Annual general meeting report 2002

Chairman's report

2001 was another excellent year for Gallaher – with adjusted EBITA up 8%, PBTA up 10%, and earnings per share up over 12%.

Our international acquisitions have more than demonstrated their value – Gallaher is now a truly international Group. We continue to underpin our overseas expansion with our highly profitable, and cash generative, UK operations.

Since I wrote my statement in our 2001 annual review, the UK chancellor again increased cigarette duty by an in-line with inflation figure of 6p per pack in his April budget. We welcome this continued recognition by the government that the levels of duty it sets play an important role in tackling the issue of non-UK duty-paid consumption. In addition, and perhaps of more immediate significance today, the progress of HM Customs’ increased efforts against smuggling is proving successful.

We remain wholeheartedly supportive of Customs’ activities, and were very pleased to announce that our long-standing co-operation with them has been further strengthened by an official Memorandum of Understanding, which we both signed on 23 April.

During the first three months this year, the UK duty-paid market appears to have stabilised. Our strong market positions – and our balanced brand portfolios in each of the tobacco categories – continue to stand us in good stead.

Our cigarette market share, of over 38%, continues to be underpinned by our commanding position in the premium sector – Benson and Hedges has maintained its total market position during the first three months of 2002.

Gallaher’s relationships with the key multiple grocer channel – which is continuing to increase its share of total consumer sales – are growing even stronger, assisted greatly by our introduction of Sterling.

Hamlet remains the UK’s pre-eminent cigar choice, while Amber Leaf goes from strength-to-strength in the handrolling tobacco market – its share of consumer sales reaching some 13% in March.

I have no doubt that by anticipating the regulatory changes to come shortly, with our focus on channel marketing and the sales force, we have placed ourselves in an excellent position. In the meantime, we intend to invest incrementally this year to further strengthen our position over the medium term.

In the Republic of Ireland, we achieved a cigarette market share of over 50% in the period January to March – spearheaded by Benson & Hedges’ further growth.

Since the start of the year, Gallaher’s organic Continental European operations have been fully integrated with Austria Tabak’s operations – headquartered in Vienna.

On a pro-forma basis, our total volume sales in this division – including export sales from our Austrian and Swedish facilities – were up 16% in the first three months of 2002, at over 11 billion cigarettes.

In Austria, our number one brand, Memphis, continues to head our leading position in the cigarette market, where we have around 50% of consumer sales. And, along with Ronson, Memphis continued to spearhead our strong growth in exports to Central and Eastern Europe.

We have grown the volumes of our own brands, led by Blend, in Sweden by 6% over the comparable period last year – increasing our market share to over 40%.

In France, Benson & Hedges American Blend has grown to over 1% of the market, building on the heritage of Benson & Hedges Virginia which holds nearly 2%.

Looking forward, I expect that the transfer of production of Gallaher’s legacy American style brands to Austria last month will assist these brands' growth in this division.

Benson & Hedges and Nil in Germany are proving resilient in the branded cigarette sector. And, although the generic sector’s growth has slowed, we have increased these export volumes over last year.

Elsewhere on the Continent – including Spain, Greece, and Italy – we continue to perform well.

We also consolidated our CIS operations into a single division at the start of this year – reporting into Moscow.

Total CIS volumes are up by some 5% – spearheaded by a near doubling of volumes in Kazakhstan over the same period last year.

In Russia, our share of consumer sales continues to grow, reflecting strong volume performance by Troika and St George, underpinned by the continued strength of LD. We continue to build our national distribution network – today, we have 26 regional representative offices and warehouses.

We have commenced local manufacturing in Ukraine, and we are currently in the process of increasing local capacity to match our growing sales requirements.

In Asia Pacific, we lifted in-market sales by 19% over the first three months of 2001. And, in April, we announced our joint venture with Sampoerna International in Malaysia. As Nigel said at the time – this marked a further step in Gallaher’s Eurasian progress.

Our distribution operations have performed in-line with our expectations.

In Austria, Tobaccoland continues to develop non-tobacco sales, while the ordering and billing systems will be further automated this year leading to efficiency improvements going forward.

As we reported in our 2001 annual review, we expect our vending operation in Germany, ATG, to encounter another difficult year in 2002.

Although pricing parity between vending and retail has been established this year, we expect that the German government’s imposition of an additional duty increase on 1 January will put further pressure on the branded cigarette sector. So far this year, this operation has met our expectations. Meanwhile, we are continuing to implement efficiency measures, and to examine innovative strategies to maximise the contribution from this business.

Last year saw productivity improvements and cost reductions across the Group, and we continue to invest further in our manufacturing operations to achieve efficiency savings and to carry on improving flexibility.

We are well-advanced in our SAP implementation programme in the UK.

There are many machinery moves and installation programmes being undertaken at present – as we configure our sites to best advantage – and I remain confident that our overall record of continuing cost benefits will be maintained in the medium term.

Current trading remains in-line with management and market expectations.

Turning to regulation and litigation.

Gallaher is only party to smoking and health litigation in the UK and the Republic of Ireland. There are three individual actions against the Company in Scotland and one in 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 400 individual plaintiffs, of which 163 are against Gallaher.

On 14 February 2002, a draft statement of claim was served in one case against Gallaher and other tobacco companies, making wide-ranging allegations against such companies and against the Irish State, the attorney general, and the minister for health and children, who have subsequently joined as parties to that action.

Whilst we can give no guarantees, 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.

The tobacco market is, of course, subject to significant regulatory influence. Last year, the European Union adopted a tobacco manufacturing and product directive. The directive includes measures setting maximum yields for tar, nicotine and carbon monoxide for cigarettes and regulations regarding ingredients. It will introduce large health warnings and will ban the use of terms such as 'Mild', 'Light' and 'Ultra Light'.

Also in Europe, the commission has produced a proposal for a new draft directive banning certain forms of tobacco advertising.

Meanwhile, in the UK the government is supporting a House of Lords private member’s tobacco advertising and promotion bill. If passed by the House of Commons, this bill would ban most forms of tobacco advertising, promotion and sponsorship later this year.

And, in Ireland, the sale and marketing of tobacco products and the smoking of tobacco products in public places will also be further restricted by recent legislation.

Lastly, on your behalf, I should like to thank all our employees for their invaluable contribution to the ongoing success of the Group.

In fact, the talents and commitment of our people is well-illustrated by the award – just three weeks ago – of Investors in People status to Gallaher Ltd. This national, government-approved, standard recognises the effective development of human resources through commitment, planning, action and evaluation of development activity. I congratulate all of those involved for this achievement.

Peter Wilson, chairman 15 May 2002