle cases, as well as the Department of Justice civil suit under the Racketeer Influenced and Corrupt Organizations (RICO) Act. Despite the substantial litigation overhang remaining, we think that the legal environment is improving for the tobacco industry. Because of this, we see litigation expenses beginning to become less of an issue.

Settlement payments related to the November 1998 Master Settlement Agreement (MSA) are treated a little differently, and, generally, are recorded as part of the cost of sales as cigarettes are shipped. This is because each cigarette manufacturer’s portion of ongoing adjusted payments and legal fees is based on its share of domestic cigarette shipments in the preceding year.


Net profit margin For companies primarily in the business of manufacturing and marketing tobacco products, net profit margins (net income divided by net sales) should be relatively high—often 15% or more. From a pure earnings standpoint, very few businesses enjoy the attractive profile of the US cigarette and smokeless tobacco industries. Thanks to significant legal and regulatory barriers to entry and the minimal capital needed by established firms, these companies can show net profit margins substantially higher than those of other packaged goods makers.

The US alcoholic beverage industry’s economies of scale and high barriers to national markets have helped to limit major new competition and to support flexible pricing practices. Although net profit margins within the industry vary considerably by company, they are generally high compared with those of other consumer products companies.

The trend in net profit margins is also important because nonrecurring events can artificially inflate or deflate the figure in any given year. A three- or five-year trend is a more telling indicator of overall profitability than that of a single year. In addition, a trend up (or down) can signal acceleration (or deceleration) in future earnings trends.

Earnings per share Earnings per share (EPS) figures should be adjusted for special items to make comparisons between quarters or years meaningful. Although the EPS figure is a good indicator of company performance, one should not place too much weight on a single quarterly, or even annual, performance. A company’s adjusted EPS trend over the course of two or three years is a much better indicator of actual earnings power.

Keep in mind that companies have substantial flexibility in propping up EPS figures. By increasing stock repurchases, a company can reduce the denominator in the earnings/share equation, thus raising the ratio. We find this technique preferable to other methods that may only be temporary, or could be detrimental to the firm’s long-term viability. By trimming its capital spending on plant maintenance, new product research and development pipeline, and/or advertising budget, the firm can allow more profits to flow to the net income line, raising the EPS figure. EPS also can be manipulated through the more elaborate techniques, such as changes to inventory valuation methods, selling assets, reversing accruals, or lengthening depreciation schedules.

Valuation: the P/E ratio When valuing a company’s stock, a good place to start is the basic investment ratio of stock price to EPS, called the price/earnings (P/E) ratio. This ratio (or multiple) can be useful, since it allows a company to be compared with others in the same industry, as well as with those in other industries.

In recent years, stocks of the major US alcoholic beverage and tobacco companies have tended to have P/E ratios below those of stocks in other consumer products industries. This is due to the greater perceived investment risk by investors, given the legal and regulatory challenges facing the alcoholic beverage and tobacco industries. In the case of tobacco companies, P/E ratios tended to be substantially below most other industries, given the number of class action lawsuits against them in the US. The low P/E ratios also reflect the slow revenue and earnings growth characteristic of these highly mature industries.

Although P/Es have remained low on a historical basis, there has been an upward shift in the peer average, particularly since 2010, attributable, in part, to perceived improvement in the litigation environment, as well as investors’ preference for higher-yielding securities in a low-yield environment. Other factors include reduced taxation on stock dividends and continued consolidation.

When comparing companies within the same industry, we think a premium or discount to the average should be applied after consideration of the level of exposure to attractive segments that are growing faster than the overall industry or have higher profitability, EPS growth rates, and sustainability of overall growth. Debt levels, dividend payout ratios, and quality of management could be other justifications for a premium or discount P/E to the industry average.


Cash flow Cash flow figures, closely related to earnings, provide insight into how a company generates its profits and where it puts its funds. Excess cash flow is generally defined as net income plus depreciation/amortization charges minus capital expenditures and cash dividends.

Most US alcoholic beverage and tobacco companies consistently generate excess cash flow that can be put to work beyond the upkeep of existing equipment. This excess cash flow arises mainly because companies within these mature industries do not have significant research and development activities. Nor do they normally face pressing needs to expand manufacturing capacity, as do companies in other industries.

It is important for a company to try to find the optimal balance between reinvesting surplus cash in its business and using the cash to reward shareholders immediately. In recent years, most domestic alcoholic beverage and tobacco companies have given a relatively large portion of their excess cash back to shareholders through stock buybacks and dividends. However, consolidation has accelerated, and several companies have utilized their cash to pursue acquisitions.

BALANCE SHEET DATA

A number of balance sheet ratios can be examined to spot the beginning of possible cash flow problems. A significant change in a company’s current ratio (current assets to current liabilities) can signal a potential drain on the capital needed to run the business. In addition, an unusual inventory increase could lead to an asset write down and cause production to slow. The rate of inventory turnover (cost of goods sold divided by average inventories) can reveal changes in production or inventory bottlenecks.

Debt load The ratio of long-term debt to total capital varies considerably among the major US alcoholic beverage and tobacco companies. In general, most aim to maintain long-term debt ratios in the 40%–50% range, though some have no net debt at all. There is no optimal amount of long-term indebtedness that a company should carry, so investors must weigh the benefits of high and low debt loads. An increased debt load can enhance near-term EPS growth and shareholder returns. A clean balance sheet, in contrast, allows for a large degree of safety, a potentially higher credit rating, and ready availability of funds for any potential opportunity.


INDUSTRY REFERENCES

PERIODICALS

Advertising Age http://www.adage.com Weekly newspaper; reports on marketing trends in the US and abroad.

Agricultural Outlook http://www.ers.usda.gov Monthly; covers news and statistics related to global agriculture-related issues.

Beer Marketer’s Insights http://www.beerinsights.com Published every two weeks, 23 times per year; provides information on the US beer industry.

Beverage Industry http://www.bevindustry.com Monthly; reports on current trends and issues related to the US beverage industry.

Beverage World http://www.beverageworld.com Monthly; offers broad coverage of current trends and issues related to the US beverage industry (including alcoholic beverages).

Handbook Advance http://www.beveragehandbooks.com Annual report from the Beverage Information Group; provides alcoholic beverage sales and consumption trends, advertising outlays, and other market data.

IMPACT http://www.winespectator.com Biweekly; covers the US alcoholic beverage industry.

Tobacco Reporter http://www.tobaccoreporter.com Monthly; covers recent developments in the global tobacco industry.

TRADE ASSOCIATIONS

The Beer Institute http://www.beerinstitute.org Members include leading beer industry representatives.

Brewers Association http://www.brewersassociation.org Members include small and independent American brewers.

Campaign for Tobacco-Free Kids http://www.tobaccofreekids.org A nonprofit organization that educates young people about the health risks of smoking.

Distilled Spirits Council of the United States (DISCUS) http://www.discus.org Represents the distilled spirits industry.

National Alcohol Beverage Control Association (NABCA) http://www.nabca.org Represents Control State Systems, the jurisdictions that control distribution and sales of alcoholic beverages

Tobacco Merchants Association of the United States http://www.tma.org Represents the interests of the US tobacco industry.

The Wine Institute http://www.wineinstitute.org Nonprofit public policy advocacy association of California wineries.

MARKET RESEARCH

The Beverage Information Group http://bevinfogroup.com Supplies market research information for the beverage alcohol industry.

GOVERNMENT AGENCIES

Bureau of Alcohol, Tobacco, Firearms, and Explosives (ATF) http://www.atf.gov Government agency responsible for regulating activities and collecting taxes within these industries.

US Department of Agriculture (USDA) http://www.usda.gov Government agency charged with providing key statistics on the US agricultural industry, including tobacco.

US Department of Commerce (DOC) http://www.commerce.gov This cabinet-level department’s mission is to ensure and enhance economic opportunity for Americans by working with businesses and communities to promote economic


growth. It provides key statistics on US industry, including the manufacturing sector.

US Food and Drug Administration (FDA) http://www.fda.gov Government agency charged with supervising the US food and pharmaceutical industries; a division of the US Department of Health (DOH) and Human Services.

ONLINE RESOURCES

http://www.beverageonline.com http://www.just-drinks.com http://www.taxadmin.org http://www.tobacco.org


COMPARATIVE COMPANY ANALYSIS

Operating Revenues

Million $ CAGR (%) Index Basis (2003 = 100)

Ticker Company Yr. End 2013 2012 2011 2010 2009 2008 2003 10-Yr. 5-Yr. 1-Yr. 2013 2012 2011 2010 2009

BREWERS‡SAM § BOSTON BEER INC -CL A DEC 739.1 580.2 513.0 463.8 415.1 411.6 207.9 13.5 12.4 27.4 355 279 247 223 200TAP [] MOLSON COORS BREWING CO DEC 4,206.1 3,916.5 A 3,515.7 3,254.4 3,032.4 4,774.3 3,995.9 0.5 (2.5) 7.4 105 98 88 81 76

DISTILLERS & VINTNERS‡BEAM [] BEAM INC DEC 2,547.3 C 2,465.9 A 2,264.8 D 6,570.5 6,205.4 7,105.1 5,912.5 A (8.1) (18.5) 3.3 43 42 38 111 105BF.B [] BROWN-FORMAN -CL B # APR NA 2,849.0 2,723.0 2,589.0 2,469.0 2,481.0 2,213.0 NA NA NA NA 129 123 117 112STZ [] CONSTELLATION BRANDS -CL A # FEB NA 2,796.1 2,654.3 3,332.0 3,364.8 3,654.6 3,552.4 A NA NA NA NA 79 75 94 95

TOBACCO‡AOI § ALLIANCE ONE INTL INC # MAR NA 2,243.8 2,150.8 2,094.1 2,308.3 2,258.2 817.4 H NA NA NA NA 275 263 256 282MO [] ALTRIA GROUP INC DEC 17,663.0 17,507.0 17,109.0 16,892.0 16,824.0 A 15,957.0 D 60,704.0 (11.6) 2.1 0.9 29 29 28 28 28LO [] LORILLARD INC DEC 4,972.0 A 4,636.0 A 4,452.0 4,053.0 3,686.0 3,492.0 2,604.2 6.7 7.3 7.2 191 178 171 156 142PM [] PHILIP MORRIS INTERNATIONAL DEC 31,217.0 31,377.0 31,097.0 27,208.0 25,035.0 25,705.0 NA NA 4.0 (0.5) ** ** ** ** NARAI [] REYNOLDS AMERICAN INC DEC 8,236.0 8,304.0 8,541.0 8,551.0 D 8,419.0 8,845.0 5,267.0 4.6 (1.4) (0.8) 156 158 162 162 160

UVV † UNIVERSAL CORP/VA # MAR NA 2,461.7 2,446.9 2,571.5 2,491.7 2,554.7 2,271.2 H NA NA NA NA 108 108 113 110

OTHER COMPANIES WITH SIGNIFICANT ALCOHOLIC BEVERAGE OPERATIONSBUD ANHEUSER-BUSCH INBEV -ADR DEC 43,195.0 39,758.0 A 39,046.0 A 36,297.0 A 36,758.0 A 23,507.0 A NA NA 12.9 8.6 ** ** ** ** NADEO DIAGEO PLC -ADR JUN 17,389.6 A 16,881.3 15,964.2 14,618.2 15,318.5 16,104.0 A 12,023.2 3.8 1.5 3.0 145 140 133 122 127

OTHER COMPANIES WITH SIGNIFICANT TOBACCO OPERATIONS

BTI BRITISH AMER TOBA PLC -ADR DEC 25,640.0 25,074.4 24,259.5 A 23,195.7 23,272.4 A 17,898.0 A 43,090.2 A,E (5.1) 7.5 2.3 60 58 56 54 54SWM § SCHWEITZER-MAUDUIT INTL INC DEC 772.8 A,C 788.1 D 816.2 740.2 D 740.4 767.9 566.9 3.1 0.1 (1.9) 136 139 144 131 131VGR VECTOR GROUP LTD DEC 600.9 A 576.5 580.4 525.0 423.7 397.0 341.3 5.8 8.6 4.2 176 169 170 154 124

Note: Data as originally reported. CAGR-Compound annual grow th rate. ‡S&P 1500 index group. []Company included in the S&P 500. †Company included in the S&P MidCap 400. §Company included in the S&P SmallCap 600. #Of the follow ing calendar year. **Not calculated; data for base year or end year not available. A - This year's data reflect an acquisition or merger. B - This year's data reflect a major merger resulting in the formation of a new company. C - This year's data reflect an accounting change. D - Data exclude discontinued operations. E - Includes excise taxes. F - Includes other (nonoperating) income. G - Includes sale of leased depts. H - Some or all data are not available, due to a f iscal year change.


Net Income

Million $ CAGR (%) Index Basis (2003 = 100)

Ticker Company Yr. End 2013 2012 2011 2010 2009 2008 2003 10-Yr. 5-Yr. 1-Yr. 2013 2012 2011 2010 2009

BREWERS‡SAM § BOSTON BEER INC -CL A DEC 70.4 59.5 66.1 50.1 31.1 8.1 10.6 20.9 54.1 18.4 667 563 626 475 295TAP [] MOLSON COORS BREWING CO DEC 565.3 441.5 674.0 668.1 729.4 400.1 174.7 12.5 7.2 28.0 324 253 386 383 418

DISTILLERS & VINTNERS‡BEAM [] BEAM INC DEC 365.5 398.2 133.3 487.6 242.8 158.6 579.2 (4.5) 18.2 (8.2) 63 69 23 84 42BF.B [] BROWN-FORMAN -CL B # APR NA 591.0 513.0 572.0 449.0 435.0 258.0 NA NA NA ** 229 199 222 174STZ [] CONSTELLATION BRANDS -CL A # FEB NA 387.8 445.0 559.5 99.3 (301.4) 220.4 NA NA NA ** 176 202 254 45

TOBACCO‡AOI § ALLIANCE ONE INTL INC # MAR NA 24.0 29.5 (71.6) 79.2 132.2 (32.9) NA NA NA ** NM NM NM NMMO [] ALTRIA GROUP INC DEC 4,535.0 4,180.0 3,390.0 3,905.0 3,206.0 3,090.0 9,204.0 (6.8) 8.0 8.5 49 45 37 42 35LO [] LORILLARD INC DEC 1,180.0 1,099.0 1,116.0 1,029.0 948.0 887.0 468.3 9.7 5.9 7.4 252 235 238 220 202PM [] PHILIP MORRIS INTERNATIONAL DEC 8,576.0 8,800.0 8,591.0 7,259.0 6,342.0 6,890.0 NA NA 4.5 (2.5) ** ** ** ** NARAI [] REYNOLDS AMERICAN INC DEC 1,718.0 1,272.0 1,406.0 1,329.0 962.0 1,338.0 (3,689.0) NM 5.1 35.1 NM NM NM NM NM

UVV † UNIVERSAL CORP/VA # MAR NA 132.8 92.1 156.6 168.4 131.7 99.6 NA NA NA ** 133 92 157 169

OTHER COMPANIES WITH SIGNIFICANT ALCOHOLIC BEVERAGE OPERATIONSBUD ANHEUSER-BUSCH INBEV -ADR DEC 14,394.0 7,243.0 5,855.0 4,026.0 4,613.0 1,927.0 NA NA 49.5 98.7 ** ** ** ** NADEO DIAGEO PLC -ADR JUN 3,779.7 3,063.5 3,052.7 2,463.3 2,663.6 2,975.9 125.6 40.6 4.9 23.4 3,009 2,439 2,430 1,961 2,120

OTHER COMPANIES WITH SIGNIFICANT TOBACCO OPERATIONSBTI BRITISH AMER TOBA PLC -ADR DEC 6,470.5 6,246.2 4,808.7 4,431.4 4,386.1 3,591.9 1,125.8 19.1 12.5 3.6 575 555 427 394 390SWM § SCHWEITZER-MAUDUIT INTL INC DEC 78.5 83.7 87.6 71.4 35.6 0.7 34.5 8.6 157.0 (6.2) 228 243 254 207 103VGR VECTOR GROUP LTD DEC 38.9 30.6 75.0 54.1 24.8 60.5 (15.6) NM (8.4) 27.2 NM NM NM NM NM

Note: Data as originally reported. CAGR-Compound annual grow th rate. ‡S&P 1500 index group. []Company included in the S&P 500. †Company included in the S&P MidCap 400. §Company included in the S&P SmallCap 600. #Of the follow ing calendar year. **Not calculated; data for base year or end year not available.


Return on Revenues (%) Return on Assets (%) Return on Equity (%)

Ticker Company Yr. End 2013 2012 2011 2010 2009 2013 2012 2011 2010 2009 2013 2012 2011 2010 2009

BREWERS‡SAM § BOSTON BEER INC -CL A DEC 9.5 10.2 12.9 10.8 7.5 17.5 18.8 24.9 19.2 12.9 25.7 27.7 37.7 29.6 19.9TAP [] MOLSON COORS BREWING CO DEC 13.4 11.3 19.2 20.5 24.1 3.6 3.1 5.4 5.4 6.5 6.8 5.7 8.7 9.0 11.2

DISTILLERS & VINTNERS‡BEAM [] BEAM INC DEC 14.3 16.1 5.9 7.4 3.9 4.2 4.9 1.3 3.9 2.0 7.5 9.1 2.7 9.1 5.0BF.B [] BROWN-FORMAN -CL B # APR NA 20.7 18.8 22.1 18.2 NA 16.6 14.3 16.1 13.1 NA 32.0 24.8 28.9 24.2STZ [] CONSTELLATION BRANDS -CL A # FEB NA 13.9 16.8 16.8 3.0 NA 5.3 6.2 7.3 1.2 NA 14.0 17.0 21.8 4.4

TOBACCO‡AOI § ALLIANCE ONE INTL INC # MAR NA 1.1 1.4 NM 3.4 NA 1.2 1.6 NM 4.3 NA 7.2 9.2 NM 22.1MO [] ALTRIA GROUP INC DEC 25.7 23.9 19.8 23.1 19.1 12.9 11.6 9.1 10.5 10.0 124.5 122.1 76.4 84.3 93.0LO [] LORILLARD INC DEC 23.7 23.7 25.1 25.4 25.7 34.0 34.3 35.4 35.1 38.7 NA NA NA NA 264.1PM [] PHILIP MORRIS INTERNATIONAL DEC 27.5 28.0 27.6 26.7 25.3 22.6 24.1 24.4 20.9 18.8 NA NA 460.0 157.4 96.0

RAI [] REYNOLDS AMERICAN INC DEC 20.9 15.3 16.5 15.5 11.4 10.8 7.8 8.4 7.6 5.3 33.0 22.1 22.0 20.4 15.1

UVV † UNIVERSAL CORP/VA # MAR NA 5.4 3.8 6.1 6.8 NA 5.2 3.4 6.2 6.8 NA 11.7 7.9 15.1 17.8

OTHER COMPANIES WITH SIGNIFICANT ALCOHOLIC BEVERAGE OPERATIONSBUD ANHEUSER-BUSCH INBEV -ADR DEC 33.3 18.2 15.0 11.1 12.5 10.9 6.2 5.2 3.5 4.1 31.5 18.4 16.1 12.3 17.5DEO DIAGEO PLC -ADR JUN 21.7 18.1 19.1 16.9 17.4 10.3 9.2 10.0 8.4 8.6 38.8 35.6 42.4 43.6 43.4

OTHER COMPANIES WITH SIGNIFICANT TOBACCO OPERATIONSBTI BRITISH AMER TOBA PLC -ADR DEC 25.2 24.9 19.8 19.1 18.8 14.5 14.4 11.3 10.3 10.5 55.9 50.3 35.8 33.5 39.1SWM § SCHWEITZER-MAUDUIT INTL INC DEC 10.2 10.6 10.7 9.6 4.8 7.4 9.7 10.3 8.7 4.7 14.6 16.9 17.5 14.2 9.4VGR VECTOR GROUP LTD DEC 6.5 5.3 12.9 10.3 5.9 3.3 3.0 8.0 6.4 3.4 NA NA NA NA 171.5

Note: Data as originally reported. ‡S&P 1500 index group. []Company included in the S&P 500. †Company included in the S&P MidCap 400. §Company included in the S&P SmallCap 600. #Of the follow ing calendar year.


Debt as a % ofCurrent Ratio Debt / Capital Ratio (%) Net Working Capital


BREWERS‡SAM § BOSTON BEER INC -CL A DEC 1.6 1.8 1.9 1.6 1.5 0.2 0.2 0.0 0.0 0.0 1.0 0.8 0.0 0.0 0.0TAP [] MOLSON COORS BREWING CO DEC 0.7 0.7 1.7 1.7 1.1 25.2 27.7 19.1 19.2 15.8 NM NM 227.7 220.9 776.6

DISTILLERS & VINTNERS‡BEAM [] BEAM INC DEC 4.1 2.4 3.2 2.1 2.6 26.5 28.6 29.8 36.5 43.5 92.7 122.4 113.5 162.7 183.3BF.B [] BROWN-FORMAN -CL B # APR NA 3.8 4.3 2.8 2.8 NA 35.5 18.4 18.6 20.4 NA 74.0 37.4 39.7 51.8STZ [] CONSTELLATION BRANDS -CL A # FEB NA 3.6 1.7 3.1 1.9 NA 48.6 42.4 50.0 51.3 NA 182.8 290.1 220.9 269.4

TOBACCO‡AOI § ALLIANCE ONE INTL INC # MAR NA 2.4 2.3 2.8 2.4 NA 70.7 70.9 73.6 66.6 NA 98.5 99.1 104.4 99.2MO [] ALTRIA GROUP INC DEC 0.9 0.8 0.9 0.9 0.7 56.0 55.8 53.7 47.1 46.9 NM NM NM NM NMLO [] LORILLARD INC DEC 1.7 1.7 1.7 2.1 1.6 238.0 233.2 239.8 114.6 89.2 328.1 264.5 240.5 117.2 85.5PM [] PHILIP MORRIS INTERNATIONAL DEC 1.0 1.0 1.0 1.1 1.3 135.5 101.7 81.3 66.5 64.9 NM NM NM NM 390.2

RAI [] REYNOLDS AMERICAN INC DEC 1.2 1.3 1.0 1.1 1.3 46.7 46.8 32.2 34.5 37.3 880.7 482.7 NM 860.7 358.1

UVV † UNIVERSAL CORP/VA # MAR NA 2.8 4.3 3.1 2.8 NA 12.2 24.2 20.7 26.2 NA 16.1 30.2 30.0 38.5

OTHER COMPANIES WITH SIGNIFICANT ALCOHOLIC BEVERAGE OPERATIONSBUD ANHEUSER-BUSCH INBEV -ADR DEC 0.7 1.0 0.6 0.8 0.8 39.5 42.7 41.5 47.1 52.4 NM NM NM NM NMDEO DIAGEO PLC -ADR JUN 1.6 1.5 1.5 1.8 1.6 49.9 52.0 53.1 63.4 66.7 278.4 308.1 303.7 273.7 347.2

OTHER COMPANIES WITH SIGNIFICANT TOBACCO OPERATIONSBTI BRITISH AMER TOBA PLC -ADR DEC 1.1 1.1 1.1 1.1 1.2 57.6 53.3 49.4 47.9 54.4 898.0 870.0 NM 881.0 816.1SWM § SCHWEITZER-MAUDUIT INTL INC DEC 3.7 3.0 2.3 1.7 1.6 37.2 21.9 22.1 7.2 7.9 96.9 59.5 75.7 34.2 37.3VGR VECTOR GROUP LTD DEC 1.5 3.3 1.6 2.3 2.6 92.7 95.1 106.1 98.9 89.2 295.0 132.2 253.6 168.7 139.4



Price / Earnings Ratio (High-Low) Dividend Payout Ratio (%) Dividend Yield (High-Low, %)

Ticker Company Yr. End 2013 2012 2011 2010 2009 2013 2012 2011 2010 2009

BREWERS‡SAM § BOSTON BEER INC -CL A DEC 49 - 25 31 - 20 23 - 14 28 - 8 22 - 8 0 0 0 0 0 0.0 - 0.0 0.0 - 0.0 0.0 - 0.0 0.0 - 0.0 0.0 - 0.0TAP [] MOLSON COORS BREWING CO DEC 18 - 13 19 - 16 14 - 10 14 - 11 13 - 8 41 52 34 30 23 3.1 - 2.3 3.4 - 2.8 3.3 - 2.5 2.8 - 2.1 3.0 - 1.8

DISTILLERS & VINTNERS‡BEAM [] BEAM INC DEC 31 - 26 25 - 20 76 - 49 20 - 12 29 - 11 40 33 88 24 63 1.5 - 1.3 1.6 - 1.3 1.8 - 1.2 2.1 - 1.2 5.7 - 2.2BF.B [] BROWN-FORMAN -CL B # APR NA - NA 26 - 19 23 - 17 19 - 12 18 - 12 NA 180 37 57 39 NA - NA 9.7 - 7.0 2.2 - 1.6 4.6 - 3.1 3.4 - 2.1STZ [] CONSTELLATION BRANDS -CL A # FEB NA - NA 17 - 9 11 - 8 8 - 6 39 - 24 NA 0 0 0 0 0.0 - 0.0 0.0 - 0.0 0.0 - 0.0 0.0 - 0.0 0.0 - 0.0

TOBACCO‡AOI § ALLIANCE ONE INTL INC # MAR NA - NA 15 - 10 13 - 6 NM- NM 6 - 2 NA 0 0 NM 0 0.0 - 0.0 0.0 - 0.0 0.0 - 0.0 0.0 - 0.0 0.0 - 0.0MO [] ALTRIA GROUP INC DEC 17 - 14 18 - 14 19 - 14 14 - 10 13 - 9 81 83 96 78 85 5.8 - 4.8 6.1 - 4.7 6.8 - 5.2 7.6 - 5.6 9.1 - 6.4LO [] LORILLARD INC DEC 17 - 12 17 - 13 15 - 9 13 - 10 14 - 9 70 73 65 63 67 5.8 - 4.1 5.8 - 4.4 7.2 - 4.3 6.1 - 4.7 7.3 - 4.7PM [] PHILIP MORRIS INTERNATIONAL DEC 18 - 16 18 - 14 16 - 12 15 - 11 16 - 10 68 63 58 62 69 4.3 - 3.7 4.4 - 3.4 5.0 - 3.6 5.7 - 4.0 7.0 - 4.3RAI [] REYNOLDS AMERICAN INC DEC 17 - 13 21 - 17 18 - 13 15 - 8 16 - 10 79 104 89 81 105 6.0 - 4.7 6.0 - 5.0 6.8 - 5.1 10.1 - 5.5 10.9 - 6.4

UVV † UNIVERSAL CORP/VA # MAR NA - NA 10 - 9 14 - 11 9 - 6 8 - 4 NA 39 58 32 30 4.2 - 3.2 4.5 - 3.7 5.5 - 4.0 5.3 - 3.4 7.3 - 3.7

OTHER COMPANIES WITH SIGNIFICANT ALCOHOLIC BEVERAGE OPERATIONSBUD ANHEUSER-BUSCH INBEV -ADR DEC 12 - 9 20 - 13 18 - 13 26 - 17 18 - 13 34 34 32 20 0 3.6 - 2.8 2.7 - 1.7 2.4 - 1.8 1.1 - 0.8 0.0 - 0.0DEO DIAGEO PLC -ADR JUN 22 - 19 25 - 17 18 - 15 19 - 14 16 - 10 47 54 51 59 53 2.5 - 2.1 3.1 - 2.2 3.5 - 2.8 4.2 - 3.1 5.6 - 3.3

OTHER COMPANIES WITH SIGNIFICANT TOBACCO OPERATIONSBTI BRITISH AMER TOBA PLC -ADR DEC 17 - 15 17 - 14 20 - 15 18 - 13 15 - 10 64 66 94 71 62 4.4 - 3.8 4.7 - 3.8 6.3 - 4.8 5.7 - 4.0 6.3 - 4.1SWM § SCHWEITZER-MAUDUIT INTL INC DEC 25 - 14 15 - 11 14 - 9 21 - 11 32 - 6 50 17 12 15 26 3.5 - 2.0 1.5 - 1.1 1.3 - 0.8 1.4 - 0.7 4.7 - 0.8VGR VECTOR GROUP LTD DEC 41 - 35 51 - 41 20 - 16 28 - 18 47 - 30 376 441 166 217 454 10.8 - 9.2 10.8 - 8.7 10.5 - 8.4 12.0 - 7.8 15.1 - 9.7


20092013 2012 2011 2010


Earnings per Share ($) Tangible Book Value per Share ($) Share Price (High-Low, $)


BREWERS‡SAM § BOSTON BEER INC -CL A DEC 5.47 4.60 5.08 3.67 2.21 23.41 18.93 14.30 12.26 12.05 265.53 - 134.42 142.50 - 94.24 115.49 - 71.00 100.93 - 30.00 48.63 - 17.50TAP [] MOLSON COORS BREWING CO DEC 3.09 2.44 3.65 3.59 3.96 (3.28) (9.48) 8.94 8.86 5.77 56.49 - 41.26 46.35 - 37.96 50.44 - 37.99 51.11 - 38.44 51.33 - 30.76

DISTILLERS & VINTNERS‡BEAM [] BEAM INC DEC 2.26 2.51 0.86 3.20 1.61 1.78 (1.67) (0.69) (6.43) (11.15) 70.63 - 59.42 64.00 - 49.74 65.48 - 42.30 63.51 - 37.05 46.77 - 17.67BF.B [] BROWN-FORMAN -CL B # APR NA 2.77 2.39 2.61 2.02 NA 1.61 3.68 3.52 2.54 76.73 - 60.90 71.00 - 51.30 54.69 - 41.43 48.67 - 32.62 36.98 - 23.31STZ [] CONSTELLATION BRANDS -CL A # FEB NA 2.13 2.18 2.65 0.45 NA (3.97) (4.24) (4.52) (4.14) 71.62 - 28.37 36.98 - 18.50 23.19 - 16.42 22.52 - 14.60 17.56 - 10.72

TOBACCO‡AOI § ALLIANCE ONE INTL INC # MAR NA 0.27 0.34 (0.81) 0.89 NA 3.50 3.34 3.12 3.88 4.23 - 2.79 3.92 - 2.62 4.44 - 2.17 5.96 - 3.17 5.71 - 2.22MO [] ALTRIA GROUP INC DEC 2.26 2.06 1.64 1.87 1.55 (6.58) (7.01) (6.65) (5.79) (6.38) 38.58 - 31.85 36.29 - 28.00 30.40 - 23.20 26.22 - 19.14 20.47 - 14.50LO [] LORILLARD INC DEC 3.15 2.82 2.67 2.26 1.92 (6.17) (4.98) (3.82) (0.51) 0.19 53.27 - 37.84 47.02 - 35.61 40.00 - 24.13 29.90 - 23.41 27.25 - 17.50PM [] PHILIP MORRIS INTERNATIONAL DEC 5.26 5.17 4.85 3.93 3.25 (12.49) (10.28) (7.76) (5.84) (3.68) 96.73 - 82.86 94.13 - 72.85 79.42 - 55.85 60.87 - 42.94 52.35 - 32.04RAI [] REYNOLDS AMERICAN INC DEC 3.15 2.25 2.41 2.28 1.65 (9.78) (9.42) (7.57) (7.16) (7.56) 52.93 - 41.50 46.93 - 38.95 42.18 - 31.54 33.41 - 18.17 27.13 - 15.77

UVV † UNIVERSAL CORP/VA # MAR NA 5.05 3.32 5.94 6.21 NA 40.55 37.46 37.56 33.05 63.59 - 48.13 52.75 - 43.57 47.70 - 35.02 56.21 - 35.36 49.74 - 25.35

OTHER COMPANIES WITH SIGNIFICANT ALCOHOLIC BEVERAGE OPERATIONSBUD ANHEUSER-BUSCH INBEV -ADR DEC 8.90 4.53 3.67 2.53 2.91 (30.44) (21.84) (23.55) (25.49) (28.28) 106.83 - 83.94 91.21 - 58.78 64.53 - 49.05 64.77 - 43.19 53.69 - 37.18DEO DIAGEO PLC -ADR JUN 6.04 4.91 4.90 3.96 4.28 (4.89) (8.13) (3.35) (6.53) (7.96) 134.08 - 111.87 121.39 - 84.44 87.49 - 71.25 76.37 - 55.90 70.00 - 40.93

OTHER COMPANIES WITH SIGNIFICANT TOBACCO OPERATIONSBTI BRITISH AMER TOBA PLC -ADR DEC 6.81 6.44 4.88 4.46 4.43 (8.03) (7.14) (6.04) (5.01) (7.48) 115.21 - 99.58 109.73 - 89.25 96.00 - 72.59 79.99 - 56.00 66.94 - 43.26SWM § SCHWEITZER-MAUDUIT INTL INC DEC 2.51 2.67 2.60 1.97 1.13 11.30 15.84 13.95 13.65 12.53 63.53 - 35.87 39.40 - 30.59 37.34 - 23.38 41.81 - 21.19 36.09 - 6.32VGR VECTOR GROUP LTD DEC 0.41 0.33 0.84 0.61 0.28 (3.75) (1.98) (2.24) (1.77) (1.30) 16.73 - 14.29 16.86 - 13.57 16.65 - 13.28 17.11 - 11.15 13.15 - 8.42

Note: Data as originally reported. ‡S&P 1500 index group. []Company included in the S&P 500. †Company included in the S&P MidCap 400. §Company included in the S&P SmallCap 600. #Of the follow ing calendar year. J-This amount includes intangibles that cannot be identif ied.

The analysis and opinion set forth in this publication are provided by S&P Capital IQ Equity Research and are prepared separately from any other analytic activity of Standard & Poor’s.

In this regard, S&P Capital IQ Equity Research has no access to nonpublic information received by other units of Standard & Poor’s.

The accuracy and completeness of information obtained from third-party sources, and the opinions based on such information, are not guaranteed.


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