Industry Surveys

Alcoholic Beverages & Tobacco

Esther Y. Kwon, CFA, Alcohol & Tobacco Equity Analyst MAY 2013

Current Environment ............................................................................................ 1 Industry Profile .................................................................................................... 20 Industry Trends ................................................................................................... 27 How the Industry Operates ............................................................................... 40 Key Industry Ratios and Statistics ................................................................... 47 How to Analyze an Alcoholic Beverage or Tobacco Company ................. 49 Industry References ........................................................................................... 53 Comparative Company Analysis ...................................................................... 55
This issue updates the one dated October 4, 2012. The next update of this Survey is scheduled for November 2013.

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Global Industry Surveys

Airlines: Asia Autos & Auto Parts: Europe Banking: Europe Food Retail: Europe Foods & Beverages: Europe Media: Europe Oil & Gas: Europe Pharmaceuticals: Europe Telecommunications: Asia Telecommunications: Europe

S&P Capital IQ Industry Surveys

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CURRENT ENVIRONMENT
Beer consolidation drama froths up
Over the last few 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 recent years. In 2008, Belgium/Brazilbased 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 Fosters Group Ltd. for $10 billion. In 2010, Dutch brewer Heineken NV acquired Mexicos 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 regions 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 StarBevs portfolio of more than 20 brands. The company expects to generate approximately $50 million in pretax operational synergies by 2015. AB InBevs proposed acquisition of Modelo hits initial roadblocks In June 2012, Anheuser-Busch InBev (AB InBev) continued to consolidate its position by entering an agreement to acquire the remaining 50% share in Mexicos Grupo Modelo SA de CV for $20.1 billion (the first 50% interest was obtained through InBevs acquisition of Anheuser-Busch). With this acquisition, AB InBev would control 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 Marketers Insights, a brewing industry trade publication. The company would also expand 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, a market research firm, 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 Becks, will control Modelos main brand, Corona Extra, which is exported to more than 180 countries. To assuage antitrust concerns, Modelo has 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 (8.5X earnings before interest and taxes), which we see as a very favorable price compared with other transactions in the brewing industry. 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 believe its longer-term growth opportunities are bright. The agreement will allow 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
INDUSTRY SURVEYS ALCOHOLIC BEVERAGES & TOBACCO / MAY 2013 1

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. According to the article, the craft brewers are concerned that following the acquisition of Modelo, AB InBevs 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 InBevs 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 soften the antitrust concerns over the acquisition, AB InBev offered to sell another $2.9 billion worth of Modelos assets to Constellation, bringing the total deal value to $4.75 billion, including the $1.85 billion deal discussed above. AB InBev proposed to sell Modelos Piedras Negras brewery in Mexico to Constellation, including licensing rights to Modelos 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 Modelos entire US business (including licenses of Modelo brand beers, its Piedras Negras brewery, its interest in Crown Imports, and other assets) to Constellation Brands in order to go forward with their merger. The proposed settlement was filed with the court and, if approved, it would resolve the DOJs competitive concerns.

BEER SHIPMENTS FINALLY TURN UP IN 2012

After a three-year decline, the beer industry experienced a 1.7% increase in beer shipments in 2012. Such shipments were down 1.4% in 2011, following drops of 1.3% in both 2010 and 2009, according to data from Beer Marketers Insights. The increase in 2012 indicated that consumers are recovering from the recession and are spending their money on beer, despite an increase in prices by the breweries. According to an article in the Wall Street Journal (WSJ; October 2, 2012), the recession affected business across a number of industries, including construction, whose blue-collar male workers in their 20s are the beer industrys main customers. The article noted that while employment figures still have not regained their pre-recession levels, they appear to be improving. Most top suppliers gain, but megabrands still lose share According to preliminary estimates from Beer Marketers Insights, eight of the top 10 suppliers reported shipment gains in 2012 versus only six in 2011. Anheuser-Busch continued to hold the top position, with a 0.6% increase in shipments in 2012 versus a US SALES OF LEADING BREWERS 2.9% decline in 2011. MillerCoors retained (Ranked by 2012 sales, in millions of 31-gallon barrels) second place, reporting a 1.8% decline in MARKET shipments in 2012 compared to a 3% - - - - - - - SHIPMENTS - - - - - - - - - SHARE (%) - decline in 2011. Crown Imports stayed at COMPANY 2012 % CHG. 2011 2012 B01: US2011 No. 3, but shipment gains fell to 3.5% in Anheuser-Busch 99.1 0.6 46.8 46.3 Sales of98.5 2012 from 4.5% in 2011. Heineken USA, MillerCoors 58.6 (1.8) 28.3 27.4 leading59.6 which remained in fourth place, reported a Crow n Imports 11.9 12.3 3.5 5.6 5.7 brewers 5% gain in 2012 versus a 3.9% decline in Heineken USA 8.1 8.5 5.0 3.8 4.0 2011. Pabst continued to hold the fifth Pabst 5.7 6.0 4.4 2.7 2.8 position, with a 4.4% increase in 2012 D.G. Yuengling 2.5 2.8 10.6 1.2 1.3 versus only a 0.4% gain in 2011. However, North American Brew eries 2.7 2.7 1.1 1.3 1.3 the market share of the top two suppliers Boston Beer 2.5 2.7 9.3 1.2 1.3 fell during the year: Anheuser-Buschs Diageo/Guinness USA 2.6 2.6 (0.8) 1.2 1.2 market share dropped to 46.3% from Mark Anthony (Mike's) 1.4 1.5 5.4 0.7 0.7 46.8% in 2011, while MillerCoors share Others 15.0 17.4 16.5 7.1 8.1 dropped to 27.4% from 28.3% in 2011. Total 210.4 214.1 1.7 100.0 100.0 In terms of the top three brands by sales, 2012s results were similar to 2011. For the second consecutive year after nearly 20 years in the lead, Anheuser-Busch in 2012 did not control the two top-selling brands in the US. Bud Light (owned by
2 ALCOHOLIC BEVERAGES & TOBACCO / MAY 2013 INDUSTRY SURVEYS
Source: Beer Marketer's Insights.

Anheuser-Busch) continued to hold the top position, though it dropped 0.5% (after a 1.2% drop in 2011), continuing its fall after its first-ever decline in 2009. Coors Light (owned by MillerCoors) remained at the No. 2 position for the second year in a row, on a 2.4% volume increase (to 18.7 million 31-gallon barrels), following a gain of 0.8% in 2011. Budweiser (also owned by Anheuser-Busch), in third place for the second year, saw sales decline 5.6% to 16.7 million barrels in 2012, following a sales decline of 4.6% in 2011.
TOP 10 BEER BRANDS (Ranked by 2012 sales, in millions of 31-gallon barrels)
BRAND BREWER - - - - - - - - - - SALES - - - - - - - - - 2011 2012 % CHG.

In order to counter the declining sales of their flagship brands, both AB InBev and MillerCoors have developed innovative products, with AB InBev launching 19 new products in the US. In February 2012, AB InBev launched Bud Light Platinum, a higher alcoholic content version of its Bud Light. Packaged in cobalt blue bottles, Bud Light Platinum has 6% alcohol content by volume (versus 4.2% for Bud Light) and is sweeter as well as smoother than the original version. In April 2012, the company launched Bud Light Lime-a-Rita (an 8% alcohol malt beverage), in addition to a tea-andlemonade alcoholic drink under the Michelob beer brand. According to Beer Marketers Insights, AB InBev recorded a gain in annual shipments in 2012 for the first time since 2008, mainly due to the introduction of these brands, which improved its shipments in the second half of the year. In early 2013, the company launched another beer named Budweiser Black Crown, a premium brand that is priced 15% higher than the traditional Budweiser beer and has 6% alcohol content by volume. The company plans to target the Millennials (also called Generation Y, people in the age group of 21 to 34) with this new offering, as it believes that they are trend-settingtype consumers. In October 2009, MillerCoors launched Molson Canadian 67, a 67-calorie drink, and Miller 64, a 64calorie drink, primarily targeted towards women. In April 2012, the company launched Coors Light Iced T in Canada. We view favorably the recent launches of innovative products by AB InBev and MillerCoors, as well as 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 AfricanAmericans are expected to drive 70% of beer growth from 2000 to 2020. 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. Trading up accelerates For the year through December 29, 2012, Nielsens all-outlet scan data, as cited in Beer Marketers Insights, showed an increase of 2% in beer volumes. Pricing improved 3% to $20.59 per case, on average, mainly due to acceleration in trading-up by consumers along with some price hikes by suppliers. According to the Nielsen data, the above-premium segment reported a gain of 3% in sales (by dollars) in 2012, while capturing a 32.7% share of total revenues. For the sub-premium segment, dollar sales grew 30% year over
INDUSTRY SURVEYS ALCOHOLIC BEVERAGES & TOBACCO / MAY 2013 3

1. 2. 3. 4. 5. 6. 7. 8. 9. 10.

Bud Light Anheuser-Busch Inc. Coors Light Molson Coors Brew ing TobacB02: TOP 10 Budweiser Anheuser-Busch BEER BRANDS Inc. Miller Lite Miller Brew ing Co. Natural Light Anheuser-Busch Inc. Corona Extra Grupo Modelo Busch Light Anheuser-Busch Inc. Busch Anheuser-Busch Inc. Miller High Life Miller Brew ing Co. Keystone Light Molson Coors Brew ing Total, top 10 Source: Beer Marketer's Insights.

39.9 18.2 17.7 15.2 8.3 7.2 6.6 6.0 4.7 4.5 128.3

39.7 18.7 16.7 14.7 7.9 7.2 6.7 5.7 4.5 4.2 125.8

(0.5) 2.4 (5.6) (3.0) (4.8) 0.1 0.8 (5.0) (5.3) (7.6) (1.9)

The sub-premium category performed poorly in 2012. Keystone Light dropped 7.6%, after a decline of 4.3% in 2011. Busch Light was up 0.8%, following a 3.6% decline in 2011. Natural Light dropped 4.8% in 2012, after a 7.8% decline in 2011. Miller High Life fell 5.3%, following a 6.9% decline in 2011.

year in 2012, and its share of total revenues improved to 7.2%. The Craft and Cider categories also witnessed increases in dollar sales, and saw their shares of total revenues grow by 13% and 79%, year over year, respectively. Beer Marketers Insights noted that though volumes were up for big brands, most of the brands lost market share in 2012. While the share of sales (in dollars) in 2012 fell 0.3% year-over-year for AB InBev and 0.8% for MillerCoors, the share for players like Crown and Boston Beer rose. The report noted that the trade-up in 2012 was mainly led by AB InBevs two new launches (as discussed earlier in this section). The companys Bud Light Platinum and Bud Light Lime-a-Rita captured 1.4% and 0.5% of dollar sales in 2012, respectively. Among the other gainers, Modelo Especial gained 0.3% of dollar sales in 2012, according to Nielsen, and Pabsts Blue Ribbon gained 0.2%. Imports gained slightly in 2012 In 2012, import beer shipments rose 1.4% (versus 0.7% in 2011), representing approximately 13.3% of the total US beer business, according to estimates by Beer Marketers Insights. Shipments of Corona Extra increased by a marginal 0.1% over 2011, while Heineken grew 2.1%. Big gainers included Modelo Especial (up 21.2%), Dos Equis (up 22.2%), and Stella Artois (up 19.9%). Mexican beers now dominate the import category, representing four of the top six brands. We believe that the rising Hispanic population in the US, particularly in California, has aided Modelos 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. Mexicos 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 2012. The continued growth in imports from 2010 through 2012 marks a rebound in beer imports from the double-digit declines recorded in 2009 and 2008. The growth in imports rode on the back of Mexican shipments, which increased by 6.6% in 2012 because of impressive performances by the Dos Equis and Modelo brands (as noted above), according to Beer Marketers Insights. While the share of imports of Mexican beer rose to 55%, the share of Dutch shipments fell to 18.9% in 2012, the second year in a row that its share was less than 20%. Canadian imports fell by 13%, while Belgium became the fourth-largest beer importer to the US. Belgium shipments increased by 10.5% (following a 27% increase in 2011), mainly due to the large increase in shipments by Stella Artois (as noted above). Since 1992, the imported beer category has typically experienced annual growth, mostly in the double digits, 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 were actually down 4.1%, according to Beer Marketers 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 find value and are willing to pay a premium for craft brands. According to the Brewers Association, the craft brewing industry grew 15% by volume and 17% by dollars in 2012, for a beer industry share of 6.5% and 10.2%, respectively. In 2012, there were 2,347 craft breweries operating in the US98% of the total 2,403 breweries. According to Beer Marketers Insights, craft beer growth has accelerated in recent years, despite difficult economic times and the increase in the segments base. Insights estimated that volume grew 5% in 2008, 6% in 2009, 10% in 2010, over 14% in 2011, and then slowed to a still-strong 12% in 2012; it pegged crafts share at about 6.6% of total beer industry volume in 2012. As shown in the accompanying table, all of the top 10 saw shipment growth in 2012; because the smaller craft brewers grew more strongly, however, most of the leaders lost share in the craft segment.
4 ALCOHOLIC BEVERAGES & TOBACCO / MAY 2013 INDUSTRY SURVEYS

Although the craft segment currently accounts for a small share of the beer market, its growth pattern indicates that it will capture a larger share in the near future. According to a November 2012 article on CNNMoney, a business website, many consumers are passionate about craft beer, similar to the way people feel about wine. Accordingly, this segment has higher consumer spending and delivers higher profit margins, which has not gone unnoticed by the macro brewers. Beer industry behemoths such as Anheuser-Busch and MillerCoors have stepped into the microbrewery segment through craft partnerships and acquisitions, launching their own versions of craft beer or acquiring partial or full control of craft breweries to benefit from the growth of the segment.
MICROBREWERY SALES (Ranked by 2012 sales, in thousands of 31-gallon barrels)
- - - - - - - SHIPMENTS - - - - - - COMPANY 2011 2012 % CHG. TobacB03: MARKET - - SHARE (%) - 2011 2012

Boston Beer 2,096 2,150 2.6 17.1 MICROBREWERY Sierra Nevada 858 12.6 7.0 SALES 966 New Belgium 713 765 7.3 5.8 Craft Brew ers 623 650 4.3 5.1 Spoetzl 487 524 7.6 4.0 Magic Hat/Pyramid 336 337 0.3 2.7 Deschutes 223 253 13.5 1.8 Lagunitas 161 235 46.0 1.3 Bell's 180 216 20.0 1.5 Matt 196 202 3.1 1.6 Others 6,377 7,422 16.4 52.1 Total 12,250 13,720 12.0 100.0 Source: Beer Marketer's Insights.

15.7 7.0 5.6 4.7 3.8 2.5 1.8 1.7 1.6 1.5 54.1 100.0

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 increasingly becoming selective about how and where the products they consume are produced. Generally, a craft brewery is small and produces less than six million barrels annually, according to the Brewers Association. The Boston Beer Co., the largest craft brewery by far and the seller of Samuel Adams, sold 2.1 million barrels in 2012, while players such as Anheuser-Busch sold 98.8 billion barrels, the CNNMoney article noted.

In addition, according to a WSJ article dated August 14, 2012, the European market is showing an interest in American craft beers, as indicated by the 52% surge in beer export volume from US craft breweries. Furthermore, the article stated that the number of breweries in the UK that are classified as small or craft almost doubled in just over a decade to 945 at the end of 2011. S&P Capital IQ attributes the success of craft beers to several factors, despite the high price points at which they tend to trade. One is their uniqueness. Innovation in the category is also strong, with the introduction of seasonal brews, products aged in whiskey and wine barrels, as well as vintage-dated beer. In a time of markedly slowing introductions, new products stand out. Supermarkets 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. We also believe craft beers have benefitted from the trade-down from wine and spirits. Boston Beer, with its Samuel Adams brand, has introduced limited-edition products, thus adding to its uniqueness and helping to differentiate its products and marketing strategy. Although Boston Beer has kept price points high, it has captured share of stomach and dollar from the major brewers. In 2009, however, several competitors successfully copied its seasonal and limited-edition strategy, leading to weakness in shipments. Molson Coors, for example, successfully marketed its Blue Moon brand in a similar fashion. Cider comeback 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 like cider because its taste is less alcoholic than beer. Hard cider was popular until the 19th century and began declining in the second half of the 19th century as people shifted to beer. Hard ciders market share dropped after Prohibition ended in 1933, and this category now accounts for a small share of US beer consumption (cider is included with beer in consumption
INDUSTRY SURVEYS ALCOHOLIC BEVERAGES & TOBACCO / MAY 2013 5

statistics). Over the past three years, 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. According to Euromonitor International, hard cider currently constitutes less than 0.5% of beer volumes in the US (approximately six million cases, or 59 million liters), but has recorded significant growth in the recent past. 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 by 65%, according to estimates by Nielsen, a research and ratings firm. In order to take advantage of this growth, several beer companies are making moves in 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 2011 in New England, New York, Maryland, and Colorado. 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 around 20% of hard ciders 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 the 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 over $20 million, will increase annual production capacity to 10 million cases from 4 million cases. According to an article in the WSJ (October 14, 2012), more than two dozen cideries operate in New Yorks Hudson Valley compared with only 11 five years earlier, and there were plans to open several more. According to IBIS World, a market research firm, as quoted in the WSJ article, sales of domestically produced cider were projected to increase from $178 million in 2007 to an estimated $601 million in 2012. According to preliminary data published in Beverage Information Groups Handbook Advance 2013, an annual report on alcoholic beverage sales and consumption, the cider category is dominated by Vermont Hard Cider Co., which had a 23.3% market share in 2012, and Boston Beer Co., which had a 20.5% share.

SPIRITS VOLUMES IMPROVE, PARTICULARY AT THE HIGH END

According to the Distilled Spirits Council of the United States (DISCUS), spirits volumes rose 3.0% in 2012, and revenues advanced 4.5%, as consumers continued trading up to premium spirits. Though the volume growth was above an average growth of 2.9% from 2000 to 2007, revenue growth remained below the averages of 6.5% during the same period. Volumes in the high-end and super-premium segments rose 4.8% and 8.9%, respectively, in 2012, after rising 5.3% and 8.9% in 2011. Value spirits edged up only 1.8%, after an increase of 0.9% in 2011. In the value segment, the rate of growth was up in vodka, which rose 4% in 2012 compared to 3.3% in 2011, but was down in tequila to a 2.9% increase in 2012, from 7% in 2011. High-end premium Irish whiskey volumes increased 13.0% in 2012 after a 23.2% rise in 2011. Secular shift from beer to spirits For decades, beer has been the preferred alcoholic beverage for Americans, and it had captured more than 50% market share (by revenues) of the alcohol industry in US. 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 three segments has been changing, with beer losing market share to spirits and wine. By 2012, beers market share had fallen to 48.8%, versus 34.3% for spirits and 16.9% for wine. According to DISCUS, the share of distilled spirits grew in 2012 mainly due to continuous modernization, product innovations, and sophisticated line extensions launched by companies operating in the segment. It further noted that increased access and a convenient shipping environment also helped the sale of distilled spirits.
6 ALCOHOLIC BEVERAGES & TOBACCO / MAY 2013 INDUSTRY SURVEYS

According to data from DISCUS, exports of distilled spirits from the US is around 20% higher than wine exports and three times more than beer, as consumers demand for American whiskey is growing around the globe. To keep track of a shift in beverage preference in the US, Gallup, a performance management consulting firm that provides data-driven news based on US and world polls, conducts a yearly survey to understand the drinking preferences of Americans. In its latest survey, conducted in July 2012, Gallup found similar preferences for beer and wine: 39% of the respondents preferred beer and 35% preferred wine. Spirits, at 22%, placed third. The percentages favoring wine and spirits are near record highs, with the percentage preferring wine only surpassed by the 39% who favored wine in 2005, when wine edged out beer as the preferred beverage for the first time in the history of the poll. Gallup found that the preference for beer fell across most age groups, with a significant drop observed in young adults (45% in 2012 from 51% in 2010), followed by old-age adults (28% from 29%), while there was a slight increase among middle-age adults (45% from 44%). Meanwhile, preference for spirits among young adults grew significantly, with 29% of young adults now preferring spirits versus 24% a year earlier. On a gender basis, Gallup found that 55% of males showed a preference for beer, followed by 21% for liquor; however, 52% of females preferred wine. According to Gallup, this pattern has remained consistent with previous years. In an earlier survey conducted in July 2011, Gallup found a difference in drinking preferences for whites and non-whites. According to Gallup, 38% of whites preferred beer (versus 27% for non-whites), 36% preferred wine (versus 33% for non-whites), and 20% preferred spirits (versus 33% for non-whites). Whiskey/bourbon boom US whiskey, which had only a small presence abroad until around 25 years ago, has been increasing its footprint outside the US. Bourbon (also known as Americas native spirit) has been a staple bar product in the US for many years and is now being favored in different parts of the globe. According to DISCUS, in 2012, US exports of spirits touched a record high of $1.5 billion, of which 68% represented whiskeys (including bourbon). Wine exports totaled $1.28 billion and beer $447 million, according to DISCUS. According to Brown-Forman Corp., its Jack Daniels brand, a leading US whiskey, is available in more than 135 countries and generates more than half of its business outside the US. Drinks International, a monthly trade magazine covering the global spirits, wine, and beer markets, ranked Jack Daniels eighth among whiskeys in 2011 (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 12th by Drinks International; it also generates a majority of its sales outside the US. Along with these established brands, smaller brands such as Makers Mark bourbon (owned by Beam Inc.) are also moving abroad. According to a forecast from Euromonitor International, a market research firm, by 2016, 70% of annual US whiskey growth will come from outside the US. Companies are already devising plans to meet the anticipated surge in demand for its products. For instance, Brown-Forman, in its fiscal 2012 fourth-quarter earnings call in June 2012, announced an increase in capital spending to over $100 million for each of the next two years to invest in barrel needs and the distilling capacity of the company. In its second-quarter 2012 earnings report, Beam Inc. announced that the company is accelerating its investments to meet the worldwide growing demand for its bourbon, scotch, and cognac brands. The company plans to expand its distillation capacity, including advancing the expansion plan of Makers Mark and constructing nine new aging warehouses in Kentucky and Scotland. In order to expand their market, distillers are coming up with such innovations as adding flavors of honey, cherry, and spice. In 2009, Beam Inc. introduced a black cherryflavored Red Stag bourbon. Its success was in doubt before the launch, but it has settled down well and has even opened the brown spirits market to women and Millennials, who prefer their drinks to be a little sweet. According to Beam Inc., sales of traditional bourbon were 80% skewed toward males. However, males and females (with a slight inclination toward the younger generation) equally favor Red Stag. Other distillers followed the success of Red Stag. In October 2011, Brown-Forman introduced Southern Comfort Fiery Pepper, and expected that the spiceflavored spirit would find as good a reception as honey- or cherry-flavored. Makers of these flavored spirits
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want to direct their focus toward this new market, but also need to ensure that they do not alienate their core whiskey drinkers. 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 recessionary economic conditions, Germanys desire for American bourbon has provided some relief for US spirits companies, according to an article in the WSJ dated October 8, 2012. The article cites data from Euromonitor International, which indicates that the consumption of alcohol (by volume) in Germany across all categories declined 1.2% in 2011. In contrast, sales of bourbon and other US whiskeys, which account for about 3% of Germanys total spirits consumption, are forecast to grow at a compound annual growth rate (CAGR) of 7.2% in Germany from 2011 to 2016, compared to a 0.3% decline expected for the overall spirits market. Beam Inc.s Jim Beam had a 44.7% market share (by volume) in Germany in 2011, while Brown-Formans Jack Daniels had 34.4%. According to Beam Inc., Germany is the worlds 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 whiskeys main competitor is Scotch whiskey, which has experienced a surge in demand from the emerging markets. While the US and France remain the worlds biggest markets for Scotch, exports to emerging countries such as Singapore, Taiwan, South Korea, and Brazil increased significantly in 2011, according to the Scotch Whiskey Association, an industry trade group. For the year ended June 2012, exports from Scotland grew 12% to 4.3 billion, according to the 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. According to estimates from Euromonitor, demand for single malt Scotch between 2010 and 2015 is expected to grow at a 16% rate in China and 19% in India. Makers Mark cancels dilution plan; other companies increase strength In February 2013, Beam Inc.s Makers Mark announced plans to dilute its whiskey to meet the increasing global demand. The company said that the brand would be diluted to 42% alcohol by volume, from 45%, without changing the taste. This would represent a cut from 90 proof to 84 proof. (The standard is 80 proof, which means there is 40% alcohol content. Anything above that is termed overproof.) However, the ensuing consumer criticism forced the company to reverse its decision within a week. This came at a time when other distillers are launching products with above-normal alcohol content, according to an article in the WSJ dated October 2, 2012. Such products, with alcohol concentration of up to 150 proof, include varieties of bourbons, rums, ryes, and gins, and the article noted that their sales are strong. Although diluting spirits could reduce costs and increase profits, the growing demand for overproof spirits, which are priced at a premium, is attracting companies attention. Spirits makers see renewed pricing power and a haven in North America Due to the economic conditions in Europe, many companies businesses have suffered and, therefore, they have turned to the US market, where they have resorted to such measures as price increases to compensate for the loss. For instance, Diageo, a London-based alcohol giant, increased prices across its portfolio in the US. According to an article in the WSJ dated January 31, 2013, the increase in prices was reflected in the companys sales figures, as it reported a 4% jump in sales in North America for the six months ending December 2012. For Diageo, North America is the largest and most profitable market. Many US-based alcohol companies also have announced plans to increase prices, which they claim are the first increases since the recession in 2008. In its fiscal 2013 third-quarter (ended January 2013), BrownForman reported a favorable market reaction to the global price increases implemented for Jack Daniels and other brands earlier in the year. In its fourth-quarter 2012 earnings call in February 2013, Beam Inc.
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noted that it took the lead in price increases in 2012 in the US for its Makers Mark and Jim Beam brands, and both have seen good performance. Tariff reductions aid US spirits sales abroad Preference for US whiskey across the world can be witnessed by the 11.9% year-over-year growth in 2012 of exports of US distilled spirits, 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. A 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 a 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 a 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 2011 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 is owned by the Bordeaux Chamber of Commerce and major companies in the industry. IWSR is a market research firm and publishes a monthly trade magazine.]

WINE CONSUMPTION, SALES ROSE IN 2012

Wine consumption rose 1.9% in 2012, after gains of 2.5% in 2011 and 2.1% in 2010; retail sales advanced 3.1%. The on-premise segment rose 0.6%, after a 1.8% gain in 2011. Off-premise growth continued in 2012, with a 2.3% gain on top of a 3.4% gain in 2011, according to Beverage Information Groups Handbook Advance 2013. On-premise sales accounted for 47.4% of total retail wine sales in 2012, compared with 48% in 2011. Off-premise sales accounted for 52.6% of total retail sales in 2012, slightly up from 52.0% in 2011. Following a significant decline in 2008 and 2009, the champagne industry rebounded in 2010 and continued to recover in 2011. According to Le Comit Interprofessionnel du Vin de Champagne (CIVC), the trade association that represents all the grape growers and houses of Champagne in France, following the downslide of 2009, when fewer than 300 million bottles of champagne were shipped, the industry rebounded in 2010, when 320 million bottles were shipped, and improved further in 2011, when shipments totaled 323 million bottles. In 2012, CIVC reported a 4.4% drop in shipments to 308.8 million bottles. Lower-priced domestic wines continued to outpace imports, rising 3.2% in 2012, while imports fell 2%. Among imports, Italy continued to lead with a 30% share of total imports (by dollars) in the year ending September 2012, followed by France (26%) and Australia (11%). Volumes from Italy rose 5.1% in the year ending September 2012 compared to the twelve months ending 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 ending 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 2012, as noted in an article in the Washington Post dated March 2012, Millennials represent the category of high-end wine buyers, buyers that purchase wine bottles that cost more than $20 at least once a month. The survey noted that Millennials experiment more with newer wines or wines with which they are not familiar, compared to people in other demographics. The group consumes more wine per occasion, reads wine reviews, and visits wine bars more often compared to people in other age groups, according to the survey. The survey also revealed that Millennials use social media platforms such as Twitter or Facebook to give reviews of the wines they try.
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The survey results show how the wine consumption pattern in the industry is evolving. People want newer varieties, in addition to the Chardonnay and Merlot, and they are willing to pay a higher price. The groups 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 the Millennials consume wine at least once a week. These young buyers have become the new target for the wine companies and they are offering wines to suit these consumers. New brands offer wine in plastic containers, boxes, and aluminum cans to break the age-old convention of wine in a glass bottle. Wine companies believe that this group looks for convenience and flexibility in any offering and, therefore, this new packaging has a high possibility of gaining acceptance. New brands such as Stacked Wines offers wine in plastic cups stacked in a box, while Bonfire Wines offers wine in a pouch. Besides changing the form in which wine is sold, these companies 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 to sell wine Before the 2012 holiday shopping season, Amazon announced the launch of its online marketplace Amazon Winethrough which the company would sell wine in the US. The marketplace features over 1,000 wines and ships 6 bottles of wine for $9.99 to 16 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 the 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% of total wine sales in the US. Amazons 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 WSJ 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. Grape shortage According to a WSJ article dated June 8, 2012, Californias wine industry, which accounts for 90% of total wine production in the US, is facing an acute shortage of grapes. According to the state governments estimates, the total wine-grape production area in California declined to 543,000 acres in 2011 from 570,000 acres in 2001. Grape farmers in the region shifted to almonds, vegetables, and other fruits following the sharp decline in grape prices during the 1990s that followed large vineyard expansions. Although grape prices have risen in the last few years, the corresponding increase in grape production has not been able to keep pace with the continuously rising wine demand. According to the Wine Institute, volume shipments of wine totaled 424.6 million liters in 2012, down from 446.6 million liters in 2011. US wine exports (of which 90% came from California wineries) rose by 2.6% (in dollars) in 2012. Californias grape squeeze has primarily been caused by the high lead-in timearound three years or morefor newly planted vines to produce grapes. The recent economic recession caused industry players to hold off longer than usual on planting new vines. Furthermore, tightened environmental rules have forced the vineyard owners in the state to delay the planting of new vines. According to Bronco Wines Co., the countrys largest vineyard owner with about 45,000 acres, it has not been able to plant a vineyard near the foothills of Sacramento (purchased by the company in 2008) as the authorities are worried about its impact on salamanders. The company said that it generally takes more than a year to gain approval to clear ground in the states coastal areas, amid concerns about soil erosion and the impact on the water supply.

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INDUSTRY SURVEYS

OUTLOOK FOR ALCOHOLIC BEVERAGE INDUSTRY REMAINS POSITIVE

Despite weak GDP growth and high unemployment, and the likely near-term effect of these two factors on disposable income, we remain positive on the US alcoholic beverage industry, given attractive demographics, longer-term trading-up activity, and significant increases in brand investments by beverage companies. Spirits. The spirits industry should see 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), a rebound in the on-premise business, and continued brand innovation. S&P Capital IQ (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. We look for pricing to continue rising as discounting pressure abates and on-premise sales recover. In 2012, Diageo and Beam Inc. increased prices on brands sold in the US, and Brown-Forman followed with its own increases. Wine. The wine industrys outlook is positive. S&P expects continued increases in demand for off-premise consumption. In addition, attractive demographic trends should support growth over the long term. Operating profits are expected to rise in 2013, largely due to reduced discounting and mix improvement. However, higher input costs could weigh on margins. We look for some higher pricing, although we think that the ability to raise prices is more limited compared to the spirits makers and brewers due to the proliferation of wine brands. Beer. S&P is neutral on the domestic brewing business. We look for volumes to rise modestly and believe that price increases will be offset somewhat by higher commodity, freight, and packaging costs. Increased marketing efforts for new and existing products should continue unabated. We look for the beer industrys operating profits in 2013 to continue to improve on better pricing and further cost rationalization measures. We think the craft segment will continue to outperform the industry, but we remain somewhat concerned about commodity cost pressures in 2013 and 2014.

TOBACCO REGULATORY ISSUES

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 packs surface area. (Currently, all packages have 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 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 companiesLorillard 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 FDAs labeling requirement, citing infringement of free speech. The judge ruled that the governmentimposed 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 WSJ 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 agencys 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
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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 governments appeal to reconsider the ruling to strike down the warnings label requirement. The federal government had the option to reach out to the Supreme Court until April 5 for a review, but on March 19, the government announced that it would scrap the requirement of graphic warning labels, according to an article in the WSJ dated March 19, 2013. The decision means that it is now up to the FDA to propose a new set of labels to discourage smoking, and any such labels wouldnt appear on cigarette packages for years.
THE NEW CIGARETTE HEALTH WARNINGS

Chart H05: THE NEW CIGARETTE HEALTH WARNINGS

Source: US Food and Drug Administration.

New director could make things more difficult In February 2013, the FDA appointed Mitch Zeller, a former critic of the tobacco industry, as the director of the Center for Tobacco Products. The Center was formed as a result of the Family Smoking Prevention and Tobacco Control Act, which was signed into law by President Obama in June 2009. The Act gave the FDA the authority to regulate the tobacco industry. Mr. Zeller replaced Lawrence Deyton, who had served as the first director of the Center. During his term, Mr. Deyton was associated with such steps as banning candy- and fruit-flavored cigarettes, and banning cigarette advertising that said low tar or light, according to an article in the WSJ dated February 22, 2013. The change in leadership comes at a time when the FDA is on the verge of making crucial decisions that will determine the fate of the tobacco industry, but decision-making has been delayed and the tobacco industry waits with much expectation. For instance, the FDA was expected to decide by April 2013 on the regulation of e-cigarettes, cigars, and a range of other tobacco products. The agency is also expected to reach a decision this year on whether to ban menthol cigarettes. In addition, on April 1, 2013, the FDA was scheduled to update the Congress regarding its efforts to reduce tobacco consumption. Meanwhile, there is the ongoing dispute over the graphic warning labels. The agency also has yet to decide on over 3,500
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applications submitted by tobacco companies for launching new products, or to change existing products, according to the Associated Press, as quoted in an article in the Washington Post dated March 3, 2013. Mr. Zeller has been associated with this industry for around two decades and has worked with the FDA on many anti-smoking programs. Impending decisions under his leadership could be harsh for the industry as he has been a critic of the industry in the past. Slow FDA approval process solidifies shares of Big Tobacco As we noted above, over 3,500 applications filed with the FDA since 2009 are still awaiting approvals from the agency. According to an article in The Atlantic magazine dated March 6, 2013, no new tobacco product has been introduced in the market since March 2011. 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 to 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 submission of an application for a new product. Since March 2011, no new tobacco products have been introduced into the market as they now have to get approval first from the FDA, which has not approved a single product since then. In a way, 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. 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 WSJ 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. Altrias Philip Morris expects to receive credits worth $450 million and Lorillard $198 million. The companies expect more states to join in. 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 Sullivanboth of whom formerly held the position of US Secretary of Healthwho 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
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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. The agency has yet to come out with a final report, which will include the scientists feedback as well as public comments on the issue. S&P Capital IQ believes 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% of the total cigarette market in 2012, 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 believe 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 committees recommendation or conclusions, as is the case for the FDAs 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 worlds 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 WSJ 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 may pose a lower risk for lung cancer than unflavored versions. The study, funded by the National Cancer Institute, the federal governments 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 Vanderbilts findings in the agencys 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 TPSACs 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 believe 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 Californias 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. Australias 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 companiesBritish 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.

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INDUSTRY SURVEYS

Despite the ruling, PMI has not given up hope. According to an article dated August 18, 2012, in The Australian, a daily newspaper, Hong Kongbased 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 worlds toughest antismoking laws, stating that these laws violate international trade agreements. Ukraine started the legal proceedings against Australia in March 2012, and 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 Australias 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. In addition, Australias 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 plainpackaging 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. In August 2012, the European Commission announced that it could make legislative proposals that would force tobacco manufacturers to distribute products in plain packets across Europe. Russia cracks down Russia, the worlds 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 WSJ 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 takes effect June 1, 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. As taxes rise, tax avoidance increases According to an article in Bloomberg dated March 1, 2013, tobacco companies are resorting to various loopholes in the law governing the tobacco industry to avoid paying US taxes. According to the article, tobacco companies have saved around $1.1 billion in taxes by making their cigarettes heavier by using fillers such as clay from cat litter. By increasing the weight, companies can categorize their products as large cigars and avoid the 2,653% increase in the federal excise tax that was imposed under the 2009 law on the tobacco companies. However, the law exempted large cigars from this huge increase and levied a tax increase of only 155%. Before the law was enacted, there were 22 companies making small cigars, after which twelve shifted to producing large cigars, according to the Treasury Departments Alcohol and Tobacco Tax and Trade Bureau, as quoted in the article. In September 2011, sales of large cigars totaled one billion units a month, more than double from 411 million units in January 2009, when the law went
INDUSTRY SURVEYS ALCOHOLIC BEVERAGES & TOBACCO / MAY 2013 15

into effect, according to estimates from the US Government Accountability Office (GAO). In contrast, sales of small cigars dropped to 60 million units in September 2011, down 86% from 430 million units in January 2009. Indian tribes exemption from New York state excise taxes a continuing issue. As sovereign nations, Indian tribes do not pay state excise taxes, and thus sell cigarettes for significantly lower prices than general retailers do. In New York, the state has attempted to collect taxes from these tribes. In 2010, then-governor David Paterson estimated the taxes would generate approximately $200 million for New York, but a federal judge temporarily blocked those plans. In May 2011, however, a federal appeals court ruled unanimously that the tribes had not proven that the states efforts to collect these taxes would violate tribal sovereignty. The Cuomo administration asserts that the state has the right to tax Indian-made cigarettes sold to nonIndians, though to date it has not enforced that claim. Tribes have complied with that ruling, though some are now manufacturing their own cigarettes, which they claim are exempt from state excise taxes because the tribes are sovereign nations. New York currently collects $4.35 per pack in state excise taxes (the highest in the US), so these cigarettes are spreading rapidly all over the state. According to a New York Times article dated February 22, 2012, the New York state police and other law enforcement agencies have seized 60,000 cartons of these Indian-made cigarettes. Roll-your-own shops may have to close. Some retailers have taken advantage of a federal tax loophole to offer discounts on roll-your-own cigarettes using high-speed rolling machines and pipe tobacco, which carries a significantly lower federal excise tax of $2.83 per pound, versus $24.78 per pound for rolling tobacco. However, these retailers may not be able to take further advantage of the tax loophole: in July 2012, President Obama signed a transportation bill that included a provision defining commercial roll-yourown (RYO) machine operators as tobacco manufacturers under federal law. What this means is that any retailers making roll-your-own tobacco products available to customers will be taxed and regulated like mainstream cigarette manufacturers. According to a WSJ article dated July 2, 2012, the US Senate passed the bill in March 2012 after the US Government Accountability Office (GAO) estimated the loss of federal revenues of around $492 million between April 2009 and September 2011, due to changes in the market for roll-your-own cigarettes. The bill was backed by heavy lobbying by cigarette companies such as Altria Group and the National Association of Convenience Stores, arguing that roll-your-own shops were not playing under the same rules. The owners of roll-your-own stores opposed the bill, stating that they should not be treated the same as major cigarette manufacturers that roll cigarettes at roughly a 1,000 times faster. Lobbyists from RYO Machines, the largest manufacturer of roll-your-own tobacco machines, backed this opposition. Since it began manufacturing the machines in 2008, RYO Machines has sold around 1,900 of them. Excise tax increase in California snuffed. Californias initiative, also known as Proposition 29, to raise the cigarette tax after 14 years could not gather majority support from the residents of the state, and the proposition was defeated by a 50.7% to 49.3% vote. According to a New York Times article dated June 3, 2012, the state governments plan to increase the cigarette tax by $1 per pack, to $1.87 per pack, met opposition from the tobacco companies, such as Phillip Morris USA and R.J. Reynolds Tobacco Co. The industry players spent around $47 million to defeat the initiative, outspending the proponents by a ratio of around 4:1. Proponents of the initiative included the American Cancer Society and Lance Armstrong, the cyclist who survived a cancer threat. The article also stated that Proposition 29 was expected to generate additional revenues of $735 million to support research on cancer and tobacco-related illnesses. In addition, increasing the tax would have increased the cost of tobacco, which is probably the most effective way of discouraging smoking, especially among teenagers. Moreover, the article stated that California had the toughest antismoking laws, including what was once the third-highest cigarette tax among the 50 states (it now stands at 33rd). The state is one of only three states that have not raised the tax in more than a decade.

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TOBACCO COMPANIES MOVE TO DIVERSIFY FROM CIGARETTES

Over the past few years, the sales of traditional cigarettes have been witnessing a decline, according to an article in the Financial Times (January 21, 2013). The consumption of smoked tobacco products dropped 27% from 2000 to 2011, according to data from the US Centers for Disease Control and Prevention. The drop is mainly due to stricter regulations, higher taxes, and increased bans on consumption at certain places. Due to these reasons, several manufacturers are focusing on product lines that can serve as an alternative to traditional cigarettes. E-cigarettes One such alternative, which is experiencing considerable growth, is the e-cigarette, an electronic inhaler that contains nicotine-based water and can be inhaled as vapor. Lorillard Inc. estimates that annualized retail sales could be approximately $1 billion. Many independent startups such as NJOY, Logic, and Vapor have launched e-cigarettes and received a huge response from consumers. According to data from a government survey, 2.7% of US adults tried e-cigarettes in 2010 compared with only 0.6% in 2009. 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 April 2013, Philip Morris USA indicated it plans to introduce an electronic cigarette in the second half of the year. The e-cigarettes category, unlike the traditional cigarette segment, is not governed by strict rules and regulations, as well as heavy taxes. E-cigarette manufacturers claim that e-cigarettes will cause less harm than traditional ones. However, regulators are still assessing the impact of e-cigarette smoking on consumers heath and whether to impose restrictions. The FDA was scheduled to give its guidance on the regulation of the e-cigarettes in April 2013. As of now, e-cigarettes cost around half of what traditional cigarettes do, another factor encouraging consumers to try them. However, all this could change if regulators decide to impose regulations and taxes similar to traditional cigarettes. Smokeless products Apart from e-cigarettes, tobacco companies have come up with various other alternatives and are awaiting an FDA response. In early 2009, Altria acquired UST Inc., the leading manufacturer of smokeless tobacco products, and has submitted a series of letters to the FDA arguing that manufacturers should be allowed to market smokeless tobacco products as less harmful than cigarettes. These products are recording growth rates in mid- to high-single digit range; cigarettes, in contrast, are seeing unit declines in the low to midsingle digit range. In May 2012, Altria announced its plans to offer a nicotine product that would not contain tobacco. The new product, named Verve, is a non-dissolvable nicotine lozenge disc that is part of Altrias ongoing efforts to diversify its offerings. The consumption of nicotine is believed to result in some health problems, such as high blood pressure and heart disease, but not cancer, as is the case with cigarettes and smokeless products. According to the company, it will launch the product with less severe health warning labels. In June 2012, the company introduced Verve in Virginia through more than 50 stores. In February 2010, Star Scientific Inc. filed the first application with the FDA to have its dissolvable tobacco lozenges certified as less harmful than cigarettes. In March 2012, the FDA scientific advisory panel found dissolvable tobacco products could reduce health risks compared with smoking cigarettes, but also warned the products have the potential to increase the overall number of tobacco users. Subsequently, the FDA said it plans to review the findings to decide any future actions, but there is no set deadline for it to act. In 2009, Reynolds American launched a line of dissolvable tobacco products in the form of Camel Sticks, Strips, and Orbs. These products do not produce smoke and dissolve in your mouth, and are marketed as products that can be used at places where public smoking is banned. The company also emphasizes the reduced risks of diseases like lung cancer in using these products. This view is supported to some extent by the American Cancer Society, which has stated that these products are less lethal, but may also expose users to other health issues.
INDUSTRY SURVEYS ALCOHOLIC BEVERAGES & TOBACCO / MAY 2013 17

In May 2011, PMI bought the patent rights to alternative nicotine-delivery systems (which create nicotine in the form of an aerosol) from Duke Universitys Duke Centre for Nicotine and Smoking Cessation Research for an undisclosed sum. According to PMI, the non-burning technology can help reduce the harm of smoking. Their steps come amid increasing scrutiny by regulators on cigarettes and declining cigarette consumption in markets such as the US. Earlier, players like BAT and Reynolds America International (RAI) also showed interest in non-tobacco nicotine products. RAI, in December 2009, purchased Niconovum AB, a Swedish maker of smoking cessation products. Niconovums nicotine replacement products (mainly Zonnic pouch and Zonnic gum) are not currently marketed in the US and would require FDA approval before they could be sold here. In April 2011, BAT established a new company, Nicoventures Ltd., that would develop non-tobacco nicotine products, which are safer alternatives to cigarettes. In early 2011, Philip Morris USA and US Smokeless Tobacco Co. were testing their spit-free, tobacco-coated sticks at select retailers in Kansas under the Marlboro and Skoal brands. Other strategies While some players are diversifying into smokeless tobacco products, Lorillard is taking a different path. In December 2010, the company, which derives the bulk of its sales from Newport menthol cigarettes, introduced a non-menthol version, Newport Red. This step came as the FDA considers a ban on menthol cigarettes. In its fourth-quarter 2012 earnings release, Lorillard mentioned that, although its Newport brand had experienced a decline of 1.9% by volume in 2012, its domestic retail market share increased to 12.1% (up from 11.9% in 2011). Overall, Lorillard reported a shipment volume decline of nearly 1.4% in the 2012, which was better than the industry decline of 2.5%. S&P Capital IQ believes that a complete ban on menthol is unlikely as menthol cigarettes account for nearly 31% of the total market, and a ban would result in a significant rise in illicit activity. Diversification is not limited to the US; big tobacco players like PMI believe that countries such as China could be a potential destination to extend its range of new alternatives. According to data from Euromonitor, as quoted in an article in the WSJ (October 29, 2012), retail sales of cigarettes in China reached $160 billion in 2011, or one quarter of total global sales. However, over one million people die every year in China because of tobacco-related diseases, according to their health authorities quoted in the article. In September 2012, PMI announced its plans to develop next-generation cigarettes that are less harmful. The new version will not be introduced in the market before 2016 or 2017, according to the company.

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 an article in Reuters 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 to other cigarettes. The court noted that this case could not be treated as class action as there were many individual issues and that the 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 MSA, according to an article in Reuters 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,
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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 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, who market their products as light or low tar.

TOBACCO OUTLOOK POSITIVE

As of mid-May 2013, our outlook for the tobacco industry was positive: competitive pressures in the US cigarette market are contained, and consumers appear to be absorbing price increases driven by federal and state excise tax hikes. Despite an anticipated volume decline at around a low- to mid-single-digit rate this year, we believe that total industry operating profits for 2013 will rise in the mid-single digits, due to positive pricing, a reduction in discounting, and cost restructuring actions. Since late 1998, when the major cigarette manufacturers pushed through significant price increases as a result of the Master Settlement Agreement (MSA), deep-discount cigarette manufacturers have had success in winning over price-sensitive smokers. Due to their price advantagedeep-discount cigarettes sell at retail for over 30% less than premium brandstheir US market share rose from about 2% in 1998 to more than 8% in 2003, and is now estimated to be about one-third of the market. However, growth for deep-discount cigarette makers has stabilized and is expected to decline over the longer term as costs related to increased regulation and litigation may further narrow the price gap, making deep-discount cigarettes less attractive to the consumer. In the near term, we think discount brands will gain incremental share, as consumers trade down in a difficult economic environment. Nevertheless, we estimate a limited impact on overall profits for large tobacco companies, as many have brand portfolios that encompass premium as well as deep discount brands.

INDUSTRY SURVEYS

ALCOHOLIC BEVERAGES & TOBACCO / MAY 2013

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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 $197.8 billion of retail sales in 2012, up 3.1% from 2011s $191.8 billion. Beer accounted for just under half of alcoholic beverage revenues, with consumers downing about $96.8 billion worth of brew in 2012. Altria Group estimates that profits of US tobacco manufacturers in 2012 totaled $13.8 billion, for a compound annual growth rate (CAGR) of 4.5% since 2007. 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. In fiscal 2012 (ended September 2012), the TTB collected taxes totaling approximately $26.4 billionmaking it the third largest tax-collecting agency in the federal government of which $10.1 billion came from taxation of alcoholic beverages and $15.7 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 201012, according to Beverage Information Groups Handbook Advance 2013, an annual report on alcoholic beverage sales and consumption. Wine and spirits volumes continued to grow in 2012, while beer volume increased for the first time after three consecutive years of declines. Beer volumes were up 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% on a doubling of the federal excise tax. In 2012, 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 2012, versus 52.0% the previous year and 51.5% in 2010; the balance was on-premise (bar and restaurant) consumption. Beer continued to lose share in the on-premise channel, where retail sales dropped 0.4%, while spirits sales rose 4.2% and wine sales climbed 3.4%. Beer claimed the largest share of sales again, in terms of both dollars and volumes. The category, with an 83.5% share of volume in 2012, lost share as spirits increased their volume share and wine maintained its share. The retail value of US beer shipments totaled approximately $96.8 billion in 2012, on a volume of about 6.3 billion gallons. In 2012, the second-largest segment in terms of sales was spirits, with total sales of $72.1 billion on 489.4 million gallons. Total volume share for spirits rose to about 6.5%. Wine made up the third group, racking up sales of $28.9 billion on 756.9 million gallons, with a volume share of 10.0%. Spirits growth reaccelerated to 3.6% growth on top of 3.4% in 2011, while wine consumption growth declined, with volume up only 1.9% compared with 3.1% in 2011. Two companies dominate US beer market Two producers dominate the beer industry in the US, accounting for about 73.6% of the nations beer supply in 2012, down from 75.1% in 2011. According to estimates by industry trade publication Beer Marketers Insights, Anheuser-Busch Companies Inc. led the pack with a 46.3% share of volume in 2012 (down from 46.8% in 2011) and MillerCoors claimed 27.4% (down from 28.3%). The No. 3 domestic supplier by volume, Crown Imports, held a 5.7% share, up from 5.6%. Anheuser-Busch. US beer shipments for Anheuser-Busch totaled 99.1 million barrels in 2012, up 0.6% from the comparable year-earlier period. Annual totals were 98.5 million barrels in 2011, 101.7 million
20 ALCOHOLIC BEVERAGES & TOBACCO / MAY 2013 INDUSTRY SURVEYS

barrels in 2010, and 104.9 million in 2009. Anheuser-Busch brews its beer through a system of 13 breweries in the US and sells it through more than 600 independent wholesalers. In 2006, it acquired the Latrobe Brewing Co. and its Rolling Rock brand, and signed deals to import and distribute a number of other brands. In 2008, InBev SA acquired Anheuser-Busch and InBev 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 58.6 million barrels of beer in 2012, down 1.8% from 59.6 million barrels of beer in 2011. For 2010, MillerCoors sold 61.5 million barrels, down from the 63.4 million sold in 2009. MillerCoors owns and operates eight US breweries. In early 2005, Adolph Coors Co. merged with Canadas Molson Inc. to form Molson Coors Brewing, the worlds fifth-largest brewer. The joint venture with SABMiller was established in mid-2008. Spirits industry restructures The US distilled spirits market grew again in 2012, for the 15th year in a row. Demand totaled 205.8 million cases, up 3.6% from 198.7 million in 2011. (A case contains nine liters of beverage product.) The total value of sales at retail in 2012 was $72.1 billion, up 5.4% from 2011s $68.4 billion, which was up 4.2% from $65.7 billion in 2010 and up from $64.1 billion in 2009. The market is relatively concentrated, with the top five marketers accounting for 55.4% of volume, and the top 10 accounting for some 74.2%.
TOP 20 PREMIUM DISTILLED SPIRIT BRANDS (Ranked by 2012 sales, in thousands of nine-liter cases)
BRAND MARKETER TYPE - - - CASE SALES - - 2011 2012

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. Its share slipped to 10.0% (17.6 million cases) in 2006, but it remained the second largest distiller by volume. In 2007, however, it dropped to No. 3 with a 9.6% share, just fractionally behind Constellation Brands, and in 2008, remained No. 3 Advance. with a 9.4% share on sales of 17.5 million cases. In 2009, it was at No. 3 with a 9.3% share on 17.6 million cases, but rose to No. 2 in 2010, with a 9.4% share on 18.1 million cases and remained No. 2 in 2011, with a 9.9% share on 19.4 million cases. In 2012, it remained at No. 2 with an 11% share on 22.7 million cases. Bacardi. Bacardi USA became the No. 2 player in 2004 after acquiring the Grey Goose brand during the year. However, its position slipped to No. 3 in 2005, when Bacardi held an approximate 9.2% share and sold close to 15.7 million cases. Its share rebounded to 9.5% in 2006, on 16.9 million cases, although it remained the third largest distiller of spirits for that year; it regained the No. 2 position in 2007, with 18.1 million cases and a 9.9% share. In 2008, it retained the No. 2 position, although its share slipped to 9.7% on volume of just over 18 million cases. In 2009, it remained No. 2 with a 9.7% share on 18.4 million cases;
INDUSTRY SURVEYS ALCOHOLIC BEVERAGES & TOBACCO / MAY 2013 21

20 PREMIUM 1. Smirnoff* B04: TOP Diageo DISTILLED SPIRIT 2. Bacardi** Bacardi USA BRANDS 3. Captain Morgan Diageo 4. Jack Daniels Brow n-Forman Bevs. 5. Absolut* Pernod Ricard USA 6. Crown Royal Diageo 7. Svedka Constellation Brands 8. Grey Goose Bacardi USA 9. Jim Beam Beam Inc. 10. Pinnacle Vodka Beam Inc. 11. Jos Cuervo Diageo 12. E&J E & J Gallo Winery 13. Skyy Campari America 14. Jagermeister Sidney Frank Importing 15. DeKuyper Beam Inc. 16. Hennesey Moet Hennessy USA 17. Seagram's 7 Crown Diageo 18. Seagram's Gin Pernod Ricard USA 19. Ketel One Diageo/Nolet Spirits 20. McCormick McCormick Distilling *Includes all flavors. **Includes full line. Source: Beverage Information Groups Handbook

Vodka Rum Rum Whiskey Vodka Whiskey Vodka Vodka Whiskey Vodka Tequila Brandy Vodka Liqueur Cordial Cognac Whiskey Gin Vodka Vodka

9,690 9,494 6,060 4,674 4,575 4,040 3,690 3,434 3,163 2,700 3,280 3,070 2,754 2,525 2,429 2,205 2,250 2,358 2,015 2,023

9,880 9,541 6,112 4,847 4,667 4,220 3,825 3,451 3,200 3,200 3,130 3,095 2,805 2,445 2,400 2,300 2,210 2,203 2,110 2,103

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 Groups Handbook Advance 2013, Diageo now holds 22.7% of the US distilled spirits market by volume, selling 46.7 million cases of distilled spirits in 2012.

in 2010, its share slipped to 9.3% and Bacardi USA fell one notch to No. 3. In 2011, it remained No. 3 with a 9.1% share on about 18.0 million cases. In 2012, it remained at No. 3 with an 8.9% share on about 18.2 million cases.
TOP ALCOHOLIC BEVERAGE PRODUCERS AND THEIR BRANDS (As of April 2013) BEER
(PRINCIPAL BRANDS IN COMPANY- DEFINED SEGMENTS)

SPIRITS & WINE

(PRINCIPAL PRODUCTS BY COMPANY)

Anheuser-Busch Premium Budw eiser family Super-premium Michelob family Specialty Beers Redbridge Rolling Rock Rock Light Wild Blue ZiegenBock Sub-premium Busch family Natural family Malt Beverages Hurricane family King Cobra Energy Drinks 180 All Natural Monster Imports Bass Becks Hoegaarden Leffe Stella Artois Nonalcoholic brews O'Doul's O'Doul's Amber Molson Coors Premium Carling Coors family Blue Moon family Molson Canadian Rickards Sub-premium Keystone family SABMiller Premium Miller family Henry Weinhard's family Leinenkugel's family Super-premium Pilsner Urquell Peroni Below-premium Milw aukee's Best family Malt Liquor Olde English 800 Mickey's Malt Liquor Source: Company reports.

Diageo PLC Vodka Smirnoff Ciroc Ketel One Gin Tanqueray London Dry TobacB11: TOP Gordons Gin ALCOHOLIC Whiskey BEVERAGE Bushmills Crow n Royal AND PRODUCERS Johnnie Walker THEIR BRANDS Liqueur Baileys Romana Sambuca Tequila Jose Cuervo Don Julio Champagne Dom Perignon Moet & Chandon Beer Guinness Harp Lager Hennessy cognac Captain Morgan rums Beam Global Spirits & Wine Bourbon Jim Beam Maker's Mark Whiskey Canadian Club Laphroaig Windsor Canadian Wolfschmidt Vodka DeKuyper cordials Sauza tequila Courvoisier cognac Bacardi Bacardi rum Grey Goose vodka Bombay gin Cazadores tequila Martini sparkling w ine Martini vermouth Noilly Prat vermouth Dew ar's w hiskey Otard cognac Bndictine liqueur B&B liqueur Captain Morgan rum

Sazerac Barton Fleischman Mr. Boston Crystal Palace Skol Czarina Meukow cognacs Brow n-Form an Whiskey Jack Daniels Gentleman Jack Whiskey Canadian Mist Woodford Reserve Don Eduardo Tequila Fetzer w ines Southern Comfort Finlandia vodka Korbel champagne Chambord liqueur Pernod Ricard Whiskey Jameson The Glenlivet Chivas Regal Ballentine's Malibu rum Beefeater gin Absolut vodka Kahlua liqueur Jacob's Creek w ine E&J Gallo Winery Barefoot Cellars Carlo Rossi Gallo family Vineyard Constellation Brands Wines Clos du Bois w ine Estancia Franciscan Estate Robert Mondavi Winery Simi Woodbridge by Robert Mondavi SVEDKA Vodka Black Velvet Canadian Whisky Paul Masson Grande Amber Brandy The Wine Group Almaden Franzia Inglenook Paul Masson Ridgemont Reserve 1792 bourbon Paul Masson VSOP brandy

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INDUSTRY SURVEYS

 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, Fleischmanns, and Montezuma tequila. It remained No. 4 in 2010 and 2011, with an 8.4% share on 16.1 million cases in 2010 and an 8.4% share on 16.6 million cases in 2011. It remained at No. 4 in 2012, with an 8.7% share on 17.9 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 its 7.6% share (13.8 million cases) in 2007. After completing the acquisition of Vin & Spirit Group, the owner of Absolut vodka, Pernod maintained its fifth place by volume with a 8.4% share in 2008 (15.6 million cases). In 2009 through 2012, Pernod maintained its fifth place position, with a 7.9% share on 15.0 million cases (in 2009), a 7.6% share on 14.7 million cases (in 2010), a 7.5% share on 14.9 million cases (in 2011), and a 7.3% share on 15.0 million cases (in 2012). In recent years, there has been a 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 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 After two consecutive years of decline, the US wine industrys sales rose in 2012 to about $28.9 billion at retail, up 4.0% from approximately $27.8 billion in 2011, according to Beverage Information Groups Handbook Advance 2013. Compared with many other consumer product categories, the US wine market is fairly concentrated, though to a TOP 20 US WINE BRANDS lesser degree than either the beer (Ranked by 2012 sales, in thousands of nine-liter cases) or distilled spirits industries. - - - - - - - - - DEPLETIONS - - - - - - - - COMPANY 2011 2012 % CHG.

Franzia Winetaps The Wine Group 25,250 Barefoot Cellars E & J Gallo Winery 13,000 Carlo Rossi E & J Gallo Winery 12,600 Sutter Home Trinchero Family 10,765 B05: TOP 20Estates Almaden The Wine Group 8,570 US WINE Twin Valley E & J Gallo Winery 8,900 BRANDS Woodbridge Constellation Brands 8,000 Beringer Treasury Wine Estates 7,248 Peter Vella E & J Gallo Winery 6,700 Livingston Cellars E & J Gallo Winery 5,900 Charles Shaw Bronco Wine Co. 5,181 Arbor Mist Constellation Brands 3,500 Corbett Canyon The Wine Group 3,400 Inglenook Francis Ford Coppola 3,250 Kendall-Jackson Jackson Family Wines 3,080 Cupcake Vineyards The Wine Group 2,400 Vendange Constellation Brands 2,725 Columbia Crest Ste. Michelle Wine Estates 2,522 Chateau Ste. Michelle Ste. Michelle Wine Estates 2,055 Black Box Constellation Brands 2,070 Total, top 20 137,116 Source: Beverage Information Groups Handbook Advance.

1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20.

23,200 15,700 12,300 10,788 9,256 8,900 8,450 7,207 6,800 5,500 5,388 3,470 3,468 3,283 3,084 3,000 2,857 2,780 2,715 2,695 140,841

(8.1) 20.8 (2.4) 0.2 8.0 0.0 5.6 (0.6) 1.5 (6.8) 4.0 (0.9) 2.0 1.0 0.1 25.0 4.8 10.2 32.1 30.2 2.7

Much like spirits, wine has been enjoying a multi-year rebound in per capita consumption following a precipitous decline. Per capita wine 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. Per capita consumption in 1970 was 1.05 gallons. It estimates that per capita consumption reached 3.08 gallons in 2012. According to Beverage Information Group, the top six US wine marketers in 2012 accounted for about 86% of
23

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ALCOHOLIC BEVERAGES & TOBACCO / MAY 2013

volume. They were E.&J. Gallo Winery, The Wine Group Inc., Constellation Wines, Trinchero Family Estates, Bronco Wine Co., and Treasury Wine Estates (formerly Fosters Wine Estates Americas). In 2012, E.&J. Gallo Winery maintained its lead supplier position, accounting for approximately 33.1% of the domestic table wine unit case sales. (A case contains nine liters of wine.) The No. 2 producerThe Wine Group, with about 24.4% of the industrys shipmentsretained 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 2012, Constellation Wines retained the No. 3 position, with a 14% share, after falling from No. 2 with the sale of its value brands in 2008. After it acquired Robert Mondavi Winery Ltd. in the fourth quarter of 2004, it had moved to No. 2. Treasury Wine Estates, Gallo, and Constellation also had a significant share of imported table wine sales in 2012. The leading importer of table wine in 2012 was Deutsch Family Wine & Spirits, with a 20.7% share of the import market, benefiting from the continued rapid growth of its Yellow Tail brand.

TOBACCO
From 2000 through the end of 2005, total domestic tobacco production declined at an estimated compound annual rate of 9.3%, according to the Economic Research Service of the US Department of Agriculture (USDA), a provider of economic information and research related to agriculture, food, natural resources, and rural development. Production is estimated to have rebounded to 727.9 million pounds in 2006, a 12.8% increase from the prior year, and to 787.7 million pounds in 2007, an 8.2% increase. In 2008, production climbed 1.6% to 800.5 million pounds. It increased 2.8% to 822.6 million pounds in 2009, but then plunged 12.5% to 719.8 million pounds in 2010 and 16.7% to 598.3 million pounds in 2011. In 2012, it increased 27.4% to 762.4 million pounds.
US TAXABLE REMOVALS OF TOBACCO PRODUCTS
Cigarettes, billion units 500 460 420 380 340 300 260 2000 02 04 06 08 10 2012 Cigars, million units 12,000 10,500 Snuff, & Other products, million pounds 110 100 90 80 70 60 50 2000 02
Cigars

TobacH02: US TAXABLE REMOVALS OF SELECTED TOBACCO PRODUCTS

9,000 7,500 6,000 4,500 3,000 04

Snuff

06

08

10

2012

Other tobacco products*

*Chewing, pipe, and roll-your-own tobaccos. Source: US Alcohol and Tobacco Tax and Trade Bureau.

Total US shipments by the three largest domestic cigarette companies dropped around 2% in 2012, after falling 3% in 2011, 3.8% in 2010 and 10.1% in 2009 (due to the significant increase in the federal cigarette excise tax). In 2007 and 2006, shipments fell a more moderate 4.1% and 4.6%, respectively. 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, antismoking advertising campaigns, and restrictions on smoking in public places. Comparisons for tobacco leaf production are difficult to make for the 2005 and 2006 seasons. The Fair and Equitable Tobacco Reform Act of 2004, signed by President Bush on October 22, 2004, finally did away
24 ALCOHOLIC BEVERAGES & TOBACCO / MAY 2013 INDUSTRY SURVEYS

with the Great Depressionera tobacco quota system. It also eliminated price supports that had been in place since the 1949 Agriculture Act. In addition to moving tobacco production to a free market system, it established the Tobacco Transition Payment Program, commonly referred to as the Tobacco Buy-Out. With the removal of quotas and price supports, many growers left the market in 2005. We believe the more efficient producers have expanded acreage, which produced its first crop in 2006. The projected 339,000 acres of tobacco grown in 2006, compared with the 297,080 in 2005, would more than offset the prior year decline and acreage rose to 356,000 in 2007. However, in subsequent years, acreage dropped, falling to 354,490 in 2008, 354,040 in 2009, 337,500 in 2010, and 325,040 in 2011. Then, it increased to 336,230 in 2012. Cigarette leaf is expected to account 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 will be flat to up 1% in 2013, on a base of approximately 5.7 trillion units. Philip Morris International is the largest producer of American-style cigarettes for foreign markets. The company shipped 869.8 billion units outside the US in 2008, up 2.5% from the previous year, and far greater than Philip Morris USAs total of 169.4 billion units. In 2009, the figures were 864.0 billion and 148.7 billion, respectively; in 2010, they were 899.9 billion and 140.8 billion, respectively; in 2011, they were 915.3 billion and 135.1 billion, respectively; and in 2012, they were 927 billion and 134.9 billion, respectively. Three companies control US cigarette market The US cigarette industry is an oligopoly. The three leading cigarette producers control approximately 90.7% of domestic sales. Philip Morris USA Inc. (a division of Altria) accounted for approximately 49.8% of US shipments in 2012, Reynolds American Inc. controlled about 26.5%, and Lorillard Inc. (formerly Carolina Group) controlled around 14.4%.
TOBACCO MARKET SHARE2012
Others 9.3% Lorillard 14.4%

H01: Tobacco market share

Altria 49.8%

Philip Morris USA. Philip Morris USA has been the nations largest tobacco company since 1983. In 2012, its US cigarette shipments totaled 134.9 billion units, down 0.2% from 2011, giving it an estimated 49.8% domestic market share. Philip Morris USA sells Marlboro, Virginia Slims, and Parliament as its major premium brands. Its principal discount brand is Basic. Philip Morris USAs Marlboro family is the largest-selling cigarette brand in the US. In 2012, shipments totaled 116.4 billion units, down 0.7% from 2011.

Reynolds American 26.5%

Source: Company reports.

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 companys combined portfolio includes premium cigarette brand, Camel, and discount brands such as Doral and Capri. In 2012, Reynolds Americans share of the US cigarette market was 26.5%, down fractionally from 27.4% in 2011. 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. Newports total US retail share in 2012 was 14.4%, up from
INDUSTRY SURVEYS ALCOHOLIC BEVERAGES & TOBACCO / MAY 2013 25

14.1% in 2011. Despite the overall industry decline, domestic sales of menthol cigarettes have outperformed the industry, benefiting Lorillard disproportionately. 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. 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 manufacturers price per cigar (with a cap of $0.05) to 52.75% (with a $0.40 cap). Cigars. Large cigar sales increased 37% over that period, 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. We believe the dramatic increase can be attributed to lower taxes and fewer marketing restrictions relative to cigarettes. Small cigars can be sold in packs of 20, in packages similar to cigarettes, but were 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 IQs estimates, the smokeless category is worth just a small fraction of the cigarette market. 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 totaled 106.2 million pounds, up 6.5% from 99.7 million pounds in 2010. The 2010 total represented a 4.4% advance from 2009 (95.5 million pounds), which in turn was up 1.2% from 94.4 million pounds in 2008. Snuff production totaled 90.2 million pounds in 2007, up 5% from 2006. 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 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. Growth categories drive acquisition and joint venture activity At the end of 2007, Philip Morris USA acquired 100% of John Middleton Inc., a leading manufacturer of machine-made large cigars. According to S&P Capital IQs estimates, the cigar market will expand at a low single-digit rate annually over the next several years. Other companies have recently moved to strengthen or expand their position in smokeless. In February 2009, Philip Morris International and Swedish Match AB announced a joint venture to market smokeless tobacco worldwide and to pressure more governments to lift bans on smokeless tobacco products. Swedish
26 ALCOHOLIC BEVERAGES & TOBACCO / MAY 2013 INDUSTRY SURVEYS

Match has sought repeal of a European Union ban on smokeless products. Critics argue that marketing smokeless products as being less harmful could appeal to non-smokers. Interestingly, Lorillard Inc. terminated its joint venture in moist snuff, or snus, with Swedish Match AB at the end of 2009 under mutual agreement. In April 2012, Lorillard acquired Blu Cigs, an e-cigarette company, for a total of $135 million, as part of its effort to diversify from cigarettes and gain a foothold in the smokeless products market.

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: they have reorganized their business structures via acquisitions and/or restructurings, and they have aggressively pursued 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 slowlyor even declining, as in the case of cigarettes. Along with rising health consciousness among consumers, greater legal and regulatory restrictions also have stymied growth.

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 beers increased popularity attracted new beer drinkers. In the mid-1980s, however, the nations 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 industrys 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 factorsincluding product innovations, aggressive marketing, falling input costs, and increased availability of affordable importshave 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 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 2012 by Gallup, a market research firm, around 35% of US drinkers preferred wine, lower than the 39% who preferred beer. 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-34 age group, where it dropped from 51% in 2010 to 45% in 2012. The preference for beer among consumers in

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ALCOHOLIC BEVERAGES & TOBACCO / MAY 2013

27

US RESIDENT POPULATION PROJECTIONS* (In thousands)

AGE GROUP 2013 2020 2030 - - - - % CHANGE - - - 2013- 20 2013- 30

the over-55 age group dropped from 30% in 2010 to 28% in 2012, while the preference for wine grew to 45% in 2012 from 42% in 2010. 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.

Under 5 yrs. % of total 5 to 14 yrs. % of total 15 to 19 yrs. % of total 20 to 24 yrs. % of total 25 to 34 yrs. % of total 35 to 44 yrs. % of total 45 to 64 yrs. % of total 65 yrs. & over % of total Total population

20,428 21,808 22,252 USPOP-1: US 6.5 6.5 6.2 RESIDENT 41,145 41,923 44,815 POPULATION 13.0 12.6 12.5 PROJECTIONS 21,108 20,806 21,946 6.7 6.2 6.1 22,766 21,651 21,940 7.2 6.5 6.1 42,820 46,271 46,052 13.5 13.9 12.8 40,430 42,230 47,826 12.8 12.6 13.3 83,052 83,238 80,865 26.2 24.9 22.6 44,689 55,969 72,774 14.1 16.8 20.3 316,439 333,896 358,471

6.8 1.9 (1.4) (4.9) 8.1 4.5 0.2 25.2 5.5

8.9 8.9 4.0 (3.6) 7.5 18.3 (2.6) 62.8 13.3

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 to 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.

Racial composition (%): White 77.8 76.5 74.7 Black 13.2 13.4 13.7 Asian 5.1 5.7 6.4 Other 3.9 4.4 5.2 Hispanic (any race) 17.2 19.1 21.9 *Based on 2010 Census. Note: Totals may not add due to rounding. Source: US Department of Commerce, Population Series P-25.

BEER WEAKNESS
Total beer consumption inched up 0.9% to 6.39 billion gallons in 2004 but then slipped 0.5% to 6.36 billion gallons in 2005. Consumption in 2007 increased 1.2% to 6.59 billion gallons on top of a 1.7% increase in 2006 to 6.51 billion gallons (results in 2006 were helped by a 53rd week). In 2008, consumption slowed to a 0.6% increase (6.6 billion gallons), but dropped 1.4% in 2009 (6.5 billion gallons). In both 2010 and 2011, consumption fell, slipping 1.9% in 2010 to 6.4 billion gallons and 1.5% in 2011 to 6.27 billion gallons. In 2012, consumption increased 0.5% to 6.3 billion gallons. S&P Capital IQ believes 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 (excluding the low-carbohydrate phase), and to a lesser extent higher unemployment trends among beers core male legal drinking age audience. Although low-carbohydrate diets seem to have lost their luster, this has not deterred growth of light and low-carb beers. With healthier living determining beer-drinking habits, light beer consumption continued to dominate the US market in 2012, with a 51.8% share of all beer consumption (down 0.2%), but this segment lost share slightly after claiming a 52.1% share in 2011. 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 five selling domestic brands in 2012 were light beers.
28 ALCOHOLIC BEVERAGES & TOBACCO / MAY 2013 INDUSTRY SURVEYS

A THREAT TO ALCOHOLS THREE-TIER DISTRIBUTION SYSTEM?

With the US Supreme Courts ruling on direct shipping in early 2005, we are witnessing the beginning of a structural shift in the domestic distribution network for alcohol. We believe the consequences of the ruling on suppliers, distributors, retailers, and customers are minimal in the short term, but the implications will be felt over the long term. Rulings in the case against Washington State will likely have larger near-term implications for suppliers and distributors. US Supreme Court rules on direct shipping In May 2005, the US Supreme Court ruled that New York and Michigan were in violation of the US Constitutions Dormant Commerce Clause in light of Section 2 of the 21st Amendment (the 1933 amendment that repealed Prohibition). The court ruled that, although the states have broad power to regulate liquorand have done so through the use of a three-tier system involving licensed distributors New Yorks and Michigans discriminatory bans on interstate direct-to-consumer wine shipments were unconstitutional. In its ruling, the Court stated that shipping should be on a level playing field: if a state allows in-state direct shipping to consumers that bypasses the distributor, then the same must be allowed for out-of-state wineries. (States may still prohibit direct shipping to consumers, but the same rules must apply to both in-state and outof-state wineries.) Following the ruling, New York and Michigan allowed interstate direct shipping to consumers, joining the 37 other states that have done soincluding California, the first to have lifted its ban. In our view, there are several plusses to the dismantling of a three-tier system. The most immediate and obvious is that the ruling provides a greater reach for very small wineries and breweries that otherwise would be restricted to sales within the state where they are located. In addition, by virtue of their size and lack of power, these small companies typically were not able to negotiate competitive distribution contracts with large-sized wholesalers, and therefore missed opportunities to get their products in front of a larger audience through that route. Furthermore, we see a possible upside potential on pricing, since costs are not restricted by the mandatory minimum wholesale markup if the distributor is circumvented. However, direct distribution interstate could be very costly for a small company. For distributors, which previously were limited by state boundaries, the ability to distribute across state lines allows for greater access to other regions and the potential for more efficient operations. The wholesale network has consolidated significantly in recent decades. Wholesalers have gotten larger within their regions and across product lines, but state restrictions on operating structures have limited their ability to take advantage of economies of scale. By opening up state lines, wholesalers could possibly scale their networks, warehouses, and relationships to improve efficiencies and lower costs. These advantages notwithstanding, the three-tier system has its benefits, both economic and regulatory. Over the years, wholesalers have established invaluable relationships with on-premise and off-premise accounts by virtue of their size and broad product offerings. These relationships have allowed products to get increased exposure that would not have otherwise been possible. We believe that small wineries or breweries seeking to sell direct will not be able to easily duplicate these relationships. Furthermore, the lack of a distributor may make it harder to push new products or for new wineries or breweries to get a foothold in a market. Most importantly, the primary purpose of a three-tier system is to give the government control of the sale and marketing of alcohol, the collection of taxes, and to eliminate underage drinking. In our view, we believe that large and small companies, as well as wholesalers, will find ways to adapt to the changing direct shipping laws. In a potential reversal, in April 2010, the Comprehensive Alcohol Regulatory Effectiveness Act of 2010 (H.R. 5034) was introduced in the US House of Representatives. This bill, which seeks to reduce federal court challenges to state laws and could potentially limit direct-to-consumer shipments, was re-introduced in March 2011 as H.R. 1161 by eight co-sponsors, but appears to have stalled.
INDUSTRY SURVEYS ALCOHOLIC BEVERAGES & TOBACCO / MAY 2013 29

Costco v. Washington State In February 2004, Costco Wholesale Corp. sued the Washington State Liquor Control Board and other parties in the US District Court of Western Washington in Seattle. In its suit, the company challenged the rationale behind the states three-tier system, which requires that wineries sell their product through distributors and that retailers buy product from distributors. The suit also questioned the part of the law that requires suppliers to charge distributors a minimum markup of 10%. Costco argues it should be able to negotiate a lower markup, which could then be passed on to customers as a lower retail price. Costco was also challenging a seemingly discriminatory practice allowed under Washington State laws: instate wineries can act as their own distributor, but out-of-state wineries are prohibited from doing the same. Costcos case questioned the discrimination against shipping directly to retailers versus directly to consumers. The company maintains that it should be able to buy directly from suppliers and sell directly to consumers or its other customers. In December 2005, the District Court agreed with Costco that Washington State law barring interstate beer and wine shipments was a violation of the commerce clause of the Constitution. Separately, the court ruled that the minimum markup and uniform pricing requirements violated antitrust law. In mid-2006, Costco won a favorable ruling in the long-running case with the state of Washington. Judge Marsha Pechman of the US District Court ruled that the states distribution restraints conflicted with federal antitrust laws. In early 2008, however, the Ninth Circuit Court of Appeals in San Francisco sided with the state on nearly all of the contested points, reversing most of the US District Courts decision. The reversal was seen as a victory for the three-tier distribution system and state regulation in general. In mid-2008, Costco declined to petition the US Supreme Court to consider an appeal. Although the reversal was a setback, the litigation led to a ruling against the requirement that wine and beer distributors post their prices with the state and hold them for 30 days. In addition, state legislators extended direct sales privileges to out-of-state wine and beer distributors. Over time, S&P Capital IQ believes that distributors will eventually have more competitors as states ease restrictions. It is likely that other major retailers, including Wal-Mart Stores Inc. and BJs Wholesale Club Inc., may become distributors of alcohol in the future. Undeterred by its loss, Costco continued to agitate to change liquor distribution laws in Washington State. The company contributed to efforts to get Initiative 1100 on the November 2010 ballot. This proposal would have privatized retail liquor sales in the state and eliminate numerous other restrictions. The initiative was defeated 53% to 47%. In November 2011, a similar initiative (Initiative 1183) to privatize the state-run liquor stores in Washington won the approval of voters by 59% to 41%. This initiative was also backed heavily by Costco, which donated the majority of the $23 million collected to campaign for the measure. In March 2012, the state started the auction to sell all of its 167 state-controlled liquor stores. Bids were accepted until April 19, winners were announced on April 23, and private retailers started selling liquor beginning on June 1.

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 Capital IQ estimates that operating margins for US alcoholic beverage companies are above 20% on average, well above the midteens 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 companiesincluding 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
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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 InBevs 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 worlds 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 fourAnheuser-Busch InBev, SABMiller, Heineken NV (pro forma for its buyout of Mexicos FEMSA in 2010), and Carlsberg Breweries A/Sheld 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 worlds 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 Compaa Cerveceras Unidas SA (Chile) and Buenos Aires Embotelladora SA (BAESA, Argentina). These investments augment Anheuser-Buschs already strong positions in its main export markets (Canada, the United Kingdom, and Japan) and complement its activities in numerous other markets. In June 2012, Anheuser-Busch InBev entered an agreement to acquire the remaining 50% share in Mexicos 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 Pacfico brands. Consumption of Corona has grown very rapidly in recent years: in 2012, it was the sixth most popular beer in the US. 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 worlds second-largest brewer. SABMiller remained in second place after the purchase of Anheuser-Busch by InBev SA in 2008. Molson-Coors. In early 2005, Adolph Coors Co. completed a merger of equals with Canadas 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 Internationalsales 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. 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.

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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 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 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, Chinas 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 Chinas 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. These include deals by Heineken, Scottish Courage Ltd., Carlsberg Breweries, San Miguel Corp., Beck GmbH & Co., Kirin Beverage Corp., Asahi Breweries Ltd., Miller Brewing, InBev SA, Lion Nathan Ltd., and Pabst Brewing Co., some of which are subsidiaries of larger international firms. In order for investments in China to provide the significant growth potential that these companies seek, they must overcome the major problems of unfavorable pricing and fragmented distribution. In early 2004, Anheuser-Buschs acquisition of a 29% stake in Harbin Brewery, Chinas fifth-largest brewery, triggered a bidding war for full ownership with SABMiller, which also held a 29% stake. Anheuser-Busch eventually won, acquiring Harbin for US$650 million. Also in 2004, Interbrew purchased a controlling interest in Malaysian Lion Groups Chinese beer business. Added to its 24% stake in Zhujiang (another Chinese brewer), Interbrew is now the No. 3 brewer in China. Heineken also upped its game in China by recently investing in Guangdong Brewery, with the intention of being able to brew its beer in the local market. In 2003, Carlsberg bought two breweries in Chinas southern Yunnan Province after previously selling a 75% stake in Carlsberg Brewery (Shanghai). In June 2010, Carlsberg reached a $353 million agreement to raise its stake in Chinas state-owned Chongqing Brewery, one of the top six domestic brewers in China with 15 breweries. The agreement called for Carlsberg to increase its interest to 30% from its original 17.5%, which it acquired via its joint takeover of Scottish & Newcastle with Heineken in 2008. It beat out Anheuser-Busch and China Resources Enterprise Ltd. for this stake. In September 2010, Molson Coors Brewing Co. bought a 51% controlling interest in a joint venture with the Heibei Sihai Beer Co. of China for approximately $40 million in cash. Of Chinas 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, at an astounding 122.8 liters in 2011. Of the top five beer markets, Russia experienced the highest growth rates in recent years, rising just under 16% in 2007, according to a local brewers estimate, as the government promoted beer consumption to
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curtail the drinking of spirits. The recent global economic turmoil hit this region particularly hard, however, with production in Russia dropping for the first time since 1996. According to the CEO of Carlsberg Bulgaria, Bulgarian beer consumption fell 12% in 2009 and started 2010 very weak. Carlsberg anticipated another decline at a low double-digit rate, driven by a sharp rise in excise tax in January 2010, but consumption recovered in the second half of the year to end with a decline of approximately 4%. More recently, this region has lost momentum. In early 2011, Carlsberg was expecting growth of 2%4% in Russia for the year; however, it subsequently reduced its forecast and ended the year with a decline of 3%. 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 countriesEstonia, Norway, Sweden, and Maltabetween 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 by 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. 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 worlds 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. FEMSAs brands include Tecate and Dos Equis. The transaction increased Heinekens 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. Schincariols 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 August 2011, SABMiller increased its bid to buy Australian brewer Fosters Group Ltd. to $10.2 billion (A$5.10 per share), after the company rejected its A$9.97 billion bid. In November 2011, in order to get the approval from the Australian Tax Office (ATO), Foster had to pay A$0.30 per share to its shareholders, prior to the acquisition, which increased their settlement with SABMiller to A$5.40 per share. In December, SABMiller completed its takeover of Fosters.

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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 liters2.0 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 is owned by the Bordeaux Chamber of Commerce and major companies in the industry. IWSR is a market research firm and 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 countrys 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 Mexicos potential. A notable development is the formation of partnerships between US and South American wineries. Several domestic wineries have made investments in Chile, responding in large part to the US grape shortages of 1996 and 1997.

TOBACCO SEES DECLINING DEMAND

From 1994 through 2003, cigarette consumption declined by an average of approximately 1.9% annually; in 2004, volume fell by 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. 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. The signing of the MSA in 1998 led to the emergence of small cigarette manufacturers (not a part of the MSA) that sold cigarettes at 40% to 50% below premium cigarettes. Market share for these deep-discount manufacturers rose substantially since 1998 and leveled off at 8% in 2003. These manufacturers produced 28.1 billion sticks (individual cigarettes) in 2003, down slightly from the estimated 28.2 billion in 2002. Between 1998 and 2003, the annual growth rate for these small manufacturers was about 32%, compared with a 3% decline in the overall US production level during the same period. However, Universal Corp., an independent tobacco leaf merchant, estimates that cigarette production by the smaller US manufacturers declined by 2.7 billion sticks (19%) in 2005, following a 15% decrease in 2004. Regulation impedes tobacco discounters S&P Capital IQ believes 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.)

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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 Capital IQ believes 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. In June 2004, New York State had enacted fire-safety standards for cigarettes sold in the state. All cigarettes must comply with the testing method for self-extinguishment at least 75% of the time. The cost of producing cigarettes may rise for manufacturers that must meet these new standards. Although the larger manufacturers likely will be able to absorb much of the cost, small players (including deep-discount manufacturers) may have to pass on most of this cost to the consumer through higher prices. As of July 2011, fire-safe cigarette laws were in effect in all 50 US states and the District of Columbia. Impact of tobacco growers buy-out In October 2004, the Foreign Sales Corporation/Extraterritorial Income Act was passed by both the Senate and the House of Representatives and was signed into law. A section of the law called for the elimination of the price support system governing the US tobacco industry through a buy-out of existing tobacco quotas. The price support system, which had been in place since 1939, guaranteed prices to domestic tobacco quota holders. This system has kept the price of US tobacco above the world rate. The new law requires cigarette manufacturers to bear the cost of buying out the quota holders at an approximate cost of $10 billion to be paid over 10 years, raising overall operating costs. In our view, the net costs to manufacturers have been modest so far, and we expect a limited impact on large manufacturers. In 2009, according to the Center for Tobacco Grower Research, the average price of flue-cured tobacco was $1.75 per pound, about flat with 2008s $1.76, but up from $1.53 in 2007. The average price of flue-cured tobacco fell slightly in 2010 to around $1.69 per pound. The average price of flue-cured leaf tobacco fell from $1.85 per pound in 2004 to $1.47 in 2005, and stabilized at $1.50 in 2006. Companies that signed the MSA in 1998 agreed to make payments totaling $2.6 billion into the National Tobacco Grower Settlement Trust until 2010. The trust fund was created to support domestic tobacco growers and quota holders and, in effect, maintain the current price support system. With the passage of the Foreign Sales Corporation/Extraterritorial Income Act, the 2004 payment was expected to be eliminated and refunds were expected for the amounts already paid in. However, in the third quarter of 2005, a North Carolina court ruled that the offset was not effective until 2005. All told, we believe the buy-out payments will partially offset the amount of the trust payments, with the difference affecting future earnings. More importantly, with waning demand and consolidation in combination with the elimination of subsidies, the number of US tobacco-growing companies fell by 83% between 1997 and 2007, according to recent agricultural census data. Many of these farmers have switched to growing other crops such as corn (especially in 200708, in tandem with the ethanol boom), soybeans, and even grapes (for wine). Cheap competition from abroad has also crimped farm profits. We think that the smaller manufacturers, which lack the economies of scale and purchasing power that large manufacturers have, will continue to struggle. Cost-cutting and consolidation efforts The major US tobacco companies have streamlined their operations continually over the years. Like most other packaged goods producers, they have sought to sustain profit margins in a mature, domestic market. In addition, because of the complexities of operating in various international markets, tobacco companies face challenges in the ways they source, manufacture, and market their products. Constant fine-tuning is necessary for these companies to operate at optimal levels of efficiency. Rising regulatory and litigation costs have compounded the profit pressures in the US market. Because of these various pressures, R.J. Reynolds Tobacco Co. and Brown & Williamson Tobacco Corp., the former No. 2 and No. 3 players respectively, merged their US businesses in July 2004.
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Tobacco companies look abroad To compensate for persistent contraction in demand at home, US cigarette companies have looked abroad for growth for many years. Their success has reflected many factors, including rising incomes in developing markets, high per capita cigarette consumption, fewer government restrictions, and a growing preference for American-style cigarettes, with their high flue-cured tobacco content. Although smoking prevalence has leveled off in many countries, we believe that cigarette consumption will continue to rise. According to the World Health Organization, even if overall smoking prevalence declined worldwide, population growth and an increasing prevalence among women will likely result in an increase in the number of smokers. In recent years, Philip Morris International (PMI) has increased manufacturing capacity and improved productivity through acquisitions and capital projects. Capital projects included modernization and expansion of facilities in Germany, the Netherlands, Switzerland, Poland, Romania, Russia, Lithuania, Ukraine, Turkey, Malaysia, and Brazil, as well as the construction of new manufacturing plants in Russia and Kazakhstan. 2011: Phillip Morris International acquired the cigar business of Swedish Match Cigars BV in the Netherlands, a subsidiary of Scandinavian Tobacco Group (STG), for $20 million. To expand its business in the Middle East, PMI acquired the manufacturing assets and trademarks of International Tobacco and Cigarettes Company (ITCC) in Jordan for $42 million. 2010: Philip Morris Philippines Manufacturing Inc., an affiliate of PMI, and Fortune Tobacco Corp. combined by transferring select assets and liabilities into a new company called PMFTC Inc. 2009: Philip Morris International acquired Swedish Match South Africa Ltd. 2008: Philip Morris acquired the remaining 60% interest in Rothmans Inc., Canadas second largest cigarette manufacturer. 2007: In early 2007, Philip Morris acquired an additional 50.2% stake in Lakson Tobacco Co., Pakistans second largest tobacco company, bringing its ownership to 98%. In late 2007, the company acquired an additional 30% interest in its Mexican tobacco business from Grupo Carso, S.A.B. de C.V., bringing its interest to 80%, with the option to acquire the remaining 20% in the future. 2006: Philip Morris acquired a smokeless tobacco company in Europe, and consolidated international trademarks with British American Tobacco PLC. Also that year, the company exchanged its interest in a Dominican brewery for 100% ownership of Industria de Tabaco Len Jimenes, S.A. 2005: The company acquired Indonesias PT Hanjaya Mandala Sampoerna Tbk., a kretek cigarette manufacturer, and closed on the purchase of Coltabac in Columbia. In December, PMI organized a joint venture with the China National Tobacco Co. for the manufacture of Marlboro and other Philip Morris brands in China, and the sale of Chinese brands through PMIs global infrastructure.

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 31.1% in 2012, 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
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segment against Newport. With aggressive promotional activity on this brand, we believe that Menthol has accounted for about half of the total Marlboro brand growth in recent years. FDA regulation of tobacco passed in 09 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 industrys 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 As the market-share leader, we see Altria Group Inc. as a beneficiary of the new 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, like 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 believe 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. The landmark 1998 Master Settlement Agreement, under which cigarette makers agreed to marketing restrictions and payments to states to reimburse them for costs related to caring for sick smokers, has claimed a notable casualty: General Tobacco, a maker of value cigarettes and the sixth largest US tobacco company. Unable to make certain settlement payments, General Tobacco announced that it plans to shut down, as reported by the Wall Street Journal in September 2010. In 2008, the company had sued states attorney generals and other tobacco companies claiming the settlement violated antitrust and constitutional law, but a US judge in Kentucky dismissed the case last year. Since then, a number of states forced General Tobacco to remove several of its cigarette brands from certain state directories of approved brands for sale, which effectively made it difficult for General Tobacco to get retail distribution in those states. While General Tobacco continues its appeal on various grounds, we think other manufacturers could follow in its footsteps, given the additional requirements under the new FDA regulations.

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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 territoriesresolved 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. DOJ trial: Big Tobacco wins, by losing The US Department of Justices legal action against domestic cigarette manufacturersi.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 governments 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 governments 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 countermarketing 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 has been 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 the uncertainty of the potential disgorgement of approximately $280 billion in past profits

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was removed for the industry. The case was expected to be returned to Judge Kessler for action on other remedies pertaining to corrective advertising. Engles 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, Floridas Third District Court of Appeals set aside the circuit court jurys decision in the Engle case, overturning the punitive damages award. Plaintiffs asked for a review, and in May 2004, Floridas 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 jurys 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 July 23, 2012, Philip Morris USA faced 3,294 cases in Florida state courts and 3,253 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 may be considered to be resolved for any potential future cases. We believe 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 believe 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 caseBarbara 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. Overall Lights class actions get new life 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
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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 believe 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.

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 nations 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 companys brewing activities to operate at optimal efficiency levels.

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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 companys requirements for liner materials used in certain parts of its beer packages. Another wholly owned subsidiary, Anheuser-Busch Recycling Corp., is one of the worlds largest recyclers of aluminum beverage containers. However, with the companys 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 traditionally are 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 2012, the US Department of Agriculture (USDA) estimated a grape crop of 7.34 million tons, a 1.4% drop from the prior year. Approximately 93% of all US grapes used for making wine are from California with about 2% to 3% from Washington. In California, the largest grape producer in the US, winegrowers were estimated to have crushed some 4.39 million tons of grapes, up 13% from 2011s 3.87 million tons of grapes. 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 of grapes 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 years grape harvest.
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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 Californias 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 materialsprincipally grainsthrough purchases from various sources via contractual arrangements. They also make purchases in the open market. Grains are mashed at company distilleries, and the finished productssuch as Jim Beam bourbons and Jack Daniels whiskeysare 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 32.3% of US distilled spirits consumption in 2012, almost flat compared to 2011 and 2010 but up from 31.0% in 2009. Rum is the second-largest category (at about 12.6%), 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 (56% of the total for brown goods, and about 13% of all spirits), followed by domestic straight whiskey, primarily bourbon (about 33% of brown goods, and 8% 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 industrys 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 continents eastern coast, they employed the lands 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 worlds 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 nations 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 cigarettes 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.

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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 nations 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 programs 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 manufacturers purchase of tobacco leaf, the tobacco is graded, cleaned, stemmed, and redried. 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 purchasedas gauged by the comparative per-unit costis 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 Morriss lead, most other branded cigarette producers instituted price cuts. Soon after these went into effect in mid-1993, discount
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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 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 to an overall company volume decline of nearly 1.4% in 2012. 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 offpremise 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 worlds developing countries will expand much more rapidly in the future than developed countries. In 1950, approximately two-thirds of the worlds 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 Bureaus 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. Americas 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.
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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 facilitiesand the costs associated with operating virtually any consumer packaged-goods business on a national scaleare 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 governments oversight of the alcoholic beverage industry goes back to the earliest days of the countrys 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 governments 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
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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 governments 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 units 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 bureaus 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. 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 courts interpretation of cigarettes as nicotine-delivery devices. However, the extent of the FDAs 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.
ALCOHOLIC BEVERAGE FEDERAL EXCISE TAX COLLECTIONS (In millions of dollars)
CATEGORY

Distilled Spirits Domestic Imported Wine Domestic Imported Beer Domestic Imported

2005 2006 B07: 2004 ALCOHOLIC 4,296 4,451 4,630 BEVERAGE FEDERAL 3,221TAX 3,316 3,395 EXCISE 1,075 1,135 1,235 COLLECTIONS

2007

2008

2009

2010*

768 548 220 3,660 3,219 442

807 567 240 3,643 3,192 451

834 575 259 3,713 3,213 500

4,728 3,444 1,284 874 589 285 3,745 3,198 547 9,348

4,840 3,559 1,281 881 610 271 3,779 3,252 527 9,500

4,800 3,564 1,236 899 609 290 3,742 3,250 492 9,441

4,924 3,667 1,257 922 621 300 3,651 3,186 465 9,496

Total excise taxes 8,724 8,901 *Latest available. Source: Internal Revenue Service.

9,177

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 $14.9 billion in 2010 (the most recent figure), 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, Congress approved implementing an additional
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increase to be effective April 1, 2009, which raised taxes per pack by $0.62 to $1.01 to finance childrens health insurance. States and local governments also impose excise taxes, ranging from $0.17 to $4.35 per pack. Since 2002, 47 states and 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 2012, real GDP expanded at a 2.2% annual pace, up from the 1.8% growth recorded in 2011. As of April 2013, Standard & Poors Economics (which operates separately from S&P Capital IQ) expected real GDP to increase 2.7% in 2013 and 3.1% in 2014. Consumer spending increased by a small percentage in 2012 to 1.9%, down from the 2.5% recorded in 2011. Although Standard & Poors Economics expects the unemployment rate to drop to 7.5% in 2013 (from 8.1% in 2012), it thinks that consumer spending will increase at only around 2.8% in 2013. Residential construction increased by 12.3% in 2012, and is projected to grow 19% in 2013. Nonresidential investment advanced by 8.0% in 2012, and is projected to advance 6.7% in 2013. 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 2012, Americans real disposable personal income increased 1.5%, following a 1.3% increase in 2011 and a 1.8% increase in 2010. As of April 2013, Standard & Poors Economics was projecting that real disposable personal income would grow 2.5% in 2013 and 5.6% in 2014. 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.

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A rise in the PPI can signal cost pressures that may hurt profit margins. Many firms cannot alter their selling prices quickly enoughif at allto 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 March 2013, Standard & Poors Economics was forecasting a drop of 1.37% in the PPI for crude oil in 2013, after a 0.74% drop in 2012, and a more significant 28.58% rise in gas fuels following a 27.22% drop in 2012. As of the end of December 2012, crude oil prices were down from their increase earlier in the year. 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 2.1% in 2012, 3.1% in 2011, and 1.6% in 2010, after falling 0.3% in 2009, a reversal from 2008s 3.8% jump. As of April 2013, Standard & Poors Economics was forecasting that the CPI would rise 1.4% in 2013 and 1.8% in 2014. 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 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 Federal Reserve bought an additional $600 billion of US Treasuries through June 2011 (yields rose to a high of 3.74% in February). However, recent 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 have remained through early May. The 10-year Treasury note averaged 1.8% in 2012; as of April 2013, Standard & Poors Economics expected the yield on the 10-year Treasury note to settle at 2.1% in 2013. Currency exchange rates. The exchange rates between the US dollar and foreign currencies are increasingly important in predicting a companys profitability. This is due to the rising proportion of US alcoholic beverage and tobacco industry sales derived from markets outside the US.

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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. Through early May 2013, the euro had appreciated nearly 2.1% to approximately $1.29. 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 brands 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 marketapproximately 46.3% of the domestic market by volume in 2012into 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 companys 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.

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Profit margins A companys 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 lowmargin 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 companys gross profit margins on an absolute basis are important to observe; a number of factorsincluding acquisitions, dispositions, fluctuations in important raw materials costs, or pricing changescan cause significant volatility. On a relative basis, if a companys 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 companys 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 companys 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 otherand potentially more rewardingpurposes. 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 believe 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
50 ALCOHOLIC BEVERAGES & TOBACCO / MAY 2013 INDUSTRY SURVEYS

each cigarette manufacturers 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 highoften 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 industrys 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 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 an acceleration (or a 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 companys 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 firms 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 companys stock, a good place to start is the basic investment ratio of stock price to earnings per share, 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 remained low on a historical basis, there has been an upward shift in the peer average, particularly in 2010 and 2011, 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, earnings per share growth rates, and sustainability of
INDUSTRY SURVEYS ALCOHOLIC BEVERAGES & TOBACCO / MAY 2013 51

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 companys 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 writedown 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.

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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 Marketers 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.

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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 departments 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 and Human Services.

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

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COMPARATIVE COMPANY ANALYSIS

Operating Revenues
Million $ Ticker Com pany Yr. End DEC DEC 2012 580.2 3,916.5 A 2011 513.0 3,515.7 2010 463.8 3,254.4 2009 415.1 3,032.4 2008 411.6 4,774.3 2007 345.5 6,190.6 2002 215.4 3,776.3 A BREWERS SAM BOSTON BEER INC -CL A TAP [] MOLSON COORS BREWING CO DISTILLERS & VINTNERS BEAM [] BEAM INC BF.B [] BROWN-FORMAN -CL B STZ [] CONSTELLATION BRANDS -CL A TOBACCO AOI ALLIANCE ONE INTL INC MO [] ALTRIA GROUP INC LO [] LORILLARD INC PM [] PHILIP MORRIS INTERNATIONAL RAI [] REYNOLDS AMERICAN INC UVV UNIVERSAL CORP/VA CAGR (%) 10-Yr. 5-Yr. 1-Yr. 10.4 0.4 10.9 13.1 (8.7) 11.4 2012 269 104 Index Basis (2002 = 100) 2011 238 93 2010 215 86 2009 193 80 2008 191 126

DEC # APR # FEB

2,465.9 A NA NA

2,264.8 D 2,723.0 2,654.3

6,570.5 2,589.0 3,332.0

6,205.4 2,469.0 3,364.8

7,105.1 2,481.0 3,654.6

8,052.2 D 2,582.0 3,773.0 A

5,366.6 A 2,060.0 C 2,731.6 C

(7.5) (21.1) NA NA NA NA

8.9 NA NA

46 NA NA

42 132 97

122 126 122

116 120 123

132 120 134

# MAR DEC DEC DEC DEC # MAR

NA 17,507.0 4,636.0 A 31,377.0 8,304.0 NA

2,150.8 17,109.0 4,452.0 31,097.0 8,541.0 2,446.9

2,094.1 16,892.0 4,053.0 27,208.0 8,551.0 D 2,571.5

2,308.3 16,824.0 A 3,686.0 25,035.0 8,419.0 2,491.7

2,258.2 15,957.0 D 3,492.0 25,705.0 8,845.0 2,554.7

2,011.5 38,051.0 D 3,281.0 22,798.0 A 9,023.0 A 2,145.8

1,259.7 62,182.0 3,130.1 NA 6,211.0 D 2,500.1 F

NA NA NA (11.9) (14.4) 2.3 4.0 7.2 4.1 NA 6.6 0.9 2.9 (1.6) (2.8) NA NA NA

NA 28 148 ** 134 NA

171 28 142 ** 138 98

166 27 129 ** 138 103

183 27 118 ** 136 100

179 26 112 NA 142 102

OTHER COMPANIES WITH SIGNIFICANT ALCOHOLIC BEVERAGE OPERATIONS BUD ANHEUSER-BUSCH INBEV -ADR DEC 39,758.0 A 39,046.0 A DEO DIAGEO PLC -ADR JUN 16,881.3 15,964.2 OTHER COMPANIES WITH SIGNIFICANT TOBACCO OPERATIONS BTI BRITISH AMER TOBA PLC -ADR DEC 25,100.4 SWM SCHWEITZER-MAUDUIT INTL INC DEC 788.1 D VGR VECTOR GROUP LTD DEC 576.5

36,297.0 A 14,618.2

36,758.0 A 15,318.5

23,507.0 A 16,104.0 A

19,735.0 A 15,009.1 A

NA 13,969.0 A

NA 15.0 1.9 2.4

1.8 5.7

** 121

** 114

** 105

** 110

NA 115

24,259.5 A 816.2 580.4

23,195.7 740.2 D 525.0

23,272.4 A 740.4 423.7

17,898.0 A 767.9 397.0

20,136.7 714.8 379.2

37,549.6 A,E 501.4 310.8 A

(3.9) 4.6 6.4

4.5 2.0 8.7

3.5 (3.4) (0.7)

67 157 186

65 163 187

62 148 169

62 148 136

48 153 128

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 fiscal year change.

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Net Income
Million $ Ticker Com pany Yr. End DEC DEC 2012 59.5 441.5 2011 66.1 674.0 2010 50.1 668.1 2009 31.1 729.4 2008 8.1 400.1 2007 22.5 514.9 2002 8.6 161.7 BREWERS SAM ! BOSTON BEER INC -CL A TAP [] MOLSON COORS BREWING CO DISTILLERS & VINTNERS BEAM [] BEAM INC BF.B [] BROWN-FORMAN -CL B STZ [] CONSTELLATION BRANDS -CL A TOBACCO AOI ! ALLIANCE ONE INTL INC MO [] ALTRIA GROUP INC LO [] LORILLARD INC PM [] PHILIP MORRIS INTERNATIONAL RAI [] REYNOLDS AMERICAN INC UVV .. UNIVERSAL CORP/VA CAGR (%) 10-Yr. 21.4 10.6 5-Yr. 21.5 (3.0) 1-Yr. (10.0) (34.5) 2012 695 273 Index Basis (2002 = 100) 2011 772 417 2010 586 413 2009 364 451 2008 95 248

DEC # APR # FEB

398.2 NA NA

133.3 513.0 445.0

487.6 572.0 559.5

242.8 449.0 99.3

158.6 435.0 (301.4)

749.5 440.0 (613.3)

525.6 245.0 203.3

(2.7) NA NA

(11.9) NA NA

198.7 NA NA

76 ** **

25 209 219

93 233 275

46 183 49

30 178 (148)

# MAR DEC DEC DEC DEC # MAR

NA 4,180.0 1,099.0 8,800.0 1,272.0 NA

29.5 3,390.0 1,116.0 8,591.0 1,406.0 92.1

(71.6) 3,905.0 1,029.0 7,259.0 1,329.0 156.6

79.2 3,206.0 948.0 6,342.0 962.0 168.4

132.2 3,090.0 887.0 6,890.0 1,338.0 131.7

9.0 9,161.0 855.0 6,026.0 1,307.0 119.3

27.5 11,102.0 681.5 NA 418.0 106.7

NA (9.3) 4.9 NA 11.8 NA

NA (14.5) 5.1 7.9 (0.5) NA

NA 23.3 (1.5) 2.4 (9.5) NA

** 38 161 ** 304 **

107 31 164 ** 336 86

(260) 35 151 ** 318 147

288 29 139 ** 230 158

481 28 130 NA 320 124

OTHER COMPANIES WITH SIGNIFICANT ALCOHOLIC BEVERAGE OPERATIONS BUD ANHEUSER-BUSCH INBEV -ADR DEC 7,243.0 5,855.0 DEO DIAGEO PLC -ADR JUN 3,063.5 3,052.7 OTHER COMPANIES WITH SIGNIFICANT TOBACCO OPERATIONS BTI BRITISH AMER TOBA PLC -ADR DEC 6,246.2 SWM ! SCHWEITZER-MAUDUIT INTL INC DEC 83.7 VGR VECTOR GROUP LTD DEC 30.6

4,026.0 2,463.3

4,613.0 2,663.6

1,927.0 2,975.9

3,005.0 2,708.5

NA 2,465.1

NA 2.2

19.2 2.5

23.7 0.4

** 124

** 124

** 100

** 108

NA 121

4,808.7 87.6 75.0

4,431.4 71.4 54.1

4,386.1 35.6 24.8

3,591.9 0.7 60.5

4,226.6 3.4 73.8

1,854.1 32.6 (31.8)

12.9 9.9 NM

8.1 89.8 (16.1)

29.9 (4.5) (59.2)

337 257 NM

259 269 NM

239 219 NM

237 109 NM

194 2 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.

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Return on Revenues (%)

Ticker Com pany Yr. End DEC DEC 2012 10.2 11.3 2011 12.9 19.2 2010 10.8 20.5 2009 7.5 24.1 2008 2.0 8.4 2012 18.8 3.1 BREWERS SAM ! BOSTON BEER INC -CL A TAP [] MOLSON COORS BREWING CO DISTILLERS & VINTNERS BEAM [] BEAM INC BF.B [] BROWN-FORMAN -CL B STZ [] CONSTELLATION BRANDS -CL A TOBACCO AOI ! ALLIANCE ONE INTL INC MO [] ALTRIA GROUP INC LO [] LORILLARD INC PM [] PHILIP MORRIS INTERNATIONAL RAI UVV [] REYNOLDS AMERICAN INC .. UNIVERSAL CORP/VA

Return on Assets (%)

2011 24.9 5.4 2010 19.2 5.4 2009 12.9 6.5 2008 3.9 3.4 2012 27.7 5.7

Return on Equity (%)

2011 37.7 8.7 2010 29.6 9.0 2009 19.9 11.2 2008 5.9 6.1

DEC # APR # FEB

16.1 NA NA

5.9 18.8 16.8

7.4 22.1 16.8

3.9 18.2 3.0

2.2 17.5 NM

4.9 NA NA

1.3 14.3 6.2

3.9 16.1 7.3

2.0 13.1 1.2

1.2 12.6 NM

9.1 NA NA

2.7 24.8 17.0

9.1 28.9 21.8

5.0 24.2 4.4

3.1 24.6 NM

# MAR DEC DEC DEC DEC # MAR

NA 23.9 23.7 28.0 15.3 NA

1.4 19.8 25.1 27.6 16.5 3.8

NM 23.1 25.4 26.7 15.5 6.1

3.4 19.1 25.7 25.3 11.4 6.8

5.9 19.4 25.4 26.8 15.1 5.2

NA 11.6 34.3 24.1 7.8 NA

1.6 9.1 35.4 24.4 8.4 3.4

NM 10.5 35.1 20.9 7.6 6.2

4.3 10.0 38.7 18.8 5.3 6.8

7.6 7.3 35.3 21.2 7.3 5.5

NA 122.1 NA NA 22.1 NA

9.2 76.4 NA 460.0 22.0 7.9

NM 84.3 NA 157.4 20.4 15.1

22.1 93.0 264.1 96.0 15.1 17.8

49.1 28.9 134.8 60.2 19.5 13.6

OTHER COMPANIES WITH SIGNIFICANT ALCOHOLIC BEVERAGE OPERATIONS BUD ANHEUSER-BUSCH INBEV -ADR DEC 18.2 15.0 DEO DIAGEO PLC -ADR JUN 18.1 19.1 OTHER COMPANIES WITH SIGNIFICANT TOBACCO OPERATIONS BTI BRITISH AMER TOBA PLC -ADR DEC 24.9 SWM ! SCHWEITZER-MAUDUIT INTL INC DEC 10.6 VGR VECTOR GROUP LTD DEC 5.3

11.1 16.9

12.5 17.4

8.2 18.5

6.2 9.2

5.2 10.0

3.5 8.4

4.1 8.6

2.5 9.9

18.4 35.6

16.1 42.4

12.3 43.6

17.5 43.4

9.1 39.9

19.8 10.7 12.9

19.1 9.6 10.3

18.8 4.8 5.9

20.1 0.1 15.2

14.4 9.7 3.0

11.3 10.3 8.0

10.3 8.7 6.4

10.5 4.7 3.4

9.3 0.1 8.1

50.3 16.9 NA

35.8 17.5 NA

33.5 14.2 NA

39.1 9.4 171.5

29.6 0.2 90.0

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.

INDUSTRY SURVEYS

ALCOHOLIC BEVERAGES & TOBACCO / MAY 2013

57

Current Ratio
Ticker Com pany Yr. End DEC DEC 2012 1.8 0.7 2011 1.9 1.7 2010 1.6 1.7 2009 1.5 1.1 2008 1.0 1.1 2012 0.2 27.7 BREWERS SAM ! BOSTON BEER INC -CL A TAP [] MOLSON COORS BREWING CO DISTILLERS & VINTNERS BEAM [] BEAM INC BF.B [] BROWN-FORMAN -CL B STZ [] CONSTELLATION BRANDS -CL A TOBACCO AOI ! ALLIANCE ONE INTL INC MO [] ALTRIA GROUP INC LO [] LORILLARD INC PM [] PHILIP MORRIS INTERNATIONAL RAI UVV [] REYNOLDS AMERICAN INC .. UNIVERSAL CORP/VA

Debt / Capital Ratio (%)

2011 0.0 19.1 2010 0.0 19.2 2009 0.0 15.8 2008 0.0 22.3 2012 0.8 NM

Debt as a % of Net Working Capital

2011 0.0 227.7 2010 0.0 220.9 2009 0.0 776.6 2008 0.0 NM

DEC # APR # FEB

2.4 NA NA

3.2 4.3 1.7

2.1 2.8 3.1

2.6 2.8 1.9

2.9 1.9 1.9

28.6 NA NA

29.8 18.4 42.4

36.5 18.6 50.0

43.5 20.4 51.3

46.5 21.2 61.8

122.4 NA NA

113.5 37.4 290.1

162.7 39.7 220.9

183.3 51.8 269.4

205.8 69.0 328.7

# MAR DEC DEC DEC DEC # MAR

NA 0.8 1.7 1.0 1.3 NA

2.3 0.9 1.7 1.0 1.0 4.3

2.8 0.9 2.1 1.1 1.1 3.1

2.4 0.7 1.6 1.3 1.3 2.8

2.0 1.4 1.5 1.5 1.3 2.7

NA 55.8 233.2 101.7 46.8 NA

70.9 53.7 239.8 81.3 32.2 24.2

73.6 47.1 114.6 66.5 34.5 20.7

66.6 46.9 89.2 64.9 37.3 26.2

65.8 46.6 0.0 56.1 40.8 23.4

NA NM 264.5 NM 482.7 NA

99.1 NM 240.5 NM NM 30.2

104.4 NM 117.2 NM 860.7 30.0

99.2 NM 85.5 390.2 358.1 38.5

105.1 199.2 0.0 237.3 409.3 34.8

OTHER COMPANIES WITH SIGNIFICANT ALCOHOLIC BEVERAGE OPERATIONS BUD ANHEUSER-BUSCH INBEV -ADR DEC 1.0 0.6 DEO DIAGEO PLC -ADR JUN 1.5 1.5 OTHER COMPANIES WITH SIGNIFICANT TOBACCO OPERATIONS BTI BRITISH AMER TOBA PLC -ADR DEC 1.1 SWM ! SCHWEITZER-MAUDUIT INTL INC DEC 3.0 VGR VECTOR GROUP LTD DEC 3.3

0.8 1.8

0.8 1.6

0.5 1.2

42.7 52.0

41.5 53.1

47.1 63.4

52.4 66.7

56.8 53.4

NM 308.1

NM 303.7

NM 273.7

NM 347.2

NM 603.9

1.1 2.3 1.6

1.1 1.7 2.3

1.2 1.6 2.6

1.0 1.2 1.2

53.3 21.9 95.1

49.4 22.1 106.1

47.9 7.2 98.9

54.4 7.9 89.2

54.7 33.4 71.8

870.0 59.5 132.2

NM 75.7 253.6

881.0 34.2 168.7

816.1 37.3 139.4

NM 462.9 355.7

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.

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ALCOHOLIC BEVERAGES & TOBACCO / MAY 2013

INDUSTRY SURVEYS

Price / Earnings Ratio (High-Low)

Ticker Com pany Yr. End DEC DEC 2012 31 - 20 19 - 16 2011 23 - 14 14 - 10 2010 28 - 8 14 - 11 2009 22 13 8 8 2008 93 - 44 27 - 16 BREWERS SAM ! BOSTON BEER INC -CL A TAP [] MOLSON COORS BREWING CO DISTILLERS & VINTNERS BEAM [] BEAM INC BF.B [] BROWN-FORMAN -CL B STZ [] CONSTELLATION BRANDS -CL A TOBACCO AOI ! ALLIANCE ONE INTL INC MO [] ALTRIA GROUP INC LO [] LORILLARD INC PM [] PHILIP MORRIS INTERNATIONAL RAI [] REYNOLDS AMERICAN INC UVV .. UNIVERSAL CORP/VA

Dividend Payout Ratio (%)

2012 0 52 2011 0 34 2010 0 30 2009 0 23 2008 0 35 2012 0.0 - 0.0 3.4 - 2.8

Dividend Yield (High-Low, %)

2011 0.0 - 0.0 3.3 - 2.5 2010 0.0 - 0.0 2.8 - 2.1 2009 0.0 - 0.0 3.0 - 1.8 2008 0.0 - 0.0 2.2 - 1.3

DEC # APR # FEB

25 - 20 NA - NA NA - NA

76 - 49 23 - 17 11 - 8

20 - 12 19 - 12 8- 6

29 - 11 18 - 12 39 - 24

72 - 29 22 - 14 NM- NM

33 NA NA

88 37 0

24 57 0

63 39 0

165 39 NM

1.6 - 1.3 NA - NA 0.0 - 0.0

1.8 - 1.2 2.2 - 1.6 0.0 - 0.0

2.1 - 1.2 4.6 - 3.1 0.0 - 0.0

5.7 - 2.2 3.4 - 2.1 0.0 - 0.0

5.7 - 2.3 2.8 - 1.8 0.0 - 0.0

# MAR DEC DEC DEC DEC # MAR

NA 18 17 18 21 -

NA 14 13 14 17

13 - 6 19 - 14 15 - 9 16 - 12 18 - 13 14 - 11

NM14 13 15 15 9-

NM 10 10 11 8 6

6- 2 13 - 9 14 - 9 16 - 10 16 - 10 84

4- 1 53 - 10 17 - 10 17 - 10 16 - 8 15 6

NA 83 73 63 104 NA

0 96 65 58 89 58

NM 78 63 62 81 32

0 85 67 69 105 30

0 113 53 46 74 40

NA 6.1 5.8 4.4 6.0 -

NA 4.7 4.4 3.4 5.0

0.0 6.8 7.2 5.0 6.8 -

0.0 5.2 4.3 3.6 5.1

0.0 7.6 6.1 5.7 10.1 -

0.0 5.6 4.7 4.0 5.5

0.0 9.1 7.3 7.0 10.9 -

0.0 6.4 4.7 4.3 6.4

0.0 11.7 5.2 4.6 9.1 -

0.0 2.1 3.1 2.7 4.7

NA - NA

NA - NA

5.5 - 4.0

5.3 - 3.4

7.3 - 3.7

6.2 - 2.7

OTHER COMPANIES WITH SIGNIFICANT ALCOHOLIC BEVERAGE OPERATIONS 18 - 13 BUD ANHEUSER-BUSCH INBEV -ADR DEC 20 - 13 18 - 15 DEO DIAGEO PLC -ADR JUN 25 - 17 OTHER COMPANIES WITH SIGNIFICANT TOBACCO OPERATIONS BTI BRITISH AMER TOBA PLC -ADR DEC 17 - 14 SWM ! SCHWEITZER-MAUDUIT INTL INC DEC 15 - 11 VGR VECTOR GROUP LTD DEC 51 - 41

26 - 17 19 - 14

18 - 13 16 - 10

NA - NA 19 - 11

34 54

32 51

20 59

0 53

NA 58

2.7 - 1.7 3.1 - 2.2

2.4 - 1.8 3.5 - 2.8

1.1 - 0.8 4.2 - 3.1

0.0 - 0.0 5.6 - 3.3

NA - NA 5.5 - 3.1

20 - 15 14 - 9 20 - 16

18 - 13 21 - 11 28 - 18

15 - 10 32 - 6 47 - 30

22 - 13 NM- NM 22 - 12

66 17 441

94 12 166

71 15 217

62 26 454

73 NM 171

4.7 - 3.8 1.5 - 1.1 10.8 - 8.7

6.3 - 4.8 1.3 - 0.8 10.5 - 8.4

5.7 - 4.0 1.4 - 0.7 12.0 - 7.8

6.3 - 4.1 4.7 - 0.8 15.1 - 9.7

5.8 - 3.3 4.6 - 2.3 14.3 - 7.9

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.

INDUSTRY SURVEYS

ALCOHOLIC BEVERAGES & TOBACCO / MAY 2013

59

Earnings per Share ($)

Ticker Com pany Yr. End DEC DEC 2012 4.60 2.44 2011 5.08 3.65 2010 3.67 3.59 2009 2.21 3.96 2008 0.58 2.19 BREWERS SAM ! BOSTON BEER INC -CL A TAP [] MOLSON COORS BREWING CO DISTILLERS & VINTNERS BEAM [] BEAM INC BF.B [] BROWN-FORMAN -CL B STZ [] CONSTELLATION BRANDS -CL A TOBACCO AOI ! ALLIANCE ONE INTL INC MO [] ALTRIA GROUP INC LO [] LORILLARD INC PM [] PHILIP MORRIS INTERNATIONAL RAI [] REYNOLDS AMERICAN INC UVV .. UNIVERSAL CORP/VA

Tangible Book Value per Share ($)

2012 18.93 (9.48) 2011 14.30 8.94 2010 12.26 8.86 2009 12.05 5.77 2008 9.78 4.13 2012 142.50 - 94.24 46.35 - 37.96

Share Price (High-Low, $)

2011 115.49 - 71.00 50.44 - 37.99 2010 100.93 - 30.00 51.11 - 38.44 2009 48.63 - 17.50 51.33 - 30.76 2008 54.15 - 25.55 59.51 - 35.00

DEC # APR # FEB

2.51 NA NA

0.86 2.39 2.18

3.20 2.61 2.65

1.61 2.02 0.45

1.04 1.93 (1.38)

(1.67) NA NA

(0.69) 3.68 (4.24)

(6.43) 3.52 (4.52)

(11.15) 2.54 (4.14)

(14.01) 2.02 (7.79)

64.00 - 49.74 71.00 - 51.30 36.98 - 18.50

65.48 - 42.30 54.69 - 41.43 23.19 - 16.42

63.51 - 37.05 48.67 - 32.62 22.52 - 14.60

46.77 - 17.67 36.98 - 23.31 17.56 - 10.72

74.44 - 30.24 42.02 - 26.97 23.81 - 10.66

# MAR DEC DEC DEC DEC # MAR

NA 2.06 2.82 5.17 2.25 NA

0.34 1.64 2.67 4.85 2.41 3.32

(0.81) 1.87 2.26 3.93 2.28 5.94

0.89 1.55 1.92 3.25 1.65 6.21

1.50 1.49 1.72 3.33 2.29 4.57

NA (7.01) (4.98) (10.28) (9.42) NA

3.34 (6.65) (3.82) (7.76) (7.57) 37.46

3.12 (5.79) (0.51) (5.84) (7.16) 37.56

3.88 (6.38) 0.19 (3.68) (7.56) 33.05

3.11 (0.14) 1.25 (1.79) (8.93) 28.42

3.92 36.29 47.02 94.13 46.93 -

2.62 28.00 35.61 72.85 38.95

4.44 30.40 40.00 79.42 42.18 -

2.17 23.20 24.13 55.85 31.54

5.96 26.22 29.90 60.87 33.41 -

3.17 19.14 23.41 42.94 18.17

5.71 20.47 27.25 52.35 27.13 -

2.22 14.50 17.50 32.04 15.77

6.60 79.59 29.74 56.26 36.00 -

1.97 14.34 17.77 33.30 18.60

52.75 - 43.57

47.70 - 35.02

56.21 - 35.36

49.74 - 25.35

68.04 - 29.22

OTHER COMPANIES WITH SIGNIFICANT ALCOHOLIC BEVERAGE OPERATIONS BUD ANHEUSER-BUSCH INBEV -ADR DEC 4.53 3.67 2.53 DEO DIAGEO PLC -ADR JUN 4.91 4.90 3.96 OTHER COMPANIES WITH SIGNIFICANT TOBACCO OPERATIONS BTI BRITISH AMER TOBA PLC -ADR DEC 6.44 4.88 SWM ! SCHWEITZER-MAUDUIT INTL INC DEC 2.67 2.60 VGR VECTOR GROUP LTD DEC 0.35 0.89

2.91 4.28

1.93 4.64

(21.84) (8.13)

(23.55) (3.35)

(25.49) (6.53)

(28.28) (7.96)

(32.11) (6.43)

91.21 - 58.78 121.39 - 84.44

64.53 - 49.05 87.49 - 71.25

64.77 - 43.19 76.37 - 55.90

53.69 - 37.18 70.00 - 40.93

NA NA 86.40 - 49.15

4.46 1.97 0.64

4.43 1.13 0.29

3.61 0.03 0.74

NA 15.84 (2.08)

(6.04) 13.95 (2.36)

(5.01) 13.65 (1.86)

(7.48) 12.53 (1.36)

(8.70) 7.93 (0.92)

109.73 - 89.25 39.40 - 30.59 17.70 - 14.25

96.00 - 72.59 37.34 - 23.38 17.49 - 13.94

79.99 - 56.00 41.81 - 21.19 17.97 - 11.71

66.94 - 43.26 36.09 - 6.32 13.80 - 8.84

81.04 - 45.49 13.27 - 6.54 16.00 - 8.90

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 identified.

The analysis and opinion set forth in this publication are provided by Standard & Poors Equity Research Services and are prepared separately from any other analytic activity of Standard & Poors. In this regard, Standard & Poors Equity Research Services has no access to nonpublic information received by other units of Standard & Poors. 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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INDUSTRY SURVEYS