Jan du Plessis,
Chairman of British American Tobacco p.l.c.
When we met last year, I was able to report our best year since British American Tobacco listed on the London Stock Exchange as a stand-alone tobacco company in 1998. We have now followed that with another strong year. Profits and earnings are up, we have enjoyed excellent growth in revenues and volumes, and there has been a highly impressive performance from our four global drive brands.
Once again, our consistent approach to balancing the four elements of our strategy - growth, productivity, responsibility and a winning organisation - has continued to deliver substantial shareholder value. Your total shareholder return over the last five years is an outstanding 26 per cent a year on average, compared to 7 per cent for the FTSE 100 as a whole, making £100 invested in British American Tobacco worth £314, against £141 for the same money in an index tracker.
As well as reviewing how your business performed last year, I will today be touching on a serious issue that I believe is of great importance to the future of your company, and which I strongly believe should be actively addressed by governments everywhere – the multi-billion pound criminal trade in contraband and counterfeit tobacco products.
First, however, I would like to pay tribute to Rupert Pennant-Rea, who retires as one of your longest serving Directors at the end of this meeting. Rupert joined B.A.T. Industries as a Non-Executive Director in 1995 and has served on your Board since British American Tobacco p.l.c. listed in 1998. We will miss his wise counsel and I am sure you will join me in thanking him sincerely for his service over the last 11 years.
2006 business review
Let me now make a few remarks about our performance last year.
In 2006, your company delivered on every financial measure, including outstanding organic growth.
Volumes were up 2 per cent for the second year running, revenues were up 5 per cent, profit from operations was up 7 per cent on a like for like basis at nearly £2.8 billion and earnings per share increased by 10 per cent.
Our global drive brands, Dunhill, Kent, Lucky Strike and Pall Mall, achieved an impressive growth of 17 per cent. Kent grew by 16 per cent to 45 billion and Pall Mall had another excellent year with 40 per cent growth to 46 billion. Dunhill and Lucky Strike were also on the up again. After a patchy 2005, Dunhill grew by 6 per cent to 33 billion and Luckies, after some slow years, perked up to grow again, reaching 22 billion. The global drive brands now account for over a fifth of Group volumes.
It was also pleasing to see positive results well spread across our regions. Europe, Asia-Pacific, Latin America and Africa & Middle East all achieved volume, revenue, profit and global drive brand growth. Inevitably, however, it wasn’t all perfect scores. America-Pacific suffered from volume and profit declines in Canada, where growth of illicit trade has played a notable part in the difficulties, but this was balanced by strong growth in profit and market share in Japan.
Our associate companies also grew volume by 4 per cent and profits were up at both Reynolds American and ITC in India. Our share of associates’ post-tax results, excluding exceptional items, was up 10 per cent at £431 million.
Overall, it was again a year when the good geographic spread of your business continued to be a source of growth and competitive advantage.
We also continued to reduce our overhead and indirect costs and to make savings in the supply chain, particularly through manufacturing rationalisation. In the last four years, cumulative savings have reached £729 million a year, of which over a third was achieved in 2006. We will maintain our focus on costs and, on completion of the current 5 year programmes, will announce a further 5 year target in a year’s time.
We are also maintaining our focus on returning cash to shareholders. You will be asked to vote today on a final dividend of 40.2 pence, increasing the year’s total dividend by 19 per cent to 55.9 pence per share. We are also proposing to increase the proportion of sustainable net earnings paid out in dividends from at least 50 per cent to 65 per cent by 2008, and to increase the share buy back programme from about £500 million to £750 million a year.
Last year we were again selected, for the fifth year running, as the only tobacco business in the Dow Jones Sustainability Indices. It is also very encouraging to be highly ranked amongst the Top 100 companies in the UK’s Business in the Community Corporate Responsibility Index, with a score of 93 per cent.
You can be confident that we will continue to ensure that we manage our business responsibly and provide, wherever we can, leadership in corporate responsibility for a business in a controversial sector.
We have said before that in several areas of tobacco regulation, we believe we have common goals with the public health community.
One of these is in product regulation, where both we and several public health stakeholders feel strongly that the potential for harm reduction through innovative products must not be overlooked in public health policy. I spoke about this last year and it is a theme to which we will no doubt return in future.
Today, however, I will focus on another key area where well-defined public policy can do much to address a significant global problem – the illicit tobacco trade.
As investors, you probably look at our performance compared to that of our competitors, and I believe you will be reassured. But the less comfortable news is that you may be looking in the wrong direction. One of our largest global competitors today, now in fourth place behind Philip Morris, ourselves and Japan Tobacco, is a growing body of criminals who are turning the illicit trade in tobacco products into a lucrative global industry.
This trade involves large volumes of smuggled genuine tobacco brands and counterfeits and, in a few parts of the world, local manufacturers who manage to persuade local judges that they don’t need to pay tobacco taxes.
The illicit trade is not only big business, but it’s growing. It is very hard to quantify but, faced with the growing threat, we have developed research methods to estimate its extent in each of our markets. Our research indicates that over 6 per cent of all cigarettes consumed in the world today, some 320 billion, do not have the relevant taxes paid on them; in other words, that global illicit volumes now exceed the combined volumes of Imperial and Altadis.
Worse, this trade is increasingly becoming dominated by organised crime, with official concerns that it has links to terrorism. Interpol, the international police organisation, notes that gangs behind illegal drugs, arms and people trafficking are also involved in the illicit cigarette and alcohol trade.
Taxes drive illicit trade
Why is the illicit trade growing? The answer rests fundamentally with governments. Excessive tax increases give a lucrative opportunity to the perpetrators of counterfeiting and smuggling.
Governments are of course perfectly entitled to tax tobacco products and we fully accept that this can be a valuable source of revenue for them. The issue is not taxes in themselves. It is very large tax increases, sometimes suddenly imposed, that push prices higher than consumers are prepared to pay and create big tax differences, and thus big price differences, across borders.
The problem is made worse by weak penalties, poor border controls and corruption in parts of the world. But the growing lawlessness is fundamentally driven by tax policies that offer huge profit margins to the unscrupulous players who are in business to exploit them.
In the UK, for example, tax on cigarettes rose by 173 per cent in the six years to 2000, and consumption of cigarettes on which no UK taxes had been paid rose from 4 per cent to an estimated 27 per cent today. It is also estimated that one in ten of these cigarettes is counterfeit.
In Hungary, tax increases of 94 per cent in 18 months saw illicit trade soar to over a fifth of the market, losing the Government, over a two-year period, a sum equivalent to its entire annual healthcare budget. In Germany, 70 per cent excise increases over four years saw a 70 per cent rise in consumption of cigarettes on which German taxes were not paid, losing the Government almost £3 billion last year alone - a sum forecast to rise by a further £1 billion this year.
More and more consumers are simply refusing to pay the fully taxed price and turning to cheap illegal offers. Consumer demand for cheap cigarettes, with no questions asked, gives the traffickers a huge incentive.
Let me give you an example of smugglers’ profit margins. Cigarette taxes in Ukraine are less than a tenth of those in the UK. An international brand bought fully tax paid in Ukraine, and sold in the UK by a street hawker at half its UK retail price, nets an illegal profit of £2 a pack, £20 on a carton of 200, £50,000 on a transit van-load and £1 million on a container-load. A so-called ‘amateur’ smuggler can get 15,000 cigarettes into two suitcases. Bought in Spain at £1.60 a pack, these can net an illegal profit in the UK of over £1,000.
Consumers should not imagine that the shadowy figures behind this trade are heroic ‘Robin Hoods’. Anyone lighting up a smuggled or counterfeit cigarette should know they may unwittingly be helping to fund international organised crime, while taxpayers foot the bill. UK Revenue & Customs puts losses to the Treasury from tobacco smuggling, over the five years to 2005, at £19 billion. That’s enough to train seven hundred thousand teachers or build 800 new secondary schools.
The UK has had an illicit trade problem for some years. But the virus is spreading to a growing number of markets, including some that are major sources of your company's profitability.
In Brazil, nearly a third of sales have no local taxes paid on them. In South Africa, 17 per cent of sales are illegal product. In Malaysia, 21 per cent of sales are smuggled product from neighbouring countries. In Canada, a survey just over a year ago found that 17 per cent of tobacco consumption was contraband, mainly product manufactured in, and smuggled from, First Nations reservations. All the indicators show things have grown worse since then. Politicians in Canada, a leading country in tobacco control, find it politically convenient to ignore this scourge, despite the disastrous social and economic impacts. Illicit trade throws markets into chaos with real losses for both governments and the legitimate industry.
For the industry, investment in distribution networks is undermined, retail jobs are threatened, margins are undercut and brands are harmed by counterfeiting.
For governments, large holes are blown in national budgets, while legitimate jobs and investment are threatened. More insidiously, a culture can develop of casual social acceptance of lawbreaking. Any government that turns a blind eye to smuggling and counterfeit on the grounds that ‘it’s only tobacco’ faces the corrosive effect of law and order more generally being brought into disrepute.
We estimate that your company’s losses to the criminals’ pockets are now well over £500 million a year, that legitimate tobacco companies as a whole are losing over £2 billion a year, and that this large-scale theft robbed governments worldwide of some £12 billion in tobacco taxes in 2006 alone.
For our part, we work to ensure that all our operations are directed only at supporting the legitimate tobacco trade. Our companies ensure that quantities they supply are consistent with legitimate demand and cut off supplies to any customers knowingly or recklessly involved in illicit trade. All our companies are required to have tight ‘Know Your Customer’ controls for ensuring that sales are only made to reputable customers and we require assurance from our key suppliers of raw materials that they have adopted similar controls.
To support governments, our products now carry a covert security feature so that we can help enforcement agencies to identify fakes. Our companies have signed agreements with customs authorities in some 35 countries for intelligence sharing and joint action. Our Brand Enforcement Group has intensified its intelligence gathering on the sources of illegal product, its target destinations and routes, and shares information with enforcement agencies. We monitor the destruction of seized products and machinery and analyse suspect fakes in our laboratories. In several countries, we help to train customs officers in tackling illicit trade.
Our companies in many markets are also researching the scale, dynamics and nature of the illicit segment and are sharing the findings with governments, to help them understand the link between excise rates and levels of illicit trade.
Where governments have responded to our calls for balanced tax policy and better enforcement, we have begun to see some success, with reductions in illicit trade in markets such as Brazil, Argentina and Hungary.