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Where There's Smoke, There Are Profits: White Hot Souza Cruz
Latin CEO / December 2001

By Larry Luxner

Flavio de Andrade begins our long-anticipated interview not with a "bom dia, how are you?" or a "please sit down," but with a cheery "mind if I smoke?"

If he were anyone or anywhere else, the request might seem politically incorrect. But this is Brazil, and Andrade is president and CEO of Souza Cruz S.A. -- Latin America's largest cigarette manufacturer and one of the world's top exporters of tobacco leaf.

"I was very young when I started, and I never quit," explains Andrade, 53, as he lights up his fourth Lucky Strike of the morning. "I like smoking."

So, apparently, do 35 million other Brazilians, which represents nearly one-third of the adult population of this vast country. Unlike the United States, where cigarette sales have been declining for years, Brazil is a growth market for tobacco companies, with consumption expected to rise by 4% this year and another 3.6% in 2002.

While the anti-smoking lobby would be appalled by such statistics, they're music to the ears of Andrade, whose 98-year-old company enjoys a whopping 80% share of the nation's legal cigarette market. Seven of its brands -- including Derby, Free, Hollywood and Carlton -- are among Brazil's 10 top-selling brands, with Derby alone accounting for over 41% of all cigarette sales.

To get an idea of the sheer size of this giant, consider the following numbers: Souza Cruz, which is 75.3% owned by British American Tobacco (BAT), expects 2001 revenues of around $1 billion, with net earnings of $245 million, making it one of Brazil's five largest privately held companies. Production of cigarettes at the company's two factories in Uberlândia (Minas Gerais state) and Pôrto Alegre (Rio Grande do Sul) is expected to reach 85.2 billion units this year, up from 82.6 billion in 2000.

On April 25, 2003, the company's 100th anniversary, Souza Cruz will inaugurate a third factory in Cachoeirinha (Paraná) -- representing an investment of $500 million.

Meanwhile, exports of tobacco leaf should hit a record 92,807 tons in 2001, up from 79,000 tons last year. Continuing political turmoil in Zimbabwe, the world's No. 2 exporter of tobacco leaf after Brazil, almost guarantees that Brazilian exports of tobacco leaf -- a field in which Souza Cruz clearly dominates -- will keep climbing at an annual rate of 10% or more for several years to come.

In a Nov. 1 report to investors titled "It Can't Get Any Better Than This," the São Paulo office of Santander Central Hispano said Souza Cruz remains its top pick in the Brazilian consumer sector. To support its "strong buy" recommendation, Santander noted that the company's consolidated net sales in the third quarter of 2001 had jumped by 27% to R$657.1 million (US$258.4 million), and that during the first nine months of this year, consolidated adjusted earnings soared 50% to R$508.9 million (US$220 million).

"Souza Cruz is expected to register solid results both this year and in 2002," says Santander analyst Daniela M. Bretthauer, "with an extremely health cash flow for three main reasons: its pricing strategy, the impact of the exchange depreciation on its tobacco exports, and the effect of the exchange depreciation on its dollar investments. Added to these factors are the company's aggressive dividend policy and its healthy balance sheet."

Founded in 1903, the Rio de Janeiro-based company has been a BAT affiliate since 1917. And despite a nationwide ban on cigarette advertising that went into effect last January, the Souza Cruz logo -- a stylized gold-and-blue tobacco leaf -- seems to be everywhere in Brazil. It's also cropping up in communist Cuba, where Souza Cruz launched a joint-venture cigarette factory with the Castro regime six years ago (see sidebar).

Robert Blocker, an investment analyst at Blocker Assessoría de Investimentos e Participações Ltda. in São Paulo, says that from the beginning, no other company has even come close to Souza Cruz in conquering the Brazilian cigarette market.

"Basically they were very agile and reacted very fast. They had a wonderful distribution system and used it to their advantage," he said. "All of the big cigarette manufacturers have tried to get in here, but nobody's been very successful because Souza Cruz was always so fast and good at marketing their brands."

So good, in fact, that last year the Brazilian anti-monopoly agency CADE ruled to abolish exclusive cigarette contracts at points of sale throughout Brazil. Says Santander's Bretthauer: "This represents a major victory for Philip Morris, which had argued that the reason it was unable to compete directly with Souza Cruz was partly due to the latter's exclusive contracts with most of the points of sale for cigarette distribution in Brazil."

Valter Brunner, corporate affairs director for Philip Morris do Brasil and the only official authorized to speak to the press, declined repeated requests for an interview. The company, which has a factory in Curitiba, wouldn't provide even the most basic information on its Brazilian operations.

But Andrade doesn't mind talking. Although it's taken LatinCEO over a year to arrange this meeting, the busy cigarette executive -- whose expansive 11th-floor office overlooks downtown Rio -- seems to have all the time in the world to discuss one of his favorite subjects: cigarettes.

"This company has been able to sustain a very high market share position, mainly competing against Philip Morris," he said. "But what we have not been able is to compete against is illegal cigarettes. We are facing unfair competition from neighboring countries, mainly Paraguay and Uruguay. The Uruguayans are developing quite a lot of expertise in contraband. They've learned from Paraguay. The other problem is counterfeit products coming from Paraguay and Asia. The majority of these counterfeit brands are Souza Cruz brands, since we're the market leader."

According to company statistics, over a third of all cigarettes sold in Brazil enter illegally. In the first half of this year, 49.7 billion cigarettes were sold in the formal Brazilian market at an average price of R$1.29 (52 cents) per pack. The illegal market -- comprising around 360 brands -- accounted for sales of 25.1 billion cigarettes over the same time period, at an average R$0.75 (30 cents) per pack.

The reason contraband cigarettes sell so cheaply is that the smugglers who supply them don't pay taxes. And in Brazil, taxes represent 71% of the retail price of a pack of cigarettes -- double the taxation rate in the United States.

"If you include unfair competition or illegal operations, our market share is only 57%," says Andrade. "We're trying to work closely with the Brazilian authorities to stop this on our border. This problem began in 1993. Before that, we had almost zero illegal offers in the marketplace, because we had price controls and were selling our cigarettes at a very low price. Back then, illegal operations represented 6-7% of total cigarette sales. Today, it's almost 35%. This has affected our sales dramatically."

He adds: "I'm completely confident the authorities will be able to solve the contraband problem. If they are successful, we expect our total market share to increase to 80%."

A racing-car aficionado who studied economics at the Universidade Católica de São Paulo, Andrade began his career at Souza Cruz in 1971 as a merchandising manager. He quickly rose through the ranks, and in 1985 become the company's first Brazilian-born director of sales and marketing. In 1986, he was appointed president of Chiletabacos, BAT's Chilean subsidiary, but returned to Brazil two years later. In January 1996, Andrade was named CEO of the entire company.

"When I took over, we had 9,000 employees. We now have 4,600," he told us. "Since then, despite the various economic problems we've had, the company has been able to produce good results. Every single day, we are updating the company. That's what I try to do."

A big part of Souza Cruz's succeess has to do with its highly efficient distribution system, unparalleled anywhere in Brazil. Six integrated distribution centers and 23 smaller operational centers keep more than 20,000 outlets across the nation supplied with cigarettes -- within a time window of only 24 hours between the salesman's visit and product delivery. To help Souza Cruz in this mission, the company operates a fleet of 1,000 delivery vehicles -- many of them powered by natural gas and equipped with Global Positioning Satellite units to help drivers avoid traffic congestion.

In some cases, cigarettes are trucked from the Uberlândia factory to Belem -- a four-day overland journey -- then put on an Amazon River barge to Manaus, where five days later they are delivered to some of the most remote villages in Brazil.

Yet for all its sophistication, Souza Cruz sometimes makes mistakes. In October, for example, the company surprised consumers by hiking the price of its cigarette brands by an average 13%, reversing a decision made last December to reduce the cost of a pack of Derby from R$1.10 (44 cents) to R$1.00 (40 cents).

Souza Cruz says it raised prices in order to make up for the year-to-date impact on its cost structure of the devaluation of Brazil's real, now trading at around 2.53 to the U.S. dollar.

"Most of the raw materials we use are commodities like paper and tobacco, and the cost of these raw materials has been increasing in line with the devalution. This dramatically affects our costs," said Andrade, noting that the last time Souza Cruz raised its prices was in September 1997.

"The reason for maintaining such a long time without price increase was related to our ability to manage costs, mainly fixed costs," he said. "The strategy was right. What was wrong was the exchange rate."

Added to that are Brazil's continuing energy crisis and a general slowdown in the economy as a result of the Sept. 11 terrorist attacks in the United States.

Says Andrade: "The Brazilian economy won't grow over 1.5% this year, which is far lower than the previous forecast we had for 2001. What is happening in the United States will not affect our company directly, since our exports to the U.S. are very small. But it will affect the local market. There is no doubt about that."

So will Brazilians' gradually changing attitudes toward cigarette smoking in general. While smokers are still tolerated in restaurants, airports and bars, "no smoking" signs are starting to appear all over the place, especially after a nationwide ban on most forms of cigarette advertising took effect at the beginning of this year.

"Brazil nowadays is one of the most restrictive countries in the world, in terms of laws affecting our industry," he said. "The only exception to the advertising ban are points of sale and promotional events, which are allowed to continue until the beginning of 2003."

For a lifelong pack-a-day smoker, Andrade appears to be in pretty good shape. The executive begins his days with a 90-minute workout at 6 a.m., then has a quick breakfast before sitting down at his desk. He rarely leaves the office before 8 p.m.

While Andrade doesn't dispute the fact that cigarette smoking causes cancer, he insists the Brazilian government was wrong to completely prohibit cigarette advertising. "The decision was more political than rational," he says. "We were not successful in explaining our position to Congress."

That position -- shared by Philip Morris and other cigarette manufacturers -- is that the tobacco sector is among Brazil's top industries in terms of job creation and tax payments. However, the Ministry of Health, which pushed for the ban, estimates that 80,000 Brazilians die of cigarette-related cancer every year, costing the public health system roughly R$2.5 billion (US$1 billion).

Not being allowed to advertise will save the company millions of dollars; before the ban took effect, Souza Cruz was spending 5% of total revenues on marketing and promotion. Andrade said his company will continue to pour US$20 million a year into sponsorship of auto racing, free jazz festivals and other events until those activities are banned as well.

In the meantime, Souza Cruz is spending a great deal of money on being a good corporate citizen. For example, Souza Cruz claims it has drastically reduced pesticide use in the cultivation of tobacco seedlings; it also says it's completely eliminated the use of methyl bromide, a chemical that damages the ozone layer.

In addition, Souza Cruz has contributed money to all manner of worthy causes, from helping preserve historical documents at a Rio de Janeiro museum to eradicating child labor in tobacco farms.

Yet that hasn't stopped the company from being targeted by lawsuits and class actions related to the obvious dangers of cigarette smoking.

"Anti-smoking lawsuits have become popular in Brazil after the U.S. government reached an agreement with U.S. tobacco manufacturers for tobacco-related disease reimbursements," notes Santander's Bretthauer. "We believe that this news, along with other ongoing tobacco-related lawsuits, could be a cloud over Souza Cruz shares in the near term. The company does not expect any outcome in the near future, as these lawsuits should continue for a couple of years given the slowness of the Brazilian court system."

No matter how bad things get, however, Andrade's company is unlikely to exit the cigarette business. Souza Cruz is in tobacco for the long haul -- whether it likes it or not.

"They've tried to diversify several times in Brazil and get into all sorts of businesses, like cellulose, but were never successful," said Blocker, the São Paulo analyst. "Their culture is one of cigarettes. They've been here forever, that's what they know how to do, and they do it well enough to keep everybody else out."

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