Annual general meeting report 2001

Chairman's report

Gallaher had another record year in 2000, with fully adjusted earnings per share up over 11%.

Our strong UK performance underpinned an excellent international result – we grew total overseas operating profit by 26% – while we continued to drive down our manufacturing costs.

Since I wrote my statement in our 2000 annual review, the UK chancellor increased cigarette duty by six pence per pack in his March budget. While this action did not, of course, reduce the significant price differentials between the UK and overseas markets, I welcome the move away from excessive above inflation duty increases that we have seen in recent years.

Although the government would appear to have recognised the need to limit widening the price differentials, I believe that it is the additional resources allocated to HM Customs to tackle tobacco smuggling which may have a measure of success going forward – and, to this end, we will continue to work very closely with Customs in their pursuit of this illegal trade. I have no doubt, however, that while significant price differentials remain, cross-border trade will continue to grow – albeit at a slightly slower rate.

In the first three months of this year the UK duty-paid market has continued to decline, but at a moderately reduced rate of, perhaps, around 8%. It is probable that this is partly related to a noticeable decline in cross-channel travel – owing to the foot-and-mouth epidemic – but I hope that this trend will continue as Customs’ activities start to have an impact.

This year has also seen the introduction of restrictions to prevent forestalling – the pre-payment of duty on stock ahead of a duty increase on which additional profit may be earned following the increase. Although we have earned additional operating profit in the UK from forestalling in recent years, the pre-payment of duty has incurred a related financing cost. The implications of these restrictions are unlikely to be material on our UK pre-tax profitability.

In the UK, our strong market positions, and our balanced brand portfolio, continue to be key to our success. Having secured our cigarette brand range through launches in the lower-priced sectors during the 1990s, more recently we have been taking consistent price increases across all our brands. Looking forward, I am confident that our successful balance between volumes, price increases, and efficiency improvements stands us in good stead to face the current market dynamics.

As was the case in 2000, I believe that the UK will carry on underpinning our successful international expansion. In the period January to March this year, we have continued to grow across our overseas operations, both in markets in which we have been progressing organically and in Russia, where we acquired Liggett-Ducat last year.

In the Republic of Ireland we continue to extend our market leadership. We have taken price increases across our portfolio while growing volumes ahead of the market.

Benson & Hedges American Blend spearheaded a 5% increase in total in-market sales in France in the period January to March. Our local operation is benefiting from the reorganisation, and expansion, of our salesforce last year.

In Greece, Silk Cut continues to lead total in-market cigarette sales growth of approaching 5%, while Old Holborn sales have, again, grown sharply – by 35% over the first three months of last year.

We continue to maintain a profitable market position in Germany, despite an overall market decline and the challenging operating dynamics for branded products in the face of the ongoing sharp growth of the private label sector.

In Spain, our total in-market sales are up over 20%. Benson & Hedges Virginia sales continue to forge ahead, while we have achieved significant distribution gains for Benson & Hedges Red following its launch in January.

The recovery of our position in Kazakhstan continues, with strong organic volume growth enhanced by the successful expansion of our brand portfolio. Sovereign’s in-market sales grew by more than 30% over the first three months of last year, while State Line’s in-market sales are increasing regularly month-on-month.

We have lifted in-market sales in Asia Pacific by over 50% in the period January to March, achieving strong growth across the region with all our Sobranie variants gathering momentum. In China, sales continue to progress well, with an increase in our official import quota. Our co-operation with Shanghai Tobacco has been strengthened following our agreement to introduce its leading premium brand, Chunghwa, into the UK in January.

Our successful strategy in Russia – to market quality brands across the full range of price sectors through a comprehensive distribution network – continues to meet our expectations. We have further expanded the regional sales force, and are undertaking specific promotional campaigns through the use of focused promotional teams. Despite the significant disruption caused in the factory through the machinery installation programme, which is progressing on schedule, our production levels in the first three months were maintained at last year’s levels. The LD brand continues to spearhead our performance in the intermediate price sector, with volume growth of 10% in the period January to March versus the last three months of 2000. In short, Liggett-Ducat continues to fulfil our expectations.

In-line with our manufacturing strategy – to cut costs while improving quality and flexibility – and in addition to our investment programme at our Moscow factory, we are also investing for the future in our UK and Kazakhstan facilities. We are currently determining the appropriate new additional mid-speed making and packaging machinery for our Lisnafillan factory, and are still on schedule to commission the new primary line at our Almaty factory in the fourth quarter.

Turning to regulation and litigation.

Gallaher is only party to smoking and health litigation in the UK and the Republic of Ireland. Within the UK, there are seven individual actions against the Company in Scotland and Northern Ireland. These claims are mainly dormant or at an early stage in the litigation process.

In Ireland, proceedings against tobacco companies have been commenced on behalf of over 430 individual plaintiffs, of which around 180 are against Gallaher – although no statements of claim have yet been served against us.

Gallaher has always maintained confidence in its ability to defend smoking and health actions. We will continue to defend ourselves vigorously, as and when the need arises. Gallaher will not settle actions.

Following a conciliation process between the European Union institutions, the EU has adopted a tobacco manufacturing and product directive. The directive includes measures setting maximum yields for tar, nicotine and carbon monoxide for cigarettes. It will introduce larger health warnings and will ban the use of terms such as ‘Mild’, ‘Light’ and ‘Ultra Light’.

Also in Europe, the commission is preparing a proposal for a new draft directive banning tobacco advertising. Meanwhile in the UK, the government’s tobacco advertising bill which sought to ban most forms of tobacco advertising, promotion and sponsorship failed to gain Royal Assent ahead of the dissolution of Parliament. As such, following the general election next month, a new government – if it wishes to introduce such a bill – will need to do so in front of the new Parliament.

I am pleased to say that current trading remains in-line with management and market expectations. On your behalf, I should like to pay tribute to all our employees for their contribution and commitment to Gallaher’s ongoing success.

Peter Wilson, chairman 18 May 2001