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Quarter 3, 2009

Changes And Fortune:
Wind Warnings In Caribbean Cigars

By Jonathan Bell

A look at how implications of the US’ Cuba policy will have far-reaching implications
for the whole cigar world.

For more than a century the “Caribbean” cigar was synonymous with Cuban production. However, when these cigars were no longer imported into the huge US. market, the production of these fine cigars surged in other regional nations in order to meet the US’ demand.

For example, it is said the Dominican Republic’s numerous factories now make between 170 and 200 mn units of premium class product, 80% of which are sold to the US.

There are also considerable amounts of premium cigars rolled in Honduras and Nicaragua. These productions, along with the large DR output, have taken a leading position over many years on the US market.

Internationally, in combination with the Cuban cigar total that nearly equals the DR’s, the great majority of the world’s premium class cigars are indeed a Caribbean delight.

Changes now seem eminent to this cigar paradise, at a time when bn dollar sales face turmoil. This comes as the prospect of, for the first time in 47 years, the legalization of Cuban cigars looms ahead. Some analysts say it might begin as early as the end of next year.

However, which Cuban brands might appear, and how they are distributed, is hotly contested. So, the actual nature of a Cuban market in the US might not fully emerge for several years.

Whether or not a Cuban market in the US emerges is of great importance to American retailers, distributors, and chiefly, to all of the Caribbean cigar factories involved.

European, Middle Eastern, and Latin American Cuban cigar retailers and consumers are also directly involved, as they currently and historically have been the avid market for Cuban premiums during the embargo.

The US battle over distribution control is beginning. Giants Swedish Match and Imperial are tangling. Swedish Match is lobbying in Washington now to protect itself, advising that upwards of 200 workers in its US operations might lose their jobs if the ban is lifted. In addition, Swedish Match is arguing that the company’s subsidiary, General Cigar, should not gain exclusive distribution rights in the States.

Conversely, Imperial’s position is that its participation in ownership of Habanos, through its subsidiary Altadis, has already procured global exclusivity in distribution of Habanos cigars - except in the US as a result of the ban. Imperial proposes that it’s only logical to also obtain distribution rights to the cigars in America.

Swedish Match, through subsidiaries such as General Cigar, has a major share of the US cigar market, especially in the premium sector - sourced by its factories in the Caribbean (not Cuba). But, Imperial is also a major player in regards to its premium cigars produced in its non-Cuban factories in the Caribbean.

The battle over distributorship exclusivity poses the potential for upheaval among these big companies and their Caribbean factories. It also could mean serious dislocation for smaller Caribbean factories that have focused their premium sales on the US

Beyond this lies the ongoing nightmare of trademark ownership of Cuban brands. The most famous involved being: Partagas, Montecristo, and Cohiba. This legal war principally involves Cubatabaco, Altadis (Imperial), and General Cigar (Swedish Match); it will not only take some time to resolve, but it will also be fierce, as billions of dollars are at stake.

The impact on the Caribbean could be harsh, seeing as these three brand families are currently produced in Cuban factories for all nations except the US For the US, the brands are made for the American premium market in non-Cuban factories. However the truly complex issue over the brands’ ownership is decided, it too could result in an upheaval to the Caribbean nations’ cigar industries.

To repeat, it might take years of court actions to sort out these issues of distribution exclusivity and the ownership of trademarks - change in full will not be rapid.

When decisions are finally reached, how harsh they affect the large companies will vary. Cubatabaco seems set to have much to gain, and little to lose, regardless of what happens. Imperial, through Altadis, with 50% participation in Cubatabaco can see mixed results, depending on who is the winner in the various decisions outlined above. Swedish Match-General Cigar has the most to lose, which is why the company has already spent several mns on lawyers and lobbying in Washington.

Another factor is that the cigar industry faces serious issues of social dislocation and economic distress in the DR, Honduran and Nicaraguan communities, where factories employing up to as much as a 1,000 workers are located.

Aside from the war of the giants, the end result will also affect the numerous smaller, independent companies producing outside of Cuba. Some of the smaller productions market famous, premium brands primarily for US distribution, but also for sales worldwide. These factories are also the key sources for private label premium cigars.

These independent factories could also face significant market dislocation. Depending on a number of aspects, the changes that now seem unavoidable must be taken very seriously, or the cigar industry’s and the region’s economic health may suffer.

How significant an impact the end of the embargo will have is still unknown. Time, as described above, is a factor. As years may go by, as we await the verdict, large and small non-Cuban cigar factories have the opportunity to develop new brands and new markets.

An important factor to consider is the capacity of the Cuban production of premium cigars. The degree of change threatening the existing non-Cuban factories obviously depends on how many Cuban premium cigars can be sourced to the US Many people may be surprised at the relatively blunt initial impact of Cuban cigars becoming available in the States will have.

The reasons for this are clear; Habanos sells virtually all the cigars it produces annually by hand. For the production capacity to be significantly enlarged from its current level would require serious investment in infrastructure and labor, meaning the training of many more rollers.

Even more important, the amount of the all-important prime Cuban tobacco for filler, binder and wrapper is indeed circumscribed - by terrain, number of experienced growers, and the island’s weather, which is increasingly prone to hurricanes that may be due to climate change.

To substantially increase leaf and rolling production, will take both time and effort. Given this, the optimum current capacity must be considered as the near-future market size of Cuban premium cigars. Cuba was selling some 160-plus mn units in recent, pre-recession years (2006–07). Prior years its capacity was thought to be at 150 mn units, so expansion in the premium sector has been slowly increasing.

The reality for the multitude of eager-Cuban cigar fans in the US is that during the 47 years of embargo Habanos, the marketing/distribution company held by Cubatabaco, has not been sitting on its hands. The company strongly supports global marketing initiatives and the expansion of its Casa de Habanos establishments (Cuban themed emporiums for buying and smoking cigars, enjoying Cuban rum, etc.), which are key to expanding the cult of the Cuban cigar.

Currently, 70% of sales for Habanos are in the European Union - primarily Spain, France, Germany, and Switzerland. But sales in other EU nations are on the rise. With the strength of the Euro, these markets will remain rich ground for exports. Habanos is unlikely to punish its prized global consumers and network of distributors by cutting off supply, especially if Euro prices remain more attractive than dollar prices.

Growth is also now moving into Asia for Habanos, again a market where price is not a major factor for a premium cigar. Sales volume and value have almost tripled for the company in the Asian region. This is another area hungry for more Cubans.

Following cigar production figures for Cuba over many years, one sees that in pre-Altadis-investment years the number of units rolled remained generally stable, despite considerable efforts to increase it. After the infusion of Altadis, investment production increased markedly but never neared the 200 mn units per year that had been set as a production goal by the Cuban tobacco authorities in the 1990s.

Recent production increases can be seen in incremental stages of 10 mn units achieved in varying time frames

Indeed, many observers feel that opening of the US cigar market might stimulate a surge in units made, but most likely not on an overwhelming scale. Crop yields permitting, it would seem that an additional 10–15 mn units of stable production could be added to the overall Cuban market in a 4–5 year term. But, again, an increase will be shared with other markets - it is rather solipsistic to think that all additional Cuban production would automatically go to the US market.

Thus, Cuban premium production seems not far from capping, unless leaf is imported from other origins. To most smokers of Cuban premiums this would be unthinkable. It would prove to be quite a major marketing problem, seeing as if a cigar is made of DR, Honduran, Nicaraguan or Ecuadorian leaf, then the distinguishing factor becomes how its been made, and there are indeed thousands of worthy non-Cuban rollers in the region.

Additionally, it is thought that, at least in recent prosperous times, as many as 20 mn premium Cuban cigars were being consumed in the US each year, obtained from border purchases, international web store sales, and from travel. This amount might be excessive. Countering it, another source supposes that only 5 mn Cuban cigars come into the US

Both the bottom and top figure may contain many fake Cuban products. Nevertheless it means that a certain percent of fervent Cuban cigar consumers in the US are already sourcing their need. Even taking the average between these consumption numbers, 12.5 mn units, prove the lust for a Cuban maybe already be partly sated for many likely consumers in the post-embargo era.

So, how large could the Cuban market be in US grow to be in future? Price, quality, availability and the strength of the American economy and dollar will decide.

In sum, the pending end of the US embargo may in fact have marginal effect on the availability of true premium Cuban cigars in American stores. For one supposition, add the existing consumption - materializing from unsanctioned outlets-- to what Cuban factories might be able to source in excess of current production (some of which assumedly will still be directed foremost at growing European and Asian markets). One guess is that the US might, perhaps in several years, see imports of 15-20 mn Cuban made premium cigars.

Compared to the 300 mn premos consumed in the States in pre-recession years, this would hurt but not necessarily be catastrophic to other Caribbean cigars. But, hurt it would, indeed, and could potentially mean the closing of some factories.

Mostly, in the tea leafs, it will come down to the price an American is willing to pay in future for a good Cuban - in competition with the EU and affluent Asian markets. And, it will also become an issue of quality.

A few quality issues have been raised over the years about Cuba’s overall premium brand range. These doubts vary by year and by brand, reflecting leaf qualities at hand (and yes crops do vary) and management of the various factories - which does change and can reflect, at least temporarily, on quality. There are some 40 factories in operation on the island.

Nevertheless, the ongoing loyalty to the cigars in highly demanding markets - despite hiccups, high prices and periods of dersity - is proof of their abiding pleasure.

If Cuba does not source the US with cigars to meet expectations, it could be a disaster. Those markets long served - the Spanish, the French, the German - are knowledgeable about what they want in a Cuban. The temptation might be to provide a less experienced American market with units of lower quality.

Given the expertise gained in leaf growing and hand rolling in other producing Caribbean nations, it could be a mistake to downgrade what the consumer expects.

Before the US market size for Cubans is ascertained or its future resolved, it can be assumed that the consumer might see primarily machine-rolled cigars from the island. If these sales are not handled carefully they could damage the Cuban premium image. Also, the country may also be deluged with fake premium Cubans, a common fear among Cubans. Habanos already must fight forgery on a major scale in its existing markets.

Change is coming to the Caribbean, but when, how, and to what effect is truly uncertain.

Three strategies will be of importance to all players in this new era: maintain or increase quality, take careful price position, and look for more sales in Europe and Asia.

Tobacco Products International - Quarter 3, 2009
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