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Executives

Alison Cooper - Chief Executive Officer

Bob Dyrbus - Finance Director

Oliver Tant - Chief Financial Officer

Iain Napier - Chairman

Analysts

Chris Wickham - Oriel Securities

Henry Davies - Merrill Lynch

James Bushnell - Exane

Chas Manso - Société Générale

Imperial Tobacco Group, Inc. (OTCQX:ITYBY) Q3 2014 Earnings Conference Call August 19, 2014 4:00 AM ET

Alison Cooper

Well, good morning ladies and gentlemen. I’m Alison Cooper, Chief Executive. I’m here with Finance Director, Bob Dyrbus and other members of the senior management team including Oliver Tant, who will be succeeding Bob as Finance Director later today, he looks right now anyway. It’s great to have someone of Oliver’s caliber on board to build on the huge contribution that Bob’s made over the last 25 years. Also in the audience is our Chairman, Iain Napier who, as you have seen, will be stepping down at our AGM in February and will be succeeded by Mark Williamson, who is also here today. On behalf of the Board I’d like to thank Iain for the service he has given the company over 13 years, the last seven as Chairman.

There’s a lot of ground to cover today so the presentation will take slightly longer than usual. And I’ll start by briefly reviewing 2013 and laying out my strategic priorities for 2014. We’ve made significant progress in the year, continuing to transition the business while the addressing the market headwinds. 2013 was a tough year for tobacco; after weaker results in the first half we said we’d improve our performance in the second half. We achieved that including improved results in the USA and Russia. We’ve realigned our footprint into growth markets and returns markets and now manage markets based on the strategic role they play, rather than their geographic proximity.

This new approach gives strategic clarity and enables us to better target resource and realize the potential of our footprint. In optimizing our portfolio, we’re enhancing our ability to deliver quality growth from our most important brands and products. We now classify these brands as growth brands and specialist brands and together they account for more than 50% of our tobacco net revenue. Each set of brands has its own distinct strengths, and we are prioritizing investment behind these brands to build sustainable quality growth. During the year, we increased the market share of our growth brands and grew revenues of our specialist brands by 5%.

We’re also making good progress with our standalone subsidiary, Fontem Ventures, which has acquired further eVapour assets and expertise from one of the pioneering e-cigarette companies and is gearing up to launch its own products in 2014. Portfolio optimization drives product cost and complexity reductions and this is a core component of our cost optimization program. The program delivered savings of £30 million in 2013 and will deliver savings of £300 million a year from September 2018. As I said, significant progress in the year and none of this could have been achieved without the support of our people. I know many of them will be watching the webcast, thank you all for your great work over the year.

Turning to the results, we’ve delivered a robust performance in a tough operating environment with our growth brands outperforming the market. Adjusted earnings per share grew 6% at constant currency with dividends per share up 10%. And we again bought back £500 million worth of shares. We achieved strong cash conversion of 86% including the impact of restructuring related cash outflows. Excluding these, cash conversion was 93% and we improved our return on invested capital to 15.1%. 2014 is an important transition year, building on our progress as we focus on strengthening our portfolio and footprint. We’re backing growth and building resilience.

Backing growth is about increasing investment in growth brands and markets and in our Fontem initiatives and we’re building resilience through our cost program and by implementing a stock optimization program to reduce trade inventories. This will improve our supply efficiency and the effectiveness of our portfolio, innovation, pricing and trade engagement initiatives. Our goal; a stronger portfolio, a stronger footprint and a stronger platform for sustainable quality growth. This slide will be familiar to you, one I first shared with you at our February Investor Day and it illustrates the transition journey that we’re on.

In the last few years, we’ve moved to putting the consumer at the centre of our business, developing a differentiated approach to understanding consumers and successfully applying these insights to grow our key strategic brands. As I mentioned, we’re now translating that focus to a broader group of brands across our footprint and refining our resource allocation so that these brands get the right level of support in the right markets to realize their growth potential. And this focus enables us to further optimize costs or strengthening our ability to deliver sustainable quality growth.

The changes we have made to the way we manage our portfolio and footprint mean we are changing the way we report, as we outlined in August. Our reporting now focuses on the performance of our growth and specialist brands and from a footprint perspective on the performance of our growth and returns markets. It’s important to understand how we measure our performance under our new operating structure and here we show the key performance metrics of our brand and market categories which you will be hearing more about later.

For our growth brands, we focus on quality growth hence we measure absolute volumes and net revenue and also focus on how the percentage of group volumes and group tobacco net revenues from these brands is developing. For our specialist brands, the focus is on value growth due to the varied nature of these brands and products, so we measure tobacco net revenue and the percentage of group tobacco net revenue from these brands. In terms of our markets, our focus in growth markets is share and revenue growth whilst ensuring the quality of that growth: hence we measure market shares and revenue and we also focus on growth brand volumes and the proportion of revenue in these markets generated by these brands.

We measure the performance of our returns markets with a focus on profitability and quality hence market share and net revenue per thousand stick equivalents alongside the proportion of revenue generated by growth brands. So, lots of theory, let’s get into the reality of the change. Our growth brands comprise the 10 brands that previously made up our key strategic and focus brands. They are high quality brands with strong consumer appeal and usually well established positions in key markets. We successfully developed a number of these brands into total tobacco offerings, providing consumers with both cigarettes and fine cut options and they are a focus of our sales growth activities, including innovation and brand pack pricing.

Our specialist brands reflect our unique total tobacco portfolio. They have strong positions in their own categories, appealing to specific consumer groups and they’re in an excellent position to capture growth from changing consumer preferences. They consist of heritage cigarette brands, traditional fine cut tobacco, papers, iconic cigars and a dynamic smokeless tobacco brand. The fantastic set of brands that are key to our quality growth agenda. The rest of our portfolio consists of brands that have the capacity to add to our revenue momentum; brands that can be delisted or that will add greater value by being migrated into the growth brands and we will be progressing a number of migrations in the coming year.

By focusing on our growth brands, we are strengthening our portfolio, supporting quality growth, volume, share and revenue. To give you a sense of some of the initiatives in the year: GlideTec has added to JPS growth in Portugal with its cigarette share climbing 90 basis points to 9.8%. JPS is also growing strongly in Italy, driven by focused customer engagement activities supporting a clear value opportunity for the consumer. And we are capitalizing on demand shifts to drive growth in slimmer formats across multiple markets. We’ve been successful with West Compact, our queen size variant in markets including Russia, Azerbaijan, Kyrgyzstan and Kazakhstan

Gauloises has grown its share in Germany through its additive free variant and there are new launches planned for 2014. Boudoir, the slimmest cigarette available on the market, has added to the growth of Davidoff in Russia and Ukraine. We launched P&S in a number of markets with particular success in Slovakia and Czech Republic. Growth brands outperformed the market with market share increasing 30 basis points. Net revenue increased 2% and we drove a further improvement in the quality of our volume and revenue with growth brands now accounting for 41% of group volumes and 39% of tobacco net revenues. JPS was the star performer, making gains in many markets in the EU and Australia.

Davidoff delivered some good in-market results but reported volumes were impacted by reduced shipments. Davidoff grew in Greece, Germany and Russia, while Gauloises Blondes generated good results in Algeria, Germany, Lebanon and Saudi Arabia and is performing particularly well in queen size and additive free. West made gains in Iraq, Kazakhstan, Taiwan and Turkey with queen size strong in Eastern Europe although price competition in Azerbaijan held back overall growth. We’re driving USA Gold to strengthen results in the USA and building quality volume in Vietnam with Bastos.

Our other growth brands, Lambert & Butler, Fine and News, together added to our volume, share and revenue development. We shifted our investment and initiatives focus behind these brands in our 2014 plans. It’s great to see them outperforming the market but they should also be growing in absolute terms going forward. There have been a number of key initiatives to drive growth in our specialist brands this year. We’ve launched Gitanes L’Esprit as an equity builder in the Middle East and it won the Gold Award in tobacco in the recent Penta worldwide packaging design awards.

We’ve continued to leverage consumer demand shifts toward slimmer formats in Russia with further growth in Style and driven growth in Cohiba through limited editions and smaller sized products. We’ve maintained our momentum in Swedish snus through new launches and redesigned packaging to further grow share in Sweden and Norway and launched modern roll-your-own variants of our heritage brands Drum and Golden Virginia with Drum Edge particularly successful in the Netherlands. We generated consistent growth in Backwoods volumes through the introduction of singles and doubles.

We have achieved an excellent performance from our specialist brand in difficult trading environments, growing net revenues by 5% with these brands currently representing 12% of our net revenues. In cigarettes, Style is performing well in Russia and Ukraine, and Gitanes delivering strong growth in Iraq. In fine cut tobacco and papers, contributions from Golden Virginia, Drum, Route 66 and Rizla in a number of markets continued to underpin our world leadership in these sectors. Our premium cigar portfolio, led by Cohiba, Montecristo and Romeo Y Julieta, performed particularly well in growth markets and through our growing mini range, we are further capitalizing on increased demand for smaller luxury cigars, while Backwoods in the USA delivered a strong performance.

Further strong revenue growth from Skruf contributing to another successful year for our dynamic snus business. While strengthening our core total tobacco portfolio, we’re also pursuing opportunities to broaden our portfolio of consumer experiences through our standalone subsidiary Fontem Ventures. Fontem is dedicated to developing a portfolio of innovative categories. Fontem’s immediate focus is to deliver eVapour offerings with high consumer relevance and will be launching its first products in 2014. Fontem completed the acquisition of eVapour assets from Dragonite International last month, one of the pioneers of e-cigarette technology. And we’re delighted that Hon Lik, the acknowledged inventor of the e-cigarette, has joined our team further enhancing our sector potential.

As you can see, 2014 is an important year in moving our portfolio strategy forward and we have clear initiatives and investment plans to further add to our quality of growth in 2014. Now let’s turn to our footprint. Starting with a reminder on the left hand side of our former sales structure, which is multi-layered, relatively complex where geography was the criteria of how markets were aligned. Moving to the right hand side, we’ve realigned our footprint into growth and returns markets to manage markets based on the strategic role they play, rather than their geographic proximity. To aid understanding of this year’s results, and as part of the transition to the new reporting structure, results on the former basis are provided in the appendix.

In addition, historic database on our new reporting structure is available in the appendix and on the IR Web site. Growth markets are characterized by large profit and/or volume pools. We tend to have shares below 15% and see considerable opportunities for share and profit growth over the long-term with our growth brands in these markets and we’ll be prioritizing investment to generate long-term returns. Our growth markets include the USA, Italy, Russia and selected markets in Eastern Europe, Asia and the Middle East. In returns markets, we have an established presence and a relatively high share, mostly above 15%. Volumes in these markets are typically in decline and where relevant we’ll be reducing portfolio complexity, including through migration.

Our objective in these markets is to build on our strong position to maximize returns over the long-term by growing profits, whilst actively managing our share. Our returns markets are split into two divisions and include a number of our larger profit pools including Australia, Germany, Spain and UK. This new approach across brands and markets enables us to better target resource, improves the effectiveness of our sales growth drivers and enhances the collaboration across markets with similar agendas to drive higher quality sustainable sales growth. An example, take Germany and Italy, both are in the EU region, both are mature but we have a 25 share in Germany and a 3 share in Italy. Irrespective of them both being in Europe, how you manage them is very different.

Germany is about driving profit while managing our share position through leveraging our total tobacco portfolio, with investment decisions made with a medium term view. Markets with similar dynamics which our German team benefit from closer collaboration, include Australia and Poland. By contrast, Italy with a 3 share is focused on driving scale and investing for the long-term and has a smaller and more focused brand portfolio to drive scale. In terms of sharing ideas and collaboration, Italy has much more to learn from, and share with, markets like Russia and Turkey than it does Germany, despite their geographic proximity.

Remember our focus in growth markets is share and revenue growth, whilst ensuring the quality of that growth. Our share in growth markets was slightly down at 5.8% impacted by significant market declines in Russia. Excluding Russia, our share grew 5% per cent. We grew net revenues by 2% and profits were up 7%and we’ve maintained the quality of our business with the revenue contribution from growth brands increasing to 37%, although overall growth brand volumes declined impacted by changes in trade stock levels, the weak Russian market and price competition impacting West in Azerbaijan.

We’ve made good progress across our growth markets. In June, we strengthened our portfolio in Italy by re-launching JPS cigarettes and fine cut tobacco brands and by September JPS had already captured 1% of the cigarette market. In Turkey, our new route to market strategy, focused on targeting major cities, continues to strengthen our position and we grew our cigarette share from 3.7% to 4.5%, driven by gains from Davidoff and West. And Davidoff and West were also key to driving share and volume gains in Kazakhstan with Saudi Arabia benefitting from growth in Gauloises. We made excellent progress in a broad spread of other growth markets including Cambodia, Greece, Scandinavia, and Taiwan.

Our successes have also been about achieving a turnaround in the USA and addressing market challenges in Russia. The USA is a highly attractive market and I’m encouraged by the recent results we’re delivering, where our focus on pricing and customer engagement has driven a stronger performance in the second half, reflective of our new strategy delivering. Our new management team re-engineered our business towards the end of 2012, applying a state-by-state model. We’ve reorganized the sales force, implemented new pricing strategies and in the second half of 2013 focused on strengthening our key account relationships.

There’s plenty more to do but the drive of our U.S. team improved the quality of our cigarette business with our cigarette share increasing 20 basis points in focus states and in key accounts. And in cigar, we delivered a stronger second half performance in premium cigars and with Backwoods. Overall, we significantly improved profit delivery in the second half in the USA, providing a strong platform for us to build on in 2014. In Russia, industry volumes have been under pressure following excise and regulatory developments, with a greater impact to the bottom end of the market, which has had a disproportionate effect on our value portfolio.

We have invested ahead of regulatory changes and have been actively managing our portfolio to strengthen our position in the high price and value segments. We grew Davidoff and Style volumes in modern formats and improved West volumes in the second half through targeted investment in new launches such as West Compact. We also improved the performance of Maxim in the second half as we expanded our portfolio into 25 packs, queen size and a Premium Line variant. Overall we grew Davidoff and Style volumes, grew Maxim’s share in the final quarter and significantly improved profit delivery in the second half in Russia, again a strong platform for us to build on in 2014.

Given its size, and in line with our management structures, we break down the results of returns markets into North and South. The names are based on the prevailing geographic make-up of each sub-region but that’s not the only driver of which market is allocated to which for example Australia is in North region which for us, has similar characteristics to markets such as the UK and Germany and that’s mature, specific tax biased and multi-channel distribution. Returns markets South include a number of former state monopolies, often with narrower distribution channels and a greater element of ad-valorem taxation, includes France, Spain and Morocco. A list of key markets in each of our new divisions is provided in the appendices.

As I said earlier, we measure the performance of our returns markets with a focus on profitability and quality. We balance share, volume and profit growth in returns markets and while our market share declined slightly to 27.3%, it was impacted by significant industry volume declines in large markets where our share over indexes, such as Spain and the UK. We grew net sales per thousand stick equivalents by 6% and improved the quality of our business with growth brands generating 40% of tobacco net revenue, up by 200 basis points on last year. In returns markets North, against a difficult operating environment in a number of markets we delivered good results, with net revenues per thousand stick equivalents increasing 10% and adjusted operating profit up 3%.

We achieved excellent results in Germany, increasing our cigarette and fine cut tobacco shares as well as growing revenue and profits. Our success was driven by our total tobacco approach which delivered further gains from Davidoff, Gauloises Blondes and JPS, supported by Route 66. In the UK, industry volumes weakened but pricing was strong, enabling us to maintain profit delivery. We also increased our cigarette share and launched portfolio initiatives including new L&B packs and a rejuvenation of the Golden Virginia brand family to reinforce its market leading position. We delivered good results in Australia, which has been in an environment of plain packaging for most of the year. JPS was the key driver of our cigarette and fine cut tobacco share growth and we have capitalized on the brand’s strong equity and leveraged our customer engagement expertise to outperform the market.

These good performances mitigated weakness in France, Morocco and Spain. Trading has continued to be particularly difficult in Spain and as a result we’ve taken a further non-cash impairment charge of £580 million. In France, the rate of market decline accelerated in the second half impacting our results. And in Morocco, regulatory changes and liberalization of the market have had a detrimental effect on market volumes, our share and profitability. We’re actively addressing our performance in these key territories. In Spain, our total tobacco focus has generated encouraging gains for us to build on in the coming year, particularly in make-your-own with JPS and Ducados Rubio and with Nobel.

We’re also making clear portfolio choices in France and we delivered some robust performances including stabilizing Gauloises Blondes and further building News, which gained share in fine cut tobacco. We’ve got more to do in Morocco to continue to secure our market leading position and it’s a priority for 2014. We’ll be building on Gauloises Blondes growth in the queen size segment and implementing portfolio and sales growth driver initiatives to improve performance. Elsewhere we delivered excellent results in Algeria, increasing share and profit, and also made good progress in Austria, Hungary, Portugal and Senegal.

Our logistics business is one of the largest in Europe with a unique network that’s difficult to replicate and has consistently delivered a robust performance in challenging economic conditions. Against a backdrop of weak industry tobacco volumes impacting Logista’s key markets, distribution fees were £850 million and adjusted operating profit was £176 million. Excluding the impact of the stock loss from the timing of the VAT increase in Italy, operating profit increased by 2%. The pleasing results are one that reflects both the expertise of the logistics management team and their diligent focus on managing costs. The team has proactively adapted to the impact of lower market volumes through increasing the variability of cost, to drive margins 50 basis points higher to 20.7% and has initiatives in place to offset the weak macro-environment, including continuing to expand its non-tobacco activities.

I’ve said 2014 is an important year of transition for the business. This is the next key and final stage on our transition journey and it’s a big agenda. We will provide update each quarter tracking our progress. Our plans for 2014 reflect our improved resource allocation with a step-up in investment behind our growth markets. Our plans also incorporate our portfolio priorities both investments but also SKU reductions and the first wave of migrations. Our portfolio agenda is key to our cost optimization program and in 2014 we will be further realizing the benefit of complexity reduction, improved factory performance via our operational excellence program and capacity optimization across our footprint and further benefits from global procurement.

And in tandem, we will be implementing a stock optimization program supporting the effectiveness of all these initiatives. Turning to reminder of our priorities for 2014, our transition achievements and stronger second half performance provided good foundation for the journey ahead and my priority for 2014 is to continue that transition. This is the big agenda and it’s great to have added to our senior executive team with Oliver succeeding Bob and Peter Corijn joining us as Group Marketing Director. In addition, we have made a number of important hires across the business including in marketing, sales, supply chain and in Fontem. Our assumption is that market conditions remain tough and likely to continue in the short term with our 2014 plans assuming no recovery.

We remain focused on maximizing our long-term growth potential. Our priority is to continue to transition the business, step-up investment behind our key brands and markets to drive quality growth and to deliver our cost and stock optimization programs. Therefore a reasonable working assumption for 2014 is modest growth in EPS at constant currency with another strong dividend increase of at least 10%. This provides us with the flexibility to invest; to reduce trade stock levels and to be able to manage market headwinds. And for the first quarter, against a relatively strong comparator, we expect headline volume and revenues to be impacted by our stock optimization program with underlying numbers a better reflection performance of the business; a big agenda, an important agenda, but one where our actions over the coming year will provide us with a strong platform for growth in 2015 and beyond.

I would now like to handover to the veteran of investor presentations accounting 34 plus eight acquisitions, that makes it over 40 and I'll hand it over to Bob for his favorite task for the last time.

Bob Dyrbus

Thanks, Alison and good morning everyone. This table shows a break-down of the year-on-year movements between foreign exchange growth and constant currency growth and I’ll be focusing on constant currency adjusted numbers for all of my comments.

Results have been adjusted and presented on our usual basis, with details in the appendices. Tobacco net revenues were down just 1% with positive price mix of over 6% offsetting volume declines. Tobacco adjusted operating profits increased 1% with a good performance in the second half and Logistics adjusted operating profits declined 2%. After tax at an effective rate of 22%, earnings per share grew by 6%. We continue to invest in the business, with overall investment levels higher than last year, to drive long-term growth, whilst generating high returns with return on invested capital of over 15%.

Against the backdrop of a difficult operating environment in a number of markets, our growth markets performed well with revenues higher and adjusted operating profits increasing 7% and margins climbing 70 basis points to 29.6%. There were strong results in a number of markets including Russia, Saudi Arabia, Taiwan and Turkey.

Profits in the USA were higher than last year, following a strong recovery in the second half. Profits in Iraq declined following the impact of movements in trade stock levels in the third quarter and Italy was impacted by market size declines though we exited the year in a stronger position. In light of difficult trading conditions in Returns Markets South, overall Returns Markets produced a robust result with adjusted operating profits declining just 1% and margins maintained at 49%.

Returns Markets North grew profits by 3%, with margins increasing a 130 basis points. We generated good profit growth in Germany and Australia, with profits stable in the division’s other major markets. France, Morocco and Spain have been difficult this year with a consequent impact on the sub-divisions revenue, profit and margin.

Effectively managing our costs is one of the key strategic pillars of our business supporting our long-term growth agenda. Our cost optimization program is on track to deliver £300 million of savings a year from September 2018, driven by savings in product costs and refinements to our operating model.

This year we generated savings of £30 million, all in the second half, driven primarily by savings in overheads, including a 1,500 headcount reduction, and the benefits of rolling out operational excellence initiatives in our factories. Cash outflows for the program were approximately £100 million and the P&L charge impacting reported numbers was £225 million. In 2014, we currently expect to deliver incremental savings of around £60 million, with cash outflows of around £150 million.

Given the further deterioration of the Spanish tobacco market, we’ve taken a conservative view of Spain. Meaning under IFRS the value of goodwill and brands previously allocated to Spain has been reduced by £580 million, following a reduction of £1.2 billion last year. This is a non-cash item, an accounting requirement that’s been excluded from our adjusted results, in line with our normal policy and, as last year, it does not impact the overall returns we expected from the Altadis acquisition.

In February, we raised £1.4 billion in the U.S. bond market, refinancing maturities due last month and later this month. Our average all-in cost of debt improved to 5.1%. 5% is our current guidance for 2014 and we currently estimate our average net debt for the year will be around £10.3 billion at the year-end exchange rates.

The net interest charge declined 2% in constant currency terms and our adjusted tax rate should remain around 22%. Our closing adjusted net debt for the year was £9.1 billion. Working capital followed its normal pattern with a significant outflow in the first half, followed by a material inflow in the second half, resulting in a net outflow for the year of £100 million.

Net capital expenditure was £300 million and is expected to be at the similar level next year, reflecting the ongoing investment in capacity to meet demand in growth segments and to continue building our innovation pipeline. Tax and interest was £1.2 billion, £300 million higher than last year, as we settled some outstanding tax matters with a cash outflow of £200 million, which last year allowed us to write back provisions we have taken in previous years. Dividends and buybacks were £1.6 billion, as we increased dividends in line with our stated policy and the impact of foreign exchange on net debt was £300 million negative. Excluding this and the one-off payments to settle outstanding tax matters, net debt declined £200 million. The appendices contain further details on our debt maturities.

We drive our business to maximize shareholder returns. Since Alison became Chief Executive in 2010, we’ve more than doubled annual cash return to the shareholders to £1.6 billion by growing dividends and through our ongoing share buy-back program. We’ll continue to drive organic growth and aside from buyback, there are still a number of M&A opportunities available for us to create value and drive even higher returns in the future.

And I'll indulge myself and if I look back further to where we were when I became Finance Director of the Group in ‘96, annual cash returns to shareholders have multiplied by 14 times and over that time we have also returned £9.5 billion to shareholders.

I’m leaving Imperial in an excellent position to drive growth over the long-term. We make strong returns against our invested capital and we’re investing in 2014 to make the business stronger in 2015 and beyond. And as I look forward at the growth coming through, dividends will continue growing ahead of growth in EPS and by at least 10% per annum and shareholders can look forward to many more years of strong returns.

It’s been a pleasure to have served Imperial for the past 25 years. At the end of today, I am passing the baton to Oliver. I wish him and everyone else at Imperial all the very best. Thank you.

We’ll now take any questions you may have. The presentation is being recorded. So please wait for a microphone and give your name and organization before asking your question.

Question-and-Answer Session

Chris Wickham - Oriel Securities

Just a couple of questions. It’s Chris Wickham from Oriel Securities. I was wondering perhaps if you go into the new basis, if you could talk a bit more about just the market share movements in Q3 and Q4 that you had in those three regions. Obviously you are growing share in growth ex-Russia across the year as a whole and you're losing interest to small amount of share in the other two regions. But I was wondering perhaps if you give us a bit more detail on the second half? And then the other one, I was just wondering perhaps to touch on Bob’s last point about sustainable 10% dividend growth. Obviously over the long-term, you wouldn’t want dividend growth to be out of line with your expectations on EPS growth. So should we be expecting or should we be assuming that over the longer term, the business will be brought back to being managed to get sustainable 10% growth in EPS?

Alison Cooper

I'll pick up on the market share point issue and then maybe come on the EPS before Bob can take it from a dividend growth point. There has definitely been improving trends in a number of our markets. If I look through the second half, clearly you are aware of the big swings around our second half numbers related to the USA and Russia which I went in some detail in the presentation, but I would say across our markets we are seeing improving trends in a number of markets in the second half, building on some of those very much there in the first half we are doing on the portfolio front with our price initiatives, innovation and customer engagement, it is absolutely key to that and that underpins all of the things we are doing in all of our markets taking the quality growth agenda forward.

If I look at earnings per share growth, our guidance for ‘14 is modest EPS growth but that’s really around strengthening our opportunity to grow EPS from 2015 onwards. So, that will align much more closely to our ambitions around our dividend growth although as you will appreciate, our overall guidance range for the EPS growth is between 6% and 10%. So we'll back in range as we go into 2015 and beyond. Do you want to comment on the dividend sustainability, Bob?

Bob Dyrbus

We have modeled numbers now. Essentially in terms of our payout ratio, there is still scope for the payout ratio to increase significantly, so I can see dividends increasing by at least 10% a year for many years.

Unidentified Analyst

Couple of questions. First of all obviously the price mix in the fourth quarter was very strong. Is that going to sort of flow into the first quarter and indeed beyond? Because from the comments you are making around the first quarter, you seem to indicate quite a weak sales performance and therefore related to that, how big is the potential reduction in trade inventories that you mentioned? Because I think concerning the Q3 stage this year, it already differentiated between a 7% decline and a 5% underlying decline on the basis of some trade de-load [ph]. So it seems to be another round. And then secondly on the new divisional, do we get the names of the heads of the new divisions? So is there a head of Growth and head of Returns Market. And then very lastly, apologies for the list here; the comments about the Fontem business, when you said that is non-tobacco, does that mean you are looking purely at e-cigarettes no heat, no burn?

Alison Cooper

I will take couple of those. I mean first of all price mix. Price mix has been very strong in the back end of the year. If we look into our plans for 2014, we still expect reasonably strong price mix coming through but we’re probably planning at the moment they [indiscernible] into 2014. They're not as strong as '13. Clearly a lot of that is embedded into the first quarter. So I think it’s important for the first quarter to really focus on what the underlying businesses do, which will give you visibility of and that will clearly help our overall sales delivery in the first quarter.

The de-stock -- we'll be very transparent around the impacts of that as we adjust and show you the underlying performance of the business. We do see a number of opportunities as we optimize the portfolio, as we look at migrations, but also just due some of the market structures, Russia, the route to market is changing quite significantly.

I mean Iraq is probably one of our biggest impact areas because we significantly restructured our route to market in Iraq. So if it used to be a several months long, it's now a few weeks long effectively. So it’s those sort of moves as we restructure it to market and get more efficient how we do with the trade because of those opportunities and actually it’s a really good result, because it means we can get our portfolio initiatives into the market quicker, being more reactive in terms of the consumer and actually helps our with the trade as well and building stronger and better businesses with them. So we'll give you the transparency on that, but I think the key things to focus on how the underlying policy of the businesses developing in 2014.

On the divisional structure, we aggregated for the external portion to make it a bit simpler, but we have five divisions which I also went through at the Investor Day. We have two profit divisions, two returns divisions and those are headed up by Titus Wouda Kuipers. Again you saw him at the Investor Day talking about JPS performance which is key in that region. Dominic Brisby, who I think many of you have met before, who used to run Spain runs the Returns South division. Then you’ve got our three growth divisions. One is headed by Amal Pramanik. Again you have met have met him before as the GM of the UK. Then Roberto Ascoli, who joined us a couple of years ago running Asia is now looking at the other growth markets and we have Kevin Freudenthal again, who you saw at the Investor Day who runs the USA division. So USA this is three subsets effectively of the growth division. The final question was on Fontem. On the non-tobacco focus, yes, the focus is on the e-vapor currently. It’s not on heat-not-burn products. I think [indiscernible].

Unidentified Analyst

A few questions from me please. Firstly I think heard you right in saying that fiscal ’14 was going to be last year or the final year of this investment phase. As I guess -- I just want to make sure I heard that right and really that you will be very surprised if you’ve [indiscernible] in the years' time and said we’ve got another year of sub-optimum growth? So that’s question one.

Question two is about the growth -- or the difficulties in the markets that you’ve seen in the last year and your expectation that that will continue. And first of all in the UK we’ve had in the last quarter, we’ve had the best GDP growth for many years. And I don’t really understand the disconnect between the market and the GDP. It is very strange to me. Does it mean to say that actually tobacco was structurally like this, but do we still think the decline is a cyclical decline? And then related to that question is if actually the market does pick-up in fiscal ’14, what would that do to your numbers? And then while I got this long list of questions?

Alison Cooper

You will have more than three, it was more to digest this time.

Unidentified Analyst

Okay, I’ll [indiscernible]. If you can just to answer those two, okay.

Alison Cooper

And I think it’s important, it’s final stage not final year. Because what we’re doing with the portfolio around the transition is very much going to kick off this year but will continue through on a couple of years to come. So we’ve gotten 12 migration plans for this year. And as we build on to get the learnings from those, there will be more for example into the out years.

So it’s a final phase and if you go back to that transition journey’s chart, I showed on the Investor Day, this is the final phase of the journey. We’ve done a lot of ground work in 2013, we’ve realized the footprint which I take it internally everyone is really excited about. It’s got real traction and focus internally and the divisional direction of the teams, the clarity they have, the collaboration this is driving is really excellent for the business and is already yielding some of the benefits you can see. They're probably towards the backend of the year but it’s coming through into the plans absolutely for 2014.

But on the portfolio side, we have got a journey to go through here. We have got the building blocks in place that we put in place 2013 that initiatives behind those growth brands, behind those specialist brands but we clearly want to move forward from the 50% of net revenue we have in those brands to further strengthen the business and increase that percentage of the business. So, yes, it’s a critical year it’s a final stage but some of that will continue into the years beyond. Around our guidance though, this modest earnings growth is for the current year and we see given the investment, given the stock program we do see that really bouncing back in terms of 2015 with stronger performance in ‘15.

On the economic environment, I noticed everything coming out of recession apparently. I think there is a lag when it comes to tobacco but I also think from our perspective and looking at what we have managed in Imperial over the last 12 months, to build plans on more optimistic assumptions at this point in time would not be sensible.

So we built our plans on a continuation of the current trends. If we see improvement in certain areas then there maybe opportunities for us to either further invest or for us to have some upside on that. But at the moment, I think it would be not sensible for me to plan on that basis until it is little bit more than the one quarter of everything popping out of recession.

Unidentified Analyst

Can I ask a quick follow-up question with that? Do you believe that actually underlying market trends will improve in the next couple of years?

Alison Cooper

Well, if you look at the decline rates we had had over the last year, I don’t think those decline rates will persist and I think we will start moderating in terms of those decline rates going forward; but I wouldn’t want to call that just yet. And you got to realize that some of the EU markets, we're definitely seeing that stabilizing. Outside of the EU we still got markets like Russia at the moment where the decline trends, assuming further valuation, Ukraine is not looking good currently for example. So, EU I think you potentially call the decline rate is only stabilizing when it will start decelerating, I think we just need to watch that currently but as far as the EU, I think there is some markets where there is still some chance.

Henry Davies - Merrill Lynch

Henry Davies from Merrill Lynch. I have a question on the second half profit delivery. There is a pretty significant swing in your margin performance. In the first half, your margins were down a lot; in the second half they were significantly -- that’s been driven in particular by the U.S., rest of EU and rest of world. I'm just wondering if you could give some color on what’s behind that. And then a similar question for price mix where on my numbers it was plus 9% in the fourth quarter and I guess the reason I'm asking this is if we work off the second half base, we get to much more than modest EPS growth next year. So I'm just wondering whether there is some temporary cost cutting measures in there? And maybe just a clarification of modest EPS growth, if we assume 2 to 3 low single-digit, is that kind of what you are communicating?

Alison Cooper

Bob, do you want to pick up on the margins in H2?

Bob Dyrbus

I will, yes, and in terms of H2 margins, effectively we have had the benefits of pricing coming through. In terms of where we were first half for example, you mentioned that but coming through, we were effectively absorbing exercise in the first half. In the second half we took pricing. So it’s basically benefits of price increases. Again year-on-year, the first half we had a significant step-up of investments that was pulling margins back in terms of comparison for Russia in particular compared to previous year and the U.S. whereas in the second half there wasn’t that step-up of investment that you like putting a relative reduction in cost there.

Obviously I also mentioned the benefit of the cost program, the £30 million of savings as it comes through from operational efficiencies, quite a lot of that will pull-through as well into inter-product cost as well and so that’s where the product is sold rather than potentially where the cost saving actually takes place or which actually takes places if it’s coming from operational efficiencies. And it’s basically those things just where we were second half, first half with U.S. particularly strong performance in U.S.

Henry Davies - Merrill Lynch

Maybe another way of asking the question; historically the last four, five years your second half margins came roughly in line with your first half. This year I don’t have the numbers in front of me but it was significantly higher and if we continue that into next year, you are going to get to very significant margin expansion.

Bob Dyrbus

I think there will be margin expansion but I don’t think you can just extrapolate it because I think there are things -- the timings of place increases in the various markets, and again Germany being a big one actually does change things but you effectively lack that in terms of where things are.

Alison Cooper

Yes, Bob said the key drivers for the second half. We have got the cost program coming through and there was a skewed investment last year as well, which we highlighted in the first half and that's particularly Russia and U.S. where there was a higher investment setup in the first half than there was in second half. You can see that coming through on the profit delivery in the second half.

If you want to modeling from H2 through to the full year, I think we’ve highlighted the key things that are going drive 2014 numbers. So we are stacking up investments given the clarity now and the detailed planning we have around what we want to do with the transition in ’14 on the portfolio and the footprint. So that step up is in there. The impacts are taking stock out system but then partly some of that is compensated with the fact they’ve got cost optimization coming through next year. So those are the key drivers that lead us to the modest EPS growth. Your point around is that 2% to 3% is less than 6%. Otherwise we’d have stayed within the model and it’s more than notes otherwise we’d have two, we wouldn’t have told you it was growth. So I think it is reasonable.

Henry Davies - Merrill Lynch

Just back on the margins maybe just Americas I think that the swing between the first half contraction and the second half of expansion was like 10 percentage points.

Alison Cooper

That would be the case because as Bob talked about, the pricing investment we put into the states, we lapped in the -- that was the first half of this year. For the second half then you can have a much more like-for-like comparison basically.

Henry Davies - Merrill Lynch

And that would lead to kind of flattish margins. I think if I remember the numbers, it was up something 500 bps.

Alison Cooper

You’ve got pricing coming through as well in the market…

Matt Phillips

We actually had pricing effect, the investment in price -- towards the very end of the period. We actually we could start taking market pricing again because we repositioned the brands. So you’ve got some of that and there was also a significant and Kevin did a significant restructure the sale force which took effect from April. So that was impacting second half as well.

Alison Cooper

Yes. So let’s not confuse the price, when it was an investment to get differentials right. Now we’ve got the differentials right, we’re very happy to move price up as long as we can maintain these differentials. Martin?

Unidentified Analyst

I have really two completely different questions. The first one just flows out of Henry’s question. So I guess a sharp way of looking at the guidance is do you expect to grow sales and operating profit? Do you expect to grow them in constant currencies in FY ’14? In other words, can you read modest as a comment on the operating line or just a comment on the earnings line?

Second question is completely different, maybe Matthew wants to comment, but just e-cigarette regulation, how do you feel about the tobacco products directive and what seems to me to be relatively sort of benign view of the e-cigarettes but then is the fact we seem to have this conflict with that the MHRA is saying in the UK and just really value your commentary on how you think that’s going to play out?

Alison Cooper

Okay. I will flag off that one for Matt to pick up on the second. You have a mic on that please. On the modest EPS growth, you are aware of the various drivers of our EPS growth. So yes we’ve got sales cost and we’ve got impact with interest in tax and then you’ve got the buyback overlay. So I think if you look at the various components of that model that will lead you to a conclusion on operating profit.

On the sales line we do expect to see underlying growth in our sales next year. Again we'll transparent about the impact of any stock impacts on that, but the underlying sales we see progressing, given the price that we anticipate and the actions with our portfolio next year. Now just pick-up on e-cig regulation.

Matt Phillips

Yes. I think it’s going to be an interesting few months because the EU is split within itself about how to regulate e-cigarettes. We’ve got a trial-on process that's running now and which is going to come to a conclusion we think some time before the end of this year and e-cigarettes is very much part of that debate and you’ve got the parliament on one side, who want e-cigarettes regulated effectively as a lifestyle consumer goods product, you’ve got the council on the other side. They were looking for pharmaceutical regulation. And I think it’s difficult to call which way that will go and my gut feel is that it would go more towards the lifestyle side than the pharmaceutical side.

But I think if you sort of stand back from regulation, I think we’re going to end up with a basket case globally and some countries are going to be pharmaceutical minded, other countries are pharmaceutical minded. Other countries have banned e-cigarettes as you know and other countries will stick with the lifestyle approach which is why from a consumer perspective we feel it's important for our portfolio to be aligned in both of those directions, to be able to actually have a pharmaceutical offering, as well as having lifestyle offering as the consumers are different, the branding, the insights are different for those two accounts is very much how we're thinking about it.

James Bushnell - Exane

James Bushnell here from Exane, two questions please. Firstly on e-cigarettes. I think Alison, you were on the wire this morning saying you will be launching two products next year. But just interested as to whether those are products you were developing before the acquisition of Dragonite, or whether one or both of those was linked to that acquisition? And then anything you can say about what those products might look like? And then secondly on the U.S., you seem to be reasonably happy with how things are going. I know you’ve never said anything to the contrary but to this minute, you are definitely retaining it for the mid to long term.

Alison Cooper

On the integration I think Matt alluded to it in his own, on the regulatory point in that we have two aspects that we are looking at because we're doing this from a consumer perspective. And one, we very much see a lifestyle opportunity. It’s a project we have been working on for some time and we will unveil it when we will unveil it. So I'm not going to give you any initial spirit lifting on that one I am afraid.

On the -- the other track is much more around the pharmaceutical route. It’s also an area that we have been reactive about looking to get into but actually the Dragonite acquisition, the IP from that and the knowhow we've got there is adding to our capability in that area. So it’s building on a project that was already existing but clearly with Hon Lik on board as well, we have got some great knowhow in that area to take forward. And also making sure that we kill any products like electric dreams [ph] out in the market as well, which I have mentioned doesn’t fit.

So we have got a lot going on in this area. Those two products will be launched next year but we will give you more information when we actually go to market with them but they are very different consumer propositions and it is important to cover off those two different aspects in terms of the opportunity in the market. On the USA, yes, we are very pleased with the way the USA business is performing and I will make a comment as [Technical Difficulty] as is any other asset that we hold. So, I will put it in that basket as a separate consideration.

Chas Manso - Société Générale

Yes, Chas Manso from Société Générale. On next year’s investment step-up, is it reasonable to assume that it’s the same order of magnitude of step up as the last one that we have just been through and could you give us some more color if possible on what the new increment investment spend has actually been spent on? And on the new sub-markets, the leakage seems to be mostly coming from Returns South. Do you expect that rate of leakage to continue? What can be done? What is being done to try and stem that leakage? And if I can squeeze in the third one, Russia, could you give us sort of update on the portfolio realignment outputs? Thank you.

Alison Cooper

Okay, I'll start with the investment step-up and I will also just give a heads up in Returns South offer [ph] could you comment on and I will pick up on the Russian portfolio as well. The investment step-up really is focused on the reclassification that we have taken you through. So the investment step-up is in the growth markets and is in two or three specific markets where we see real opportunities to build the momentum we have and take our performance forward in 2014. I'm not going to be particularly explicit about them just because clearly it’s competitively sensitive, but it is on two or three key markets. It is very focused, very measured and very, very, very targeted around where we see those growth opportunities. So it’s not just let’s generally increase investment in growth markets. It's two or three key markets.

Again with the growth brands, incredibly detailed planning going behind the initiatives that fit within the markets behind those growth brands next year and it’s broadly aligned with the growth markets as well where we're stepping up investment behind those. So, it’s very much joined up around how we're taking that forward but again it’s the key brands in the portfolio that we see making the difference in those growth markets. So it is brands like West, its brands like Davidoff, its brands like JPS where we're stepping up our investment behind and also some investment behind those migrations. Migrations without risk, we need to manage that. We need to make sure we put the right consumer focus behind those to make sure those are successful as well. Of the comments on Returns South and some more challenges there and what we are doing about…

Bob Dyrbus

Yes, Returns South, the issues that were faced in 2013 are specifically with regard to France. In France, we have done a lot of work to now have been able to stabilize our Gauloises Blondes market performance. We have a more work to do on the rest of the portfolio and that is very much the focus for 2014 specifically with News and potentially with one or two other brands, I believe that we can support two, maybe three brands and focus on those brands in the French market.

In Spain, Spain obviously we have commented on them on the number of occasions. In Spain, we have in 2012 an actual stabilization to small improvement in our Blondes’ market share. We have not been able to hold that in 2013. We believe there is more work that needs to be done on the portfolio and if you think about the portfolio in Spain that is very much local brands with Ducados Rubio, with the Fortuna brands and both those brands we have a lot more work to do to be able to strengthen the brand equity, having already price positioned them in the right way to take things forward and that will be the focus for 2014.

In Morocco, there has been a number of things actually impacting the market performance. That’s a third key market for division profit south that has been asked for in Morocco. We have a number of things coming together, both macroeconomic environment as well as excise changes and pricing regulation as well as listed to trade impacting the business in Morocco. We are very focused on strengthening our portfolio in Morocco. We have a very significant brand called Marquises and it holds a significant market share. That brand is at the bottom end of the pricing ladder and is impacted severely by some of these pricing regulations as well as illicit trade and therefore our focus is on addressing that with both portfolio initiatives as well as with the illicit trade initiatives into 2014.

And there was a third question with regard to Russia. In Russia as have been presented, we're making very -- we continue to make very good progress on the top end of our portfolio both with West, with Davidoff and with Style, and we continue to see very good performance, continued strong performance where we’ve had a specific issue in 2013 first half that we have been able to address in the second half and particularly more in quarter four is at the value side of the price ladder with Maxim brand as well as with Balkan Star, two brands that make up a very significant part of our business in Russia and where we have been facing very significant competition, price competition, price drift in the competition, as in competitors repositioning brands and as a result we’ve had in the first half some market share loss, which now we’ve been able to address with the Spain's [ph] words BPPC options that we put into the markets. So brand pack price for channel options on the Maxim brand with [indiscernible] with Queen Size with premium line which is giving us very much confidence in the fourth quarter about being able to address this price repositioning by seeing our market share keeping going up and we have a lot more in the pipeline to sustain that into 2014.

Unidentified Analyst

Really I was trying to look for a little bit more sort of actual numbers or expectations. I guess following Chas' you’re not going to give us more detail on the AMP [ph] step up, but can you specify at all what we should expect from this de-stocking in fiscal '14, how we should quantify some of it?

Also just again quantifying the cost savings, am I right to think, look we’ve got £30 million in the second half of fiscal ’13. So we should double that, annualize that for fiscal ’14, so it can be 60 and then add something to that. So how should we think about, if you can be a little bit more precise about that?

And also can you quantify what actually happened in Morocco? Can you say I mean what is the market -- what happened to the market size, what happened to the market share. And as you are just talking about this now, should we expect there is a full year effect in fiscal ’14? Thank you.

Alison Cooper

In this session, I'm not going to go into a detailed modeling session. I will have some conversation [indiscernible] modeling session on the modest EPS growth which gives us the flexibility to invest. It gives the flexibility where we see opportunities to take stock out of the system. And you are right, the cost savings are going to roll off into next year. So that’s part of the mitigating impact on that. And within the numbers that you are seeing, yes there will be a full effect of Morocco coming through next year. But overall four our Returns Markets South next year, we do expect an improved performance from where we are sitting under the 8% profit decline you’ve seen in the current year through the actions we’re taking in these various markets. But the market decline impacts in Morocco will absolutely hit next year. But we’re looking to mitigate that through the actions we’re taking and in across the Returns division South in its entirety looking at how we manage that overall piece, because that is really where almost challenging economic and tobacco industry environment existing issue is sitting at the moment.

Unidentified Analyst

In the past, you have given market share -- annual market share. Are you able to do that for Morocco, and I can’t see any market share data in the [indiscernible].

Alison Cooper

Market share is come off in Morocco to roughly to low 70s [ph] effectively.

Unidentified Analyst

[Indiscernible] from Canaccord. Just looking at the portfolio of brands, you’ve sort of shown the description but you sort of done a good bank, bad bank type of thing here with the portfolio of brands not having any specific metrics that we might look at and I can understand why. They account for 49% of revenue in the year just reported. What proportion do you think that might be in say three years' time? I appreciate some will move into the other categories. Some might be lost, sold bottom [ph]?

Alison Cooper

Well, we mentioned at our Investor Day that we have a medium term target to get to 80%. So that’s a very much where we want that proportion to get to, but I think you’ve got to put on the context that the overall revenue developments of the business. So even though we’re not getting and focusing on specific volume metrics for those portfolio of brands, clearly how we manage it then is going to have an impact on how our total net revenue develops.

So we’re going to have to manage them carefully within that, so but we’re not just achieving that percentage wise, the portfolio of brand disappearing off the face of the earth, which wouldn’t be the result we’re looking for. So we have got a medium term target of 80%. That’s not going to happen overnight but we’ve got the migrations to do, we’ve got some of us had this year, we’ve got more than plan for ‘15 and beyond. So it’s going to take few years to get there but that’s where our medium term target is for that percentage there.

Unidentified Analyst

Just on the acquisition that you have made, are you going to take on all the litigation they seem to be talking about into the U.S. and so is that something you will be pursuing?

Alison Cooper

We have clearly acquired IP in terms of e-cigarette category and that’s something we paid money for and clearly we are keen to strengthen and protect as part of this acquisition. And we have some ongoing cases around it. It’s not the prime focus but clearly we will protect our IP.

Unidentified Analyst

So you're saying you will pursuing the cases in the U.S. the ones which were already seem to…

Alison Cooper

We are evaluating those at the moment to see the strength of cases and what it's worth putting resource behind.

I think that's everything. Well, thank you everyone and I would just like to mention clearly, Gerry is departing for [indiscernible] shortly as well. So thank Gerry for the last five years before he moves back to the dark side. And if you don’t know, Tom Corran at the Frontier has joined us as Director of Investor Relations taking over from Gerry. And if you have got a few minutes, you can also catch up with Peter Corijn here as well today and check out some of our new team. And thank you very much.

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