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BAT Industries document for Province of British Columbia 22 April 1999

TOBACCO
Current Group Tobacco Interests
The B.A.T Industries Group, Including the sales through Austil and Imasco
(but excluding Mexico?), is currently the second largest manufacturer in
the 'from world' with a [19.5%] market share, having lost the position of
market leader (which has been held since 1111) to Philip Morris (see chart
X).
The single largest domestic market volume commended by the Group is in
Brazil (C. I 28 billion), followed by the USA (61 billion), which Ls by far
the most profitable market. The 10 largest cigarette markets In the 'free
wocId', and the Group's oLa rkat share in those markets, are shown In chart
XX- Worldwide, the Group is market leader in torus of share In XX
markets, with the Group's strong positions being largely in the developing
rather than the developed economies.
Sales volumes and trading profits for the Group's major markets ace shown
in chart XXX.
In 1989, total Group Tobacco sales were L7003 million, with trading profits
of L756 million end not assets of LX million.
Recent Market Growth
1. Total world cigarette demand En 1986, at 5.279 billions, was 2.8Z up
compared with 11161, Communist bloc sale, to" by 1,52 while fraa
world sales at 2,850 billions. were Little changed from the previous
year. although volume declines were experienced In Argentina, Brazil,
USA. Canada, France, Spain. Japan and Pakistan.
Prospects for Demand
2. The main determinants of the demand for cigarettes are the number of
adults. the incidence of smoking and the number of cigarettes smoked
per person. Kajoc forces influencing the incidence of smoking and
per-capita consumption are social and health pressures. real Incomes
and the relative price of cigarettes. Although studies differ
slightly In their results, it appears that. in the developed
countries at least , a 1% rtse(f all) in real Incomes is associated
ith a rise(fall) in cigarette demand of about 0.42, whilet a 12
with a rLs in the price of cigarettes relative to other products Ls
associated with a fall(rise) of between 0.4% and 0. 6Z In cigarette
demand. in recent years, anti-smoking pressures have led to declines
in the Incidence of smoking in many countries, and this has had a
downward trend affect on consumption of perhaps 2Z-3% a year. If
these broad trend@ were to continue over the sodium term, this would
suggest that cigarette consumption in the developed economies would
fall by 12 or more a year an average whtlst that in the developing
markets would rise by about 1Z a year because of faster growth La
their adult populations.
Jo 00,
3. Although "Les growth within the Communist bloc (including China) Ls
expected to remain strong over the madium term at about 32 a year.
free world cigarette sales are expected to either decline by about 1%
P.a. or, at best, to remain flat. with a rising world population
barely compensating for falling Incidences of smoking. Within the
free-world total, however, considerable variation between regions and
countries can be expected with the developing sockets achieving growth
of 1% or more a year an average, compared with an expected decline La
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BAT Industries document for Province of British Columbia 21 April 1999

2
sales in the developed markets of about 1% a year. In North Amcica,
there are fears that antismoking pressures and weak economic growth,
allied with the possibility of increased taxation in the USA, will
result in a sharp fall In cigarette demand, averaging perhaps 4Z-S%
p.a. Demand is also likely to fall in Europe, though less markedly at
around JZ-1% P.&. and with notable differences between markets such
that France, Spain, Greece and Portugal might experience slight -
increases in sales I CHECK) - In Latin America, the difficult economic
conditions that are expected to prevail over the medium term suggest
only limited growth in the demand for cigarettes, despite continued
rapid growth in the adult population. Similar constraints are likely
to apply in most of the more populous states of Africa and the Middle
East though sustained recovery La oil prices could Lift cigarette
demand in the oil-exporting nations above the projected growth rate of
about O.5Z p.a. The areas of strongest volume demand growth are
likely to be the Indian Sub-Continent and the Far Eastern markets,
with growth rates of lJ% a year or more (excluding Japan, which is
expected to experience sales declines averaging about lZ p.a.).
4. in recent years, the International Filter Brand segment has been
recovering from the depressed markets experienced in the early 1980a
and this recovery has been supported in 1987 and 1968 by the
opening-up of certain Far Eastern markets, primarily Japan, China and
Taiwan. Such sales are expected to continue to increase from choir
1988 level of 447 (CRICK) billions at lit-2% p.a., with the growth
coming from US-type brands which are likely to increase at ZJZ-3% a
year. The regions where international filter brands have the largest
share of sales are the Middle East (40%). Europe (30%) and North
America (29%). 'Reasonable growth rates in volume over the medium term
are likely to be found in Europe, Africa and Latin America, but the
strongest growth to likely to be found in Asia (particularly in China,
Taiwan, South force, Thailand and Japan, where Import penetration is
expected to rise from. 11% to about 15% in the 149 t-named market).
5. The ZEC Commission has put forward various proposals relating to
duty-free: sales to intra-Community travellers which could have a
sacked adverse impact on sales and profitability. The Commission has
made three different proposals:-
(a) to include pack health warnings on tobacco products sold in
duty-free outlets;
(b) to ban the sale of tobacco products to intra-Community
travellers before the end of 1992 (as part of the Europe Against
Cancer action plan);
(c) to abolish all duty-free sales. The draft Directive an VAT
refers to this abolition taking place an 31st December 1992, but
the Commission is believed to have accepted that the date of
Implementation should be directly linked to the date of excise
duty harm*nixation.(CHFCKI
6. Of the three proposal*, there is a strong likelihood that the first
and third will be Implemented, rather than the selective ban on sales
of tobacco -products. At current Volumes and VC1C*8, the Potential
trading (CHECK?] lose to the Group of a complete abolition Of such
duty-free sales would be about M million P.&. , af tar account is N)
taken of some Improvement in domestic sales that could be expectod to
result.
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7. BATCc. is playing a loading role in co-ordi"ting the of facts of
tobacco companion and other interested parties to lobby both national
and European authorities against the abolition of the duty-free
market. However. it is believed that there is little likelihood of
the duty-free concession continuing (such) beyond the date at which
indirect tax, and in particular excise duty, is of fectively
harsonised.
S. The movement towards lower-priced, value-for-manty brands is likely to
continue, for example in the USA, Brazil, Australia. the Middle East,
Argentina and the Indian Sub-Continent though in the rapidly
developing economies of the Far East some trading-up could occur as
per-capita incomes rise. Profit margins are also likely to come under
further pressure as a result of excess capacity in many of the
industrialised nations leading to increased marketing efforts and, in
some markets, discounting. However. in the USA, azceso'capacity is
unlikely to be a major factor as the capacity availability arising
from weak domestic sales Is likely to be fully absorbed by gains in
export volumes. Competitive pressures, with manufacturers
increasingly using pricing or the postponement of price increases as a
competitive tool, allied with price controls and excise duty increases
in some markets. are likely to mean continued dif f iculty in raising
product prices in real tares, though overall profit levels will also
be influenced by the strategic need for both PhIllp Morris and R.J.
Reynolds to maintain the cash flow from their tobacco businesses.
Such pressures suggest that future sustained growth in profits will be
particularly dependent on achieving share Was in growth segments and
by continued improvements in productivity. In the absence of such
market share improvements, it might be necessary to consider
harvesting strategies in mature markets.
Tobacco Taxation
9. In most countries, tobacco taxation is likely broadly to keep pace
with Laf lat Lou, reflecting governments' concerne over both tax
revenues and smoking and health. Of particular note are the
possibility of a sharp rise in Federal Excise Tax an cigarettes in the
USA. (possibly in 1991) and the expected harmonization of tobacco taxes
within the ZEC. It has been suggested that the US Federal Excise Tax
might be doubled to 32c per pack. Such an increase could be expected
to result in a fall in US domestic demand of perhaps 5%.- although the
extent of the decline night be mitigated LE manufacturers' own price
increases are below the inflation rate, thus containing the real
increase in retail prices. In addition to the possibility of a rise
Ln the Federal excise tax, further increases in individual State
excise taxes can be expected. While the form which ZIC tobacco tax
harmonization will take has yet to be settled, agreement will be
reached and it will almost certainly involve an increased tax burden
in soon countries possibly combined with decreases in others. BATCo.
has estimated that, if harmonisa.tion is broadly in line with the
present proposals put forward by the Commission (sea table Y), total
cigarette sales in the EEC would fall by about 7Z. Sharp declines
ranging from 13% to 30% could be expected in France, Spain, Belgium,
Holland, Portugal and Greece. Total demand could, however, rise
slightly in Denmark and possibly the UX, West Germany, Ireland, and
Italy. Rocau se there is likely to be a move away from the currant
high reliance on ad va loran taxation. there would also be 6 narrowing
of the price range of cigarettes in France, Italy, Spain, Portugal and
Greece, which would provide a stimulus to hLgher-priced international
brands relative to lower-priced national brands.
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BAT Industries document for Province Of British Columbia 21 April 1999

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Communications Restrictions
10. Anti-smoking pressures are expected to continue to increase. with
hardening social attitudes and further restrictions on tobacco
advertising. In North America, the Canadian Tobacco Products Control
Act came into force at the start of 1989 with an immediate ban on
print advertising and a four-year phased reduction in tobacco
sponsorship. The advertising ban is applicable to Canadian newspapers
and magazines but not US once In circulation La Canada which, combined
with the phased reduction in import duties on US products as's
consequence of the US/Canada Free Trade Act, suggests that US imports
will be better placed to establish an increased share of the Canadian
market. In the USA, Increased efforts are anticipated at the Federal.
State and local levels with regard to attempts to ban or restrict
certain types of advertising. sampling or promotion. In particular,
efforts have been stepped up to ban cigarette advertising on
transportation facilities, to curtail or eliminate billboard
advertising and to prohibit some forms of tobacco spovisorshi With
R.J. Reynolds, in particular, likely to be seeking to concai or
reduce its promotional expenditures, overall industry spendl@ on
advertising and promotion is expected to stabillse in 1989 and 1990.
In Brazil. the voluntary advertising code has been suporceded by
formal restrictions and there is the danger of further legislation,
possibly involving the bannLag of tobacco advertising an TV and radio,
being introduced in 1989. Continued pressure is also to be expected
in Europe, reinforced by the Europe Against Cancer programme (see
below). In the developing nations, such as Hong Kong and Singapore.
further restrictions an tobacco advertising can be expected.
II. In markets where such advertising restrictions are introduced and/or
strengthened, it can be expected to have the affect of slowing down
changes in market shares as successful new brand Introductions will
become harder to effect, thus strengthening the position of brand
leaders and dominant producers. Although there will be potential
savings through the (enforced) lower advertising expenditure, it La
unlikely that this will result in higher profitability as other
promotional costs are likely to rise (possibly by more than the saving
La direct advertising expenditure).
Smoking Restrictiog
12. In addition to communications restrictions, there will be pressures to
restrict smoking by restricting the places where smoking is permitted.
Such restrictions have already been enacted in Singapore ICHECK]
and.... while some cities (Now York and ... I CHECK I) in the USA have
introduced similar restrictions. In the USA and Canada in particular,
smoking restrictions at the workplace are expected to increase in
number and severity. Similar measures have been proposed in Europ*,
led by the EEC In its Europe Against Cancer campaign, and such
pressures can be expected to cont inue.
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BAT Industries document for Province of British Columbia 21 April 1999

Europe Against Cancer
13. In 1997, the EEC Commission first put forward a plan against cancer.
The Europe Against Cancer programme includes many proposals which are
not relevant to tobacco products. but also contains a number of
proposals which will affect the tobacco industry. The key proposals
are:-
(a) to raise the average incidence of taxation from 72% to 75% of
the retail price (this was first proposed as part of the 1967
draft Directive on excise haruonisatLan);
(b) to impose pack health warnings on the front and rear of packs
with tar and nicotine numbers printed on the sides. This
measure cam close to being adopted In December 1988 and is
likely to be agreed at the May 1989 Health Ministers' Council
for implementation by and 1991. A, key aspect of this proposal
which has yet to be determined is the method of measurement to
be used In determining product deliveries as this could have an
unduly adverse affect on Group products;
(c) to impose tar ceilings for all products of 15 a& by the and of
1992 and 12 mg by and-1995. This proposal has received
considerable opposition from tobacco growers, the tobacco
Lrbdus try, Member States and also from within the European
Parliament and is not expected to progress in its present form;
(d) a recommendation that Hember States introduce bons on smoking In
public places. based an the premise that non-smokers' rights
prevail over those of smokers;
W to limit tobacco advertising, including sponsorship and trade
mark diversification as wall as more conventional advertising.
14. The implications of such proposals would be far reaching, affecting
pack design, product design and market positioning and communications
strategy, and the Group needs to maintain both a close involvement in
influencing their development and also to prepare strategies and
action plans to limit their potatially adverse effect on Group sales.
Tobacco Litigation
15. Despite the damages award against Liggett in the US Courts La 1988
(and which is being appealed), recent court decisions in the USA have
generally supported the Tobacco industry on major issues and tend to
limit the probable are** of future suite. There have also been
developments in State product liability lave which suggest a
legislative trend in favour of defendants (including Tobacco
companies) in product liability claims. California has passed a law
exempting manufacturers from product liability claims if consumers are
aware of possible dangers, associated with a product; Texas now has a
law ruling that there can be no claim in a cast alleging injury if the
claimant is 60% reponsibl* for the injury; and Now Jersey has banned
the risk/utility asmsent in Product liability lawsuits. Despite
these encouraging developments and the reduction in the QuWRC Of 1&V
suits pending, the future legal environment in the USA will remain
extremely challenging. The extent to which cases are brought in
countries other than the USA is likely to be sensitive to developments
in the US courts.
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Tobacco Leaf
16.. In recent years, weak demand for cigarettes in the USA and Western
Europe combined with increasingly effective competition from volume
tobacco leaf producers such as Brazil and Zimbabwe have contributed to
excess production of leaf in the USA and depressed prices at auction.
With the worldwide demand for cigarettes expected to grow by about 1%
a year, the demand for traded tobacco leaf is likely to grow somewhat
slower at perhaps J% & year as continuing improvements are achieved in
the amount of tobacco used per cigarette as a result of greater
efficiency, weight reduction and the use of expanded tobacco.
Although leaf prices will continue to be subject to the vagaries of
supply associated with most agricultural products, the outlook to for
the underlying trend in leaf prices to be relatively weak. with
VO increases (in US dollar terms) a little below the US rate of
inflation.
Development Opportunities
17. The main opportunities for extending sales appear to be through share
gains firstly in domestic markets an consumer loyalties are weakened
through increased emphasis on price/value-f or-money, &ad secondly
through pining a strong presence in export markets. The strongest
export markets are. likely to continue to be found in the far East
(Japan, China and Taiwan, but also new markets such as South Korea,
Thailand. Cambodia and Vietnam) with significant opportunities also
likely to be found in Europe. notably through the opening-up of the
monopoly markets in Italy, Greece and France, but also tn Eastern
Europe and Turkey. Other markets where further progress night be made
are Iraq and Iran (as they rebuild their economics), the Philippines
and Puerto Rica. The US/Canada Free Trade Act will also provide
opportunities for US sanufaccurore to penetrate the Canadian domestic
market.
Sensitivities
18. Although the central projection in this paper is for moderate volume
growth in sales with reasonable expectations of sustained improvements
in profits and cash flow, there are a number of issues which could
significantly alter thts outlook. The main sensitivities are:-
(a) The general economic environment. As noted elsewhere in this
paper, the most likely path for the world economy is for a
moderate slowdown in the rate of expansion over the next year or
two followed by a strong recovery In the early 19909. However,
there is a significant possibility of the slowdown in growth
being somewhat more pronounced than this and for there to be an
adverse knock-on affect on the demand for tobacco products in
both the developed and developing markets. Such a slowdown in
economic activity could alto adversely affect the opening-up of
monopoly markets. as governments seek to protect their
countries' balance-of-trad* positions, which would further
endanger the prospects for cigarette export growth from the USk
and UK.
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M The Of fectLvantss Of AntL-900king activities, *specially those
seeking a ban on smoking in public places. Although the primary
concern 'is that such moves will lead to a faster-than-expect*6
decline in the incidence of sucking, it is pos a ib la that the
extent of the decline in the USA and Canada will be I*ss than
currently projected.
(c) The "tent to which tobacco advertising and/or promotion are
further restricted and the consequent limitations an the Group's
ability to improve market share. Such restrictions are likely
to be particularly damaging to the Group in those is rkets where
we art not market leader, reinforcing the need for Group
businesses to focus an innovative ways of securing strong market
positions ahead of any such restrictions.
(d) The form and timing of tobacco tax harmoni sat ion in the EEC.
There is considerable opposition to the Commission's detailed
proposals for harmanisation, both from the monopoly producers
(who are seeking a system with a high ad-valoren element) and
the private-sector producers (who are seeking a system with
greater reliance on specific taxes). The final outcome will
have a marked effect on the structure of cigarette demand across
EEC markets as a high ad-valor** element would favour low-priced
products compared with the high-quality international brand
segment. and thus reduce the opportunities for markot-share
gains by the private-sector producers.
(e) The. competitiveness of the operating environment and, in
particular. the exttat to which the new financial pressures on
Philip Morris and R.J. Reynolds will cause then to concentrate
on cash-flow and profit enhancement rather than investing La
market share growth.
GJ1/DJA
3rd April 1989
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BAT Industries document for Province of British Columbia 21 April 1999