2000 interim results presentation
6 September 2000
Nigel Northridge and Mark Rolfe
Slide 1 |
(Gallaher) |
Slide 2 |
(Nigel Northridge) Good morning ladies and gentlemen. Thank you for joining us to discuss Gallaher's interim results for 2000. I am very pleased with these results. They reflect a strong underlying performance across our business. We have outperformed the market place in the UK - and internationally, we have sold a record 8.6 billion cigarettes. As I see it, there are five key issues at present: what changes are occurring in the dynamics of the UK market, and how are we performing; is the fabulous growth we have achieved in international volumes sustainable going forward; can we keep squeezing costs out of the business; how are we going to maximise the returns for shareholders following our significant acquisition in Russia; and, lastly, what is the scope for continuing the share buyback programme. Here are the key highlights to our results. I should like to take this opportunity to welcome Mark - in his first presentation as finance director - to take you through them in more detail. He and I will deal with the five key issues in the course of our presentations. |
Slide 3 |
(Mark Rolfe) Thank you Nigel, and good morning everyone. Gallaher's results for the six months to 30th June 2000, demonstrate a robust underlying performance. Last year's first half benefited significantly from changes in the timing of duty and price increases in the UK market. You will recall that these benefits reversed in the second half. As, therefore, the current comparison with 1999 is distorted, a more meaningful measure of our performance is the 8.4% compound annual growth in operating profit from 1998 to 2000 - and the increase in operating margin from 37.8% to 42.3% over the same period. |
Slide 4 |
Last year's UK interim operating profit of £205mn was up from £135mn in '98. '99 benefited from the sale of some stock on which duty was paid at rates prior to the December '98 duty increase, and from the timing of Gallaher's own price increase in July - trade buying in advance of this price increase led to the pull-forward of some sales into the first six months from the second six months of the year. Due to the changes in the timing of Gallaher price increases in 2000 - to February and August - there was no corresponding pull forward of trade sales in the first half of this year. The compound growth rate over '98 - and the underlying improvement in operating margin - reported this year, include the benefits from price increases, and continuing cost savings, productivity improvements and lower marketing expenditure. |
Slide 5 |
International turnover and operating profit growth were driven by significant volume gains, price increases and lower product costs. This is a record performance, achieved despite the adverse impact of exchange rates, and after increased marketing expenditure in a number of markets. |
Slide 6 |
The net interest charge was down from £49mn to £41mn, reflecting the later duty increase - which delayed the cash pre-payment of duty until April - and from lower average interest rates. These benefits were partly offset by financing costs arising from the step-up in Gallaher's share repurchase programme. Of course, looking forward, interest expense related to the pre-payment of duty in the UK will disappear, as the practice of forestalling will cease from 2001. This interest charge has partly offset the additional operating profit earned through forestalling, and, therefore, we anticipate that the imposition of restrictions on the pre-payment of duty will not be material to our UK pre-tax profitability. |
Slide 7 |
We continue to manage actively our capital structure in the best interests of our shareholders. I am targeting EBIT interest cover of between four and five times - balancing our cash generation, with the need to retain the flexibility to respond to potential investment opportunities. This year, we have repurchased 39 million shares, accounting for some 6% of shares in issue at the start of the period, at a cost of £122mn. All told, since demerger, we have repurchased around 10% of our original share capital - returning £230mn to shareholders. Since the period-end, the acquisition of Liggett-Ducat increased debt by around £264mn. But next year we will not incur the financing costs associated with forestalling, so we still have the headroom - consistent with our interest cover targets - to buyback more shares. Currently, we have committed debt facilities amounting to some £1.8bn, including longer-term bonds totalling around £470mn. |
Slide 8 |
2000's effective tax rate remains above the UK standard rate, and is higher than 99's - as there was a higher impact of non-deductible expenses, on a lower taxable profit, this year. Although goodwill amortisation will increase as a result of L-D, the impact of this on our effective tax rate is expected to be mitigated by the benefit of the current local tax holiday. |
Slide 9 |
Basic earnings per share of 16.2p, compares with a reported EPS of 18.7p for '99, and 12.6p in '98. The current year reduction reflects the lower profits, partly offset by the effect of our share repurchase programme. We have declared an interim dividend of 7.65p per share, an increase of 5.5% over our '99 interim dividend of 7.25p per share. |
Slide 10 |
The effect of the changes in duty and price increase timings are evident in our operating cash flow. Neither the first half of 2000 - or of '99 - show a cash conversion rate which is representative of our historic average annual rate. The first half of last year saw the unwinding of the high debt, and working capital, levels set at the end of '98, resulting from the pre-payment of duty ahead of the December '98 duty increase. This gave rise to substantial cash inflow in the period. By contrast, the first half outcome for this year shows lower profits, and an increased working capital position relative to the 1999 year-end. This reflects a high level of duty in stocks relating to the pre-payment in connection with the March 2000 budget, partly offset by a favourable movement in receivables, as sales in December '99 were increased by trade demand ahead of the millennium. I would expect our conversion rate for the full year to be more in line with the historic average. |
Slide 11 |
Net cash flow. Capital expenditure is lower in this period, mainly due to the cost of trademark acquisitions in the first half of '99 - principally the rights to the Dorchester and Dickens & Grant brands, and for Benson & Hedges in Spain. In addition, last year included much higher expenditure associated with the Lisnafillan factory investment programme. On 22nd August, we announced the purchase of the Benson & Hedges and Silk Cut trademarks in certain EU accession countries. And, currently, we are investing in additional kiosks and gantries in the UK, and improved IT systems, as well as our ongoing programme of investing to obtain production cost efficiencies. All told, we therefore expect second half expenditure to be higher than the first half, at around £40mn, before addressing the requirements of our Russian business. |
Slide 12 |
Liggett-Ducat has received environmental approval to increase production to up to 65 billion cigarettes a year. This has enabled us to crystallise the significant investment opportunities at L-D. Currently, L-D is operating at maximum capacity - about four billion cigarettes a month - and it is not able to increase its production rates to meet the growing demand for its products. L-D has started to transfer production lines to Sovereign - rather than manufacturing this higher-margin brand in addition to its existing business. This is the right thing to do for the bottom line, but means that we are not reaping the full potential of L-D. We will invest to accommodate the growing intermediate- and higher-priced volume sales, while maintaining the existing levels of lower-priced volumes, thereby providing even greater security for the total business. We shall install seven new making and packing complexes - ranging from mid-speed through to UHS - by the end of 2001. This is a very challenging goal, in such a short time-frame - but if anyone can do it, we can. And, to meet the increased production rates - and to provide additional business security - we are installing a second primary line. This investment totals some £40mn - about £10mn this year, and the remainder in 2001. |
Slide 13 |
As was the case when evaluating the acquisition of L-D, we have been prudent in our financial assumptions. The rate of return of the additional investment exceeds that of the purchase of L-D, comfortably beating our original deal specific WACC of 20%. We have not assumed in our models that the incremental profit earned on this investment will qualify for the Russian corporation tax holiday in 2000 and 2001. The financing of this investment will comprise a combination of inter-company loans, bank debt and capital contribution - providing us with the flexibility to repatriate our cash in a tax efficient manner. And now, I should like to hand you back to Nigel. |
Slide 14 |
(Nigel Northridge) Thank you Mark. The legitimate UK market continues to decline at around 10% - reflecting bootlegging. Although earlier in the year there were some small signs that the rate of growth of smuggling was flattening, non-UK duty-paid product accounted for some 25% to 30% of consumption during the summer months. The government has announced its plans to tackle this illegal trade - and I support these measures. Unfortunately, however, the proposed scanners will not be in place until the back-end of this year, and it takes time to recruit and train new customs officers. I suspect that we will not now see the impact of the proposals until next year - but, when the measures do start to bite into the smugglers' trade, and the UK market begins to develop more order, then Gallaher's leading position places us in good stead for the future. |
Slide 15 |
We significantly outperformed our competitors in the low-price sector this year. We were the only company to grow volumes, lifting our sector share to over 30%. Mayfair continues to grow, and this is after significant MPIs last year, and in February. |
Slide 16 |
Since acquiring Dorchester, we have doubled its share of the total market by improving its distribution, and concentrating on key outlets and trade sectors. Dorchester is securing its position in the market, providing us with a strong foundation for our full brand portfolio. |
Slide 17 |
This year, we saw all prices go up at the same time following the duty increase in March, which led, quite naturally, to a less pronounced period of downtrading from premium to low-price. As a result, the premium sector only fell to around 38% of the market. Benson & Hedges continues its resilient performance - broadly maintaining its share of the total market for over a year now, thereby growing its share of premium. |
Slide 18 |
We continue to lead the highly-profitable cigar market. Hamlet has long been the number one large whiff cigar. Now, following volume growth of nearly 17%, Hamlet Miniatures has overtaken Café Crème as the top brand in the small whiff market. In June we launched Sobranie Cuban Collection - a range of premium cigars at an affordable price. |
Slide 19 |
Amber Leaf continues to storm ahead - volumes up over 50%. Following the launch of the innovative piece pack, Amber Leaf now has over 10% of the legitimate handrolling market. |
Slide 20 |
A word on regulation. We await the ECJ ruling on the European ad ban - and, as a result, the lords seems to be delaying its ruling on the UK government's plan to introduce the ban as secondary legislation. I think we could well win at the ECJ - which has relevance to us in certain of our international markets. Whatever the outcome, however, I have no doubt that we will see legislation here in the UK. But, we have long anticipated this, and our pre-eminence at point-of-sale, our sophisticated sales force, and our leading brand portfolio, places us in a strong position looking forward. The European Union is currently considering a second comprehensive tobacco directive - again, under the auspices of the single market - which encompasses a wide range of issues. As you would expect, we are monitoring events in Brussels closely, and have made representations - both as Gallaher itself, and as part of the industry. As events develop, we shall keep you informed. |
Slide 21 |
So, although the UK market dynamics remain challenging, our successful strategy continues to deliver good performance. In the first half of this year, we have reinforced our leading positions, and outperformed the market place, providing solid foundations for the future. |
Slide 22 |
We lifted international volumes by 27% this year - achieving a record first half by growing sales across our established businesses, and through developing new markets. Excluding contract manufacture, volumes rose by 40%. |
Slide 23 |
Despite the 50p duty increase last December, we increased our domestic volumes in Ireland by over 2%. We successfully launched Mayfair in March, and, along with Berkeley, we are now well-placed at the lower end of the price basket. Meantime, B & H continues to grow share. An advertising and sponsorship ban came into effect on the 1st July - but I have no doubt that our brand portfolio places us in a good position looking forward. |
Slide 24 |
As I said in March - after the significant margin enhancement last year, 2000 is about volume growth in France. In-market sales grew 9%. This is, of course, a market that already has an ad ban - yet we have tripled our market share since '93, building brand salience. In May we introduced the eye-catching lock and can OPF designs, that were originally developed so successfully in the UK - for B & H Virginia - ensuring we continue maximising point-of-sale opportunities. Following on from the success with Davidoff, our sales promotion agreement with Reemtsma has now expanded to include a second brand, Coburn. |
Slide 25 |
Reemtsma now distributes our main brand in Germany, and here too our agreement is progressing well - and is delivering operational savings. Invoiced sales were up sharply, partly reflecting a run-up in stock levels at the start of the year. In the market, Benson's continuing house volumes were up 2.4%, with Lights generating incremental sales. |
Slide 26 |
Our Greek domestic business continues to outperform the market, achieving record market share - while we have also grown our share of tourist sales. Sales of Old Holborn - the most expensive handrolling brand in Greece - were up over 33%. In March, I told you that we were close to finishing a thorough review of our international brand portfolio - we have examined our blends, trademarks and price positioning across our international division. One outcome has been the development of State Line - an economy cigarette, which we believe has potential in some of our overseas markets to complement existing Gallaher brands. State Line - as an American blend - was launched in Greece in August, in 25 packs at a competitive price. |
Slide 27 |
Our ability to grow B & H where we own it was evidenced, yet again, in Iberia. In-market sales demonstrated a dramatic increase. We are currently expanding our sales capability in Spain, and will open an office in Madrid this year. Bensons has a saliency, which, with the right positioning, can be exploited amongst indigenous smokers as well as tourists. |
Slide 28 |
I also told you in March that we were looking at Italy and Holland. From very low bases, we have sharply increased sales this year. More importantly, we have appointed local management for both markets. These appointments are external, and both managers have relevant country-specific experience. |
Slide 29 |
As expected - with around 70% of historic duty free sales relating to intra-EU travel - our duty free sales are down by about that amount. Within the remaining duty free market, Silk Cut has performed strongly. We increased our share of this market to over 17%. Much of the historic duty free volume has transferred to continental Europe, although the RMOs - i.e., ferries - have retained a reasonable share of their historic volume. Bensons is the leading RMO brand, with a quarter share of sales. We have introduced an 800 packing - which currently accounts for more than half of the brand's volume - and continue to examine other opportunities to maximise the potential on offer. Meanwhile, volume sales to Belgium and Luxembourg continue to grow. |
Slide 30 |
Economic conditions in the CIS are showing a steady recovery. In Russia, the difficulties of obtaining tax stamps and the changes to Russian customs regulations were more than challenging while we were a pure importer. The in-market demand for Sovereign was not met through importation in the first half. With Liggett-Ducat, I see an improvement for Sovereign's prospects. But, I'll come back to this a little later. In Kazakhstan, the devaluation in April '99 put pressure on mid-price brands, and we didn't have a value offering. During 2000, Sovereign's monthly in-market sales and market share has been growing steadily. But, as I've told you before, we needed to enhance our brand portfolio - and, in July, we launched State Line. In August, we agreed to end our manufacturing joint venture with Reemtsma. We will now utilise the available on-shore production capacity for State Line, as well as evaluating the potential for some of the Liggett-Ducat brands. State Line has been formulated by our central marketing team - but the packing sizes and exact price positioning will depend on individual market dynamics. Although these posters are the same in Greece and Kazakhstan - in Kazakhstan it's a 21s pack. We now have a value brand in this market to meet the consumer trends - and to provide a degree of protection to mid-price Sovereign. |
Slide 31 |
Sobranie Pinks and Mints continue to record strong in-market sales growth, and earlier this year, we launched the one milligram variant in Japan. This is already resulting in some incremental house sales. Initial research in Taiwan, on a newly-designed pack for Sobranie Classic, is encouraging. In China, we anticipate a further increase in our official import quota - and are currently evaluating the best means of improving our distribution presence. |
Slide 32 |
When we last met, I told you about the development of Dorchester International, and how this brand was helping us to begin selling to new markets. I also told you that we were examining other products' potential to add security to this new business. Although we originally developed Sovereign Classic for the CIS, this brand is now showing a strong potential outside that region. These two brands have spearheaded our move into new emerging markets, principally in Africa and the Middle East. Incremental international volume of some 1.3 billion cigarettes provides a good base for the future. We have already begun to move into the third element of the sell a little / earn a little / spend a little philosophy, with the introduction of some point-of-sale and promotional material in selected areas - examples of which are in the display outside. |
Slide 33 |
And now I'd like to return to Liggett-Ducat. From announcement to completion, L-D continued to perform exceptionally well - the barrier to further monthly sales growth from earlier in the year being its production constraints. Since June, we had - of course - already begun to consider L-D's integration, and the potential for accelerating its growth. Last month, on completion, we were in a position to begin implementing the integration plan. We are augmenting L-D's phenomenal entrepreneurial spirit - the foundation of its success to-date - with Gallaher's strengths and experience. Let me tell you what's happened so far: the appointment of Nigel Simon, as chairman, and Jon Moxon (Gallaher's financial controller) and Simon Witham (senior legal advisor) to the L-D board; the appointment of Jonathan Wale, who has been with Gallaher since January '98, as FD in Kazakhstan, as finance director; some immediate cost savings have been identified in leaf, with a thorough review of both leaf and packaging sourcing happening as I speak; on Monday, L-D began manufacturing Sovereign; and, ....... |
Slide 34 |
.......... as Mark has already told you, we have identified the investment opportunities which will enable us to further enhance the returns from this acquisition. Once L-D begins distribution of Sobranie, the business will benefit from a full brand portfolio. Looking forward, I am very excited about the growth potential offered by Gallaher and Liggett-Ducat together. |
Slide 35 |
Our international strategy is to continue to develop a balanced portfolio of interests in established and emerging markets with growth prospects, both organically and through potential M and A or partnership opportunities. This strategy has delivered fabulous growth this year - providing a platform for the future. And, with our recent acquisitions, of L-D and the B & H and Silk Cut trademarks in some EU accession countries, neither of which are reflected in our first half numbers - I look forward with confidence to further international growth. |
Slide 36 |
Our manufacturing division's drive to reduce costs, while improving quality and maintaining flexibility, remains on track. With the productivity improvements coming through from the Lisnafillan project, and the continuing benefits from leaf and packaging initiatives, we have further reduced cigarette unit costs this year - by over 9% in real terms. |
Slide 37 |
In 2000, we introduced our new in-house cigar filler expansion process, and despite the labour intensive product mix resulting from the launch of Sobranie Cuban Collection, we reduced cigar unit costs by over 6% real. Costs have reduced by 30% real since 1986. |
Slide 38 |
We also have a long-standing record of reducing tobacco costs. Since 1986, we have cut tobacco unit costs by 45% real. Historically, productivity improvements have been the main drivers of this performance. Recently, however, despite the higher mix of labour intensive manufacturing, unit cost reductions have continued - by over 5% this year - through leaf and packaging benefits. Our manufacturing division's drive will continue - and the team are looking forward to working closely with Liggett-Ducat, to introduce some of Gallaher's leading-edge practices to our business in Russia. |
Slide 39 |
Our successful first half confirms that we are well-positioned for the future. To recap on the five key issues: The UK: despite the challenging environment, our portfolio of strong market positions stand us in good stead. Internationally, we are delivering strong organic growth across our business. L-D has tremendous growth potential - and with us, this business has an even brighter future. Our manufacturing division just keeps on delivering those cost savings - without compromising quality or our need to remain flexible. And, our focus on using our cash judiciously continues to benefit shareholders. We still have headroom to return more capital, while keeping our eyes peeled for investment opportunities that would deliver even greater value. Thank you for your attention. |