"Whether new challenges come from our own evolving standards or from regulatory restrictions, we can grow if our positioning and strategy are right."

Paul Adams, Chief Executive

We have reported another good set of numbers for 2006 but what is the state of the tobacco industry and how is British American Tobacco expecting to fare in the future?

Before looking forward, it is worth examining our recent past. Over the last five years we have grown volume, with our four GDBs leading the way, up 57 per cent against a backdrop of quickening regulatory changes, excise increases and declines in the incidence of smoking. Not all the changes have been external, some are self-imposed. Five years ago we pioneered the industry’s first voluntary code, a set of restrictions on our marketing activity worldwide. The conclusion I’ve drawn is that it is still possible for us to succeed in an ever tougher environment. Whether new challenges come from our own evolving standards or from regulatory restrictions, we can grow if our positioning and strategy are right.

We have a strong and complete portfolio of brands at different price points. As well as our GDBs, it includes an unrivalled range of regional and local brands which play a vital role in our success in many markets. We have a full range of tobacco products and we have a track record of innovation that our competitors struggle to match.

In addition to the opportunities for top line growth, there are very significant opportunities to make cost savings through our productivity initiatives. As you can read in Our strategy in action: productivity, we are ahead of schedule and the more work we do in this area the more we identify further savings.

We also believe that we have the right responsibility strategy for both the short and the long term and we position responsibility as a key part of our overall business strategy. Consequently, we have invested significantly more in R&D, particularly around harm reduction.

We agree that risky products such as tobacco should be regulated. Currently, tobacco regulation broadly focuses on three areas: preventing people from starting to smoke, encouraging quitting and protecting people around smokers.

However, we strongly believe that these prevention, cessation and protection efforts are missing an important ‘fourth dimension’, namely, harm reduction, for the millions of adults globally who will continue to be tobacco consumers.

Current and future market

Currently smokers consume over five trillion cigarettes a year globally.

China, the world’s largest cigarette market, makes up 35 per cent of global volumes. Outside China, over half the global market is held by the six biggest international manufacturers which, in 2006, were: Philip Morris, with a global market share of 18.7 per cent, British American Tobacco (including associates’ total volumes) with17.1 per cent, Japan Tobacco with 7.7 per cent, Imperial Tobacco with 3.5 per cent, Gallaher with 3.1 per cent and Altadis with 2.1 per cent.

Regulation of the industry and its products has increased in recent years, including graphic health warnings on packs, advertising and promotion restrictions and, more recently, restrictions on public place smoking. Future regulation will largely be framed by the World Health Organisation’s Framework Convention on Tobacco Control, which entered into force in 2005. Increases in excise rates in many of the higher-price markets are leading consumers to switch to cheaper brands and this trend is expected to continue. However, in emerging markets, consumers are increasingly trading up, so premium brands are growing.

Over the next decade, we expect the average daily consumption of cigarettes to fall in many of the world’s largest markets. We also expect a declining incidence of smoking generally, leading to smaller percentages of populations being smokers, particularly in currently high margin markets such as Canada, Germany and Japan. However, the number of adults over the age of 20 in the world is forecast to grow 11 per cent by 2015. As a result, although the proportion of adults smoking will probably decline, global volumes are expected to be broadly unchanged at some five trillion in 2015. This future market represents a volume and profit pool where, for those who are best positioned, there will still be a great deal to play for.

Unfortunately, the market has also attracted illicit manufacturers and distributors of tobacco. We estimate that some 6 per cent of tobacco consumption, about300 billion cigarettes a year, is supplied by smuggled or counterfeit trade. It is a key concern for us. How much of the industry will become illicit in the future? We continue to work proactively with governments and customs authorities to try to stem this rising tide.

While volumes are forecast to decline in some markets, mainly the current higher margin markets, they are set to grow in others, mainly in lower margin markets. Nevertheless, global industry profits are also set to increase over the next decade. British American Tobacco’s broad geographic base means that we are well represented in many of the lower margin markets where volume and profitability are expected to grow, and that we are not so reliant on high margin markets, where volumes are declining faster than the global average.

So, despite a changing business environment, we are confident that the tobacco industry has a secure future and that British American Tobacco has the strategy and products to prosper in it.

The evidence of the past decade bears this out. Although the total global volume of cigarettes has been broadly static over that time, our global market share has grown significantly as a result of both acquisitions and organic growth, and our operating profit has increased by over 60 per cent.

Conclusion

The tobacco industry is mature and all players, including us, face some big challenges, but we still have lots of room for growth. British American Tobacco’s strong brand portfolio and record of innovation, our trade marketing expertise, our cost savings potential, the global diversity of our earnings base, our presence in emerging markets and the future size of those markets: these are all reasons for us to believe that our business can continue to grow.