'RESTRICTED. NO. 57 A- -A REVIEW OF TRENDS IN THE TOBACCO INDUSTRY OVER THE LAST 10 YEARS AND OF BAT'S POSITION WITHIN THE INDUSTRY 1. Major Events Since 1970 1.1 The tobacco industry has survived the economic problems created by the oil crisis of 1973 more successfully, and more robustly, than most industries. Although the industry has had difficulty maintaining prices in line with the inflation of costs, profits for the industry generally have g;own in line with inflatiod. 1.2 From 1975 onwards, the repercussions of international and national "Smoking and Health" activities, particularly in the developed countries, have been reflected in a gradual decline in the annual growth rate of cigarette sales. The growth rate of Free world sales has declined from 4.5Z in 1970, to 2.3% in 1975, and to 1.9% in 1980. 1.3 Within Europe, the expansion of the EEC,and in particular Britain's entry, have caused a re-shaping of-the industry, for example, the BAT/Imperial separation and the liberalisation of the French and Italian monopolies. The need to develop and manufacture cigarettes to specific standards and deliveries, and inflationary cost pressures, together with the growing consumer demand for American blended cigarettes have -resulted in a proliferation of brands, and a more competitive situation within the industry. 1.5 The role of Multi-National Enterprises has come under severe scrutiny by national and international institutions. This scrutiny has resulted in the preparation by the OECD and the UN of . Codes of Conduct for MNEs, particularly in the areas of pricing, taxation and industrial relations. 1.6 Within the UK, the introduction of Advanced Corporation Tax has accelerated,for BAT, the urgency to maximise UK income. 2. Total Free World Sales 2.1 Over the 10 years 1971-1980, total sales of cigarettes within the Free WorI4 have risen from 2167 billion to 2835 billion, as ifidicated in the following table. This represents an average annual rate of increase of 3%. C> (-n CDO til C71N BATCo document for Legal Services : Health Canada 22 October 1999 2 Trends of Sales (Free WoXld Groupings) 1971 Share Z 1980 Share Z Cumulative GR bne rU__9 Major Four Cos. 942 1472 52 5.1Z Other Independents 640 30 646 23 0.1% Monopolies 585 27 717 25 2.2% Total 2167 100 2835 too 3.0% 2.2- Within the Free World BAT haazilightly improved its market share 10 years from 19.7% to 20.3%. R.J. Reynolds has i mproved ,t from 9% to 9.9% and Rembrandt/Rothmans Group from 5.71 to 6.32. t;::~ i.-.The most significant performancehas been that of Philip-Morris, which has improved from 8.9% to 15.2%. 2.3 These market 'share increases"by the leading manufacturers have been gained almost wholly at the expense of the smaller independent .companies, whose market share has declined from 29.5% to 22.7% over the 10 years. This is partially due to the-poer~'performande of the smaller independents, as well as to the acquisition by BAT of the Lorillard export rights, and by Philip Morris of the Liggett & Myers export rights. Most recently Philip Morris have gained a significant interest in Rothmans International. The state monopolies share of Free World sales has declined from 26.9% t1o 25.2% over the period. 2.4 BAT's performance over the 10 year period, in relation to its three major competitors, is indicated below, both for the total of Free World sales and for the international Brands segment. The general pattern, albeit with significant exceptions, i4ithin thdividual: Operating Companies, is of a company starting the decade from a higher overseas base thari its competitors and waging a sustained fight to maintain and improve upon its market share. Total Sales 1971 'Share % 1980 Share Z Cumulative GR bna bns BAT 428 45 577 39 3.1% Philip Harris 193 24 432 29 9.32 R.J. Reynolds 196 21 282 19 4.1Z Rembrandt/Rothmans-- 125 13 181 13 4.2% .942 .100 1472 5.1% International Brands BAT 43 31 83 23 7.5% (ZD Philip Morris 32 24 139 39 17.7% R.J. Reynolds 21 is 31 13 10.3% C7\ Rembrandt/Rothmans 42 30 83 23 7.8% CXD 138 100 357 100 11.1%, UTI BATCo document for Legal Services : Health Canada 22 October 1999 3 2.5 international Brands have grown from 8% to 13% of Free World sales during the 10 years 1971-80. The average'annual growth rate for International Brands has been 8.62. Within this segments US type brands have grown at twice the rate of Virginia brands. The four major companies have been responsible for almost all of this growth. Because of the success of Philip Morris in increasing their shares of the International Brands segment from 18.2% to 37.52, R.J. Reynolds share of the International Brand segment has increased only from lZ% to 13.7%, while BAT's share has declined from 24.5% to 22.42 and Rothmans from 242 to 22.4%. 2.6 Exports from the USA, with an annual growth rate of 7.4% per annum, have increased from 2.3% to 3.3% of Free World sales. Exports from the UK with an annual growth rate of 8.1% have increased from 0.9% to 1.4% of Free World sales. Over the same period, Philip Morris has increased its share of US exports from 23.9% to 46.1%. !..Of UK exports, Rothmans have improved their share from 54.1% to 59.9%, while BAT's share has declined from 44.4% to 35'.3%, albeit increasing in size from 8.7 billion to 14.0 billion units. 3. Financial Results 3.1 ;n attempting to compare the financial performance of BAT's tobacco interests with those of Philip Morris and RqJ, Reynolds, data has been extracted only from the published accounts of the three companies. In the case of the American companies,attributable assets were taken to be similar to BAT net assets. In the comparisons that follow, the gross turnovers and the net turnovers of the three companies respectively have been aggregated and expressed as each company's share of the total. Only the tobacco interests of the three companies have been included. The trends are plotted in Graph 1. Gross Turnover 1971 1980 BAT 53% 46% Philip Morris 21% 29% R.J. Reynolds 26% 25% Net Turnover 1975 1980 BAT 40% 39% Philip Morris 27% 32% R.J. Reynolds 33% 29% is the The difference between gross turnover and net turnover level of excise duties levied. Thus, BAT's lesser share of net, compared with gross, turnover indicates -it~r- greater proportion of operations in those areas of the world where the excise element -,J of retail prices is high. -rl~-- co ~_n CC) BATCo document for Legal Services : Health Canada 22 October 1999 4 3.2._Operating Profits (World-wide) (Graph II) Graph II aggregates the total tobacco operating profits of BAT, Philip Morris, and R.J. Reynolds and plots each company's share Over the 10 years. Operating profits are defined as pre-tax, pre-interest profits derived from tobacco trading. The figures at the beginning and end of the decade.were as follows., 1971 1980 BAT 35.2Z 27.7% Philip -Morris 22.1% 33.2% Reynolds 42.7Z 33.8% ..3-'-Operatina Profits (USA Domestic) (Graph III) A similar calculation for pfofits defined from the USA Domestic market (excludid exports) indicated the following trends: 1974 '1980 BAT 22.5% 15.6% .Philip Morris 32.9% 41.8% R.J. Reynolds 44.6% 42.6Z 3.4 Operating Profit (World-Wide excluding USA) (Graph IV) The same calculation was prepared for operating profits derive from Ekee World sales of tobacco, excluding USA Domestic sales The tradds are as follows: 1974 1980 BAT 70.0% 30.0% Philip Morris 23.7% 32.5% R.J. Reynolds 6.3% 17.5% In all cases, the above comparisons confirm the picture of BAT fight.ing to sustain its leadership in the world markets. 4. ''Competitive Efficiencies 4.1 The table below compares the return on investment achieved by the three leading companies since 1976. The trends are P16tted in Graph V. The information is taken from published sources. 1976 1980 Asset Asset Margin% x '.Utiligation = ROIZ Margin% x . Utilisation 0 1110 t z C> BAT 8.4 x 2.52 21.2 7.7 X 2.52 1` 4 -cha (ON PM 17.4 x 1.36 1 = 23.7 17.2 x 1.65 or ~ 1; 4 ( n RJR 16.1 x 2.08 33.5 17.4 2.53 4 it. j co (-n '\0 BATCo document for Legal Services : Health Canada 22 October 1999 5 4.2 The apparent decline in BAT margins compared with Philip M6rris and R.J. Reynolds may well reflect differing investment and machine maintenance policies between the companies. The reversal of the trend in 1980 may prove to herald the increasing proportion of BAT's competitors' business. which is being derived from less profitable mark&ts. 4.3 The significantly better performance by R.J. Reynolds than either Philip Morris,or BAT could be reflected in any or all of the following factors. a) Less tobacco per cigarette b) Basically soft cup 20s packs C) Smaller range of brands d) Run down and replace machinery policy e) Less production units, i.e., more concentrated on USA 4.4 Although in 1980 49.8% of Philip Moriis' gross turnover and 37.2Z of R.J. Reynolds' gross turnover were derived from sales outside the US, only 29.4%*and 18% of their operating profit, respectively, was earned from the same'source. 5. Broad Conclusions The following broad conclusions can be drawn from the preceding sections of this teview. 5.1 BAT has slightly improved its world market share through the performance of Operating Companies in their domestic markets. BAT's performance in the International Brand and Export segments has fallen below that of its major competitors. As both these segments have,grown at more than twice the rate al total world growth, the need for BAT to prevent a worse decline in market share by promotion of appropriate International Brands is under- scored. 5.2 As a groups despite their combined growth rate of 2.2% over the period, the state monopolies still control over 25Z of the Free World sales. All the major international organisations have - succeeded in penetrating monopoly markets, including BAT, albeit to a les.ser extent than our more aggressive competitors. 5.3 BAT's financial performance compared with Philip Morris and R.J. Reynolds reflects: a) The Aifferences*in volume performance of single brands b) BAT's wider global presence 0- The benefits the competition companies derive from a very large US domestic market. ON (_n Equally, the contrast in financial performances also indicate co CN opportunities for BAT which have yet to be grasped, such as the benefits from tobacco expansion techniques and a greater rationalisation of brands. BATCo document for Legal Services: Health Canada 22 October 1999 6 .5.4 -Although only crude data is available from,the low delivery -segment, such data as is available would indicate that with certain obvious exceptions in the deviloping countries, the segment is growing extremely rapidly. BAT is generally well represented in an -increasingly competitive situation. I 0 . 29th October 1981 0 4 Cr,% (_n CXD C7% BATCo document for Legal Services : Health Canada 22 October 1999