英美煙草 (BTI) 2004 Q2 法說會逐字稿

Well, good morning, everyone. It’s for me great to see a number of familiar faces. But of course, for those of you who have not met me before, I’m Jan du Plessis, and it gives me great pleasure to welcome you all to this morning’s presentation of British American Tobacco’s results – the interim results for 2004.

A welcome also to those people listening to the conference call, as well as for those watching the presentation on our website, BAT.com. With me today I have Paul Adams, our Chief Executive, Paul Rayner, our Finance Director. And after my initial introduction, the two Pauls will take you through our results in more detail.

As has now become our custom, it is my duty to urge investors to read the complete forward-looking statement that is part of today’s presentation pack, and that you can also see on our website. On the assumption that you’ve all read it in great detail, I think we should move on.

Now, it has been an eventful three months, since the announcement of our interim results in April. Martin Broughton left us at the end of June, after what one can describe as an outstanding career over many years with British American Tobacco. All that we can do this morning is to wish Martin all the best for his new role at British Airways.

Whilst this is a new role for me, I have been a director of this company for the last five years. And I therefore would like to assure you that I have been fully supportive of the strategies that have been followed and developed by this Group over the last 5 years, since the merger with Rothmans. And I would like to emphasize to shareholders that you must not expect any change in direction or any change in strategy of this Group as a result of me becoming Chairman of the Company.

One of the Group’s significant achievements in recent years has been a commitment to corporate social responsibility. And this is an area which I, as Chairman, certainly intend to maintain and develop further. Last month, British American Tobacco published its third Social Report, and if you have not yet had the opportunity to look at it, please go to BAT.com and look for yourself how seriously we take CSR as a Group.

After 3 years and the rollout of social reporting to more than 30 markets, from my perspective, I think we have now demonstrated that this is definitely, to us, not a public relations exercise. Corporate social responsibility and our business principles are being firmly embedded in our business strategies and in our organization.

Tomorrow our shareholders will have the opportunity to vote in favor of the Reynolds American transaction, and with that agreement, this deal should close over the weekend. As a result, the Group will own a 42% shareholding in a much stronger and a more sustainable business, with a shareholding in the new company that will be valued transparently. And Brown & Williamson will be indemnified for all existing and future litigation.

For British American Tobacco shareholders, this merger is expected to be both earnings and cash-flow enhancing in 2005. Securing FTC, SEC and tax approvals for the deal has been a remarkable collaborative effort, involving a whole number of people, at R.J.R., Brown & Williamson, as well as here in the UK. And on behalf of shareholders, I really would like to take this opportunity to thank them for their tremendous effort.

Susan Ivy and her new team have already done a great deal of work on how they would want to integrate the businesses, with the obvious exception of brand strategies and marketing issues, although following this completion over the weekend, I know that they will now want to get to work together to decide how they were going to manage our brand portfolio and develop a marketing strategy for what is the world’s most profitable market.

Finally in terms of corporate activity, 10 days ago we announced that we the central government of China, in Beijing, has approved the Group’s major strategic investment in China. We have approval to build a new factory, with an eventual manufacturing capacity of 100b cigarettes, in a joint venture with our partners, China Eastern Investments, and to distribute and sell, nationally, brands like State Express 555 or Kent.

Now, we are, naturally, aware of questions being asked about the nature of the approval that we have received. And we would like to assure shareholders that we have, indeed, received approval from the highest levels of government in China. While there are still some sizable hurdles to overcome, in terms of, for example, the final location of the factory and our sales and distribution strategy, this is a significant milestone.

And although, like much else of what we do, this is the result of a tremendous team effort over many years, can I again take this opportunity, personally, to pay tribute to Martin Broughton for his efforts in enabling us as a Group to reach this point.

Turning to today’s announcement. The results for the first 6 months of the year have been affected by the strength of sterling and overall market declines in a number of key countries, such as France, Germany and Japan. As a result, operating profit, before goodwill amortization and exceptional charges, improved marginally to £1,346m. At constant rates, or comparable rates of exchange, operating profit would have risen by 7%.

As you will hear later from Paul, there were mixed performances in the regions. Asia-Pacific was adversely affected by downtrading in Canada. Europe was affected by excise increases in Germany and France. And although the increases in that region were mainly attributable to the acquisition of ETI, operating profit would still have increased without the acquisition.

The headline 25% increase in pre-tax profit reflects the higher level of exceptional charges that we took in 2003. The 7% growth in adjusted earnings per share benefited from the share buy-back program, which by the way intend to resume very shortly after this announcement, as well as the lower tax rate.

For the year as a whole, the downtrading in Canada will significantly affect our results, whilst sterling has strengthened further against the US dollar since the end of June, and we expect these factors will negatively impact earnings in the second half. Shareholders will also take note that we had some one-off tax benefits in the second half of 2003. However, the 8% increase in our interim dividend signals the Board’s obvious confidence in the center of our business.

Whilst we completed -– expected completion, I should say, of the Reynolds American transaction, together with the important new in the state of our progress in China -- represent important steps in improving our long-term prospects.

That concludes my introduction, and I hand you over to Paul.

Thank you, Jan, and good morning everyone. Volumes were ahead by 3%, to 396b sticks, benefiting from acquisitions and some organic growth. The declines in industry volumes in a number of markets, as a result of excise-driven price increases, shipment timings and some other one-off factors, has led to a disappointing result from the global-drive brands, which were marginally lower.

Looking at those brands individually, Kent continued to make good progress in Eastern Europe, but the growth was almost entirely offset by the impact of the 11% market decline in Japan, where the brand maintained share, and also low volumes in Iran.

Following the slow-down in Q1, due to competitors’ new brand launches, Dunhill has recovered in South Korea, where its year-to-date share is 12.5%, and almost 13% in Q2. However, overall Dunhill volumes were down 3% for the 6 months, due to the market decline and some share loss in Malaysia, and lower volumes in a number of smaller markets.

Lucky Strike volumes were down 4%, due to lower industry volumes in 2 key markets, Germany and Japan, despite growing share in both markets. Pall Mall volumes grew 3%, with good progress in Italy, the US, Russia and Germany.

Despite the lower global-drive brand volumes for the first half, we still expect to see overall growth for these brands for the year as a whole.

Looking at Group volumes on a region-by-region basis. In America-Pacific, there were volume declines in the US, Japan and Canada, with volumes up in South Korea. There continued to be good volume performances in Asia-Pacific, in particular Pakistan, Bangladesh, India and Vietnam.

Latin American volumes were flat, as the increases in Venezuela, Chile and Central America and the benefit of the acquisition in Peru were offset by declines in Brazil, Mexico and Argentina.

In Europe, BAT Italia accounted for 15.3b cigarettes, and there continued to be strong growth in Russia, partly offset by the industry declines in France and Germany following excise increases.

The Africa and Middle East region saw volumes increase, mainly as the result of the strong growth in Nigeria, partly offset by declines in South Africa and Zimbabwe.

Turning now to our key markets. In Canada there appears to be a degree of stabilization in industry volumes. A 1.5% reduction in the cigarette market, year on year, is a significant improvement over the trend, since the massive excise increases imposed in July 2002. But this stabilization has come at a cost -- the rapid growth in the value-for-money segment, which now accounts for almost 28% of the cigarette market, versus 11% a year ago.

Imperial Tobacco Canada took the decision to compete more vigorously for its share of downtraders and repositioned Matinée in the value-for-money segment in May. Matinée achieved a 5.8% share in June, compared to a 5.3% share in Q1. So, the initial signs are encouraging. An average retail price per pack in Canada is difficult to quote because of the varying provincial taxes, but on a weighted average basis, premium brands sell at CA$7.43 per pack of 20, and value-for-money at CA$5.96.

Lower volumes, adverse sales mix and exchange have resulted in a £44m decline in Imperial’s profit, to £169m at current rates. The rate of decline will increase during the remainder of the year.

This should be the last time we report on a full-quarter’s performance for Brown & Williamson in the USA. Intense competition continued, but with no particular developments in Q2. Brown & Williamson’s shipment share continues to be relatively stable, at 9.7%, and the strategic brands performed well, with volume up 7.1% year-on-year, with increased market shares for Pall Mall and Misty. These increases were offset by declines in the non-strategic brands, mainly GPC.

The contribution from Brown & Williamson’s US cigarette business was 13% lower, at £110m, reflecting adverse exchange rate movements and the non-recurrence last year of a gain on the settlement of certain disputed MSA payments. Excluding this one-off item, the increase at comparable rates exchange, would have been 23% as a result of lower supply chain and marketing costs, partly reflecting one-off trade costs last year, which more than offset lower volumes and lower net prices.

All in all, a good performance ahead of the merger.

The Group’s overall market share in Japan was slightly higher, as Lucky Strike and Kool continued to grow share. Volumes were, however, down, as the overall market size continued to decline. Due to trade loading in anticipation of the Y20 excise-driven price increase in July 2003, industry volumes in Q2 this year were down 17% against the very strong corresponding quarter last year. The lower volumes led to a lower profit contribution. There should be an unwinding of the trade loading effect in the third and fourth quarters of this year.

Australia continues to go from strength to strength. Market share has risen to 45%, with good performances from the premium brands, Winfield and Dunhill. Higher margins, through an improved sales mix and lower costs, have resulted in strong profit growth.

Local currency profit in Malaysia was ahead of last year, due to improved margins. But volume was lower, due to a reduced total market and some share loss. The timing of shipments has impacted our share, although in retail off-take the effect is not so great.

In Brazil, Souza Cruz’s share fell 1.8 share points to 75.1%. Cigarette volumes fell as a result of excise-driven price increases. Profit was affected by this, and lower leaf volumes, as well as the depreciation of the real against sterling.

In Mexico, profit was down, mainly as the result of lower volumes, driven by a contraction of the market and the devaluation of the currency. Competitor activities at the end of Q2 resulted in the decline in market share, to 39.6%, despite a strong performance form the Group’s premium brands.

In Europe, Italy continues to perform well, with a profit contribution from the combined businesses of around £86m, which is ahead of expectations. For the first time in many years there was an overall reduction in the size of the Italian market, down around 2.3% following last year’s price increases. The Group’s market share was 31.3%, with Pall Mall increasing its share from 6.1% to 6.6%, despite its higher price positioning.

MS, ETI’s key local brand, has a 16.1% market share, and continued to decline, but at a much slower rate.

Following the excise-driven price increases in March, the total tobacco market volume in Germany is down around 8%. Within that figure, cigarette volume is down 13.5%, and a full 20% down Q2 on Q2 last year. Trade brands now have 16.9% of the cigarette market. Roll-your-own and make-your-own segment volume is up 6%, and sticks have more than doubled as a segment, to around 7% of the total tobacco market.

The Group’s 3 main cigarette brands, Lucky Strike, Gauloises and Pall Mall each grew share, while our market share of cigarettes was stable at 22.7%. In the roll-your-own and make-your-own segment we have grown share 1 share point to 32.2%. And in the rapidly grown sticks segment, we have added 8 share points, to 23%. With additional manufacturing capacity producing Pall Mall sticks, we should see volumes grow further in the second half of the year.

Our share of the total German tobacco market now exceeds 25%, ahead of our share of the cigarette segment. Increased profitability from our Smoking Tobacco and Cigars operation compensates for lower profit from BAT Germany.

Whereas the safety net of other tobacco products in Germany has enabled the Group to weather the turmoil in that market, the French market is deteriorating badly. There was no manufacturer’s price increase taken in July, and despite growing share slightly to 15.8%, our volumes were down 25%, in line with the market.

Profit was obviously impacted by the volume decline. Winfield’s and Lucky Strike’s market share continued to perform well.

BAT Russia delivered an excellent result, with a significant increase in volume over the comparative period last year. BAT Russia continues to gain share in the top 30 cities, and Kent delivered an excellent performance, which resulted in significantly higher profit.

On an underlying basis, excluding acquisitions and currency, the Europe region’s profit would have risen around 8%, mainly due to a higher profit contribution from Russia, the pre-acquisition Italian business, other tobacco products and cost savings arising from the factory closures.

Profit in South Africa improved strongly, with higher margins and currency stability. Volumes were lower due to a decline in the total market. However, Peter Stuyvesant, Rothmans and Dunhill each made share gains, although there was some overall market share loss, which was down slightly, to 92%.

In the Nigerian market, improved distribution led to a 7 market share point increase over last year, to 72%. In the Middle East and North African area, profit was slightly lower as a result of market entry costs in North Africa, and higher brand support expenditure in the Middle East, largely offset by margin gains in Saudi Arabia.

Volumes increased, with good performances by Viceroy and Craven ‘A’ in Iraq, partly offset by volume declines in the Gulf and Iran.

Paul will now take you through the remainder of the presentation. Thank you.

Thank you, Paul, and good morning everyone. Net revenue was clearly affected by the ETI acquisition. The Europe region revenue was up 41%, due to the contribution from ETI, of which £551m came from the non-BAT distribution business, in Etinera. If we exclude ETI, the Europe region’s net revenue would have been in line with last year, and total Group revenue down 5.5% at current rates.

As Paul mentioned earlier, unfavorable foreign exchange translation movements have been the most significant factor affecting operating profit this year, which unfortunately masks good underlying performances in many markets.

Despite the difficult trading conditions in key markets, in North America and Western Europe, BAT’s unique strength comes from its geographic diversity, demonstrated by the strong contributions from Asia-Pacific and the Africa and Middle East regions. At constant rates of exchange, the momentum of the Group continues.

On this chart, you can see that operating profit at comparable rates in the America-Pacific region is down 12%, due to a 7% decline in volumes, mentioned by Paul earlier, adverse mix, adverse pricing, with a move with efficient, premium price delivery for Kool, and the one-off items at Brown & Williamson last year.

At current rates, operating profit was 18% lower. Margin improvement in Asia-Pacific was as a result of strong performances, mainly in Australia and India. However, currency reduced operating profits to an increase of 11%. At constant rates, the Latin America profit was 2% lower, mainly due to Brazil.

In Europe, even though the high-margin market of France and Germany saw volume declines, while there was volume growth in the lower-margin markets of Eastern Europe, there were significant cost savings, resulting in an increasing profit for the region, if you exclude the ETI acquisition.

While margins improved in Africa/Middle East as a result of price increases and improved mix in South Africa, this was partly offset by the continued cost of growing our business in Turkey and the ongoing economic difficulties in Zimbabwe.

Moving now to the profit and loss account. Restructuring costs for the half year were £41m. Bringing some carryover costs from Canada and the UK, together with various cost savings projects across Europe. Net interest during the quarter increased due to the impact of the share buyback program, and the cost of acquisitions carried out in 2003. Gross interest cover now stands at 7.8 times.

The tax charge was £4m higher, at £404m, a number representing an underlying tax rate of 34.1%, versus 35.8% in 2003. The decrease in the rate reflects changes in the mix of profits, particularly Canada.

The minority interest charge reflects exchange and the lower profits from the Latin America companies that have minority interests. Profit for the period was 70% higher, at £470m.

Moving to the adjusted earnings per share calculation. During the half year, the Group purchased a further 34m shares, at a cost of £279.8m, bringing the average number of shares on issue, for this calculation, to 2167m shares, compared to 2269m in the previous year.

The operating profit on a per-share basis increased by 5%, to 62.1p. And profit before tax increased by 3%, to 56.1p. However, the lower effective tax rate and reduced minority interest charge resulted in earnings per share being up 7%, to 33.9p. The favorable comparison on the tax charge is not expected to continue in the second half of this year.

Net operating cash flow was 8% higher, at £1328m, despite the strength of sterling. This is due to more favorable working capital movements in the USA. and South Africa, and in part as a result of the timing of cash flows. In terms of working capital movements, the most significant is the effect of pre-payment to BAT by ETI.

The depreciation movement reflects the exceptional charges in 2003 for the closures of the Canadian and the UK factories. Capital expenditure and financial investment were £75m lower, following completion of the factory projects in Nigeria and South Korea in 2003. Net cash generation was therefore £158m higher, at £591m.

The acquisition list disposal last year related principally to the transactions in Peru. The cash outflow to finance the purchase of shares under the share buyback was £280m The net debt movement for the first half was an outflow of £99m, and net debt stood at £5.3b at June 30, the ETI transaction at the prior end being the principle reason for the movement from June 30 last year.

The Group continues to enjoy a strong balance sheet across all measures, including our credit ratings. I would like to explain how we view the ratings provided by the agencies. This chart shows our ratings with the three main rating agencies. Our approach is to maintain a minimum of mid-BBB rating or Baa2, with a long-run target of BBB+ or Baa1, which are the ratings we currently have with Standard & Poor’s and Moody’s.

We closely monitor the flexibility we have in the balance sheet to raise further debt. Much of this flexibility is driven by the rating targets that we have set ourselves. The agencies adopt different approaches to assessing credit quality, so to give ourselves a clear and simple guide to our debt capacity, we still look at interest cover. But we also review our debt coverage ratio. And that measures the extent to which the Group’s net debt is met by free cash flow.

I should stress that the rating processes are more complex than simply monitoring a series of financial ratios, and our regular discussions with the agencies cover a wide range of topics, such as the stability in the business, our brand and geographic diversification in our underlying business strategy.

As I mentioned earlier, this year 34m shares have been bought back. This brings the total number of shares bought back since March last year to 140m, at a cost of almost £980m. We remain committed to the share buyback program, and intend to restart it following the announcement of these results, although we are aware of the importance of our credit rating.

In addition, we may need to scale back the program from time to time, in the light of investment opportunities, as and when they may arise.

At that point, we’ll pause for your questions.

Thank you, Paul. Can I just ask that before we take questions, that we need you to please state your name and the name of the firm that you represent. I will also, in each case, briefly repeat the question for the purposes of the conference call and the simultaneous webcast. So who’s first?

David [indiscernible] from [indiscernible]. A couple of questions, please, picking up on the Cantos interview with Jan this morning. First of all the implication that you expect, realistically think you can grow EPS by around 8% [inaudible] over the next 5 years. Would that still be after reflecting the benefits of Reynolds American, [indiscernible] in due course, buybacks and another major deal, if the valuation was appropriate? And secondly, at the end of that interview, the usual, obvious major potential targets, not presenting you with a potential financial returns that shareholders expect.

Does that mean that you don’t think you can get returns on a par, say, with ETI from any of the usual, obvious major targets? And also that you have possibly given up your hope of regaining global leadership in volume terms over the next year or two?

Three questions in one. I shall try to summarize that for the purpose of the webcast. The first question related to the achievability of an 8% earnings growth target over the next 5 years, the second related to the potential of major acquisitions, and thirdly, our ambition of achieving global leadership in the tobacco industry.

On the first point, no, in my interview this morning I simply – when I was talking there about our long-term objectives, I was saying nothing new. We’ve been saying consistently that we believe that over the medium term, by which I would mean something like about 5 years, we can on average aim to achieve high single-digit earnings-per-share growth. Now I wasn’t talking about, of course, the performance of any given year. I was talking about an average over a notional 5-year period. And, yes of course, in order to arrive at that, clearly we do reflect already the benefits of transactions such as the ETI acquisition or the North American transaction.

The second question related to the question of what I’ve called major acquisitions, and I want to emphasize that I’m talking about major acquisitions in a context of a company on the scale of British American Tobacco. Our view is that the list of usual suspects currently are trading valuations which in our opinion, once we have, for example, added the conventional premium on top, simply wouldn’t give us the kind of financial returns that I believe our shareholders expect from us.

So my answer is yes. If you contrast that with the ETI acquisition, ETI was an excellent transaction. I know that some people at the time, by the way, felt that we paid too much. But we have been very happy with that, and I think the investment community today accept that.

But no, we do not believe that an acquisition by British American Tobacco of some of the major players out there would give us an acceptable financial return. Now, does that mean that we’ve given up on ambition of becoming the leader in the global tobacco industry? Absolutely not. I think that ambition absolutely stays in tact. And we will get there eventually, one day. I don’t know when, but we will get there through a combination of organic growth plus selective acquisitions.

Next question.

Hi, it’s Jon Leinster, UBS. Just to go back to the credit rating that you talked about there. One of the things that the credit rating agencies have looked in the past is litigation outlook. With the completion of the Reynolds American deal would you expect any change from the credit rating agencies on that, given the increased flsxibility? And it seems quite surprising that with rates of interest around about 7 or 8 times and net interest cover at double digit rates, that you’re already talking about scaling back share repurchases. Why are the credit rating agencies maintaining you on such relatively low rating, when Imperial Tobacco, say, on a net interest cover of 5.5 times seems to have exactly the same rating?

The question, I will say falls into two areas. The first part of the question relates to the impact of the Reynolds American transaction on our overall rating, which Paul will be answering in a few moments. Connected to that question, you also asked questions relating to the relevance of interest cover and the impact of interest cover ratios on rating, and again, Paul will be dealing with that. And the final part of your question related to, as you say, our stated intention to scale back our share buyback program.

What I’d like to do is I’d like to answer the third part first, while Paul will afterward deal with the actual ratings issues. To be very clear, we did not say that we intend to scale back our buyback program. All that we said this morning, in fact, was nothing new. We made 2 statements. In fact, 3 statements.

First of all, we have reconfirmed, for the avoidance of any doubt, our absolute commitment to the share buyback program. But we are saying that commitment needs to be qualified by reference to two issues. First, I have often experienced determination to maintain investment growth ratings in respect of our debt, and Paul will be dealing with those in a few moments in more detail. And secondly, the absolute obvious, which is that if we do make acquisitions or investments that require cash, that of course, to that extent, we would have to be flexible and possibly scale back our program from time to time.

So I don’t think we’ve actually said anything new, but we did think it was quite important to restate very clearly where we stand on this. Now with regard to ratings issue itself, Paul, can I ask you to take that?

Yes, the Reynolds American transaction, as you know, is expected to be significantly cash flow positive going forward. So that’s a positive thing from the rating agencies’ point of view. And EPS accretive. I think from a litigation point of view, even though the indemnity is certainly a positive thing from the rating agencies’ point of view, I think they were already satisfied that we had a very strong ring-fence in place in relation to the US And from that point of view, even though the indemnity, if you like, perhaps puts a ring-fence around the ring-fence we already had, that perhaps wasn’t as significant as the cash flow accretion may have been, in terms of the Reynolds transaction.

So a positive thing, but I wouldn’t say it was necessarily positive from the agencies’ point of view, as far as litigation is concerned, because they are satisfied, I think, with the current position.

Having said that, the litigation environment in the US goes up and down, so we have had the reopening of the Ingle case and the DAJ case. And even though we have an indemnity, we still have a significant business in the US, and that would be an issue that the rating agencies would be concerned about.

As far as the interest cover is concerned in comparison with other tobacco companies, that’s a question, I guess, better directed to the ratings agencies. I mean, we have a very strong interest cover that we use to manage our balance sheet, primarily with an interest cover, as I’ve said before, we try to keep it between 5 and 9. And if the balance sheet got strong because the interest cover got above 9, then we would start to buy back our shares. And that triggered the buyback last year.

But now the rating agencies tend to not only look at that. They look at cash flow as a percentage of net debt, and they include in net debt, the pensions deficit that we have, which is still pretty small as a percentage of shareholders’ funds, but they include that nevertheless. And that’s the ratio which they tend to look at.

Now we still have a higher credit rating than that of Imperial and Gallaher, but I don’t want to get into the detail as to how they assess their credit rating versus ours. I mean, we are on a long-term target now, which is BBB+. And we’re content with that.

Good. Next question.

It’s Adam Steelman here, from [indiscernible]. Two questions, if I may. The first concerns the cost savings programs that you announced and were so successful last year. I was wondering to what extent you could quantify the incremental savings you’ve got this half. If I was a pension of £100m, how unhappy would you be? I was wondering related to the cost savings. I noticed that there haven’t been any new announcements recently, and I was wondering if we should sit on the edge of our seats, expecting a big announcement similar in scale to the ones you’ve announce in Belgium and Canada and the UK historically. Or whether, frankly, we shouldn’t be expecting anything on that scale coming up?

And the second set of questions. I noticed that some of your underlying trends in some of your big markets appear to have deteriorated slightly. And I’m thinking particularly of Brazil, where volumes are down, underlying profit seems to be negative this most recent quarter. And also in Malaysia, and I do appreciate there’s a [indiscernible] of shipment issues, but you appear to be losing market share, and the market looks harder than it did six months ago for you. And I was wondering if you could just talk about the long-term trends you see, particularly in those markets, and perhaps South Africa too, if I can add that.

Just to restate very briefly. The first question, of course, will be taken by Paul Rayner, related to the question of cost savings that we previously announced, and the potential quantification of the savings that we’ve achieved in the first half of this year. And I guess, Paul, you have an open invitation to say whatever else you would want to say about the question of cost savings in the future. I think that’s how I read that question. And the second question, of course, which will be taken by Paul Adams, relates to the question of volumes, market shares and profitability in certain major markets. And you were interested specifically and asked Paul to comment on the position in Brazil and in Malaysia.

So cost savings.

Yes. The £100m figure we suggested for the first half was probably a touch too high. But the cost savings continue. We did have the effect in the first half of the cost savings resulting from the closure of the factories in the UK and Canada. We said the annual effect of that was round about £64m or £65m, and we did get a significant portion of that. Nearly a full half-year effect of that coming through from half year affected that coming through for the first half.

And we do have the flow-on from the cost savings we announced last year, the £64m, which were achieve in 2003. We got the flow-on for that into 2004. So the cost savings are significant, and we’ll see that the operating profit per thousand, in some regions, such as Europe, Africa & Middle East, Asia-Pacific is significantly up, despite some of the difficulties in some of those markets. And I think that’s a reflection of some of the cost savings coming through.

In terms of new initiatives, I think we continue to announce restructurings. Not major, in terms of the size of Canada and the UK But we did announce in the first half downsizing of our business in Germany, and that’s the reason for one of the exceptional items in the first half.

We continue to look at opportunities for our supply chain. We’ve always said that. We continue to look at our factory footprint. But we have got nothing to announce at this stage in relation to that.

I understand the question, which is always a useful start. I understand the reasons behind the question. I think with the possibility of Malaysia, which I’ll come back to, we’ve had some pretty good brand-share performances. Even in Germany, we talked about Pall Mall and Lucky Strike increasing share, and how our overall share of the cigarette market was stable.

In France, our share is slightly up. In Japan, our share is stable, and we’ve seen growth in Japan on Kool and Lucky Strike. In Australia, we’ve had good share performances. In Russia, good share performances, particularly on Kent. So there’s a lot of very good brand-share performances around.

Your point on Brazil. Yes, when you’ve got 75% market share and you have a very broad portfolio in terms of pricing, with a market very competitive on price and, to some degree, downtrading, you will lose a little bit of share, particularly on the small or lower-priced brands. It’s interesting that Kent and Carlton, both premium brands in Brazil, are growing shares. So we dig in hard on our premium brands.

Coming back to Malaysia, yes, we’re not happy with the share performance in Maylaysia, to be clear about that. There were some shipment timings, but you’re right, the decline of share of Dunhill is a concern, and we are focused very hard on that. But with one exception of Malaysia, I’m not uncomfortable at all with our brand market performances in share terms.

The gentleman at the front.

Michael Smith from J.P. Morgan. In respect of the agreed deal in China, could you talk a little bit about your joint venture partner, and give us some details on the background to your relationship with them and the structure of that joint venture? Secondly, can you talk about your options for distribution of cigarettes in China? And finally, I know it’s quite difficult, but there’s been a 3-year lag between the announcement of the purchase of land and this further announcement. Is it fair to expect a much shorter timeline now on further announcements around this deal?

The question is related to our position in China. The first question was that we should expand somewhat on the identity of our joint venture partner and the relationship that we would have with China Eastern Investment. Second is related to the nature of the distribution arrangement that we want to establish in China. And thirdly a reference to the timescale, the fact that it’s taken us 3 years to get to this [indiscernible], and I think the question is how long will it take us to report further progress?

Paul?

Okay. Well, the first thing to say is that we haven’t announced a deal in China. We’ve announced approval to do a deal in China. So the deal is not yet done. There are still some significant hurdles to overcome in China, and those discussions are [indiscernible]. You will see the reactions in the Chinese market already.

So we have yet to conclude a deal, and in the absence of the conclusion of that deal, it’s very difficult to be precise on what the structure of that deal may be going forward, and it certainly wouldn’t, I think, help our discussions to go public on what those discussions will be going forward.

To talk around our JV partner, though, China Eastern: it’s a local partner based in Hong Kong. In many of the markets where we’ve gone into, principally Eastern Europe and elsewhere, we think there is value in having a local partner to help us through the local issues there.

China Eastern is well respected, has good contacts with the government. It is an enterprise which has been handling our imports in China for the last couple of years. Those imports have increased, so they’re doing a good job for us on that. But going further on that, I think we still have to wait and see how we construct a deal with them, and what the nature of that deal is.

In terms of distribution options, yes, we’re aware of the challenge. We have said that there are two things, at least, that we need to conclude going forward. One is the location of the factory, and second is our distribution strategy. And I think we’ll keep quiet on both of those until we get further down the track.

In terms of the timing, yes it has taken us 3 years. I would hope that it won’t take us 3 years before we come out with another announcement, but I think it would be a very brave and possibly foolish man to give any timing around it.

Well said. Next question?

It’s John Bell, Morgan Stanley. A question about competitive activity, really. On their results call last week, Philip Morris International was remarking that they’re spending, I think almost two-thirds of their currency gains this year so far, which if totted all up adds up to several hundred million dollars. Are you noticing the effects of that Philip Morris reinvestment anywhere, and are you coming under pressure to match that in some of your markets?

Can I just say, Paul, for the website that the question related to the question of competitive activities and whether we have seen any impact of that in our business?

Yes, I think that we’ve commented on that before. But we do see Philip Morris becoming much more price-competitive. I think they have stated a strategy of becoming more focused on sub-premium. I think that’s a public statement on their part. We certainly see that around the world. They’re getting more aggressive on mid-price. They’ve been aggressive on pricing, particularly on L&M. And they’ve then produced a number of very low-priced brands in certain markets.

Now what they include in their definition of marketing spend, I don’t know, but certainly from a pricing perspective and a portfolio perspective, we’ve seen a far more aggressive Philip Morris over the last couple of years.

Next, at the back.

Robin Asquith from J.P. Morgan Fleming. In the past, you’ve had a target for Group volume growth. I think it was 1% or 2%. Given what you’re seeing in a number of markets, do you think you can meet that target within the next few years?

The question relates to our target volume growth that we could achieve on an organic basis in the next few years, and whether that is achievable in the context of current developments in certain of the major countries that we operate? Paul?

It’s a good question. I mean, what we’d said in the past is 1% to 1.5% on average over the medium term. I think this year I indicated something around 1% to 1.5%. We’re not going to get that. It’s going to be below 1% this year. I don’t think we had – I don’t think anyone in the industry had actually forecast the degree of decline that we saw in France and Germany. So our overall volumes will be lower than 1% this year.

Front, second row.

It’s Chris here, from Lehman Brothers. Just three quick questions. First, I’d like to go back to the first question. When do you acquired ETI, or made the announcement a year ago, I think the return you were telling us that you required was around 6%, and I was wondering what the return that you require to make a sizeable acquisition financially attractive would be? Whether we would be talking about – what sort of number we should be having in our mind?

The second point is just on Germany. Perhaps you could give us an update on Q2, what happens with those 3 brands you mentioned, Gauloises Blondes, Lucky Strike and Pall Mall?

And then third, I was just wondering if you can confirm what the organic constant exchange rate growth was in EBIT in Europe in the first half. I think it was something like 2% or 3%. Is that’s the number we should [indiscernible]?

The questions are three-fold. First I think our Finance Director will answer, which related to the question of returns that we would expect on investments before, in our view, they would make financial sense to our shareholders. The second questions related more to the business itself. First you want us to comment on the position in Germany, and development of our 3 brands there. And finally, to be absolutely clear on the question of organic growth, excluding the impact of currency and acquisitions in Europe.

Why don’t with -- Paul?

Okay, yeah, the required rate of return we put on the ETI transactions wass 6.5%, Chris. And the criteria we’ve got in terms of the internal rate of return we want on a transaction is we adjust our weighted average cost of capital, which is 7.5%, up or down for the project-risk and country-risk associated with a particular acquisition. Or any project that we want to look at.

Now with ETI, the weighted average cost of capital was 7.5%, and we adjusted that down by 1% because of low country-risk. And, really, any project, the required rate of return will probably range between 5.5%, if it’s extremely low risk, to well over 20%, depending on the risks we see with a particular transaction.

So obviously if you look at something such as Turkey, for example, the Turkey project, where we put a bid in last year for Tekel. There would be a substantial rate of return on that, because there were significant project-risks and significant country-risks associated. So it’s a case-by-case basis, and you have to look at those 2 particular factors and determine the required rate of return that we want. And that’s the way that we look at it.

Paul, would you like to deal with the question on Germany?

Yeah, okay, let me give you the Q1 and then the Q2 market shares for the 3 brands that you mentioned, which I think was Lucky Strike, Gauloises and Pall Mall? Yeah. On Lucky Strike, Q1 was 5.1%, Q2 was 5.4%. On Gauloises Blondes, 5.3% going to 5.6%. And Pall, 2.4% going to 2.6%.

I should just also point out that on Pall Mall, of course, we’ve done extremely well in the sticks segment. We launched Pall Mall sticks, I think in February. From a standing start, Pall Mall sticks is now 16% of the sticks market in Germany. So I think you could arguably add – and we haven’t done in the figures that I’ve given you – but you could arguably add that back to the Pall Mall brand share, which would take it even higher.

In terms of your question on how does Europe look if you exclude acquisitions, which is the organic growth. Volumes were fairly flat. In fact, they’re down around 0.7%, but with operating costs at a constant rate, is actually up 8% for Europe, if you exclude the effect of acquisition.

And I referred to that earlier. The operating profit per thousand for Europe was up substantially, at constant rates. It was up something like 23%, so a significant improvement in profits organically. At current rates, it would have been up 3.4%, because of the weakness of the euro.

Next question, yes.

Mark Lynch, Goldman Sachs. Could you just give us a bit more detail about the spend on restructuring in Germany? What exactly are you doing there? And should we take the 30-odd percent decline in Canada in Q2 at a sort of run rate for the second half of the year?

The question relates to the extent of our spending in the context of the German restructuring. Paul, I’m sure you will deal with that. And secondly, to comment on the decline in the size of the Canadian market and what that might mean in terms of run rates for the remainder of the year. Why don’t we start with Germany.

Yeah, I’m not sure about the question, but we did have exceptional charges for the first half of £140m. A significant portion, I think slightly less than half of that, related to Germany, where we’ve taken out a number of costs in the business. A lot of them relate to the head office in Hamburg, where we’ve slimmed down the head office. And then we’ve slimmed down other parts of the business, as well.

The costs relate to mainly redundancy costs associated with that, and we’ll see those people leaving during this year. And we would expect the cost savings from that coming through next year.

On Canada. If you look at the discreet second quarter, at constant rates the profits were down around 27%. And I think for the second half you should expect profits to be down slightly more than that. Because we repositioned Matinée in May, so we had the effect for around six weeks of the repositioning of Matinée down to value for money, which meant that the drop in profits for the second quarter, of 27%, was significantly higher than the drop in profits for the first half, at constant rates, of around 16%.

So for the second half, it will be worse than 27% down as you get the full effect of that coming through.

Terry?

Unfortunately I’ve got three questions. First on the buyback. I’m trying to just reconcile the comments you’ve made. I think most of us would have assumed – perhaps I’m wrong, but – that if you carried on at the current run rates and chose to take R&R up to a 30% holding, you’d be looking to have completed that buy-back at the end of next year, give or take. Would that be something you would be prepared to comment on?

Secondly, I wonder if Neil could give us a comment on the DAJ disgorgement process, the appeal there, what the appeal court’s going to be looking at, and his prognosis for the appeal?

And thirdly, just Jan. You mentioned that you’ve been with BAT for 5 years now, as a non-exec. But your role has become more prominent in the last week or so. Could you maybe give us a view of what you think, given your new role, BAT does well, and perhaps comment on areas where you will be looking to exert a bit of influence, where you think you could do things better?

Thank you, Terry. Well, three questions there. The first relates to the question of buyback and the rate of the buyback and the position of R&R in this connection. Secondly in a few moments I will ask Neil Livingston, our Legal Director, to comment on the legislation in regard to the DAJ case and disgorgement. And thirdly, I’m asked to comment, in connection with my new role, as to what I think BAT does well, and perhaps what it does rather less well.

So let’s start with the first one, on the buyback.

Now, I think that we’ve always taken the view that the R&R threshold of, say, 30% or 29.9%, is something that we will deal with when we get there. Honestly, we will cross that bridge when we get there. I doubt very much whether we will be there by the end of next. If that’s 2005, I actually can’t believe that would become an issue. But at the same time, we are quite relaxed about it, and, quite frankly, we will cross that bridge when we get there. I don’t think we have anything else to say on that for the moment.

Neil, I think I’ll just jump to the third question, and then you can deal with afterwards the DAJ situation.

With regard to my role. Yes, it’s an interesting position I find myself in. I’ve been with the company for a long time. Of course, you might say as an outside director, I would have had lots of opportunities to scream and complain and suggest things should be done differently. And now I’m in a somewhat different position.

I will say, quite frankly, and I’m not saying this to play to the audience. This is a great company, and I am genuinely privileged to be chairman this company. This is today, I think in the British context, one of the few truly world-class companies, and that’s not an understatement. I think we are well managed. I think the guys are very clear on their strategy. And I can give you a long lecture on strategy, and you’ve heard Paul talk about this often before.

And I really, I endorse that strategy entirely. I think that it really is, as you know, and I won’t give you that speech now, but the three pillars are growth, productivity and responsibility, all of them being equally important. I think that’s the way to go forward, and I genuinely believe that we have the right quality of people and skills of management across the organization, and absolute commitment to take the business forward.

Will we become the leading player in the tobacco industry? I am very confident we will. Don’t ask me when, but we’ll get there. And I’m very happy to be with this company. I think we do things very, very well. And I can honestly say that in the bigger scheme of things, I’m not sure there is anything that I can criticize of what the guys have done in recent years. No, I’m very happy.

Neil, why don’t you deal with the DAJ situation?

I’m moving from the inspirational to the little more mundane, actually, on the order of those. The issue around the DAJ case, and the current appeal on disgorgement is fairly current, fairly straightforward, in fact, although the law is actually pretty unclear in terms of how things are in the US But it’s a significant point in the context of that case, which as you know is scheduled for trial by a judge alone in middle of September this year.

The United States Government are claiming various monies – values at various amounts. I think $280b was a figure that was floating around at one time, in what they call ill-gotten gains. But the joint defendants in this case have argued, based on pretty strong authority, principally from the Second Circuit Court of Appeals, have begun with the RICO statutes, which is effectively what this case is continuing under, that the limit on the amount of ill-gotten gains to be disgorged, which is what the Government are claiming, is the amount presently available to fund future RICO violations.

There is, indeed, an argument as to whether or not you can recover disgorgement under RICO per se, but the issue, really, we think, floats around this question of disgorgement to fund future violations. Now, the D.C. Circuit Court of Appeal is a good Circuit Court of Appeal. A number of matters in this case have gone up to it already. We’re very confident of getting a fair hearing from that tribunal. That’s the industry take, I believe.

And if they uphold the joint defendants’ arguments on this particular issue, then the joint defendants would be arguing that not only would the funds presently available be be a lot less than the amount that the US Government is alleging. But the US Government isn’t entitled to any disgorgement, because it has not produced any proof of the amount presently available to the defendants to fund future RICO violations. If that makes sense to everybody.

So essentially our view is that there is a real issue here. There is a genuine issue around the pecuniary valuation of this case, and it’s in front of a tribunal that, interestingly enough, not only did they willingly accept that appeal, but the judge herself certified this is an appropriate matter to go to that court at this time. That’s it. Unless there are any other questions on that.

If things are going your way, effectively then in terms of monetary damages, potentially against the industry through DAJ would just disappear.

Depending on what they decide. Then the only – the balance of the case would be with respect to injunctive relief. A different series of arguments altogether.

Thank you, Neil. Well, ladies and gentlemen, I know that you’ve got, of course, as usual, access to a whole variety of our colleagues to pursue further questions and issues you want to discuss, so I would actually like to draw the presentation to a close.

Now I think just, in summary to say, of course this set of results has almost been dominated by the Reynolds America transaction, our announcement concerning China, and to some extent the headwind of some adverse currency developments. I would say all in all, despite currency developments, and despite the problems we’ve discussed with regard to some of our important markets, all in all adjusted earnings per share still increased by 7%, and operating profits by 1%. So to me, I’m tempted to say, yet again our geographic strength and diversity has allowed us to produce a very solid set of results.

So finally I would say to you that our 8% increase in dividend, plus our restatement again to our share buy-back program, really should reflect, I believe, what I would describe as our obvious confidence in the long-term future of this business.

Thanks for coming this morning, and good luck.