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June 2009

As I had previously done for Philip Morris and BAT, I would like to provide JTI an
assessment on issues that could adversely affect the operating environment of the tobacco
industry in the Philippines in the following areas:

I. Business

Short-term – The misfortune of Fortune.

In JTI’s International Tobacco Business Results for January-March 2009, it was interesting
to note the performance of several Global Flagship Brands (GFB) manufactured by Fortune
Tobacco. Winston’s sales volume decreased in the Philippines and the Ukraine. Camel
declined in the Philippines and Latin America. It concluded, “decrease in the Philippines due to the
business model change and temporary shipment delays in the Near East.” If a long-term partnership
with Fortune Tobacco has been established due to a change in the business model, this
could be adversely affected by the government’s bolstered ill-gotten wealth case against
Lucio Tan and his companies. However, if a partnership with Fortune will only last until
2010, then it might be advisable to consider La Suerte Cigar and Cigarette Factory (the
former makers of Marlboro and Philip Morris) as a manufacturing partner. A litigation-
weakened Tan Group and a physically-weakened Lucio Tan (he is reportedly ailing) will
result in the weakening of Fortune Tobacco’s hold on the local market and the concerned
branches of government. The Dept. of Finance (DOF) assessed that this will level the
playing field. The point being JTI should not strike out on their own in the Philippines
without a level playing field. This could either be an opportunity or threat. Then again,
Fortune just might partner with Philip Morris in the country soon.

Present Threat – Cigarette smuggling in the Philippines.

The Philippines has become a favorite transshipment point for the smuggling of tobacco to
countries where governments are charging exorbitant taxes to curb domestic production and
consumption. Among the Southeast Asian countries, the Philippines imposed the heaviest
tax on cigarettes from 1989 to 1995, according to the latest available figures from the World
Bank. The tax accounted for 63% of the retail price, almost double the rate imposed in
China, another huge cigarette market. China, which constitutes 35% of global cigarette sales,
imposed taxes equivalent to 38% of the retail price. Taxes collected from tobacco sales in
the Philippines constitute 20% of all government revenues, and industry insiders complain
that they are the government’s favorite whipping boy.

Yet the business remains highly-profitable. There are only five major players in this highly-
protected industry. Fortune Tobacco and Philip Morris Philippines Manufacturing Inc.
(PMPMI) corner over 90% of the local market. The smaller players include Mighty Corp., La
Suerte Cigar & Cigarette Factory, and Associated Anglo-American Tobacco Corp.!/genegregorio
Common interests, such as taxes and other laws that affect the entire industry, compel them
to close ranks and move as one. This has resulted in a virtual monopoly that keeps other big

players, like British American Tobacco or Japan Tobacco International, out. This is crucial
for an industry that requires heavy capitalization. With taxes and other production costs
eating into revenues, the lure of smuggling for those who profit from the tobacco trade has
become stronger. In 2006, the country lost P29-B in revenues due to smuggling. The cost of
production in the Philippines is relatively lower compared to other countries so that today,
smuggling, according to some experts, is actually more outward bound. China’s underground
manufacturers and its trillion-stick-a-year market is a present threat. From the present to the
long-term, the tobacco industry has to regard the gray market as its third or fourth biggest
competitor. This doesn’t help a new player like JTI compete fairly.

II. Litigation

Short-term to medium–term - Lucio Tan’s feud with brother Mariano Tanenglian

The feud between Lucio Tan and his younger brother Mariano Tanenglian appears to have
reached the “point of no return.” Last April, The Philippine National Bank and Eton
Properties Philippines removed Tanenglian from the list of board nominees. A Lucio Tan
Group official also disclosed that Tanenglian will also be dropped from the boards of
Philippine Airlines, Tanduay Holdings, and MacroAsia. Tanenglian reportedly told his
friends that Lucio is not his blood brother and that he was mad to the point of mutual
destruction. Tan made no secret his dislike of Tanenglian’s wife, which added corrosive and
combustible effects in the light of the findings of an internal audit that an estimated P60-
billion loss in trading, fuel hedging, and metals hoarding led directly to Tanenglian’s treasury

Rumors of the falling out between Tan, 74, and Tanenglian, 69, have been swirling in the
Chinese community since February after Allied Bank Director Tanenglian sued the bank’s
security chief and his men for grave coercion after his car was stopped and prevented from
entering the bank building. The feud has largely been kept out of the mainstream media, but
the first public confirmation that the amicable settlement was going nowhere was when
Allied Bank was forced to make a disclosure last April that it was withdrawing Tanenglian
from the board nomination in the May 20 stockholders’ meeting.

After 22 years of litigating Tan for getting rich allegedly on Marcos money, the Presidential
Commission on Good Government (PCGG) said last April that it will finally present its
evidence in the multi-billion peso lawsuit against Tan. Expected to testify is former First
Lady Imelda Marcos, who claimed that her family rightfully owns some 60% of several
companies “held in trust” by Tan. These are: Fortune Tobacco Corp., Asia Brewery Inc.,
Allied Banking Corp., Foremost Farms, Himmel Industries, Inc. Grandspan Development
Corp., Silangan Holdings Inc. Dominum Realty & Construction Corp., and Shareholdings
After having been identified as a possible witness earlier, PCGG Commissioner Ricardo
Abcede confidently announced that the testimony of Mariano Tanenglian will boost the
government’s efforts in the ill-gotten wealth cases against Tan last May 24.

Inside information from the Marcos family revealed that Mariano has been in talks with
Imelda. The prosecution of the case depends on the political will of this administration or
the next. This could mean serious trouble for Lucio Tan and Fortune Tobacco in the short
to medium-term with a change of ownership in the cigarette firm. While this could level
playing field for JTI, this could be either be a threat or an opportunity unless younger
brother Harry Tan’s mediation efforts succeed.

Short-term – Public Awareness of Vincent Reyes case.

After five years, the Makati Regional Trial Court has finally started hearing the P500K
damage suit against Philip Morris Philippines Manufacturing Inc. (PMPMI) filed by Vincent
Reyes on May 31, 2004. On Jan. 26, 2005, PMPMI moved to dismiss Reyes’ complaint for
damages on the grounds of prescription and lack of cause of action. After hearing the
motion to dismiss, the Makati court ruled on Aug. 12, 2005 in favor of the complainant.
PMPMI filed a motion for reconsideration which was denied by the court on Jan. 4, 2006.
PMPMI elevated the case to the Court of Appeals (CA). The CA ordered the hearing of the
civil suit to proceed in October 2008. The formal trial of the case was postponed several
times after PMPMI asked the CA to stop the lower court from hearing the suit. The CA
junked PMPMI’s motion last March 2009. Also last March, the Makati court granted the
Reyes family’s petition to substitute the late Vincent’s heirs as plaintiffs in the case. Last
April, PMPMI asked the court to reconsider its motion to suspend proceedings. Dr.
Encarnita Limpin – executive director of the Framework Convention on Tobacco Control
Alliance Philippines (FCAP) – is very supportive of the case. Limpin was encouraging others
to file civil suits against cigarette makers because cigarette smokers in the country rose from
33% to 35% citing the 1998-2003 Food and Nutrition survey. If this case prospers, FCAP
and its allies might be able to break the litigation floodgates that have remained firm since
1999. Presently, many lawyers are monitoring developments on the case. A definite threat.

III. Regulatory

Short to medium-term - FCTC-Sicpa collaboration

This is expected to be implemented because it is supported from the government’s highest
levels. The Sicpa system is in Malaysia already, talks are ongoing in Taiwan. It is now in
China, California, Turkey, and Brazil. It will be the industry standard for tracking and
tracing. In addition, the Southeast Asian region is set to adopt this. The FCTC-Sicpa alliance
is not new. In the 23 November 2001 issue of Alliance Bulletin, the “Counter-smuggling expert
visits INB today” article announced that John Thorpe - a former Sicpa CEO – will describe
how “trace and track sytems can simply and affordably be applied to tobacco.” In October 2008,
Framework Convention Alliance published a paper entitled “The use of technology to combat the
illicit tobacco trade.” The paper described “the use of codes and markings on tobacco packaging and tax
stamps to allow a better monitoring of the tobacco trade.” It also gave an overview “of coding technologies!/genegregorio
that are used, or are in development, in the tobacco industry and other sectors.” Sicpa even provided data
on the illicit trade in Turkey.

Furthermore, Sicpa explicitly stated that it is assisting international organizations achieve

their goals. Quoting its statement on business offerings to international agencies, “SICPA has
developed strong ties with numerous international organisations, cooperating on the exchange of market
information and actively promoting programs that will help and support them in achieving their goals. Our
tax enhancement, anti-counterfeiting and anti-illicit trade programs address many challenges outlined by the
organisations within the UN System as well as other non-governmental organisations and support groups.
We are an active participant and member of organisations such as the World Economic Forum, as well as
long-standing privileged partner of Interpol, Europol and other organisations that share the common goal of
combating illicit trade.” Despite opposition from the industry and its allies, the adoption of the
Sicpa system in the Philippines is a foregone conclusion in the short-term because of the
triple alliance between FCTC, Sicpa, and the government.

Long-term - FCTC is tightening the noose on the industry and will raise serious
health issues again within 10 years.
While the publicly-stated main objective of a tracing-and-tracking regime is to facilitate
investigations into tobacco smuggling and identify the point where tobacco products are
diverted to an illicit market. The reality is that it is designed to complement a two-pronged
approach that will eventually link health issues to manufacturing. Sicpa’s trace-and-track
system will not only enable WHO-FCTC to accurately monitor and control tobacco firms’
manufacturing capacity and distribution but also their health liabilities. This is an internal
assessment from a DOF source who is cognizant of the fact that JTI is committed to further
establishing mutually beneficial cooperation arrangements with governments across the
world to address contraband and related counterfeit trade.

From the SICPA website, its Secure Trail system is explained in the following manner:

• Allows regulatory authorities and consumers to verify product authenticity and

compliance, thereby alleviating public health hazards.
• Allows governments to independently reconcile excise incomes against production and distribution levels of
highly regulated products such as tobacco, alcohol or pharmaceuticals.
• Provides an indispensable tool for gathering legal evidence and applying
repressive measures in the case of a counterfeiting crime.
• Allows manufacturers to monitor, securely track and authenticate their own products, without interfering
with the manufacturing process or disturbing international trade.

The first and the third points reveal the real intent of the system and its adverse impact on
the industry. Beyond counterfeit crimes, Sicpa will help the FCTC alliance to gather legal
evidence against public health hazards. In fact, the Framework Convention Alliance “The use
of technology to combat the illicit tobacco trade” paper concluded:!/genegregorio

“Governmental requirements for identifying and tracing tobacco products will

intensify in upcoming years. The coding technology is evolving quickly and offers opportunities for
governments to control and monitor the tobacco trade. A tracking and tracing regime for tobacco products is

being considered as one of the obligations in the FCTC protocol on illicit trade in tobacco products. The
challenge in the tobacco sector is that cigarettes are a mass consumer product, and the coding should apply to
290 billion cigarette packs that are sold globally each year.”

With all these, it is evident that the technology infrastructure for correlating health/
mortality statistics with cigarette production will be in place globally within the next decade.
Cigarettes are a legal but controversial product. But the FCTC wants to further punish
tobacco firms by moving cigarettes closer to an illegal product. Certainly, this is a long-term
threat that is imperative for the industry to prepare for. Possibly, the single global “solution”
to the tobacco controversy.

IV. Legislation

Short to medium-term – Bills on picture-based warnings on tobacco products

FCAP Executive Dir. Encarnita Limpin rabidly railed that despite the passage of the
Tobacco Control Act, more Filipino youths are now smoking. “This indicates that the law
has not been effective,” she said. A recent global youth survey showed that smoking
prevalence among Filipino youth had jumped from 15% in 2003 to 21.6% in 2007.

In the Senate, SB 2377 is now being discussed in the plenary on second reading. Senators are
deliberating on it and amendments are being introduced. But in Congress, HB 3364 has not
passed the committee level because of the opposition from legislators. Rep. Raul Daza – its
main author – said, “It is being blocked because of fears that it would kill the tobacco
industry.” An economic reason to counter a health concern has been the customary House
tactic to delay or kill a measure. Dr. Franklin Diza of the Department of Health’s (DOH)
National Center for Disease Prevention Control said that aside from the Northern bloc of
lawmakers, the lobby of the tobacco industry “is also strong.” With ardent allies in the 14th
Congress, passage of HB 3364 won’t be seen until probably the 15th Congress at the earliest.
There are fears that the Senate’s preoccupation with the sex video scandal and the ethics
probe on Senator Villar will derail its focus on the passage of SB 2377 by the June 5
adjournment. When both houses reconvene by late July, the legislative agenda will be on re-
election in 2010.

Medium-term- Implementation of the 2-tier tax system

Since the start of the year, DOF Secretary Gary Teves has been pushing for legislation that
would simplify the current complex “sin tax” system to a simpler one. The proposal imposes
a 2-tier system on the first year and a single-rate on the second year in the case of cigarettes.
The current 4-tier system was based on a mix of specific and ad valorem system in place since
1997 wherein cigarette brands are classified into four categories – low, medium, high, and!/genegregorio
premium – based on their net retail price. The 4-tier system slaps lower taxes on certain
locally-manufactured cigarette brands, such as those of market leader Fortune Tobacco.

At the extreme, there is a 640% tax differential between low-priced and premium-priced
brands. Based on a study by the IMF, the Philippines has the lowest tobacco excise tax in the

Asia-Pacific region. Teves said that the proposed simpler tax system could raise P20-B to
P30-B on the first year, P30-B to P40-B on the second year, and P40-B to P50-B on the
third year. These revenue assumptions were based on DOF’s proposal submitted to the
House last year and Senator Lacson’s measure - SB 2980. Quite simply, this is a case of
shooting for Mars but expecting to land on the Moon. At best, proponents expect the 2-tier
system to be more acceptable than the 1-tier system.

The lobby against this proposal is formidable. Legislation on it certainly will not pass in the
14th Congress because congressmen and senators will already be focusing on the 2010
elections when congress resumes this July. This assessment from a DOF source is based on
past experience on tax legislation since the 1990s. In 5 to 8 years, we can realistically expect
the 2-tier system to be implemented. Perhaps a combination of political will in the 16th
Congress and a diminished lobby from Fortune Tobacco due to successful litigation on an
ailing Lucio Tan will be the breakthrough. The passage of a 2-tier tax system will favor JTI
because it levels the playing field for new players.

V. Conclusion
These are the opportunities to consider in the local market:
1. The 1998-2003 Food and Nutrition survey reported that cigarette smokers in the
country rose from 33% to 35%. (Understanding that JTI doesn’t encourage smoking
among youth because smoking is an informed adult choice, let me just cite that the
2005-2006 Tobacco and Poverty Study in the Philippines reported that smoking prevalence
among Filipino youth has increased from 15% in 2003 to 21.6% in 2007);

2. Moreover, industry insiders disclosed the country ranks among the Top 10 or 12 in
the world in terms of per capita consumption of cigarettes, with 80-Billion sticks sold
annually. It has also earned the distinction of being a predominantly “stick sales”
market, with sticks (as opposed to packs) accounting for about 70% of cigarette
sales; and

3. Finally, cigarette prices here are among the cheapest. For example, a pack of Winston
sells for about $.50 or P20-plus, whereas in other countries, this could sell 10-fold
for as much as $5 or $6.

For these reasons, it comes as no surprise that the Geneva-based headquarters of JTI is
counting on the Philippine operations to eventually play a key role in the region. Asia looms
to be the biggest market among the other new frontiers of tobacco profitability: Latin
America, Eastern Europe, Russia, and Africa. Looking back on the identified issues in the
following fields:
• Business – Smuggling, Fortune Tobacco partnership;!/genegregorio

• Litigation - Tan-Tanenglian feud, Vincent Reyes case;

• Regulatory - FCTC-Sicpa collaboration, FCTC tightening the noose on the industry

and raising serious health issues again within 10 years; and

• Legislation - Bill on picture-based warnings on tobacco products (SB 2377 and HB

3364), DOF proposal on simpler tax-tier system based on SB 2980.

These factors indicate that there are big silver clouds of opportunity followed by dark storm
clouds gathering in the background. The short-medium-long term threats will combine to
create an increasingly restrictive operating environment.