Annual general meeting report 1998

Chairman's report

It has been a momentous year for Gallaher; a year of great change, excitement and opportunity.

Our demerger from Fortune Brands, last May, created a newly independent and revitalised company. Gallaher is the leading tobacco company for the UK market - we are proud of our Company and the great brands we produce.

Independence has reinforced the spirit of enthusiasm and commitment among our staff - a remarkable 64% of those eligible have taken an equity interest through the Gallaher employee sharesave scheme. Independence has heightened the sense of focus for management, and brought new responsibilities too. It has been greatly rewarding to see everyone within the Company rise to the new challenges. We achieved record turnover and operating profit in 1997, and increased our operating margin.

Our strategy for the UK cigarette market - to vigorously defend our share of the premium sector while increasing our share of the growing low-price sector - was successful. We continued to build on the equity of our brands and increased our share of the UK cigarette market.

We grew our share of the low-price sector with Sovereign, from Benson & Hedges, and Mayfair, our price-fighting brand. Together they increased volumes by over 65%. In fact, these two brands were the fastest growing brands in the UK market in 1997. And, within the premium sector, Silk Cut Ultra grew its share, not only of the sector, but of the market as a whole.

Our commitment to efficiency continued in 1997, with each of the three product areas, cigarette, cigar and tobacco, all raising productivity levels. Moreover, we have identified further capital investment and productivity improvements for implementation this year and beyond. In addition to our ongoing programme, the consolidation of our UK cigarette manufacturing onto one site is proceeding to schedule. The projected total annual cost savings will be around £23m once this project is complete.

Looking further afield, we continued to build on the success of Gallaher’s international operations. We are developing a strong presence across Europe and the emerging markets of the former Soviet Union, and pursuing opportunities in the Asia Pacific region.

We have selected key target markets and our broadly based presence continues to secure underlying volume growth. We increased international volumes by some 23% during the course of the year, with cigarette unit sales approaching 16 billion sticks.

Our success has been built on our proven brand building skills. The strength and diversity of our brand portfolio gives us tremendous leverage to attack every sector of the UK market and to exploit key market opportunities overseas. Our strategy is clear and will continue to benefit shareholders.

Turning now to current trading. We estimate that the underlying rate of decline in the legitimate UK cigarette market edged up to just over 4% during the first three months of this year. I say legitimate UK market, as bootlegging remains a significant issue, and, in terms of total UK cigarette consumption, I believe the market may well be roughly flat.

The tax differentials between the UK and Continental Europe continue to widen - and the recent UK budget has only served to exacerbate this problem. There is little doubt smugglers largely concentrate on international premium brands such as Benson & Hedges, but, do not forget, we own our brands across Europe, and we will continue to sell them legitimately in those markets in which we operate. However, the UK government needs to take the whole issue of smuggling more seriously - ultimately it is the small retailer who is being punished.

Looking at the legitimate UK cigarette market. Following the 19p duty increase which came into effect on 1 December 1997, the low-price sector has grown to 33.5% of the market in the period January to March, compared to 29.9% in the first quarter last year.

Managing the margin diminution created by downtrading - from the premium sector to the low-price sector - is something we are good at. That said, we will not chase market share at any price. Against this proven management of the overall mix of our business, I am very pleased to say that our strategy of growing our share of the low-price sector continues to be successful. We increased our share of the low-price sector to 20.5% in the first three months of 1998, from 16.2% a year ago. Both Sovereign and Mayfair continued to increase volumes - by over 30% compared to the corresponding period last year - growing their shares of the overall market to 2.6% and 4.2% respectively.

The high margin premium sector, though impacted by downtrading, still represents some 45% of consumer sales. Again, I am very pleased to say that our strategy continues to be successful. We maintained our clear leadership of this sector in the period January to March, commanding 53% of this market.

We continue to build on the strength and depth of our international operations. Although the rate of growth achieved in 1997 is unlikely to be repeated, our international volumes have shown solid growth during the first three months of this year.

Our performance in the Republic of Ireland goes from strength to strength, with our cigarette volumes rising again this year. In France, following a series of industry price increases, Benson & Hedges American Blend has maintained an advantageous pricing position. This position, combined with the success of our dedicated sales force, has resulted in steady growth for the brand, with Benson & Hedges Virginia also benefiting. In Greece, a new style advertising campaign for Silk Cut was introduced in January and has assisted the further growth in volumes we have experienced in this market. Volumes in the former Soviet Union are also increasing from the record 1997 levels. The latest available market research in Kazakhstan shows that Sovereign is the number one brand in Almaty, the largest city. Progress continues on the construction of the factory in Kazakhstan (a joint venture with Reemtsma), and production is expected to commence towards the end of this year. In Asia Pacific, we have continued the roll-out of Sobranie Pinks and Mints into other major cities in Japan. In China, following the official listing obtained at the end of 1997 for Sobranie, small shipments have now begun.

Closer to home - 'the millennium bug' is an issue that concerns every business. We recognised the problem early on, and have examined, converted and tested most of our systems already. We are well advanced in terms of auditing our suppliers, and are on track to complete the entire process by the end of this year. I am very pleased to say that early recognition has meant a relatively low level of expenditure to ensure full compliance. In total, we estimate that this process will cost some £1.5m pounds, and most of that expenditure has already been incurred. I should like to add that we are also well underway in addressing the implications of EMU.

Lastly, I should like to update you on my views regarding the environment in which we operate. Two weeks ago the European Parliament agreed not to amend the draft directive to ban tobacco advertising and sponsorship despite strong opposition from over 200 MEPs. Four out of 10 of those MEPs voting shared our view that the directive had no legal basis. Nevertheless, the directive will now be passed to the Council of Ministers for ratification. We expect the planned UK white paper on tobacco in the summer, and it is most likely that the government will aim to introduce legislation during the 1998/99 parliamentary year.

I remain convinced that this proposed advertising ban will not reduce consumption, and may well contribute to a more disorderly UK market. That said, we have a long history of managing our business within an ever-tightening regulatory climate, and we shall continue to benefit from the enormous equity we have built in our premium brands over many, many years.

I should like to remind you that Gallaher is not party to any smoking or health litigation in any jurisdictions other than the UK and the Republic of Ireland. The most significant cases here are, of course, the Leigh Day cases where proceedings have commenced in England against Gallaher and Imperial. Although, at a hearing earlier this year, the Court of Appeal lifted the 'gagging order' that had previously been made, I am sure you will agree that it is not in shareholders’ interests for us to fight these cases in the media rather than in the courtroom.

What I will say now is that the recent hearings have all been concerning procedural issues. The underlying facts or merits of these actions are yet to be heard in a courtroom. However, I should like to repeat what we have often stated before. We believe that Gallaher has meritorious defences, and we shall continue to vigorously defend these claims. We have every faith in the UK judicial system and will not be settling cases.

To conclude; I am pleased to say that current trading remains in line with management's expectations, and I am confident that our successful strategy - which is being implemented by a first-rate team of people within the Company - means that we are well placed for future growth. On your behalf, I should like to thank all Gallaher employees for their contribution to our success.

Peter Wilson, chairman 27 May 1998

Your questions and answers

How will the change to the split of interim and final dividends affect shareholders?

As we have stated before, the payment of equal and final dividends in 1997 was a transitional measure from 1998 onward we intend to split the total annual dividend in accordance with the usual UK practice of roughly one-third/two-thirds. Therefore, it would be inappropriate to compare the 1998 interim dividend - which will be roughly one-third of the anticipated total annual dividend - to the 1997 interim dividend - which was half the total annual dividend. If we had followed the usual UK practice for 1997, the net dividends per ordinary share probably would have been 6.4p interim (25.6p per ADS) and 12.85p final (51.4p per ADS). Therefore, when we announce the 1998 interim dividend, and propose the 1998 final dividend, you should compare them to these adjusted figures.

Are you considering diversifying into non-tobacco related businesses?

No. Gallaher is a focused tobacco business, and we intend to remain so. It is the industry we understand best, and we are confident that by continuing to implement our successful strategy we will continue to benefit shareholders.