Annual general meeting report 1999

Chairman's report

1998 was another record year for Gallaher. The strong improvement in operating profit and operating margin underlined the continuing success of our strategy and our commitment to increasing the efficiency and flexibility of our operations.

A key element of our UK strategy is to increase our share of the growing low-price sector. Sovereign, from Benson & Hedges, and Mayfair remained the two fastest growing brands in the UK market, increasing volumes by nearly 40%.

Within the premium sector, we maintained our clear leadership. Together, Silk Cut and Benson & Hedges accounted for over one-fifth of total consumer sales last year.

Internationally, our strategy remains to develop a balanced portfolio of interests in established and emerging markets. We further strengthened our position, growing volumes to a record 16.7bn cigarettes.

Gallaher's focus is to build domestic brands for local smokers. Our success is driven by the equity we have built in Benson & Hedges and Silk Cut in Europe, and Sovereign and Sobranie further afield.

Our manufacturing division is committed to maximising production efficiency, whilst supporting Gallaher's marketing-led approach. We accelerated the rationalisation of our UK cigarette production, and reduced actual cigarette unit costs to below 1986 levels.

We ended the year in a stronger position than when we started.

Turning now to current trading. The key issue in the UK is smuggling. The government's policy of increasing duty by 5% above inflation is making the problem worse. The government acknowledges the scale of the problem and admits it is costing £1.5bn in lost duty revenue. The government has even announced that it will appoint a smuggling Tsar. Despite this, I have to express total bewilderment at the chancellor's recent actions. In December, duty on cigarettes was increased by some 22p, and in his March budget, the chancellor announced a further, and immediate, increase of another 18p. Widening the price differentials between UK and overseas markets twice in four months will only encourage this illegal trade.

Historically, the incidence of adult cigarette smoking has fallen sharply immediately following a duty increase. This year, the incidence of adult cigarette smoking remained constant with 1998 levels. This reflects increased availability of bootlegged product. It's too early to determine the effect on the legitimate market, but we estimate that the underlying rate of decline could be similar to, if not slightly ahead of, last year's level.

There will be a one-off effect on Gallaher's volume sales this year. Previously there was a 'pull forward' of sales by the UK trade from the following year into the preceding November or December. This year this will not now happen. The impact of the 18p duty increase on our pre-budget duty-paid stockholdings will, however, assist in offsetting this phasing of volume sales.

The majority of downtrading takes place in the period immediately following a duty increase, and, following the 22p increase last December, the low-price sector grew to 41.7% of the market in the first three months of this year. Owing to the second duty increase in March, I expect to see a further period of downtrading this year.

Our strategy of increasing our share of this growing sector continues to be successful. Sovereign and Mayfair lifted their share to 23.2% in the period January to March. They remain the two fastest growing brands in the UK.

Our recent acquisition of RJR International's Dorchester and Dickens & Grant business in the UK further strengthens our position in this sector. Together, these brands accounted for 3.6% of the low-price sector in the first three months of this year.

We also signed a distribution agreement for Camel and More. Camel, in particular, has strong brand awareness but has not benefited from a strong distribution base - something Gallaher will provide.

I am pleased to announce today, that we are in the final stages of negotiating a distribution agreement with Reemtsma to launch West in the UK. West is a leading brand in Germany and has a growing international presence. With strong marketing support from Reemtsma, and our distribution clout, we expect it to develop a worthwhile position in the UK.

From January to March, we maintained our clear leadership of the high margin premium sector, which accounted for 40.3% of the market. With three Gallaher brands within the top five in the UK, we continue to lead the UK cigarette market, with a share of 38.5%.

Looking further afield, the Republic of Ireland continues to drive ahead with cigarette volumes rising again this year.

In France, we took advantageous price increases on Benson & Hedges Virginia and American Blend at the start of 1999. And, we have entered into a contract with Reemtsma to provide sales promotional support for the re-launch of Davidoff, which began in March.

So far this year Gallaher is the fastest growing tobacco company, with a significant market share in Greece. Silk Cut volumes continue to grow.

As I speak, we are launching Benson & Hedges Lights in Germany, to capitalise on the growing preference for lower tar products in this market.

At the end of last year, we successfully negotiated the termination of licence arrangements for Benson & Hedges in Spain with BAT and Tabacalera. The highly successful local sales team will now promote all our brands with Gallaher securing the full margin benefit.

At the onset of the economic crisis in Russia, sales to consumers of imported cigarettes all but disappeared. Slowly the situation is beginning to recover and Sovereign is now selling to consumers at about 40% of the pre-crisis levels. I anticipate that we shall soon recommence shipments. Although volumes to this market will be down this year, our international strategy is deliberately designed to ensure that short-term difficulties in one particular market do not disproportionately affect our overall international operations.

We started high quality production at the local factory in Kazakhstan in March. I am pleased to say that we have just sold the first volumes from this factory, and that this locally produced Sovereign is selling to the consumer at the same price as imported Sovereign. Although the Kazakhstan currency, the tenge, was devalued in early April, local pricing is taking account of the situation, and our brand's performance is being maintained.

Although still a very small proportion of our total international business, our volume sales to Asia-Pacific continue to grow.

Intra-EU duty-free is scheduled to be abolished in six weeks time, although there is still some spirited campaigning for its retention. If it is abolished, the impact for Gallaher will be broadly neutral. Within our tourist markets - where we reported strong volume growth last year - we believe that we can further build our business this year.

I am pleased with our international performance so far this year. Having enjoyed strong volume growth over recent years, 1999 will be a year of margin expansion in certain of our markets.

In April, we installed the world's fastest cigarette machinery - up to 16,400 cigarettes a minute - at Lisnafillan. We will install a second such machine shortly. Production at Hyde is now expected to cease in June, with the site decommissioned by the end of September. The projected annual savings are some £23m.

In 1998, we determined that limited share repurchases - which enhance earnings per share - would be in the best interests of shareholders. To date, we have bought some 23.5m shares in the market accounting for about 3.4% of our share capital.

Your board constantly keeps under review Gallaher's capital structure against the high level of cash flow generated by the Group. Our objective is to reduce Gallaher's cost of capital while preserving flexibility. We are today proposing that you renew the power for the Company to repurchase its shares.

Lastly, I should like to update you on our operating environment.

Last year, the European Union Council of Ministers approved the directive banning tobacco advertising and sponsorship. In December, Gallaher and other members of the UK tobacco industry, successfully applied to the UK High Court for it to refer the directive to the European Court of Justice. It is likely to be the end of the year 2000 before we receive the ECJ's judgement.

In the UK, the government's white paper on tobacco was published last December. It included a wide range of measures, but little indication of precise details regarding timing. Some better idea is expected when the government publishes its regulatory impact assessment and draft regulations.

Whatever the outcome, we shall seek to continue to invest in our brands in creative and effective ways. The challenge for Gallaher will remain the same; to maintain existing smoker loyalty and grow market share by encouraging smokers to switch to our brands. I believe our superior marketing skills, and proven ability to build brand equity in markets with ever-tightening restrictions, stands us in good stead for the future.

Turning to litigation. Gallaher is only party to smoking and health litigation in the UK and the Republic of Ireland.

In Ireland, 25 writs have been issued against Gallaher, on behalf of 55 individual plaintiffs, although no statements of claim have yet been served.

In the UK, the most significant cases were the so-called Leigh Day cases. On 26 February, the lawyers acting on behalf of these claimants announced that they were to drop the case and, at that time, 46 out of 53 plaintiffs abandoned their claims. Since that time, a further four claimants abandoned their actions, and, at a hearing on 23 April, the Court dismissed the claims of the remaining three plaintiffs, only one of whom was suing Gallaher. He has been refused leave to appeal by the Judge, but he may renew his application for leave to appeal to the Court of Appeal.

Although this decision does not mark the end of all litigation against Gallaher, it is, nonetheless highly significant. Gallaher has always maintained confidence in its ability to defend smoking and health actions. We will continue to defend ourselves vigorously, as and when any need arises. Gallaher will not settle actions.

To conclude. I am pleased to say that current trading remains in line with management's expectations. I remain confident for the future. On your behalf, I should like to thank all Gallaher employees for their invaluable contribution to our Company's success.

Peter Wilson, chairman 18 May 1999