GARETH DAVIS - IMPERIAL TOBACCO - (ITY)
CEO Interview - published 08/14/00

DOCUMENT # KAP002

GARETH DAVIS, is the Chief Executive of Imperial Tobacco Group Plc. He joined Imperial Tobacco Ltd in 1972 and has held a number of senior positions including Manufacturing Director of Cigarette and Roll Your Own Tobacco from 1987, and Managing Director of the International Business from 1988. He was appointed Chief Executive on the Group's Listing in 1996. He has wide experience of all aspects of Imperial Tobacco's business and has played a key role in the development of both general strategy and the Company's ongoing international expansion.

Sector: Tobacco

TWST: Please give our readers a brief overview of Imperial Tobacco Group

' the company's history, products, activities and markets, including your own involvement in the firm. Mr. Davis: Some parts of Imperial date back to the late 1700s, but in essence Imperial was formed in 1901, when 13 British tobacco companies merged in order to fight off competition from the American Tobacco Company. It has played a leading role throughout the twentieth century in the UK tobacco industry. Also, back in 1901 Imperial formed BAT as a joint venture with the American Tobacco Company. So we have a long and quite illustrious history. Certainly, in the 1960s, Imperial began to use its tobacco cash flow to acquire branded-product businesses outside of the tobacco industry, notably in brewing, foods, and catering and leisure sectors. However, this effectively weakened the company, and it was acquired in May 1986, by what was then Hanson Trust, an Anglo-US conglomerate. That's where we stayed, as a subsidiary of Hanson, which latterly became known as Hanson Plc. In October 1996, we demerged from Hanson and became a stand alone business, with a listing on the London Stock Exchange. Two years later we listed on the New York Stock Exchange, to better service the American shareholders that we largely inherited from the Hanson years. The company went through a tremendous transformation in the period of Hanson ownership with a massive emphasis on pushing productivity and reducing unit costs, and that was particularly successful. There was a significant amount of rationalisation, not only of the manufacturing facilities, but also of the brand portfolio to bring more focus in an industry that is characterised by brand proliferation. We actually reduced the number of brands so that we could concentrate on focused, core brands. That had the effect of taking our market share back into growth in the UK and, of course, reducing our unit costs, which enabled us to start competing effectively in export markets. Since about 1993-1994 the thrust of the business has been very much to grow internationally. If I go back to the early 1990s, only about 5% of our profit was coming from international operations, and by our half-year in May 2000 that figure had risen to over 45%. So our strategy on de-merger was very much to continue to emphasise productivity and efficiency, to strengthen our already strong UK position, and to grow our international business, fast-track both in Western Europe and in selected emerging markets. That has remained our strategy since de-merger and has been pursued very successfully, augmented by, so far, three significant acquisitions. The first acquisition was in February 1997, when we bought the Rizla business, which is the world market leader in cigarette papers. This was followed in July 1998, with the acquisition of the tobacco business of Douwe Egbert Van Nelle, the world market leaders in roll-your-own tobacco, from Sara Lee. And then in September 1999, we acquired a number of brands and a factory from the newly merged BAT Rothman's combine in Australia and New Zealand. They had to shed some market share for regulatory approval purposes. So those have been our major acquisitions since we de-merged, and they have contributed significantly to the pace of international growth.

TWST: Will acquisitions continue to be part of your future?

Mr. Davis: Yes, I'll come on to that. The situation now is that in the UK we have the market-leading brand in four out of the five tobacco- product categories, and internationally we are the world leader in roll- your-own and cigarette papers, and we are growing strongly in cigarettes. Clearly, we are a very small player internationally in cigarettes compared to the likes of BAT, but we're also a relatively recent entrant, so our growth potential is significant.

TWST: What are some of your brands?

Mr. Davis: Our main brand in the UK is Lambert and Butler, which is the market leader. Our other famous cigarette brands are Embassy, Regal, Superkings, and John Player Special. Our main roll-your-own brands are Drum and Golden Virginia, and our main paper brand is Rizla, and we have a number of very popular pipe brands and cigar brands as well.

TWST: You're the market leader in four out of five areas.

Mr. Davis: In the UK, we have the market-leading brands in cigarettes, roll-your-own and pipe tobacco and cigarette papers.

TWST: What else sets the company apart from your competition? What are

your other competitive advantages? Mr. Davis: We consider ourselves to be one of the lowest-cost producers of quality tobacco products, due to our continued emphasis on productivity. We are, I believe, recognised in our industry world-wide as one of the most efficient practitioners, and of course this gives us a significant opportunity to grow the business internationally, by continuing to emphasise productivity. We're very much a decentralised organisation. We believe in devolved management structures with a small corporate centre, with the vast majority of decisions being made by the operating units. So we permit them a significant degree of autonomy, but they are subject to a small number of very strong controls. And there is a very significant and longstanding belief in incentivisation. So if management teams make or exceed their targets, they're well rewarded for doing so. That's the philosophy we've taken forward since the Hanson days, really, when they introduced that decentralisation theory. Prior to that, we were heavily functionalised and centralised.

TWST: How is your management team doing? Are they equipped to accomplish

your ambitious goals? Mr. Davis: Yes. I'm often asked about personnel. Certainly, in the UK we have a tremendously experienced management team, but on the international side we have acquired some very high-calibre expertise from the world-wide tobacco industry, and a lot of that is the result of consolidation that's been taking place in the industry. But also, through our acquisitions, we have acquired some very high-calibre people with those businesses, and that is giving us tremendous confidence for the future, and the ability to integrate further acquisitions.

TWST: Could you discuss regulatory matters, litigation, the climate in

Britain and Europe regarding tobacco? Mr. Davis: I think in the States this is a massively high-profile issue. If one looks at the legal situation in the UK, we had a major legal action known as the Leigh Day case, which was discontinued a couple of years ago. So, at the moment, in the UK, the situation is fairly settled. Then, the legal system is significantly different in the UK and Europe to the United States. We don't have punitive damages, we don't have class actions, we have trial by judge, not jury, etc. So the situation on legal issues is significantly less worrying than in the United States. We have no exposure to tobacco litigation in the United States, so that is a good thing, and we are not in that market for obvious reasons. Because of the wash-back from the States on legal issues, there is a high degree of interest in Europe, but the legal system is very different and there is nowhere near the activity that we see in the States. That puts us in a comparatively strong position. In terms of regulatory pressure, increasingly the tobacco industry world- wide is subject to massive regulation on tar and nicotine yields and marketing freedoms etc., and those pressures are getting greater. Having said that, we've been in this business long enough to be able to operate within the guidelines and the rules that are laid down. We have been fighting a European advertising directive, and that is currently awaiting decision from the European Court of Justice. But an Advocate General of the European Court of Justice has passed his Opinion that the directive as laid down has no legal basis and he recommends that it should be annulled. But that opinion has yet to be ratified by the ECJ.

TWST: When do you think this will be resolved? By the end of 2000? Is

there a time frame? Mr. Davis: To be honest with you, I couldn't really put a time to it, but what I'm hearing is that the ECJ will consider the Advocate General's opinion in the autumn. The industry is no stranger to regulatory issues, and we're used to handling them and managing within the rules. We very much stick to the rules and, after all, it is a legal product, but marketing freedoms have been limited. In fact, over a period of nearly 30 years in the UK, we've had a situation of voluntary agreements with successive governments, which have presided over one of the fastest reductions in tobacco consumption in the world in the UK, and one of the fastest reductions in sales-weighted average tar yields as well. So we're no strangers to regulatory issues.

TWST: Where would you like to see the company in three years?

Mr. Davis: Our emphasis is very much on international growth. This time around, there is no diversification out of tobacco. We're wedded totally to tobacco and tobacco-related products and focused very much on them. In three years' time, I'm very confident that our international side will have grown further, because we have a strong underlying rate of organic growth in our international businesses. One would hope that that could be augmented by further judicious acquisitions.

TWST: What do you see as the single biggest opportunity for Imperial

Tobacco internationally? Mr. Davis: I think it has got to be in Western Europe. We bought, as I say, the Douwe Egbert Tobacco business, and whilst we acquired some extremely strong brands and global leadership, we also acquired some very strong sales forces throughout Western Europe. On the basis of these, we've formed integrated trading divisions throughout Northern Europe, and in January this year, we started operating a trading division in Southern Europe, through which we leverage all the Imperial portfolio of products. And as a late entrant, although the markets are mature, there are considerable growth prospects, and it's going very well for us. So I think that's a big opportunity. And then beyond that, one looks at the emerging markets of the world, and I believe, given our product style, our quality and our efficiency, we have considerable opportunities going forward in Asia and Africa, which are regions with a Virginia blend preference which we specialise in, rather than an American-blend preference. In parts of the former Soviet Union, we're seeing some surprising results as well. So Western Europe and those three emerging markets are the areas we're focusing on.

TWST: How is the company taking advantage of the Internet?

Mr. Davis: Certainly as far as the supply chain is concerned, very much so. We have a lot of e-commerce applications focused on our supply chain management. With regard to selling to consumers on the Internet, I think you have to take account of the regulatory position of our industry, and our very genuine concern not to sell to under-age people. So selling through the Internet would pose quite difficult issues for both us and the industry. And whilst we use it on the supply-chain side for procuring materials and services, and building relationships with our supplying companies, in terms of selling our cigarettes and tobacco on the Internet, it is something we do not do as a point of voluntary regulation. But I'm sure if it wasn't voluntary, it would be compulsory. So it's an issue we pursue with great caution. We do have a company Website, but that is not used for promoting our brands, more for providing corporate information.

TWST: What percent of increase in sales and earnings should investors

expect from Imperial Tobacco over the next several years? Mr. Davis: We've been growing very much in the area of 8%, 9%, 10%. And if one looks at the consensus of analysts' forecasts going out, we're looking at an 8%-9% earnings growth.

TWST: What should long-term investors focus on when reading your

financial reports, your numbers? Mr. Davis: I think the situation with us is they should very much focus on the profitability of the business. I think we have managed to expand the international business very significantly with minimum margin dilution. One tends to find that the rule of thumb is the wider the geographic spread, the lower the overall operating margin. At this point in time we have, I think, managed the situation whereby we have targeted higher margin markets. Our continued emphasis on costs enables us to replicate good margins when we do go into new territories. It also affects the performance of our acquisitions. We integrate them very quickly and reorganise them very quickly and drive their productivity very hard. That enables margin stretching in those businesses as well. So our overall profitability and the speed at which the international business is growing should be of interest to shareholders. And our lack of exposure to US litigation is a significant issue for shareholders these days.

TWST: What steps has the company taken to improve productivity?

Mr. Davis: It's been a combination, both in our core business and in the acquired businesses, of genuine working practice restructuring, and significant capital investment. We have a great belief in technology, and we have invested heavily in the latest machinery, to further improve yields. So we give our people the best opportunity by ensuring they're working with the best equipment, and we encourage the acceptance of change throughout the business. And again, with our philosophy of incentives, people are increasingly incentivised to do well. We have a very high calibre and supportive work force, and a significant number of them are shareholders, so that's something that we're particularly delighted about. Since we de-merged, around 67% of our UK employees have a shareholding interest in the company, and 40% of our international employees have the same. If one goes back to the time of de-merger, only 5% of our total employees were based outside of the UK, and most of those were in Ireland. As I speak today, around 50% of our employees are based outside the UK. So there's been quite a transformation in a very short time, and it's very much enriched the company.

TWST: How do you feel about your current stock price?

Mr. Davis: Well, we have seen some recovery, and we were delighted to return to the FTSE 100 Index in July. We had a very torrid time in December of last year and January-February of this year. Having posted a record increase in profits and earnings per share, and declared a very healthy dividend increase, we watched our share price crumble in the wake of the dash for dot-com stocks. In Britain, it was the Vodafone Mannesmann issue, which institutions had to have their share of, and it wasn't unique to Imperial. Most tobacco, food and brewing stocks fell quite dramatically over that three-month period. Since that time, we have seen something of a recovery, but still below our historic high of around GBP7.70. So we have still some way to go to catch up, and one would have to say, given our financial characteristics and our financial track record, we would hope to see the share price considerably higher than it is. But, the tobacco factor does come into play, particularly the adverse news flow from litigation in the States, which tends to have an effect on the whole of the sector in terms of sentiment. Even though we have no exposure, it's quite frustrating for us, but one has to accept that in the short-term, the market isn't perfect. But there again, no one has ever found a better way of allocating resources, so we just keep faith in the concept of the market. Our problem is if we spend all our time worrying about the share price, we won't be optimising the performance of the business. So we concentrate on running the business well, in the belief and faith, ultimately, that we'll be recognised by the market. I haven't found a better way yet.

TWST: What two or three reasons would you give long-term investors to

buy stock in Imperial today? Mr. Davis: I think the two or three reasons I would give would be that it's an attractive price, that the company has a track record of growth, and looking forward, one can see significant further growth prospects. The dividends are extremely attractive, and we do not have the exposure to the issue of US litigation. So I think that those are the things that make our stock look attractive. We also have a track record of making acquisitions, and those acquisitions, in terms of performance, have exceeded our weighted-average cost-of-capital in a very early time frame, which of course has created significant shareholder value. Tobacco, everyone knows, is an extremely strong cash flow business, and we are no different in that. We are very, very cash generative. The question is how well that cash can be used for the benefit of shareholders, and so far I think we've demonstrated that we've used it extremely effectively. I believe our shareholders have great confidence in our ability to acquire companies and then actually manage those companies to create more value for them. And we are, at the end of the day, shareholder-driven. That is not something we just say, we actually have a track record of demonstrating that we do just that.

GARETH DAVIS
Chief Executive
Imperial Tobacco Group Plc
P.O. Box 244
Upton Road
Bristol BS99 7UJ
United Kingdom
+44 (0)117 963 6636
+44 (0)117 966 7859-FAX
www.imperial-tobacco.com

Each Executive who is the featured subject of a TWST Interview is offered the opportunity to include an Investors Brief or other highlight material to be provided and sponsored by and for the company. This interview with Gareth Davis, Chief Executive of Imperial Tobacco Group Plc, is accompanied by an Investors Brief containing corporate information.

To ask a question of this or any other publicly traded company, visit QAWire.com


Copyright 2001 The Wall Street Transcript Corporation
All Rights Reserved

The Wall Street Transcript (TWST) interviews are published verbatim, and TWST does not in any way endorse or guarantee the accuracy of any information or opinions expressed herein and all opinions are subject to change without notice. Nothing herein constitutes a solicitation to buy or sell any securities. TWST interviews with CEOs may include include "forward-looking statements", which are based on factors that involve risks and uncertainties. Actual results may differ materially from those expressed or implied. TWST shall have no liability whatsoever for any trading losses arising out of use of this information. Copyright 2001 Wall Street Transcript Corporation. All Rights Reserved.