Philip Morris, Japan Tobacco seek Russia advantage with $1.5 bln deal

* Firms buy into distributor Megapolis for $750 mln each

* To support expansion in world No.2 market by volume

* Megapolis may still pursue IPO

* Russia cracking down on tobacco consumption

By Maria Kiselyova and Martinne Geller

MOSCOW/LONDON, Dec 4 (Reuters) - Philip Morris International (NYSE: PM - news) Inc and Japan Tobacco Inc (Other OTC: JAPAF - news) are buying 20 percent stakes in their Russian distributor Megapolis for $750 million each, strengthening their grip on the world's No.2 cigarette market by volume after China.

Russia, where 40 percent of the adult population smoke, is a key battleground for foreign tobacco companies grappling with dwindling sales in many developed markets where government regulation is becoming stricter and smokers fewer.

Foreign players - British American Tobacco (LSE: BATS.L - news) , Imperial Tobacco (LSE: IMT.L - news) , Japan Tobacco and Philip Morris - supply more than 90 percent of the Russian market, worth about $20 billion a year.

However, distribution has stayed mostly in Russian hands with Megapolis - majority owned by Igor Kesayev, who also controls the Degtyarev arms factory and food retailer Dixy - controlling about 70 percent.

"This is a milestone deal," said an analyst who declined to be named. "Tobacco producers have dreamed of breaking this monopoly."

By partly owning Megapolis, Marlboro cigarettes-maker Philip Morris and Japan Tobacco, home of the Winston brand, may be hoping to reduce their distribution costs and raise their profile compared with Imperial Tobacco, whose Davidoff and Gauloises brands are also distributed by Megapolis.

Imperial was not immediately available for comment.

Philip Morris said it expected the deal to lift its earnings as of the first quarter of 2014, without detailing how.

Tougher regulation is lifting cigarette prices in Russia, crimping sales and limiting product availability as President Vladimir Putin's Kremlin (Hamburg: KMLK.HM - news) strives to improve public health and stem a population decline that began after the Soviet Union collapsed in 1991.

Morningstar (NasdaqGS: MORN - news) analyst Thomas Mullarkey predicted Russian cigarette sales volumes would fall nearly 10 percent next year due to an increase in excise taxes, but said the price of a pack was still cheap.

"It's still an affordable habit, and the excise taxes are still going to be low compared to U.S. and UK standards, even after the increase," he said. "In the long run, the Russian market has ample opportunity to continue its trend of going from low-level brands to higher-margin and higher-priced brands."

STEP TOWARD OPENNESS

Megapolis said the deal was the first time that the world's leading cigarette makers had access to local distributors and that the cash inflow did not mean the company would not resurrect plans for a flotation, pulled in 2011.

"This deal is for Megapolis a step toward being more open; we are not giving up the idea of holding an IPO," a spokesman for the Mercury Group, Kesayev's holding company, said.

The deal includes possible additional payments by each stake buyer of up to $100 million based on Megapolis' performance over the four years following the closing of the transaction, expected this month.

Japan Tobacco has a 36 percent share of the Russian market and runs factories in St Petersburg, Moscow, Leningrad Region and Yelets. Philip Morris has 26 percent and has facilities in Krasnodar and near St Petersburg.

Megapolis delivered more than 260 billion cigarettes in 2012 to 150,000 outlets and had revenue of around $12 billion.