Talk with Imperial Tobacco CEO Gareth Davis
Gareth Davis: "No one wins a price war"
Gareth Davis, chief executive of Imperial Tobacco Group Plc (2008 revenues: €22.3bn), had none of these allures.
Under the long tenure of Mr Davis (59), Imperial Tobacco has undergone significant expansion – not least through its acquisition of Reemtsma in Germany.
The Bristol/UK-based company's major international competitors have also grown, however, taking the industry to what many observers see as the end-game phase of global consolidation.
Meanwhile, Big Tobacco has been hit by a wave of litigation in the US and a huge flourish in international contraband. Tough times for a high-margin industry?
During the interview, Davis was surprisingly forthright about smoking and didn't dodge the contentious issues. The urbane chief executive began by asking whether he could smoke.
Having someone puff away in an enclosed space is not so thrilling for those who do not indulge the habit. However, journalists must agree to such requests because it is essential that one's interview partner feels at ease. So the non-smoker resigns himself to a sick headache and a bill at the dry cleaner's.
Imperial Tobacco's top man lit his first cigarette, just as he claimed that there was little peer pressure to smoke. As he did so, all his press team reached for their cigarettes and lit up in unison. When he stubbed his cigarette out, they did too.
As Mr Davis is quite a heavy smoker this procedure was frequently repeated during the interview. In fairness to him, however, one didn't gain the impression that he was pressurising his subordinates to smoke, but the simultaneity of the puffing bouts did belie his message somewhat.
Another interesting moment occurred, when Davis insisted that the dangers of passive smoking had been overplayed in the media. It was here that colleague Gabriel von Pilar, a light social smoker, but who didn't puff away during the interview, started to cough.
Needless to say, by the end of the interview Gareth Davis didn't succeed in convincing Lebensmittel Zeitung that smoking isn't dangerous for one's health. One merely left his office regretting that such a likeable person should abbreviate his life by smoking.
Mr. Davis, people say that, due to the tax increases in, for instance, the UK, up to a third of all cigarettes is supplied illegally. Worried?
The situation in the UK is not quite as bad as it was. Manufacturers have worked very hard with customs to try and get things under control. Basically cross-border or non-UK duty paid is just over a quarter.
According to customs estimates, a third of that is legitimate cross-border trade. This occurs, for example, when Brits go to Spain, where there is a large enough price differential to justify the trip, and can bring back 3,200 cigarettes per head.
As regards smuggling, we and our competitors have established memoranda of understanding with HM customs authorities and have reduced the problem considerably. Customs figures highlight a considerable reduction in seizures of genuine Imperial Tobacco products.
Evidence of our success can be seen in the increase in counterfeiting.
Overall, the British market has been quite stable for the last few years because the Chancellor of the Exchequer has found a formula whereby annual tax hikes are around inflation level, which has increased his revenues and undermined smuggling.
The lesson is simple. If governments want to increase tax revenues, then raise taxes modestly over a long continuum, rather than do nothing for three years and then raise them substantially.
It’s that huge volatility and surge in prices that triggers all the instability in the tobacco trade in any country.
Do you think the same will happen in Germany?
I can see history repeating itself there. The country has undergone a double shock, where a very significant tax increase was accompanied by a liberalisation of its borders. This was too much in one go and caused a huge spike in prices.
So the poor old smoker has no option, if he wants to go on smoking, as most smokers do, he has to down-trade and find something else to smoke whether OTP (other tobacco products), private label, or cigarettes purchased in the Czech Republic or Poland.
So you believe in medium-priced brands?
The tobacco manufacturer today cannot afford just to concentrate on premium brands. We are here to supply smokers. Therefore, it is our responsibility to provide tobacco products which smokers find both affordable and satisfying and thus to cover off the price points.
Would you ever consider a price war in order to gain market share?
No, we are not people who initiate price wars, and that’s the last thing we ever want. We’re very competitive, but we don’t want to see price wars where nobody wins. We’ve seen this happen in Poland and refuse to get involved in it.
If in times of recession and high taxes you invest more in the lower price segments of your portfolio, won’t that hurt your gross margin?
This is where the other part of our model comes in, i.e., productivity and focus on costs will unlock everything. So, if you’re obliged to go down the price spectrum, increase your efficiency and get your costs out.
After the fall of the iron curtain in 1989 why was Imperial Tobacco initially so slow in seizing the opportunities in eastern Europe?
At the time, we were a part of Hanson which didn’t want to extend its tobacco exposure beyond ourselves. We were therefore a very UK-centric business. By the time we demerged in 1996 a lot of the privatizations in eastern Europe had already happened.
How do you view the potential in the region?
It has become very crowded with multinationals. In Russia, you have us, BAT, Japan Tobacco, and Philip Morris. The Ukraine is pretty similar. We’re all in Hungary.
And that’s why the margins are lower in the region because purchasing power is lower and there is a lot of competition there.
So are you looking more towards south-east Asia?
In terms of growth philosophy our world is basically east of the Americas.
Due to fear of litigation?
If we entered the States tomorrow, the likelihood of us being sued is minimal because now there are health warnings on cigarette packs, master settlements etc.
However, stock market investors have always seen us as a stock with no US exposure and would be disappointed because they still have this perception that it’s a very litigious and risky environment.
So the US is an issue of reality vs. perception, but it’s a big enough world without the States.
Why not Latin America?
There are little segments there, but, on a large scale, central and southern America are difficult for new entrants because of Philip Morris and BAT.
Where are you looking to grow?
We are looking to grow in Western Europe where there are good margins.
Where else are you interested in growing?
Certainly, we are keen on expanding our good position in the Asian-Pacific area. We should also like to continue growing in Africa, where we are a distant number two player. Basically, wherever we are already, we want to continue growing.
Do you favour acquisitions or share buy-backs within your international expansion strategy?
Our preference is what would create most shareholder value. Inherently, I prefer acquisitions because historically they have created more value for our shareholders than buy-backs would have done.
On the other hand, one has to say that, as acquisitions become scarcer, prices go up, and maybe the value creation isn’t there. So you’ve got to keep the discipline not to pay stupid prices for things where you are not going to create value.
In fact, it’s a very easy alternative: if you can’t create value, give the money back to the shareholders and let them invest in whatever they want to invest in. There’s no point in us wasting shareholders’ funds.
We’ve worked very hard to make our shareholders happy, and we intend to keep doing that. So, if the acquisition is there at the right price, yes, we shall continue acquiring.
What potential do you see in China?
I think it will be very slow and gradual. Tobacco is a massive industry there and is extremely well-run by the state tobacco monopoly administration.
However, we are already well placed with a very good cooperative venture with STMA and Yuxi-Hongta, but it’s a slow build.
That said, China is globalizing, and possibly ten years hence there may be the opportunity for a western company to acquire assets there, but that’s not relevant at the moment.
India is not a state monopoly; instead you have private Plc-type companies such as the Indian Tobacco Company (ITC) with a 60-odd per cent market share, VST, and Godfrey Phillips.
Certainly, the problem with India for people like us has always been that imports were historically banned.
However, I see India as one of the great potential future markets when one considers that there are over a billion people there and yet the market for manufactured cigarettes is larger in Germany.
There are only about 100 billion manufactured cigarettes consumed per year in India, but they smoke about 900 billion domestically produced bidis. Each village has a bidi-maker, which gives it a huge political lobby, and, of course, bidis have a massive tax advantage.
So, over time, one would hope that the bidi smokers would graduate to manufactured cigarettes with filters. Then, India will be tomorrow’s great market.
Regrettably, I wouldn’t like to put a timeframe on it because in reality the Indian cigarette market should have been developing much more than it has. But the tax structure there is basically geared against cigarettes and in favour of bidis.
If the tax structure was changed, the government would make so much more money, and there would be a much bigger market for cigarette manufacturers.
In view of the health problems associated with your product, do you have any moral qualms managing your company?
No. I’ve been with this company for over 30 years, and I am as committed both to it and smoking as I ever was. However, I am equally committed to people’s right not to smoke; it’s a matter of personal choice.
I also think that smokers should show courtesy to non-smokers. Sometimes smokers aren’t considerate enough, stubbing their cigarette out on the street etc., but, by and large, I think smokers are a pretty decent lot who have had to put up with an enormous amount of pressure and vilification.
How do you stand on passive smoking?
Despite being extremely active, hugely well-resourced and networked, the anti-smoking lobby is obliged to admit that, after nearly 50 years of rhetoric and campaigning, a quarter of the world’s adult population still smoke.
Having failed with smokers, the anti-smoking brigade is now targeting non-smokers in order to get them to put pressure on the smokers.
So, the whole passive smoking issue grows. Certainly the vast majority of research on this subject has shown that the risk of passive smoking to a non-smoker, if it exists at all, is absolutely minimal, but the whole subject has been hyped-up massively.
But it’s not just hype; an increasing number of countries are banning smoking in public places.
One of the great failures of our industry is that the public has been massively hoodwinked on the passive smoking issue, and we’ve done too little to set the record straight.
The general public now has this picture that there is a nasty great beast called "Big Tobacco" which is always lobbying and seeking to unduly influence. It’s a load of nonsense.
We haven’t stepped up our lobbying. In fact, we have no problem with sensible regulation at all. Within the WHO framework convention, there are certain parts with which we fully agree.
We think there should be serious action to counteract illegal smuggling, counterfeiting, and children’s access to tobacco etc. So we are supportive of this, but we just think that governments and some non-governmental agencies go too far when they start to restrict individual choice.
So you would prefer voluntary agreements to reserve only a limited amount of space for smokers on their premises?
Yes, but please also remember that a high percentage of workplaces, pubs and restaurants already have a smoking policy, and it’s growing all the time. So that’s happening naturally by voluntary agreement and common sense, so why legislate?
The problem with governments world-wide is they’re trying to legislate on everything.
I think this is one of those areas where legislation is unnecessary. If you look at the Irish situation, pub revenues are seriously down, tourism has been affected, and there are big groups of people standing outside pubs smoking, surely that can’t be right — especially in winter.
So you’re only against total bans on public smoking?
Yes. I’m equally happy with a situation where a pub decides to be non-smoking, that’s fine, as long as they don’t have to be because it leaves customers with a choice.
Governments can’t keep limiting personal choice all the time. We see this in so many aspects of our lives today. It’s starting on food and has been going on with alcohol for a long time.
Sensible, moderate regulation we have no problem with at all, in fact we support it, and we never question the public health message to smokers. However, it’s when it goes to the extremes of public regulation where it is totally disproportional and unnecessary.
How about the debate on light cigarettes?
That’s one of the world’s great hypocrisies. I’ve been in this industry long enough to remember what has really happened.
In the 50s, and certainly in the 60s, when the whole smoking and health debate was starting to rage, the tobacco industry and governments worked very closely together. No one knew the scientific answers at the time, but governments worked on the basic principle that less must be best.
Therefore, all the manufacturers quite willingly pushed tar levels down because it seemed to be the right thing to do. You have to differentiate between a full flavour and a lower tar which then was called "low tar", and later "lights" or "mild".
Having complied with these government requests, the industry is being vilified by the anti-smoking lobby for saying that it misled the public. It is absolute nonsense and a total misrepresentation of historical fact.
Has EU legislation restricting the manufacture and export of cigarettes with over 10 mg of tar disrupted your production and could it force you outside Europe?
It hasn't been terribly disruptive because, if you look at our portfolio produced within Europe, most of our products are 10 mg or below, so it’s not a big issue for us.
Does Imperial Tobacco have sufficient critical mass to avoid being taken over ?
It’s not impossible, and you can never rule it out. There would be certain anti-trust aspects, but these are not insurmountable.
However, if anybody came for us, we would be hugely expensive; and I would be deeply insulted, if they were coming after us for cost leverage, because we think that we are the best cost managers in the industry.
From our point of view, our situation is clear. We exist for the benefit of our shareholders.
If someone came forward with a huge offer, which meant that they would get more value than my management team and I can generate for them, then we shall always act in their best interests. It’s a simple rule, but it makes life pretty straightforward.
Due to its corporate history, ITG didn’t start developing its international tobacco business until the 1990s. To what extent were world markets already claimed by your rivals, and did you come too late to the party?
Certainly, by the time we came to internationalise, Philip Morris, BAT and R.J. Reynolds were already very significant international companies. I wouldn’t say it was easy starting off in competition with those guys, but we’ve proved it’s possible.
We expand organically, using our low cost base to lever some break-through strategy, and also make acquisitions.
Will we ever be as big as BAT or Philip Morris? No, but profit is much more important to us than volume alone.
How much scope do you see for further international consolidation in your industry?
There are many conceivable combinations, but this industry is in the final phases of consolidation. There are four major international tobacco companies today, i.e., Japan Tobacco, BAT, Philip Morris and us. Will it ever be three? Who knows?
You wouldn’t include Reynolds in this list of major international companies?
Not really, because Reynolds is basically US-centric. In any case, BAT now owns 42 per cent of RJR American.
To what extent has geographical diversity diluted your margins, and in what time frame do you think you will be able to achieve UK-level returns abroad?
It is possible to achieve UK-type returns, and we already do so in some European countries, but there is no strict recipe.
Basically, we say that, when we make an acquisition, we expect to beat our weighted average cost of capital in the first full year of ownership; and we always have. Shortly afterwards, we expect to beat 10 per cent.
Now it just so happens that we’ve always got to 10 per cent post tax return within the second year without tying ourselves to that. But even if there is margin dilution, it is part of the strategic decision you’ve taken.
Margin is always important, but the thing to look at is not the absolute margin today, but the rate of growth. As long as margins are going upwards, you’re O.K.
Why is your core strategy aimed at strengthening your UK and western European business which are mature markets?
If I say to you, today country "x" in Europe is a 100 billion stick market and Imperial has a 1 per cent share in that market, and in five years time that market will be 85 billion and Imperial will have a 10 per cent share, then that’s big growth, which is why we’re very keen on western Europe.
How are new distribution channels such as e-commerce (duty-free online cigarette shops) affecting you?
I don’t think that e-sales will develop very much; I think they will be restricted by regulators. After all, duties are different in different countries; the e-selling aspect of cigarettes presents massive customs problems. Also youth access is a problem.
In what segments of your industry do you see the most promising trends and exciting innovations? Will kiosks be important?
I think kiosks will be very important. As countries become more affluent and mature, the number of distribution channels increases.
When I started in the industry over 30 years ago, I don’t think you could have bought a packet of cigarettes in a garage, but now it represents about 21 per cent of the German and 12 per cent of the UK market.
Tobacco creates tremendous customer footfall, and is therefore listed in many different sales channels.
There will be huge innovation in packaging because, if markets continue to go dark, the packaging is the only chance to display the product to the customer.
There will also be increases in the value-added of packaging, for example, re-sealable pouches for roll-your-own tobacco, as we’ve introduced with Drum.
Obviously, tar yields will continue to come down, and PREPS (Potentially Reduced Exposure Products) will continue to be developed.
Also the number of brands will contract, which doesn’t worry us, because Imperial Tobacco has been traditionally very good at getting complexity out of the business.
It’s not unusual in our experience to find that 80 per cent of the gross profit comes from 20 per cent of the portfolio, so you just have to kill slow-moving SKUs to make the business simpler.
This is also better for the factories, because they get longer runs, and for the sales force because they can concentrate on the winners.
It’s also better for the trade which doesn’t want slow-moving stuff on its shelves. To a lot of the tobacco industry that is a pretty alien thing to do because it’s an industry which has been characterised by SKU proliferation in the past.
What type of boss are you?
I try to include people, but again, I know what I want. I certainly do not believe in this concept of the celebrity CEO, so I don’t go in for a personality cult.
It’s like football really, you’re only as good as the team you play in, and you’re only as good as your last result.
The cumulative results over the last ten years have been great, but I’m old and experienced enough to know that people are pretty intolerant if that track record isn’t kept up.
I know where the door is, and I don’t have to do it, but I like doing it, and my enthusiasm hasn’t diminished at all either for the business or indeed for the product.
Related article in German: Interview by Mike Dawson & Gabriel von Pilar in Lebensmittel Zeitung, no. 40, 01.10.2004