18880 vol.1 Oct.1997 Proposal for a Joint Venture ECONOMIC between a Multinational DEVELOPMENT Company and a Local INSTITUTE Tobacco Factory Djordjija Petkoski of the World Bank ED! Ca>. Su dciCS e ~ ~ t , . yL4. * * , , ,, ~. . $bV . V ,' ~ ~ ~ ~ ~ K ~ r '. '.-.. al 555 .'" .. A - >#. ,$ . ~ <......... ,. R,,, * - .s . ]JI , .zi ; b'-s"N''''>zo''te-_@_ i~~~~q _, , , , .,.- . ~ ~ ~ ~ ~ s.' . s at >. ~,.> .. Proposal for a Joint Venture between a Multinational Company and a Local Tobacco Factory in an Economy in Transition Djordjija Petkoski Regulatory Reform and Private Enterprise Division Economic Development Institute October 1997 Copyright (C 1998 The International Bank for Reconstruction and Development/The World Bank 1818 H Street, N.W. Washington, D.C. 20433, U.S.A. The World Bank enjoys copyright under protocol 2 of the Universal Copyright Conven- tion. This material may nonetheless be copied for research, educational, or scholarly purposes only in the member countries of The World Bank. Material in this series is subject to revision. The findings, interpretations, and conclusions expressed in this document are entirely those of the author(s) and should not be attributed in any manner to the World Bank, to its affiliated organizations, or the members of its Board of Executive Directors or the countries they represent. 670/049 E 1993 1Z ........................ . ..... S3AaJ Z3IO3J P0PA pUB uou1su3d1uoD 3o1dtug ize ................................ .... - - -SUIm Oilo iu;udop3a( pui 2U111.11rn oz .......S......O).d .3kO1d1NF3 GNV 1N21N3DvNvw 61 .uatudolaAaa XUIouOIV ooouqoL 61 .------------------ siu3uwjinbad a2ssn pur XgawiS Ź1ddnS o03oqoj 61.----- A--- IddflS -iVif1Lvw VINV O)V o0 81.. oluoD Xigini 81.. UIeW laipj1 L I.ulov3ed Pu's fuI?A OU.1011D I I ........................................ 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HdOSO-I]Hd lN3WIMS NI 6 .................... -------------------------------..------ Nolioldn o-dlml 6 ........................................esodoida JuatujsaAUI alnXuJaA JU!Of 8 .................................................................SILldNgg -IVllN210d -qHLO 9 .........................................I d2fU-vd Sv DW A O SIIA2K9 9 ............... ..................-INV-9O-ddLR3N S3WAS I RHI JO SLIdA gKg f - -~~~~~~~~~~~~~~~~~........ uoljanpojjul LI.AI~~~~SIN1Nd Employee Safety ........................................... 22 MARKETING, SALES AND DISTRIBUTION ........................................... 22 Current Market Analysis ........................................... 22 Product Quality and Strategy ........................................... 22 Distribution ........................................... 23 Marketing and Advertising ........................................... 24 PRO FORMA FINANCIALS ........................................... 24 Exhibits and Figures ........................................... 25 2 PROPOSAL FOR A JOINT VENTURE BETWEEN A MULTINATIONAL COMPANY AND A LOCAL TOBACCO FACTORY IN AN ECONOMY IN TRANSITION Introduction Peter was glad that he was selected to participate in the second module of the EDI seven- part training program on Enterprise Management for Restructuring and Privatization. The selection was exacting, but his hard work before and during the first module paid off From 64 participants in the first module, only 30 were selected to continue the program. During the month-long program, he did not get much sleep, but he learned a lot. Accounting and corporate finance became his favorite topics. The only problem he had to resolve immediately was how to prepare a business plan with his colleagues from the training program, which was a requirement for participation in the second module. One of his colleagues was an enterprise manager who was very interested in developing a business plan for his company. Peter went to his boss to ask for flexible working hours while he worked on the business plan. "Out of the question," was the short answer of his boss. "You have already spent too much time this month on your training - in total, over two weeks. We have work to do here. The representatives of the Multinational Company are coming in three months to discuss their proposal for a joint venture with the local tobacco company. The formal proposal was received yesterday, and we have to work on it." Peter was deeply disappointed, but he was not in a position to argue. Only recently, immediately after graduation, had he joined the Ministry of External Economic Relations. He was a member of the group for foreign investment. Although his country had abolished the central planning system and had gone through democratic elections several years ago, not many foreign investors expressed significant interest in his country. A number of small and not very promising investors had spoken to the Ministry, but no substantial agreements had been signed. Peter thought that maybe one of the reasons for this lack of interest was that privatization was being implemented slowly. He thought another reason might be that most of the enterprise managers were not capable of preparing feasible business plans. Their lack of enterprise management skills in an emerging market has been very evident. This void motivated Peter to apply for the EDI training program. At first his boss had serious reservations about the idea. "You work in a ministry, not in an enterprise. You don't need that type of training." Peter managed to convince him that this type of knowledge is extremely relevant for them. "How can we be involved in policy decisions and implementation if we don't understand what managing an enterprise in a market economy is about?" was his main argument. 3 Multinational Company Investment Proposal For Local Tobacco Factory Overall Approach Internationally known Multinational Company (MC) is interested in jointly collaborating with Local Tobacco Factory (LTF), which is situated in a country whose economy is in transition. This is to be the first MC investment project in this country. MC and its sister company are committed to developing diverse businesses in this region and are interested in other potential projects. The government of the country is interested in proceeding rapidly with the privatization of selected industries and in encouraging an influx of foreign, private sector capital investment to help revitalize the country's economy. In order to guarantee the long-term success of LTF and to enable it to compete with imported products, it should develop the capability to produce international quality cigarettes as well as traditional products. Growth in and development of the existing business of LTF will benefit the country, the factory's region, and the employees and management of LTF through larger revenues to the government, substitution of local products for imports, enhanced prosperity for the community and LTF personnel, transfer of technical and management expertise to the country's agro-processing industries, and an increased supply of cigarettes for domestic consumption and export. MC proposes to link its major investment program for LTF with the simultaneous privatization of LTF, thus creating a model for similar privatization programs in the country. This approach can be negotiated and implemented rapidly. This program is expected to act as a magnet that will attract other international investors to the country. This investrnent proposal is preliminary and is intended to assist in discussions and negotiations. This proposal is supported by the management of LTF; it is based on guidance from specialist advisors to the government and industry of the country and on MC's extensive worldwide experience in the cigarette and agricultural industries. MC has approached LTF for several reasons: * The country provides a stable political environment that seems to promise a smooth transition to a market economy. * Current MC manufacturing facilities in Europe and the former Soviet Union are close to full capacity, and MC needs additional capacity in the region. * The LTF management team has the skills, qualities, and strengths with which MC can work successfully as partners. 5 * LTF is one of the few manufacturing enterprises in the economies in transition with a strong enough potential for modernization to meet MC's standards for international quality products. * Regional government officials have been extremely receptive and supportive of MC-LTF project discussions. Cooperation with MC will provide tremendous advantages to LTF upon its integration into the MC network of affiliated businesses. As a large worldwide tobacco company, MC can provide LTF with significant advantages in acquiring quality tobacco and materials at low cost, technical assistance in processing and production, and strength in product development, management, marketing, and distribution. Benefits of the Investment Program MC proposes to bring these key benefits to LTF, the region, and the country: * Rapid negotiation and implementation of a visible and substantial investment project will attract other foreign investments to the country. Excise and income taxes and greater economic activity caused by MC's presence and investments in LTF and the regional community will increase contributions to the state budget. * Imports of cigarettes and tobacco will be reduced through LTF's increased production capacity and quality and an estimated reduction of tobacco waste equal to at least 10 percent of the total tobacco throughput. * Employment levels will substantially increase because of increased production capacity. * Cigarette production output will nearly double, over 27 billion units, by the third year of the project. * Development of a Tobacco Agronomy Program will increase agricultural productivity in the country. * Improved processing and packaging technologies will be introduced and transferred to the agro-processing industries of the country. * Financial reliance of LTF on state assistance for imported materials will be reduced as MC's network takes on this responsibility. * An influx of Western management and technical training will enhance the quality of the regional work force and will set an exarnple for regional industry. * MC will sponsor community education programs. Benefits of MC as Partner MC is a world leader in the manufacture and marketing of consumer packaged goods and is one of the largest consumer companies in the world, producing several famous 6 cigarette brands. These brands are enjoyed all over the world and have a growing consumption in the country. MC is the strongest possible ally for LTF and will enable it to face the challenges of the restructured regional tobacco industry successfully. In the last several years MC has established a range of joint ventures in some countries in transition. MC proposes to use this experience to lead LTF into the 21st century as a consumer-oriented company producing unsurpassed quality products at affordable prices. * Wealth creation - MC's strengths as outlined earlier will ensure the development and future profitability of LTF in an extremely competitive environment. Through the combined efforts of planned activities in and around LTF the employees of LTF can be assured of maximum professional development and premium compensation. The local economy will benefit as LTF expands its business activity and investment. * MC's commitment to the community - MC has a reputation as a model corporate citizen in the communities around the world in which it has activities and understands the value of contributing to community educational and cultural organizations. Traditionally MC presents a gift of welcome to the community in which new ventures are established. MC would like to contribute to the development of young civic and business leaders in the country and will work with local authorities to find an appropriate venue for this work. Emerging market economies - MC already has several investments in countries with economies in transition. Commitment to compete globally - MC is active in more than 150 countries and competes successfully with other international cigarette compames. * Commitment to local management and employees - MC recognizes the talent and quality of the existing LTF management and employees and will provide additional resources to enable the organization to grow significantly in the future. MC will maintain and work with local management and employees to achieve the strategic objectives set out in its business plan, an approach that is unique to MC and that is implemented in all of its operations worldwide. For instance, in the first joint venture (JV) in a country with an economy in transition, MC increased employment by over 25 percent in the first year of partnership operations. * Strong worldwide brand portfolio - MC has several international brands that have substantial market share in many countries around the world, including those with economies in transition. A selection of MC's brands are planned for production at LTF by the second year of the project. * Experience in diverse markets - With its global presence, MC has experience in working with diverse cultures and markets. MC's operations 7 in each of these countries are staffed and managed with local personnel. Each site is supported by a tight network of MC international business and management contacts. * Technology leader - With its significant R&D operations and facilities, as well as its substantial investment in financial and human resources, MC is one of the world leaders in all areas of tobacco technology. MC is the best international partner for LTF. MC is large enough to have achieved global market penetration, an unmatched level of technological expertise, and extensive experience in diverse markets, but not so extensive as to maintain LTF's identity in its own country by generating most of its products specifically for the country's market. LTF and MC need each other. The joint venture will provide LTF with expertise, international products, and investment capital to meet the challenges of the new environment and will give MC additional manufacturing capacity to provide products for its growing markets. Other Potential Benefits The geographical positioning of the country and the city in which LTF is situated, as well as the vast markets of the economies in transition and the stability of the country with its highly educated work force, make the region highly attractive to commercial development. Following the start-up of the MC-LTF project, several related investment and development projects have been identified in which MC would be interested: - Development of modem business hotel accommodations at an existing hotel in the city in which LTF is located; - Development of a secure bonded warehouse facility in the city for storage and distribution of imported products and materials for the country and neighboring markets; and * Investigation of potential development projects in sectors related to MC activities such as the production of packaging materials used in the consumer goods industry and the processing of materials used in the packaged foods industry. Some projects could be developed in the area of food production. 8 Joint Venture Investment Proposal Introduction LTF and MC propose to establish a tobacco joint venture (JV) in the country with an economy in transition with the principal objective of expanding LTF's existing cigarette manufacturing business. The proposal calls for the simultaneous privatization of LTF with the JV and petitions the government of the country to pursue this project rapidly as a precedent-setting case for the privatization of the country's industries. In order to modernize LTF's production facilities to increase output and improve operating efficiencies, a major capital investment program is required. LTF has no ability to fund such an undertaking because of the high commercial risk created by the transformation of the country's economy. MC is both capable and willing to invest in the redevelopment of LTF's facilities but requires a degree of management control and a reasonable financial return from the profits of the enterprise. MC believes its expertise in the tobacco industry worldwide will provide some degree of assurance that it can generate a financial return sufficient to cover the cost of the investment. The financial projection shown later in the financial forecast has been developed on the basis of an optimistic business outlook and assumes a rapid solution to the problems inherent in the country's economy today. As these problems are very real and serious, it is possible that these financial returns will be somewhat diminished. For this reason, MC believes that the proposed management control and sharing of profits is favorable for LTF and the country. The JV contemplates full operations on a local currency basis with a major portion of annual profits to be re-invested in the business during the initial years to build a strong working capital base, necessary to enhance profitable operations and growth. Investment Philosophy There are two possibilities: to have a pilot privatization or a traditional joint venture. Pilot Privatization Option The project postulates the formation of a JV by LTF and MC with the immediate privatization of the state-owned assets of LTF. This approach is preferred by both MC and LTF management and has considerable benefit for the government of the country in creating a model investment and privatization project to serve as a magnet for further investment and privatization in the country (see Diagram 1). 9 DIAGRAM 1- PILOT PRIVATIZATION OPTION Loca Tobacco Factory (LTF) 37% equitv Local Tobacco Factory Assets MC-LTF Joint Golden MC Investments: Stock Share Government Capital Expansion Company Management Systems and Technology 63% equity Multinatoa Company (MC) JOINT STOCK COMPANY. The JV will be implemented through a newly created, closed joint stock company (MC-LTF JSC); 37 percent of the stock will be held by the management and workers collective of the state-owned LTF, and 63 percent will be held by MC. GOLDEN SHARE. In order to assure the government of the country that commercial management of the JV does not conflict with the general interests of the state, a golden share of the JV can be held by the government with certain negotiated controls. Traditional Joint Venture Option If this pilot privatization option is consistent with government policy regarding LTF and the tobacco industry, MC would agree to a more traditional joint venture option where the government would maintain a stronger active interest in the business. The project concept would be similar to that discussed in the following sections, except that the government's golden share would include 37 percent of the joint stock company created by the JV, as in Diagram 2. 10 DIAGRAM 2 - JOINT VENTURE OPTION MC Investments: Local Capital Expansion Tobacco Management Factory Systems and Technology Assets MC-LTF Joint Stock Company 37% equity Golden Share 63% equity Multinational Government Company (MC) Paid-in Capital MC shall make the following contributions, which will constitute paid-in capital for its 63 percent equity stake of the MC-LTF JSC: 3 Additional production equipment to improve and expand LTF's current cigarette manufacturing capacity * Capital for upgrading or replacing designated tobacco primary processing equipment * Filter-making equipment * Spare parts * Cigarette manufacturing materials * Working capital support * Improvements in factory buildings and necessary ancillary equipment (generators, boilers, etc.) * Technical expertise * Marketing and management know-how * Specific industrial property rights * Training programs for specific manufacturing and administrative personnel 11 LTF will make the following contributions, which will constitute paid-in capital for its 37 percent equity stake in the MC-LTF JSC: * Present production, administration, and warehousing facilities * Machinery, equipment, inventories, and stocks * Land-use rights * Inventories and stock * Work force * Any and all other assets under the control and use of the factory (such as kindergartens, clubs houses, dachas, and employee apartments) Management Structure MC-LTF JSC will be managed by a five-member Board of Directors. The Board of Directors will be appointed by the shareholders, with the country partners appointing two members and MC appointing three members. MC envisions temporarily assigning expatriate managers to work with local managers, particularly in finance, marketing and sales, and production management. These expatriate managers will be expected to train local managers in Western (MC) management skills and systems within the first few years following start-up so that expatriate managers will no longer be required (see Management and Employee Programs). Preliminary Assessment of Investments The total volume of MC investments will be made during four years and is equal to US$88.8 million. For detailed information about MC's projected investments in the MC- LTF JSC, see Exhibit 1. Project and Investment Implementation Schedule The implementation schedule for MC-LTF JSC covers four phases (see Table 1: Investment Implementation): Phase I Finalization and signature of agreements and the charter (January-February of the project's first year) * Agreement and signature of investment program TEO * Negotiations of founding agreement and JSC, including charter fund contribution annex and other annexes 12 * Signature of foundation agreement and JSC charter conditional on: (a) board approval and (b) approval by the government of the country Phase II Registration of JV and MC-LTF JSC (March) * Founding meeting and election of Board of Directors * Registration of JSC * Contribution to paid-in capital in accordance with the founding agreement Phase III * Conversion of LTF from a state enterprise to a private enterprise owned by the newly formed JSC (April-May) * Conversion of LTF into a private enterprise via the pilot privatization Phase IV MC-LTF start-up and development program implementation (April-May) * MC-LTF start-up * Immediate active program to provide critical raw materials and spare parts * Refinement and implementation of production strategy * Implementation of equipment refurbishment and investment program TABLE 1: INVESTMENT IMPLEMENTATION': Year I Year 2 Year 3 Year 4 Building Improvements I, II, III, IV II, III General, Computers, Utilities II, III, IV I, II, III I, II, III, IV Primary Processing III, IV I, II Spare Parts II, III I, II Making and Packing Overhaul III, IV I, II, III Add Making and Packing Lines III, IV 1, II, III Equipment Replacement Program III, IV III, IV III, IV Filter-Makers Addition III (I-IV indicate year quarters) The above timing is indicative of MC's planned expansion of LTF. This timing depends on the equipment suppliers' ability to provide and deliver equipment within the target deadlines. It is anticipated that minor deviations could occur to this schedule on a year-to-year basis. 13 Production Volume Forecast Full production capacity, including the installation of additional lines of 27.1 billion units, will be reached by Year 3. See Exhibit 8. Financial Results Forecast See Exhibit 7. Local Partner Development Program Local partner development program consists of several elements, discussed below. General Strategy for Development The overall strategy of the development program has the following major objectives: Manufacturing Operations T o improve the technical capability of LTF quickly To upgrade the LTF manufacturing plant so that it can produce superior quality local cigarettes with vastly improved efficiencies of production To more than double the current production capacity of the factory and develop the capability of producing international quality cigarettes over the next two to three years Tobacco and Material Supply * To implement barter trading operations quickly to assure the supply of all required raw materials at levels to assure the production of consistent, high- quality products To integrate the MC-LTF supply system into MC's regional supply network to take advantage of the volume buying power of MC in purchasing high- quality materials at the best possible prices * To work with the country's suppliers of materials, if required, to improve the quality and efficiency of their operations, thus minimizing the need to import materials 14 Management and Employee Development * To install computerized financial, accounting, and production management systems and train the appropriate personnel in their use so that senior management has access to management information required for the fast changing commercial environment * To implement training in and systems of modem material management and production flow for efficient operations To implement a revised compensation program to reward the most productive workers and motivate the entire work force Marketing, Sales, and Distribution * To refine a business strategy focusing on current production brands with long- term potential for growth in the region * To implement quality improvement initiatives for gradually improving the product line in terms of taste, smoking characteristics, and brand image * To implement a sales and distribution system capable of assuring that MC-LTF products are delivered to all appropriate retail locations across the country as well as to neighboring export markets * To develop a new international quality country's brand with international market potential. Production of local brands will be expanded to the maximum levels attainable on existing equipment in order to meet the strong market demand for inexpensive papirossi and plain and filter cigarettes. Additional capacity and improved production will be achieved through the installation of modem high-efficiency plant equipment. Manufacturing Operations Manufacturing operations consists of several elements, discussed below. Objectives and Programs KEY OBJECTIVES. The key objectives of the new MC-LTF manufacturing operations will be: * To maximize manufacture of traditional product lines (papirossi and oval non-filters) for the country's market and for export barter to finance imports of raw materials; * To improve quality significantly and install additional throughput for tobacco primary processing to provide capacity for 27 billion units per annum on a two-shift basis and to allow for international blend production; 15 * To revitalize existing Western making and packing equipment; and * To move aggressively to install additional high-speed modem make and pack capacity. KEY PROGRAMS (YEAR ] - YEAR 4). The key programs for the first four years of operations include: * Installation of computerized financial, accounting, and production management systems and training of required personnel * Immediate purchase and use of necessary spare parts to achieve planned production levels on all Western equipment lines * Overhaul and refurbishment of all existing make and pack production lines * Installation of additional modem high-speed filter cigarette make and pack equipment lines with an output of 9.4 billion units * Gradual replacement of existing cigarette make and pack equipment as necessary * Replacement of existing one-ton capacity tobacco primary processing lines with a new high-capacity unit to achieve higher output of high-quality cut tobacco filters and to produce international type tobacco blends * Installation of additional cut filter silos * Build up of spare parts inventory to ensure continuous operation of equipment * Installation of modem filter makers with sufficient capacity for 10.8 billion units of filter cigarettes per annum Primary Processing ExSTING EQUIPM;ENT. The existing tobacco primary processing system will be improved considerably by: Installing an on-site steam plant with input water treatment; Refurbishing steam supply lines to and controls for existing vacuum chambers, conditioning drums, and re-drying cylinders; and Modifying equipment to incorporate tobacco by-products into cut-filter blends. These improvements will be made on an urgent basis following the JV start-up in order to maximize the quality, filling-power, and throughput of the five existing 0.85 ton per hour primary lines. ADDITIONAL CAPACITY. Additional primary processing capacity is required to fulfill the projected production volumes anticipated by Year 2 and to replace the existing capacity with higher efficiency modem processing. This high-capacity primary line will be installed 16 in re-constructed space in the warehousing facility near the existing primary processing workshop. Additional cut-filter storage silos will be installed to provide maximum flexibility of manufacturing planning. The following activities will be undertaken: * Reconstruction and site preparation of the new primary processing workshop Installation of a modem high-efficiency primary line with complete flow and process controls and international blend capability * Installation of additional cut-filter storage silos Cigarette Making and Packaging The make and pack equipment is in moderate running condition; however, the old machinery for the unfiltered cigarettes continues to run at acceptable efficiency levels. Efficiency of the equipment producing filtered cigarettes (about 23 percent of total production) is low (around 62 percent), and an extensive overhaul and equipment refurbishment program is required to improve efficiency and product quality levels. The program will include: Overhaul of all existing equipment of Western origin used for the manufacture of filtered cigarettes (Overhaul of existing Western-type packers 1Build-up of spare parts inventory to cover one year of full operations, and Implementation of a modem manufacturing planning and reporting system, which will allow plant operation at maximum possible efficiency. INCREMENTAL CAPACITY. The existing production building has sufficient space for the planned additional make and pack lines. The additional lines will increase the capacity for filtered cigarettes by 9.4 billion units per year. Incremental capacity includes: . Installation of cigarette makers and packers in international king-size configuration, and * Installation of the first line, anticipated for the fourth quarter of Year 1 with 9.4 billion units of additional capacity available by mid-Year 3. The package configuration will depend on commercial factors. REPLACEMENT CAPACITY. Gradual replacement of existing make and pack capacity will be implemented as market forces shift demand from traditional oval unfiltered cigarettes to filtered cigarettes. The investment budget allows for the replacement of about 3.6 billion units of making and packing capacity between Year 2 and Year 4. 17 Filter Making In order to reduce the hard currency requirement for imported acetate tow filters, filter rod assembly equipment will be installed to meet the factories' demand for filters. For details of projected filter production, see Exhibit 10. The balance of required filters (Years 3-5) is anticipated for light cigarettes, requiring special filters to be supplied externally. Quality Control A modern quality-assurance laboratory and all necessary production floor quality control equipment will be installed. MC specialists will work with LTF management to develop and implement procedures, specifications, and tolerances for quality control of raw materials, production, and finished products. Furthermore, technical and management assistance will be provided to the local materials suppliers to assure improvements in quality material supply. General Improvements This includes site improvements and improvements in buildings and utilities. SITE IMPROvEMENTS. In order to improve site utilization, the following steps will be taken: Redefine areas of greenery, access roads, parking, and material handling access (including loading and unloading facilities) Implement a complete site security system including fencing, electronic safety device, and admission procedures (check in/out of vehicles and personnel). This refers to both the factory site in town and the warehouse facilities in the outskirts. * Completion of paved area * Installation of a sheltered area for loading and unloading * Completion of loading and unloading equipment, such as lift trucks and truck dock levers BUILDIAGSAAD UTiLiTIEs. The following areas will be upgraded: * Flooring * Windows and doors * Furnishing * New fire and security system 18 The urban steam supply will continue to be used to heat the buildings. To improve tobacco processing, a new on-site steam plant, including water treatment, will be installed to provide food and tobacco industry-quality steam. In order to ensure the required power supply at any time, an on-site power generator will be installed. Furthermore, the total power consumption will be reduced through appropriate building and process energy management. A functional overhaul of ventilation, air conditioning, and dust extraction equipment will be necessary, accompanied by the replacement of existing duct work where necessary. It appears that vacuum chanbers do not operate up to expectations because of insufficient vacuum capacity. The complete replacement of existing vacuum pumps is a contingency. The existing compressors do not appear to have acceptable capabilities for the food and tobacco industry. The replacement of these units with new machinery may be necessary. Tobacco and Material Supply Tobacco and material supply elements are described below. Tobacco Supply Strategy and Usage Requirements The factory purchases its tobacco on a contract basis with deliveries being fulfilled effectively only for convertible currency payments or the equivalent in barter trade. MC will work with LTF to procure tobacco from traditional suppliers as well as MC worldwide suppliers. All tobacco supplied can be procured through barter in exchange for the export of MC tobacco products and other exportable goods produced in the country. MC has begun to cooperate with tobacco growers and fermentation plants in other countries with economies in transition to maximize the acquisition of tobacco from the traditional trading areas of these countries. Exhibit 9 represents projected tobacco use by the JV. Tobacco Agronomy Development To reduce the need for importing tobacco and to assist in the economic development of the agricultural sector of the country, MC will work with the growers of tobacco and similar crops to develop the full potential of tobacco growing in the country. 19 MC will integrate agronomy programs operating in other regions to provide development assistance to farms in the country suited for commercial development of tobacco growing. In spite of climatic limitations on the commercial viability of tobacco agronomy due to the length of the growing season, certain tobacco species are adaptable to large volume production with the appropriate support. EXPERIMENTATION FARMS. MC will develop pilot growing schemes to select and develop varieties of tobacco most suited for commercial development in the country. MC will work with the selected farm to develop proper planting, curing, and processing facilities to produce high-quality tobaccos for international blend cigarettes. PILOT PROGRAM. MC will commit to establishing the first such development program within six months of the JV's start-up. This program will include the following features: * Farm and acreage selection for initial pilot crops * Seed bed preparation and selection of tobacco varieties - Implementation of initial crop planting with advisory assistance to participating farmers and crop technicians - Development of curing facilities as required for initial crops -- Continued training and assistance to expanded groups of farmers - Expansion of the program with more farmers * Ongoing assistance Other Raw Materials Cigarette paper, tipping, and wrapping materials are purchased when possible from domestic suppliers. Acetate filter rods are being procured from abroad. MC will work with the country's suppliers to improve their capability of producing quality components and will obtain imported components through barter trade from other countries in economic transition. Management and Employee Programs MC will support the management of LTF through the participation of MC expatriate managers assigned to LTF, MC representation on the Board of Directors, and initially with an on-site integration team. The integration team will consist of a group of ten to fifteen highly qualified MC experts from all business areas and from all over the world. They include primary processing specialists, making and packing specialists, quality assurance specialists, inventory specialists, finance and management specialists, and computer and systems specialists. In this respect, experience accumulated while working in other economies in transition will be used. 20 Training and Development Programs The JSC will be managed by a board comprising three MC nominees and two LTF (Workers' Collective) nominees. This board will nominate a general director who will oversee the management of MC-LTF operations. The principal priorities of the management team will be: Rapid implementation of an appropriate management structure capable of developing modem and efficient controls and procedures for accounting, production, material procurement, inventory control, and personnel management. This new structure will be supported by the appropriate automation and systems. Development of a broad-based training program calling for Western business training for administrative staff and quality training for machine operators and key production personnel. These training programs will be conducted both on-site and at selected MC facilities worldwide. The overall objective of the management program is to strengthen the MC-LTF JSC qualitatively to ensure that it becomes a notable example of a successfully restructured market-oriented competitive organization serving as a model for both regional and national industry. MANAGEMENTAND STAFF. Training will be given to staff as follows: 3 General Director - Two months' training in business administration; one month of intensive English training per year for three years plus periodic ongoing training; MC internal management development program; other designated training programs v Management - At MC facilities or elsewhere, training provided over the first three years of the JV; on-site training to finance staff and production staff * Sales and marketing staff- Training for technical staff on an as-needed basis * Employees - On-site training for production operators as required, as well as at selected MC facilities worldwide Employee Compensation and Work Force Levels MC will work with LTF management to review current salary levels. MC anticipates that salaries will be adjusted considerably within the first three months of the JV. MC-LTF intends to implement new systems of compensation including bonus payments and incentives to reward productivity. Given the increased activity anticipated for LTF, the number of employees is expected to rise. 21 Social Facilities MC has no current wish to dispose of any social assets belonging to LTF or to change traditional practices of LTF in providing social services that are consistent with similar former state enterprises in the region. As these traditions change with the economic situation, MC will assist in implementing sound realistic solutions that protect the interests of LTF and its productive employees. Employee Safety MC has extremely high standards for safety in its production facilities around the world. Primary safety concerns in a cigarette manufacturing operation are fire, industrial equipment accidents, and respiratory problems caused by dust levels. A safety audit will be conducted by an MC safety specialist to assure proper systems and operating procedures regarding fire and industrial accidents. The proposed investment plan includes improving the air conditioning and ventilation system for the production areas, which will lower the dust levels considerably. Marketing, Sales and Distribution Marketing, sales and distribution consist of the following elements: Current Market Analysis The market for cigarettes in the country of project implementation is estimated to be 21 billion to 22 billion units per year. The total projected output of LTF for Year 0 is estimated at 13.2 billion units. The current cigarette deficit is estimated to be between 8 billion and 9 billion units. As a result, the JV's objective is to increase capacity. The planned product mix is presented in Exhibit 11. As part of the domestic market demand for cigarettes is expected to continue to be met by imported products, a substantial portion of MC-LTF's production will be available for export to generate hard-currency financing for raw materials. Product Quality and Strategy All efforts will be made to ensure that the best quality products, produced within the cost limitations set by each product segment, can be commercialized successfully. With the addition of improved tobacco processing equipment, the refurbishment of cigarette-making equipment, and improved operating and maintenance procedures, product 22 quality and uniformity will be increased dramatically while product costs are reduced because of efficiencies gained in material usage. Better tobacco conditioning, flow control for feeding to tobacco cutters, and application of tobacco casings are expected to: * Reduce tobacco usage and loss by over 10 percent of the total tobacco throughput, significantly reducing the current LTF estimated waste rate of at least 144 to 24 percent, and * Assure quality products with fresh tobacco filler and with good burning and taste characteristics. It is anticipated that the cigarette market will move gradually towards the quality level set by Western premium importecd cigarettes as the average income increases for the country and the region. LTF management, working with MC marketing and product development specialists, will refine the product strategy with the following objectives: * Rationalization of the current production brands, focusing on those brands with identifiable long-term market potential * Development, introduction, and marketing support for a new filtered cigarette brand with a strong country brand identity using high-quality consumer packaging and professionally proven brand imagery and advertising themes * Introduction of international MC brands during the second year of the JV through imports. MC will work with LTF management to detenrnine the best approach to promoting local brands and introducing selected MC internationally renowned brands. Initial efforts will focus on maximizing production of low-priced local brands in order to meet the demand of the local consumer market. MC will extend its brand development efforts in progress in other joint ventures in economies in transition (production of international blend products) to the LTF venture. Production and development of filtered cigarette brands will increase during the three-year investment plan with the installation of the additional make and pack lines and appropriate filter equipment, which will increase the production capacity of filtered cigarettes to 13.9 billion units. 23 Distribution Initial efforts for the development of MC-LTF distribution will focus on: * Increased delivery to the state distribution network; * Development of sales to emerging private distribution channels; * Direct relationships with large commercial enterprises in the country and in other economies in transition; * Participation in retail merchandising and sales, where feasible, with development and training of a LTF sales force, further expanding employment; and * Distribution and sales offices will be opened in the capital and other key cities of the country. Liaison offices will be established in key export markets in the countries with economies in transition. Marketing and Advertising Marketing and advertising campaigns will be developed quickly for key local brands with registerable trademarks that can be defended under emerging trademark laws. This campaign will be concentrated initially on promoting the image of MC-LTF as a producer of high-quality affordable cigarettes with the additional promotion of specific local brands. Marketing and advertising will be promoted aggressively to build current brands with identifiable long-term potential. Pro Forma Financials The following financial projections have been developed for indicative purposes only, on the basis of approximate costs and prices anticipated for the first and second years, depending on domestic inflation and changes in currency exchange rates. The estimated profit generation is optimistic in the short term but considerable over the long term. See Exhibits 1 through 7. 24 INVESTMENT AND GROWTH OF SHAREHOLDERS' VALUE Exhibit I Capital Investment/Expansion (US$ Thousands) Year 1-4 Year I Year 2 Year 3 Year 4 Year 5 Building and site improvements 2,484 1,242 1,242 0 0 0 Primary processing improvements 20,700 5,175 15,525 0 0 0 Overhaul of existing western make/pack lines 4,830 2,415 2,415 0 0 0 Spare parts for existing western make/pack lines 2,300 1,150 1,150 0 0 0 Additional cigarettes make/pack lines 27,600 4,600 23,000 0 0 0 Equipment replacement program 10,350 0 4,140 2,070 4,140 0 Filter-making equipment 4,968 3,312 1,656 0 0 0 Computer/office equipment/expatriate housing/etc. 3,105 1,656 1,035 414 0 0 Plant utilities (including steam and electricity) 1,380 0 0 0 0 0 TOTAL FIXED CAPITAL EXPENDITURE per year 77,717 20,930 50,163 2,484 4,140 0 WORKING CAPITAL 5,750 5,750 0 0 0 0 Non-capitalized foreign investments 5,325 Training, development, and technical assistance 828 828 828 828 0 Sales and marketing organizational development 863 575 575 0 0 TOTAL MC INVESTMENTS 88,792 28,371 51,566 3,887 4,968 0 CUMULATIVE MC INVESTMENTS 28,371 79,937 83,824 88,792 88,792 GROWTH OF SHAREHOLDERS' VALUE 15,529 34,886 35,771 37,788 LTF collective 37% equity value 26,440 59,401 60,908 64,341 MC 63% equity value 25 INCOME STATEMENT FORECAST Exhibit 2 (US$ Thousands) Year I Year 2 Year 3 Year 4 Year 5 Papirossi net sales 2,217 2,217 2,349 2,349 2,349 Oval non-filter net sales 26,723 26,723 27,524 27,524 27,524 Soft pack filter net sales 10,600 11,130 11,464 11,464 11,464 CPB Filter net sales 9,263 35,664 47,402 49,771 49,771 TOTAL UNIT VOLUME (Millions) 18,600 24,840 27,120 27,120 27,120 TOTAL REVENUE FROM NET SALES 48,803 75,734 88,739 91,108 91,108 COST OF RAW MATERIALS 34,204 52,713 59,475 59,475 59,475 % of net sales 70% 70% 67% 65% 65% Distribution expenses 357 476 520 520 520 Utilities 342 527 595 595 595 Direct labor (wages) 753 1,006 1,098 1,098 1,098 TOTAL VARIABLE CONVERSION COST 1,452 2,009 2,213 2,213 2,213 Salaries administration and production 374 499 545 545 545 Payroll social benefits and taxes 462 618 674 674 674 Commercial office expenses 46 46 46 46 46 Spare parts (year I parts capital) 0 0 920 920 920 Advertising and market budget 684 1,055 1,189 1,189 1,189 Maintenance and office overhead 1,150 1,150 1,150 1,150 1,150 Depreciation buildings and equipment 2,983 8,041 8,331 8,745 8,745 R and D budget 0 0 0 0 0 Training and development budget 0 0 0 0 0 TOTAL FIXED OVERHEAD 5,699 11,409 12,855 13,269 13,269 PBT 7,448 9,603 14,196 16,151 16,151 % of net sales 15% 13% 16% 18% 18% TAX 33% 0 0 4,685 5,330 5,330 PROFIT AFTER TAX 7,448 9,603 9,511 10,821 10,821 26 INCOME STATEMENT FORECAST (Summary) Exhibit 3 (US$ Thousands) Year I Year 2 Year 3 Year 4 Year 5 Total unit volume (millions) 18,600 24,840 27,120 27,120 27,120 NET SALES AFTER EXCISE TAX AND VAT 48,803 75,734 88,739 91,108 91,108 TOTAL COST OF GOODS SOLD 40,671 65,076 73,354 73,768 73,768 GROSS MARGIN 8,132 10,658 15,385 17,340 17,340 Total marketing/advertising 684 1,055 1,189 1,189 1,189 Selling expenses 0 0 0 0 0 Administrative 0 0 0 0 0 R and D/technical support 0 0 0 0 0 OPERATING MARGIN 7,448 9,603 14,196 16,151 16,151 Misc. oper. (income)/expense 0 0 0 0 0 Business unit contribution 7,448 9,603 14,196 16,151 16,151 IBT 7,448 9,603 14,196 16,151 16,151 TAXES (33%) 0 0 4,685 5,330 5,330 NET INCOME 7,448 9,603 9,511 10,821 10,821 PROJECTED CASH FLOW Exhibit 4 (US$ Thousands) Year 0 Year I Year 2 Year 3 Year 4 Year 5 Joint venture's equity injection [7,841] [26,680] [50,163] [2,484] [4,140] 0 Inv. equity (PV @ 5%) [80,265] Net income after tax 7,448 9,603 9,511 10,821 10,821 Depreciation and amortization 2,983 8,041 8,331 8,745 8,745 Incremental working capital [5,394] [6,028] [1,615] [89] 0 Net residual book value 102,129 Annual cash flow generated [80,265] 5,037 11,616 16,227 19,477 19,566 Cumulative cash flow [80,265] [75,228] [63,612] [47,385] [27,908] [8,341] 5-Year Basis 10-Year Basis Cumulative cash flow net of invest. 71,924 172,411 Cumulative discounted PV @ 12% 48,791 67,332 Project IRR (10 years) 20% Payback period 6 Years Average R.O.I. 18% 21% 27 PROJECTED BALANCE SHEET Exhibit 5 (US$ Thousands) Pre-JV Start-Up Year I Year 2 Year3 Year 4 ASSETS Cash (build-up from depreciation) 79 76 4,885 9,052 16,102 26,127 Accounts receivable (8 days) 152 152 1,627 3,156 3,697 3,796 Leaf and NTM's inventory (1.6 month) 253 253 4,561 8,785 9,912 9,913 Finished product inventory (4 days) 29 29 813 1,578 1,849 1,899 Other current assets 120 120 120 120 120 120 TOTAL CURRENT ASSETS 630 630 12,006 22,691 31,680 41,855 Fixed assets 7,671 7,671 34,351 84,514 86,998 91,138 Accumulated depreciation 0 0 [2,983] [11,024] [19,355] [28,100] Investments 0 0 0 0 0 0 TOTAL PPE 7,761 7,761 31,368 73,490 67,643 63,038 TOTAL ASSETS 8,301 8,301 43,374 96,181 99,323 104,893 LIABILITIES AND EQUITY Accounts payable 230 230 1,405 1,894 2,644 2,764 Short-term loan (1) 230 230 0 0 0 0 Long-term debt 0 0 0 0 0 0 TOTAL LIABILITIES 460 460 1,405 1,894 2,644 2,764 Reserved fund 0 0 0 0 0 0 Accrued dividends 0 0 7,448 9,603 9,511 10,821 Collective equity 37% 7,841 2,901 12,773 31,333 32,252 33,784 MC com. equity 63% 0 4,940 21,748 53,351 54,916 57,524 Other equity 0% 0 0 0 0 0 0 Retained earnings 0 0 0 0 0 0 TOTAL EQUITY 7,841 7,841 41,969 94,287 96,679 102,129 TOTAL LIABILITY AND EQUITY 8,301 8,301 43,374 96,181 99,323 104,893 28 GOVERNMENT REVENUES FROM THE PROJECT Exhibit 6 (US$ Thousands) Year I Year 2 Year 3 Year 4 Year 5 Revenues from excise tax (56-58%) 62,222 102,472 121,624 125,180 125,180 Revenues from VAT on cigarettes 0 0 0 0 0 TOTAL EXCISE AND VAT 62,222 102,472 121,624 125,180 125,180 Income tax on TF profit 0 0 4,685 5,330 5,330 TOTAL REVENUES GENERATED 62,222 102,472 126,309 130,510 130,510 CUMULATIVE 5 YEARS 552,022 PROJECTED FINANCIAL RETURNS Exhibit 7 (US$ Thousands) Year I Year 2 Year 3 Year 4 Year 5 LTF revenues 2,756 3,553 3,519 4,004 4,004 MC's revenues 4,692 6,050 5,992 6,817 6,817 MC's investments [28,371] [51,566] [3,887] [4,968] 0 Government's revenues 62,222 102,472 126,309 130,510 130,510 Cumulative LTF cash flow 2,756 6,309 9,828 17,836 17,836 Cumulative MC cash flow [23,678] [69,194] [67,089] [65,240] [58,423] Cumulative government cash flow 62,222 164,694 291,003 552,022 552,022 29 PRODUCTION VOLUME FORECAST Exhibit 8 (Unit millions) Before Year I Year 2 Year 3 Year 4 Year 5 EXISTING EQUIPMENT Papirossi 1,200 1,200 1,200 1,200 1,200 1,200 Oval/non-filter 10,800 12,000 12,000 12,000 12,000 12,000 Filter soft/box 1,200 4,560 4,560 4,560 4,560 4,560 ADDITIONAL EQUIPMENT Projected capacity* 840 9,360 9,360 9,360 9,360 TOTAL 13,200 18,600 27,120 27,120 27,120 27,120 PRODUCTION OF MC BRANDS 0 600 4,200 4,800 4,800 5,400 Additional capacity--foreign brands 0 240' 5,160 4,560 4,560 3,960 * Newly installed manufacturing line will reach 100% capacity of 9,360 million units by Year 3. TOBACCO USAGE Exhibit 9 Year 0 Year I Year 2 Year 3 Year 4 Year 5 Production volumes (unit billions) 13,200 18,600 24,840 27,120 27,120 27,120 Estimated tobacco usage (kg/1,000 cig.) 1.15 1.05 1.00 0.95 0.93 0.90 TOTAL USAGE (tons) 15,180 19,530 24,840 25,764 25,222 24,408 30 FILTER MAKING PROJECTION Exhibit 10 (Billion units) Year I Year 2 Year 3 Year 4 Year 5 Cigarette volumes 5.4 11.6 13.9 13.9 13.9 FILTER-MAKING EQUIPMENT Two lines 3.6 7.2 7.2 7.2 7.2 Third line 1.7 3.6 3.6 3.6 3.6 TOTAL 5.3 10.8 10.8 10.8 10.8 MARKET ANALYSIS Exhibit 11 (Unit millions) PRODUCTION MIX CURRENT PRODUCTION PLANNED CAPACITY Non-filter cigarettes 10,800 12,000 Filter cigarettes 1,200 13,920 Papirossi 1,200 1,200 TOTAL 13,200 27,120 31 Figure 1 FOREIGN INVESTMENTS STRUCTURE (YEAR 1-4) Computer and office Plant utilities (including equipment, expatriate steam and electricity) housing, etc. 2% 4% Building and site improvements Filter-making equipment 3% 6% Primary processing improvements Equipment replacement 27% program 13% Overhaul of existing western make/pack lines 6% Additional cigarettes Spare parts for existing make/pack lines western make/pack lines 36% 3% 32 Figure 2 12,000 10,000 Qw 8,000 en o 6,000 0 4000 ~~~ ' ~~~1 2,00Oi Year 1 Year 2 Year 3 Year 4 Year 5 33 Figure 3 CUMULATIVE FINANCIAL RESULTS First Bar = LTF Cumulative CF Second Bar = MC Cumulative CF Third Bar = Government Cumulative CF 600,000 500,000 .n 400,000 CI 300,000 - __ __ _ __ i- 200,000 , 100,000 -100,000 Year 1 Year 2 Year 3 Year 4 Year 5 34 The Economic Development Institute (EDI) was established by the World Bank in 1955 to help promote international development. EDI conducts learning programs for officials from developing countries to assist them in planning and managing their investments more productively. The Institute produces and disseminates publications and electronic information products that support these objectives. For information on EDI publications write to: EDI Learning Resources Center Economic Development Institute The World Bank 1818 H Street, N.W. Washington, D.C. 20433 Tel: (202) 473-6351 Fax: (202) 676-1184 Visit EDI/s home page on the World Wide Web at: http://www.worldbank.org/html/ edi/home.html