"VIABLE SMOKING FOR THE UNDER-SERVED: COMPANY GROWTH

STRATEGY"

Mr Avinash Krishna Kumar, Vice President - Marketing of HCC Ltd. (Hindustan Cigar
Corporation Limited), flicked the ash out of his cigarette on the ashtray and pondered, not just
about the cigarette prepared with the new cigarette blend but also about the future strategic
direction for the company. He gazed through the piles of paper about the previous quarter results
and felt quite happy. The quarterly sales result of 2008-09 was promising. In fact, the company
had shown decent performance with year on year (YoY) growth in line with the category growth.
However, the reports submitted by the consultants for the company's strategic advances left him
a little baffled. HCC is the market leader of the tobacco segment with over 70% market share by
value catering to the second-most populous country in the world, India. HCC was forced to move
out of the non-filter cigarettes due to the change in the excise rate levied by the government,
which made the segment unviable. Though the non-filter cigarettes is a low price variant with
nominal value in comparison to the high end filtered cigarettes, Avinash felt unjustified. "For a
market leader like HCC, not serving the largest segment of the population at the bottom will not
reflect well with our mission to reach the masses. We can be satisfied with our current status, but
it is important to reach the aspiring consumers concentrated in rural pockets for continued
success in future". The top-of-mind question is finding an effective way to cater to the under-
served price-conscious aspiring consumer base and choose the strategic alternative that will be
effective to regain the shifted consumers in the changed regulatory setup. Avinash captures the
situation by commenting, "We cannot be satisfied by looking at the tip of the iceberg. The un-
served segment is huge and will be the key to unleashing future potential".

COMPANY BACKGROUND
HCC is one of India's foremost private sector companies with a market capitalization of nearly
US $ 20 billion and a turnover of over US $ 6 billion. HCC is rated among the World's Best Big
Companies, Asia's 'Fab 50' and the World's Most Reputable Companies by Forbes magazine,
among India's Most Respected Companies by Business World and among India's Most Valuable
Companies by Business Today. HCC ranks among India's '10 Most Valuable (Company)
Brands', in a study conducted by Brand Finance and published by the Economic Times. HCC
also ranks among Asia's 50 best-performing companies compiled by Business Week. HCC has a
diversified presence in Cigarettes, Hotels, Paperboards & Specialty Papers, Packaging, Agri-
Business, Packaged Foods & Confectionery, Information Technology, Branded Apparel,
Personal Care, Stationery, Safety Matches and other FMCG products. While HCC is an
outstanding market leader in its traditional businesses of Cigarettes, Hotels, Paperboards,
Packaging and Agri-Exports, it is rapidly gaining market share even in its nascent businesses of
Packaged Foods & Confectionery, Branded Apparel, Personal Care and Stationery. HCC is the
market leader in cigarettes in India. With its wide range of valuable brands, it has a leadership
position in every market segment. Its top-rated portfolio of brands includes Emblem, India Tsars,
Model, Gold Chips, Silk Scratch, Armada, Cutters, Captain, Bermuda, Pistol and Fleck.

INDIAN CIGARETTE INDUSTRY

Avinash gazed over the picture of tobacco plantation that hung in his office and wondered how
the tobacco smoking culture has changed among Indian consumers that was totally foreign till
the 17th century. Though Cannabis smoking in India is a prevalent practice known since time
immemorial and has its mention in ancient literary works like Atharvaveda, tobacco smoking in
the Indian context could only be traced back to the early 17 th century under the rule of Mughals.
Currently, India is the third-largest tobacco producer, producing 600 Million Kilograms annually
and has the second-largest tobacco consumers, consuming 500 Million Kilograms annually.
Adult males predominantly drive the consumption as female usage is considered a social taboo.
The excise duty levied on cigarettes in India is based on filter size (FT) and are segmented as
king size, longs, Regular Size Filter (RSFT), plains and micros (Exhibit 1)

The cigarette industry in India continues to operate in a challenging economic environment,

particularly concerning taxation and regulations relating to communication and consumption.
The Cigarettes and Other Tobacco Products Act, 2003, popularly known as COTPA, prohibits
the advertisement of and regulates the trade and commerce, production, supply and distribution
of cigarettes and other tobacco products. Although the industry has seen a steady increase in
excise duty budget after budget, 2008 was particularly significant. In the Union Budget for 2008-
09, excise duty rates on cigarettes went up by 142% for non-filter cigarettes below 70mm, and by
388% for non-filter cigarettes below 60mm. As a result of this steep increase, non-filter
cigarettes became economically unviable for the legitimate industry. Consumers of these
cigarettes were unable to afford the higher prices post the increase in excise duty. Major
legitimate players in the cigarette industry lost volumes, and HCC withdrew its presence from
the filter segment.

The most dangerous outcome of this has been that it has given a massive fillip to the
manufacture of illegal cigarettes. The vacuum left by the virtual wiping out of the legitimate non-
filter cigarettes is being rapidly filled up by illegal filter cigarettes, sold to consumers at INR.10/-
per packet of 10 cigarettes. Such a low market price is being made possible by evading payment
of the required excise duty. Unwittingly, the increase in the excise duty rate on non-filter
cigarettes has been instrumental in spurring a considerable growth of this illegitimate segment of
the cigarette market. As per the report, this activity has gained momentum, and currently, the
market share of these illegal INR.1 RSFT cigarettes stands at 7% of the total industry. The report
hinted that if this activity of excise evasion by small manufacturing units is left unchecked, the
market share from such manufacturers could increase to 20%, thereby severely affecting the
exchequer and legitimate duty-paid cigarette manufacturers such as HCC.

Mr Cherian, Chief Consultant – Indian Consumer Goods Research Bureau (ICGRB), proposed
HCC to create and develop a new segment, namely, a 59mm Micro Size Filter (MSFT) segment
at INR.1 per stick offer, i.e., at the same price as the illegal filter cigarettes, which would enable
the company to compete with the illicit segment effectively. This segment will target the
erstwhile consumers of legitimate non-filter cigarettes who have switched to other illegitimate
low-priced filter cigarettes or who have down traded to other forms of tobacco consumption like
beedi, gutkha, khaini, etc. This segment will also target new consumers of the illegitimate low-
priced filter cigarettes who have switched from other forms of tobacco consumption and a low
hanging fruit for HCC with its strong portfolio of brands that stand for quality.

COMPETITORS

Currently, the cigarette market is dominated by HCC with few key players like Godfrey Phillips
India (GPI), VST Industries Limited and GTC Industries Limited (Exhibit 2). Each player is
positioned uniquely with products different from others in various attributes like quality and
price. Also, the market coverage was not too aggregated to be present all over the country
(Exhibit 3).

INDIAN MARKET SCENARIO

Avinash saw the Quarter 4, 2008 figures. The INR 1 RSFT sales stood at around 745 million per
month, approximately 7% of the total market. The INR.1 phenomenon is an All India one, but a
state-wise breakup of the sales data shows that a few states contribute significantly more to the
all India INR.1 RSFT sales than the others. While reflecting on the complexities in the market,
Mr Girish - Marketing commented, "The states that HCC catered are unique in their own way
with respect to consumer preferences. The price segment preferences are also different, thus
making the competition challenging for major players like HCC Ltd. as not all regions show the
same level of affinity for RSFT cigarettes. In fact, the state-level differences make the market
even more challenging" (Exhibit 4 & 5). For instance, Andhra Pradesh, Uttar Pradesh,
Maharashtra, Gujarat and Madhya Pradesh contribute more than half of all India INR.1 RSFT
sales (Exhibit 6). Avinash had a critical assessment to make as to go ahead with a national launch
across all states or only in select states; if so, in what order? Ms Shabana from the consumer
insights team pitched in the recent meeting that the INR 1 RSFTs play purely on their low price
factor, and hardly any brand building is done. Hence the existing players like 'Midland' and
'Forever' don't have any advantage as the customers are price driven and not value-driven,
thereby exhibiting no loyalty. Though there are several INR.1 RSFT brands concentrated in
different pockets across India, top three INR.1 RSFT brands account for more than 50% of total
INR.1 volume, while top ten accounts for around 70% of the same (Exhibit 7).

Further explaining the consumer dynamics, she pointed that smoking is on a decline, though
minimal, which needs to be considered while entering into new segments (Exhibit 8). Mr
Sanjeev – General Manager (Sales), claimed that the consumers of this segment were erstwhile
consumers of discontinued non-filter cigarette brands of HCC (Captain Standard and Costa
Rica), and it shouldn't be an issue to bring them back. He also assured that our robust distribution
setup and higher bargaining power with the wholesalers and retailers would bring success for this
new venture. The key to success in such brands competing at low price points lies in the
shopkeepers' trade margin.
A nationwide survey conducted by Indian Consumer Goods Research Bureau (ICGRB) alarmed
that tobacco usage is declining after stabilizing in 2004, especially the smoking tobacco scenario
was even worse than the non-smoking tobacco scenario (Exhibit 9). Cigarette consumer usage is
classified as regular use and occasional use. The incidence of regular cigarettes has steadied
since 2003, but the overall cigarette usage declined due to the falling levels of occasional usage
(Exhibit 10). Cherian – Chief consultant, ICGRB suggested that the INR 1 RSFT should focus
on consumers of the illegitimate low-priced Regular Size Filter Tips (RSFTs) and other forms of
tobacco like beedi, gutkha, khaini etc. The male tobacco consumers below the age of 35 from
Socio-Economic Classification (SEC) C, D, and E are potential demographic segments. He
further elaborated the psychographics of the consumers as value for money seekers who are
hard-working, ambitious and innovators looking out for constant betterment. Cherian commented
about the geo-demographics as "One thing is clear that the target consumers are concentrated in
rural and semi-urban pockets of the country".

In the report, the consultant also gave a sneak peek of the passive supply chain followed by the
illegitimate INR 1 RSFT industry (Exhibit 11) and recommended targeting them while launching
the new product. They do not have appointed distributors as they do not want themselves to be
tracked (since they avoid taxes). Their modus operandi is to dump their stock to a few key
wholesalers in a town. The stock gets picked up by smaller wholesalers catering to nearby towns
and villages or by mobile hawkers who deal in illegal gutkha (a preparation of crushed areca
nut, tobacco, catechu, paraffin wax, slaked lime and sweet or savoury flavourings). These
smaller wholesalers and the hawkers then supply to the retailers. With this mechanism, the
manufacturers do not have to invest in developing the channel and also reduces the risk of
getting caught by the excise department. While talking about the INR 1 RSFT consumer base,
Shabana pointed "the INR 1 RSFT consumers were at the brink of their 30s with no new takers
from the later generations and are especially concentrated in SEC E" (Exhibit 12)

FUTURE GROWTH OPTIONS AS OF APRIL 2009

In the last cross-functional meeting in Mumbai to discuss the MSFT proposal, Sanjeev put forth
the idea to revive the discontinued non-filter cigarette brand Pistol. Post excise change in 2008,
HCC discontinued its non-filter brand Pistol Standard, a brand extension of respective junior
RSFT. He stated, "It will be easier to connect with the erstwhile consumers of non-filter. Also, it
will be a game on familiar terrains for the retailers and distribution channel". However, the
biggest drawback is that in certain states, for example, Madhya Pradesh, INR.1 RSFT activity is
very high, but HCC did not have any significant non-filter brand. Also, the revived brand might
give an initial connotation of being a non-filter cigarette.

Shabana suggested an alternative to developing a totally new brand name for its MSFT segment
of cigarettes and added that it should have no connection with the existing portfolio. She stressed
that there would be no risk of Brand Dilution, and the possibility of down-trading is minimal,
though not wholly ruled out. On the flip side, given that the MSFT segment would be the lowest
in HCC's portfolio in terms of value, it would not be prudent to invest a lot in brand building
activities. Brand building for cigarettes is a tedious process, given the COTPA regulations.
Hence, a high level of brand recall cannot be achieved, and the consumers might be confused as
one of the other INR 1 RSFT brands.

As per the strategic alternative suggested by Girish, brand extensions of the leading INR.2
RSFTs (Pistol, Captain, Cutters and Fleck) could be developed for the MSFT segment. In certain
states, where the non-filter brand was stronger than the existing INR.2 RSFT brand, a brand
extension of the non-filter brand should be done. For example, in south Andhra Pradesh, Cutters
Standard used to do well and is currently the leading INR.2 RSFT in that region in Pistol. In such
a scenario, a brand extension of Cutters should be done for the MSFT in that region. He further
added that the brand extension in such a case should not include any reference to the non-filter
brand name (should not have the word 'Standard'). Sanjeev was suspicious and expressed his
concern about down trading and brand dilution. For which, Girish stated, "The non-filter
cigarette brands were also extensions of superior brands and still did not lead to brand dilution or
substantial down trading. Moreover, the parent INR.2 RSFT cigarettes should be distinctly
superior to the smaller INR.1 MSFT cigarettes, thus minimizing the risk of down trading".

Avinash joined HCC in 2000 after a decade long experience as a Partner with McKenzie. As one
of the most trusted advisors of the company for the last two decades, he had played crucial roles
in the development of various projects. So, he is well aware that this meeting for quarterly results
would discuss the strategic options put forth by the consultants. He was contemplating the three
options but found it challenging to come up with the ideal choice. Should he propose to launch
the INR 1 MSFT as a new brand or revive the discontinued non-filter cigarette brand or a brand
extension of the INR 2 RSFT brand? As his secretary Ms Laxmi reminds him of his flight to
Chennai, he grabs some of the key papers and sighs with a deep breath. "For a better future, the
decision needs to be made now". She was bemused by his comment but could sense that some
important decision was being made and wished with a pleasant smile "Au Revoir". Given that all
the options have merits and demerits, it was critical for him to be decisive at this juncture.
 EXHIBITS

Exhibit 1: Excise & Product Segments

Value Volume
Segment Definition Excise Rate
Share Share
Tariff Others 2101 0.0 0.0
King Size < 85 mm FTs 1709 17.5 8.1
Longs < 75 mm FTs 1285 8.9 5.3
RSFT < 70 mm FTs 796 59.8 58.1
Plains < 69 mm 530 9.5 13.4
Micros < 60 mm 163 4.3 15.1
Source: HCC Management Information System

Exhibit 2: Company-wise Performance

2000-01 2006-07 (Est.)
Company Volume Value Volume Value
Share Share Share Share
HCC 66.0% 73.4% 68.7% 76.3%
GPI 11.0% 8.7% 11.5% 9.0%
GTC 9.0% 4.8% 6.6% 2.2%
VST 12.0% 7.5% 7.1% 4.3%
NTC 0.3% 0.1% 0.9% 0.6%
CONTRA 3.0% 5.4% 4.4% 7.2%
OTHERS 0.0% 0.0% 0.7% 0.5%
INDUSTRY 100.0% 100.0% 100.0% 100.0%
Source: HCC Management Information System
 Exhibit 3: Key Industry Players & Strategies

Area HCC GPI VST GTC

Pricing Value+ Mid-Market Low-End Low-End

Trade Margins Low Medium High Very High

Portfolio Full Regional Nil Nil

Quality Very High Very High High Medium

Execution High High High Medium

Source: HCC Consumer Insights Division

Exhibit 4: INR 1 RSFT Volume Share – 2008

All
Zone LT MT ST Rural
Market
North 1.55 1.36 1.74 4.79 2.94
East 0.97 1.33 2.38 4.40 2.74
West 1.71 2.84 6.86 19.56 9.44
South 0.19 1.39 0.57 4.50 2.89
All Market 0.77 1.53 1.60 5.56 3.49
Sample Sizes 22,871 12,672 9,245 14,130 58,918

LT –Large Town (10 Lakh + population); MT – Medium Town (1-10 Lakh

population)
ST – Small Town (less than 1 Lakh population)
Source: HCC Management Information System

Exhibit 5: INR 1 RSFT Volume Share – 2008 – By State

All
States Sample Size LT MT ST Rural Market
Delhi NCR 2,390 0.43 1.86 0.00 0.00 0.58
Haryana 2,390 0.00 0.00 0.53 0.00 0.03
HP 2,357 0.00 0.00 0.00 3.16 2.71
Punjab 670 7.02 6.19 5.60 5.08
Rajasthan 2,032 1.84 2.04 9.85 6.90
UP 2,803 0.83 2.01 0.00 1.41 1.47
Uttaranchal 4,724 0.00 0.00 0.00 2.41 1.68
Assam 339 0.00 0.00 0.00 0.00 0.00
Bihar 2,259 19.62 8.42 11.04 12.01 12.19
Jharkhand 2,784 0.31 0.21 0.35 1.32 0.83
Orissa 1,250 0.00 1.75 2.92 3.71 2.92
West Bengal 1,786 0.03 0.00 0.84 1.07 0.37
Chhattisgarh 5,080 4.94 6.66 12.62 10.09
Gujarat 1,205 0.90 0.00 0.00 0.00 0.74
Madhya Pradesh 3,819 8.13 3.85 7.90 32.45 18.24
Maharashtra 4,173 0.32 0.63 5.13 1.22 1.09
Andhra Pradesh 7,219 0.54 2.96 1.45 7.81 5.78
Karnataka 3,649 0.00 0.00 0.00 0.00 0.00
Kerala 3,691 0.00 1.62 1.73 3.41 2.89
Tamilnadu 2,942 0.00 0.00 0.08 0.18 0.09

Source: HCC Management Information System

 Exhibit 6: RSFT (% of Total)

Bihar

Madhya Pradesh
Indian States

Gujarat

Maharastra

Uttar Pradesh

Andhra Pradesh

0 2 4 6 8 10 12 14 16
Volume Share (in %)

Source: HCC Consumer Insights Division

Exhibit 7: Key INR.1 RSFT Brands

Top Ten INR 1 RSFT Proportion (2008) within Total INR 1 RSFT (3.5%)
Brands Metro Other Urban Rural All Market
   MIDLAND FT 22 28 28 28
   FOREVER FT 14 18 17 17
   HARBOUR FT 4 6 9 9
   PERFECT FT 8 6 3 4
   SUNIL FT 10 1 2 3
   VINTAGE FT 0 3 2 2
   CLUB 10 FT 0 0 2 2
   GRAND MASTER FT 0 6 1 2
   KARTOOS FT 0 3 1 1
   IMPACT FT 10 1 0 1

Source: HCC Consumer Insights

 Exhibit 8: Consumer Dynamics
  1999 2000 2001 2002 2003 2004
% Smoke Cigarette regularly 8.9 8.3 7.5 7.3 7.5 7.6
Numbers (Million) 24.0 23.0 21.3 21.3 22.4 23.2
 
% TTS (of Adult Males) 0.6 0.8 0.6 0.6 0.6 0.6
 
% Quit (of Regular Cigarette
9.7 10.2 10.9 10.1 9.2 8.7
base 1 year back)
 
ASB 7.5 7.4 7.2 6.8 6.5 6.4
 
Up trading 2.6 2.8 1.8 2.3 1.5 1.4
Downtrading 3.2 3.5 3.9 3.1 2.3 1.8
(TTS – Tobacco Type Switching; ASB – Average Smoker Base)
• The regular cigarette smoker base has increased due to:
- Decline in quitting ; TTS steady
• Up trading continues to show declining trend. Downtrading situation has
improved considerably as a result of price stability.

Source: HCC Consumer Insights Division

Exhibit 9: Tobacco Penetration in India

80

63 62
% of adult males

61 62 60 58 58 55 55 54

40
34 34 33 34 33 32 33 32
31 31

Any Tobacco Any non smoking Any smoking

0
'95 '96 '97 '98 '99 '00 '01 '02 '03 '04

Exhibit 10: Cigarette Incidence in India

20 18.3
%age of adult males

15.9
15.0
15 14.1
12.9 13.1 12.4
9.4
10 8.9 8.3
9.0 7.5 7.3 7.5 7.6

5 7.0 6.7 6.6

5.6 5.6 4.8
At all Use Occasional usage Regular usage
0
'98 '99 '00 '01 '02 '03 '04

Exhibit 11: INR 1 RSFT Supply Chain

Manufacturer
 Smaller Smaller Gutkha
Wholesaler Wholesaler Hawkers

Source: Indian Consumer Goods Research Bureau

Retailer Retailer Retailer Retailer Retailer

Exhibit 12: Profile of INR.1 RSFT

INR 1/- RSFT Smokers
All Smokers
2006 2007 2008
Age
ASU 30 46 53 51 31
ASO 30 54 47 49 69
SEC
SEC A,B 22 9 5 7
SEC C,D 44 43 35 34
SEC E 34 48 60 59

(ASU – Average Smoker Under, ASO – Average Smoker Over, SEC- Socio-
Economic Class)
Source: HCC Consumer Insights Division