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Edited Transcript of SMDS.L earnings conference call or presentation 6-Dec-18 9:00am GMT

Half Year 2019 DS Smith PLC Earnings Call

London Dec 11, 2018 (Thomson StreetEvents) -- Edited Transcript of DS Smith PLC earnings conference call or presentation Thursday, December 6, 2018 at 9:00:00am GMT

TEXT version of Transcript

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Corporate Participants

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* Adrian R. T. Marsh

DS Smith Plc - Group Finance Director & Executive Director

* Miles W. Roberts

DS Smith Plc - Group Chief Executive & Executive Director

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Conference Call Participants

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* Alexander Mees

JP Morgan Chase & Co, Research Division - Head of UK Small and Mid Cap Research

* David A. O'Brien

Goodbody Stockbrokers, Research Division - Investment Analyst

* Justin Joseph Jordan

Exane BNP Paribas, Research Division - Analyst

* Robert Chantry

Joh. Berenberg, Gossler & Co. KG, Research Division - Analyst

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Presentation

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Miles W. Roberts, DS Smith Plc - Group Chief Executive & Executive Director [1]

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Okay. Well, firstly, welcome to our results announcement for the first 6 months this financial year. Thank you very much for spending the time to come and join us. We very much appreciate it because we're very pleased to talk about our results. We are very pleased.

In our results, I think there'd be a number of really key things here, which we'll continue to come back to. Firstly, it's around the strong fundamentals that underline our business while we continue to keep growing even in more uncertain times. So strong fundamentals to our business.

Secondly, we'll be talking very much about the acquisitions that we've made and the substantial progress we've made there but then, also, around our future acquisition and our preparedness for that. And then lastly, we'll be talking about that resilience of the business but also the strength of the balance sheet of the group, how we see things going forwards.

So in terms of our half year results, we're pleased. We're pleased with those results. You've seen the headlines. It's a very substantial improvement in, really, all of our metrics. But I think particularly we're pleased to how we have fully recovered all of the raw material and increasing input costs that we've incurred over the 6 months and, indeed, in the period leading up to that.

Our volume, we've grown well ahead of the market, and that is despite having fully recovered our input costs -- the increase in input costs. So as a result of that good growth and a full recovery, our margins have increased by 120 basis points to 9.9%, and we think we're going to go further.

The U.S. has, again, performed very, very strongly. We'll come back and talk about that. But very good returns, and I have to say, an excellent outlook. And turning to the balance sheet, we've seen the good cash flow. We saw our net debt to EBITDA fall to 2.1x, getting closer to our longer-term -- our medium-term objective of 2x. And very importantly now, a new long-term financing facility that takes out any refinancing until 5-plus years.

And Plastics, the strategic review is going very well. And as a result of that, we've treated it as a discontinued business in these half year results. On Europac, this next -- our next acquisition, which we're very excited about, we expect this to complete around the end of the financial year, fully in line with our expectations, and it's performing exactly as we expect it to. And most importantly, half 2 has started well. We are -- a lot of momentum going for second half, and I have to say, we're looking forward to it.

But first of all, before I come back and build on those key themes, Adrian's going to take us through our half year results.

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Adrian R. T. Marsh, DS Smith Plc - Group Finance Director & Executive Director [2]

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Thank you, Miles. Sort of working out whether it's a clicker with the ball on it. Yes. So good morning, everyone. And as usual, I'm going to take you through our results for the half year. And unless otherwise explained, changes referred to are on a constant-currency basis. I'll also principally be talking about the group on a continuing operations basis, so that is excluding Plastics, which is now on the balance sheet as held for sale and treated as discontinued.

We've again delivered on our target with good volume growth as previously indicated, back to more normal levels from the exceptionally strong growth of last year. The standout number as highlighted at the preclose is return on sales. I'll be going through the bridge in a minute. But achieving such an improvement in a period when we were still very much in price recovery mode is a great achievement and testament to our robust business model.

Also on the subject on margin, you may remember that this is now stated on an IFRS 15 basis that requires certain cost-sharing items, such as energy, to be treated as revenue rather than net cost, which is an overall effect in the half of increasing revenue while having -- while leaving profit unchanged. While it's not material, it does have a small 10 to 20 basis points difference. It has the same impact on prior years, so the 9.9% achieved this year is actually more like 10.1% in old money.

The return on capital has been steady period-on-period, so you'll be forgiven if you think that this looks like lower than the prior period. The reason it's reduced is that Plastics has historically had a much higher return on capital than the group overall, hence, the dilutive effect when it's taken out. We also have a full year effect of Interstate Resources in these numbers. However, despite both of these, we remain in the upper half of our target range.

Net debt to EBITDA is 0.8x on a straight calculation basis. We are, though, in a somewhat unusual situation at the moment of holding cash for the Europac deal, which we raised in the summer, which will only be paid out in a few weeks' time on completion. So if we exclude the rights issue proceeds, we're at 2.1x, which is still a decent improvement of 0.1x since the year-end. And we expect the full year to be on or under 2.3x predisposals, which is again better than the 2.5x we described when we announced the rights issue. Cash remains strong, as I'll describe in more detail on the cash bridge chart.

Summarizing our financial headlines, all excluding Plastics. Revenue's up 16% and operating profit up 32%. I'll take you through the bridges for these key line items in a moment. The improvement has flowed through to earnings per share up 9% on a constant-currency basis. The reason the EPS growth is lower than profit is the rights issue in July, fairly obviously. Dividend per share is up 14%, reflecting decent growth despite the rights issue effect, and it's a strong statement of confidence that the board has in the group prospects.

Turning to the revenue bridge. This is our continued operations, excluding Plastics as I've mentioned before. The adjustment for acquisitions is GBP 247 million, as you can see, which is principally the 4 extra months of Interstate Resources and also a contribution from EcoPack, EcoPaper and Corrugated Containers Corporation.

Volume from boxes was GBP 48 million with a negative balance on other volume, principally the impact of Chinese regulations on recycling flows. The increase from sales price/mix is primarily driven from increases in box prices, which has now recovered the paper price rises from previous periods. Overall, the result is a 6% organic rise in revenue.

Turning to EBITA. The contribution from acquisitions is as I've described previously, and you can see the synergies coming through from Interstate Resources acquisition consistent with previous guidance. The volume contribution is a net of the positive from packaging, which had a similar drop-through to previous periods, partially offset by a small decrease in other volumes, principally recycling, as I noted before.

As a number of analysts have asked, you can now see the full benefit of sales price and mix improvements coming through and the effects of the paper price rises still impacting comparable period input costs but absent the headwind of previous periods. We believe we've now fully recovered the historic price rises and current sales prices fully reflect this. The GBP 141 million input cost is a net number, which reflects all input costs, albeit paper is by a long way the most significant.

Margins by regional segment have all improved since the full year with the strength of the margin to some degree reflecting the mix of business, however, packaging -- mix of business between packaging and paper in particular regions. The region with the least paper, Western Europe, has obviously had the toughest time recovering margins, although not particularly bad when you compare it to the comparable returns the packaging assets will be acquiring in this region.

Whilst the U.S. is the standout region, it has, of course, benefited from synergies coming through as well as strong underlying trading and being long paper. As I mentioned at the start, these figures are all on the new IFRS 15 basis, which for the group as a whole reduces reported margins by between 10 and 20 basis points.

Plastics, as I said, is now accounted for as discontinued as a result of the review process and the discussions with potential buyers, which we expect to conclude in this financial year. It's an excellent business with strong fundamentals. This particular period, it's reported there is no profit that's been impacted by lag in the recovery of polymer pricing, which is a dynamic well understood by those of you who follow plastics businesses.

The recovery of input prices is well underway, and the underlying business performs consistently well. Its profits have likewise unsurprisingly been impacted in the first half by separation activities, which are required should the business be sold.

Exception operating costs were GBP 29 million, excluding those related to Europac, which is in line with the guidance previously given. This also excludes a significant noncash item relating to future pension obligations for certain population of the U.K. pension fund during the period 1990 to 1997. This is known as the guaranteed minimum pension equalization and follows a ruling which became effective on October 26. Unfortunately for us, applied to any company with the reporting date after then.

This is quite clearly an educated estimate, given the limited amount of time we've had to assess the impact, and we've made an assumption in the midpoint of the range of potential exposure. We'll revise this over the next few months, but based on our preliminary advice, I don't foresee any significant change. And just be clear, it's noncash.

Of the GBP 29 million charge this period, about half directly related to Interstate and other related acquisitions and the remainder was an IT optimization project that one could argue is in and of itself also resulting from integration requirements.

I've noted here, we now expect the costs to play out -- how the costs expect to play out over the remainder of the year. Excluding Europac costs and the pension equalization charge, you should see these costs reduce, such that our guidance for the full year operating cost adjusting items is now under GBP 45 million or there or thereabouts, a reduction on our previous guidance of GBP 53 million.

Europac exceptional costs are expected to come through in line with the guidance, given that the time the deal was announced, with a total additional cost for integration of around EUR 40 million split across this year and next year. Some of that will be front loaded for fairly obvious reasons. There'll also be the balance of costs relating to the transaction itself, and I should also point out that there's around about GBP 3 million relating to more business as usual type of restructuring that's been included in our reported EBITA we haven't adjusted for.

Cash flow's been good. Starting at the top line with the EBITA, working capital delivered an inflow over the period. Recognizing the high degree of interest in this, I should note that, in this period, our nonrecourse receivables factoring balance fell slightly, so you can be assured that this improvement in working capital was not a function of greater nonrecourse factoring.

Our projects to improve underlying working capital are various but focused around inventory reduction, reducing overdue debtors and rationalizing our supply chain. The benefits from these initiatives are expected to continue through the second half and also over the next financial year.

CapEx is similar to the prior period on what is now a larger business, and I can confirm that the full year for Europac CapEx will be in line with our previous guidance of around GBP 270 million. The tax and interest cost is higher -- principally higher for the period principally due to the phasing of payments for the bond we issued in July 2017, which falls annually in July, and that will be a benefit in the second half of the year; and payment of tax in North America following the Interstate acquisition, which was paid in the period before our acquisition last year. So that's a normal cancellation cost. So that's what we do expect going forward.

Having talked about this for a number of years now and being one of the first companies to disclose, I thought it worth reminding everyone of the economic rationale and the way it gets treated by both ourselves and our lenders. I realize that this subject of invoice discounting or sale of nonrecourse receivables receives a lot of interest, particularly in light of the recent collapse of the contracting company that may not have had either the same rationale or liquidity risk management as ourselves.

We've always -- we're always reminded by our shareholders that they consider efficient balance sheet management as extremely important. Similarly, if we can economically anticipate our cash receipts, then we should. Many of our customers, such as the big FMCG groups, are very high credit quality, so if we were to -- wish to receive their payments on, say, 15 days rather than the 90 or 120 days that we may have commercially agreed to, then we've got 3 choices.

Firstly, we can do nothing and wait for the payment to occur. Second, we can offer more attractive terms for early payment within our overall commercial terms. And thirdly, we can sell them without recourse -- sell the receivable without recourse. Given the quality of our customers and the development of this market for securitized receivables, it's often more economic to do this rather -- this third option rather than the second option, which is what we have been doing. And to be clear, the subsequent impact on our cash flow is exactly the same as the second option.

But I've also asked -- been asked a number of times why this isn't debt or isn't treated as debt, and my answer is always the same. Because actually, it isn't debt, given it's a sale without recourse and treated correctly and accounted for under IFRS. But most or even more importantly, it isn't treated as debt by our financing banks. Our financial covenants are exactly as we calculate them in our annual report.

The follow-up question to this is, normally, but okay, what happens when these reverse, then what if the market for these shot? And again, if in my earlier example, what if they don't provide them to you any more specifically? To which my answer is so long as the facility is committed, which are these for 3 years, as it happens, and the customers remain excellent quality credit, which they are, then simply, we don't consider that, that will be an issue.

Those are long memories. You may remember problems in the past when companies sold receivables which either did have recourse or are only covered by short-term, uncommitted facilities, typically commercial paper programs, for which the market dried up completely during the credit crisis. And I can assure you, this is absolutely not the case with us. If our committed facilities cease to be available, then we have 3 years in which to modify customer commercial terms to deal with it.

The total cost of what we're currently doing on an annualized basis is approximately GBP 7 million. And to get the same cash flow through early payment discount, we believe would cost us around about double that or an additional GBP 8 million. So we're getting a P&L benefit of around about GBP 8 million, and you can liken that to about 10 basis points of margin.

Moving to the cash flow bridge. As mentioned before, it's skewed at the moment because of the rights issue proceeds. The other items, as previously described, is a GBP 41 million in acquisition being the Corrugated Containers Corporation business bought in the U.S. right at the start of the year. There've been no further acquisitions since June, and none are foreseen for the remainder of the year.

Our gearing technically sits at 0.8x based on our balance sheet or 2.1x if you exclude the rights issue proceeds. Once we've completed Europac, there'll be an additional circa GBP 600 million of debt related to the balance of payment to the Europac shareholders and the ongoing debt of the business, which would bring us to a gearing at the balance sheet date or our balance sheet date of on or around 2.3x, which is lower, as I said, than we previously guided.

We expect to further deleverage as we continue to generate cash flow. And in addition to this, there should be the net proceeds from the disposal of Plastics and the remedy disposals associated with the antitrust clearance for Europac.

And you may remember at the time we announced, we talked about the potential to the requirement to dispose of 2 plants, well, that's exactly what the requirement was in the end, 1 in Portugal, 1 in France, the collective of which is less than 1% of profits within the business case and not material from a profitability perspective, but they will also generate cash flow. Given these various asset disposals and taking into account the put option on Interstate, which I would think of as around about GBP 200 million, even if it's actually slightly less at the moment, then you can see why we're very comfortable with our 2x guidance.

Whilst I cannot comment on the likelihood of the put option ever getting exercised, I can note that the related shareholder fully participated in the recent rights issue and remain 5% owners of the group. Whilst the put is not included in our calculated leverage, as I said at the time of the rights issue, I do fully take it into account when we calculate liquidity.

Which leads me to advise you that we're delighted that our banking group, many of which are sat here today, have also expressed their commitment to our company by signing a new 5-year, plus 1, plus 1, committed facility for GBP 1.4 billion, which replaces an GBP 800 million maturing facility and also Europac Bridge facility and gives us significant liquidity headroom without any assumption regarding asset disposals.

Whilst I've absolutely no doubt about the importance the U.K. stock market places on absolute leverage, my equal focus as Finance Director is always on liquidity and refinancing risk, particularly in times of increasing uncertainty, which is the reason why I'm extremely pleased to have secured the new facility now for the next 5 to 7 years.

Here's the usual technical guidance slide. And the main point here is that it remains pretty much unchanged with the exception of the adjusting items which have changed from the full year, and that our expectation for the full year is now lower on a like-for-like basis, albeit we do have this GMP pension adjustment, which we related to the pre-1997 balance sheet as I described before, which again is a noncash item.

If there's anyone who's got any specific questions on the GMP adjustment, I'm happy to take them off-line or in the Q&A. But you're going to see it with a number of -- pretty much every U.K. company. It relates to the so-called Barber ruling or Barber judgment to do with equalization of guaranteed minimum pensions, and it particularly applies the period 1990 to 1997. But we can discuss that at length, I'm sure.

We have and continue to provide as much detail as required on adjusting items and clarity as and when they will conclude. Our expectation is next year will have a significantly lower figure reflecting Europac integration and nothing much else.

So looking at our track record, and again, I can't not stand here and be very pleased to show a continued upward trend in trajectory of earnings per share and dividend per share, which this period is also contributing. We're very pleased with the performance.

And with that, I now hand over to Miles, who'll take you a little bit more detail about what's going on in the underlying business.

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Miles W. Roberts, DS Smith Plc - Group Chief Executive & Executive Director [3]

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Okay. Thank you. Thank you. Thank you. No, thank you, Adrian. You can see why we're pleased with the results. You can see, during the period, we have fully recovered the input costs, not just on paper but also on energy, on labor, on distribution.

There is some uncertainty, I think, in a lot of people's minds about the overall markets, however, we show that we've grown -- again, we've taken market share. The result of this -- of those price increases, which have now averaged between 8% and 10% over the time that paper price have gone up. We then did the lag, which we talked about. So we're now in a period where we're starting to over-recover, which is pulling back on the lag we've seen previously. And as said -- and the volume continues to grow. I have to say when we look forward into the second half, we see continuing good, solid volume growth.

Of course, it would be because we're based on FMCG. We're based on food and drink. We're seeing our customers continue to consolidate their supply chain. We're seeing some really exciting moves in new innovation coming through. So we're pleased with the volume, and we have a very solid outlook for that. So we've got good underlying fundamentals to our business.

And we've talked about the acquisitions. I'll come back to them later on. But in North America, we are very pleased with that, particularly in how we've been able to apply our commercial and our operational best practice into that business, a business thousands of miles away and how we obviously generate real value for our shareholders and also for our customers on that basis. So we're pleased with the overall results. As I said, I'm sure you can see why.

Over the last few years, if I go back to 2010 -- in fact, if we go back prior to that, the margins were lower. I show here how our margin has developed over the period. I've also put on this graph the price of testliner. And let's not go -- let's not forget, we go back to the period January 2010, the economy was in a very difficult position. We had a big position particularly in France, in the U.K. as well or in Italy. You can see, during that period, we faced really quite challenging economic conditions -- general economic conditions.

Now Adrian took you through how our earnings have gone in that period. I think it's important here to highlight how our return on sales has also developed as the price of paper has gone up and down. Now during this period, we also made a number of significant acquisitions. Then if you remember, you go back to 2012, we bought the SCA business, a business where its margin, it's return on sales was significantly below the 7.2% that DS Smith was making on its own.

In fact, with the exception of North America, every single business we bought has had a lower return on sales than DS Smith core business. So during this period, we had growing margins, bringing businesses with lower margins. And as you can see, we've had a very variable paper price.

You go back to the last time paper prices fell, which isn't that long ago, so that's 18 months, you can see how the margin initially improved. And as you brought in some other businesses, it held steady, going up to 9.9% at this time. So I think it's important when we look forward, we actually see further progression in the return on sales that DS Smith will make.

Now we'll come back and outline more about that when we complete the Europac acquisition. But standing here today, our upper end of our range will certainly be improving when we come back and update all the guidance at the time of our full year results.

Then I wanted to return to North America because it's only a year since we've had this business. Just a year of ownership. And in that time, we are very pleased with the integration. Many of you was at Capital Markets Day and you saw Jim Morgan, our President to the U.S. business, talk about it and the excitement that's there by having a new entrant into the market with new ideas with a different way of focusing on the customer.

I said earlier how we've taken our excellence in operations and in commercial and applied it to the business thousands of miles away. We are delighted with the customer reception. We are now signing up -- we have signed up and have a good pipeline of opportunities signing up customers on an American and a European basis because they want the same solution, and they know they can only get that solution from DS Smith. Indeed, we highlight some of the customers there where we have now have those international, intercontinental deals.

You have seen on Adrian's bridge of the profit, this business in this half year is making return on sales -- sorry, return on the capital employed in excess of 11%, and that's in the second 6 months of owning it we're above an 11% return on capital.

Adrian's outlined the synergies there, the figure there of GBP 12 million. If we look at the Interstate position within that and add on the first half of last year, we can see that it's making in the first half about $16 million of cost synergy. On a full year run rate, that's $32 million, 1 year into the acquisition. That's had operational excellence coming through. That's why we've revised the target for synergies from -- of this deal initially from $25 million, then to $30 million to $35 million. And currently, we're projecting to get at least $40 million of cost synergies from that business.

The outlook is very positive. We've acquired a small but very important business to us in Corrugated Container Corporation. We've previously announced that. Again, we're very pleased with the increased capacity that has given us. Capacity is an issue for us there, such has been the demand on the business. We haven't been able to take in all the business that we were able to take into. We're not going to let our customers down, so we've had to defer some of it whilst yet Container Corrugated -- Corrugated Container Corporation up and running and properly integrated.

And on the back of that, we've also announced a new greenfield in Indiana positioned where many of our customers are. We're getting advanced orders for that business. It's going to use a lot of the technology that we have in Europe. It's a very exciting move, but I have to say the commercial opportunities are very attractive there.

If we turn to Europac, we talked about this at the half year. We're very excited by the opportunity. We set out a financial projection for that business of being above cost of capital in the first full year of ownership, and that's exactly where we see that business still performing today.

A lot of work has occurred in terms of planning for the integration. As you know, we've got a very experienced team here. The team that has integrated the U.S. in many of our previous acquisitions actually came back to Otor in France some years ago. It's the same team with the same processes but more experienced and knowledgeable.

The planning has been excellent. We're ready for when this deal closes around the end of the year. The process to get here in terms of shareholder approval, in terms of the antitrust approval, in terms of now in the CNMV offer period has been exactly as we expected. Adrian has outlined the remedy disposals exactly in line with what we told shareholders. The profitability, though, is about 1% of the Europac's profits, so we're left with 99% of the profitability of that business after the merger review by the European Commission.

We can see our short paper position. We outlined this at the calendar full year when we talked about this proposed acquisition. We had 1.4 million tonnes short position last year. Obviously, the packaging has now grown by about another 150,000 tonnes by the time we'll close this deal. Europac brings in a net -- about a net 500,000 tonnes.

So you can see there is still a very, very substantial short position in DS Smith. That's the position we are very comfortable with. Although we are taking the opportunity, as I said previously, to reassess our paper asset base so as we bring some more in, how we can reposition this. So we're excited. We're committed to the returns. The integration work is going well. And as I said, the inbound for the number of customers has been very positive as well.

When we talk about the resilience of the business model, and again, this is what's really delivered those returns over many years, why we've been able to improve our profitability and dividend consistently over the last 8, 9 years despite some difficult economic conditions because the fundamentals are that we're built on working for those big customers. That FMCG basis, the reason we focused on this because of that predictability of demand.

We always know there's going to be some cyclicality, so how do we prepare ourselves? So in the good times, when the markets have been moving forward, we haven't focused on construction and other areas like that, which we know will come off, we focused on building our position with these customers. We've grown our average share of the business from our big customers from 36% to 41%, and we brought in more of those customers.

So today, just under 80% of our business is what we call the FMCG and resilient categories. And that means those volumes have never gone down. People don't stop eating and drinking, and that is what the business is based on. That is why we maintain a positive outlook to the business. That's why we believe it's resilient, not just in the short but in the long term as well.

We can build on that further, those customers, about the whole development of the solutions that they need. At the moment, we are extremely busy making sure that Christmas is delivered because most people are buying their Christmas presents in advance this year. And my goodness, are we busy. My goodness. Without us, there'll be no presents.

I modestly say that. And that's just to remind ourselves of those structural underpins for our company. We got the e-commerce growth. We've got a huge change in the proliferation of retail channels. We're happy not just in the U.K. but right across Europe. There's more organization. We're getting more discount, more convenience stores being built.

People are changing the way they're shopping. Families are getting smaller, people are living alone or in smaller units more frequently. That means they have more choice. That means they can decide what to buy when to buy, really, on that day, and that means a proliferation of packaging. People buying smaller quantities. That drives packaging volume.

So we're seeing a good fundamental demand in that FMCG sector where 80% of our group is. The increasing focus on sustainability. You heard in the last budget in U.K. alone about how they want to put a tax about -- or proposing to put a tax on packaging that uses less than 30% recycled paper. In the U.K., we only make recycled. How many [percent,] call it 50%, call it 80%. Yet, this is what we're based on.

So we're very comfortable with that. In fact, we're going to see a lot more legislation coming out in Europe as well. We're encouraging that. We think it's a more sustainable way people can consume, and we're in pole position to capitalize. Our investment, our scale across Europe is simply unparalleled.

Moving into the U.S., we're very pleased with that reaction. We're pleased with the reaction from the customers about the Europac move. Our investment into innovation, we outlined a lot of that our Capital Markets Day. It's really coming through in our margins and our market share gains.

But for the group, what are we going to be focused on? Well, we've got to continue delivering from Interstate. We're really looking forward to Europac. Cash generation, organic and inorganic cash generation, so you can see our debt coming back to our medium-term target exactly as we've done in the past.

So the summary and the outlook for us. We're pleased with the results. Top-end margins, material growth market share gains. We can see a material differentiation of our offering with customers, and that's increasing, to see a good, strong balance sheet and happy with how we're delivering, particularly after the Europac acquisition. And that's why we have a positive outlook with really good momentum into the second half of this year, and I have to say, beyond that as well. Thank you very much.

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Questions and Answers

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Miles W. Roberts, DS Smith Plc - Group Chief Executive & Executive Director [1]

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So we're happy to take questions. Anybody, you're going to have Adrian and myself on that. Let's just -- we'll just start at the front here with -- why don't you say your name and where you're from.

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Alexander Mees, JP Morgan Chase & Co, Research Division - Head of UK Small and Mid Cap Research [2]

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Miles, it's Alex Mees from JPMorgan. Three questions, please. Firstly, on margins, obviously a strong performance from the first half. You've referred to an expectation that margins will continue to improve from here. I just wondered if that's still your expectation if you exclude Europac, which clearly has an effect on the mix. And secondly, just on margins. I wondered if you could just comment on the seasonality of margins first half to second half. That's a rather long first question. Question number two, just after Europac, have you gotten into a lower level of gearing. I just wonder why that is, whether it's savings driven or cash generation, lower level of gearing versus Europac. And finally, I wonder how you see the market for Plastics assets as you look to potentially divest this. And also, if you were to sell paper assets, I think you alluded to having a rethink in terms of your asset base, whether you'd expect any further delevering to come from that.

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Adrian R. T. Marsh, DS Smith Plc - Group Finance Director & Executive Director [3]

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Do you want me to take the second and you do the first?

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Miles W. Roberts, DS Smith Plc - Group Chief Executive & Executive Director [4]

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Do you want to do 2, 3 and 4? [Can you do them?] You do the most.

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Adrian R. T. Marsh, DS Smith Plc - Group Finance Director & Executive Director [5]

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I'll do the most. I mean, I can do it. I'd do margins if you want as well.

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Miles W. Roberts, DS Smith Plc - Group Chief Executive & Executive Director [6]

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Fine. I'll be quiet.

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Adrian R. T. Marsh, DS Smith Plc - Group Finance Director & Executive Director [7]

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Margins, yes, we'd expect -- we'll be expecting, obviously, as the run rate of box price recovery, and we would expect a small improvement in the second half, too. No great seasonality. As you know now, Alex, the business has a sort of a distinct rhythm. So we have a good period in the autumn, as you'd expect, as you build up for Christmas. And then in the spring with the food and drink company, there's always a good performance then. So it's a fairly natural rhythm. And roughly, roughly now across Europe, it sort of evens itself out. On the U.K., it always used to be very front loaded because it's a stand-alone country. But as the business has spread, it's much more balanced now. It's still slightly on a -- if nothing else changed, you'd expect a slightly better first and second half normally. Because we're still in this sort of moving period, I'd expect a small improvement again second half. And I think a lot is to do with seasonality, hopefully. In terms of leverage, it's 2 things. One is just the underlying activities we're taking, as we've said we would last year. Clearly, last year, the focus was about integrating Interstate. It was about driving volume. It was about starting and initiating the price recovery unless pull was made on the level of working capital. I mean, we've been quite sort of open about that. This year, we've got a large number of initiatives in place going across the whole group, particularly around inventory, finished goods, spare parts, for that matter, as we're trying to optimize how we manage our asset base. Overdue, going hard across all of Europe on where they sit and really focusing on working capital, supply chain as well. Again, every time you make an acquisition, you have an opportunity to manage through on that, and getting Europac will give us a bit of an opportunity there again. And the Europac business we're acquiring. I think generally, when you look at its numbers, it's slightly better than we thought it would have been at this period. They also have had a -- and they will have disposed of the Caradec business, I think, they announced or that was described earlier in this week. Certainly, I saw something yesterday in the newspaper that was describing who had bought it, and there'd be proceeds of that in there. So we're looking at -- the combination is clearly [2.3 as is]. The business in Europac has done well in the first half, now that's well publicized. Our business is doing well. We calibrated on it, and we're managing cash flow. So I'm reasonably comfortable with that number. And then do you want to do Plastics or -- since I'm on a roll?

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Miles W. Roberts, DS Smith Plc - Group Chief Executive & Executive Director [8]

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Sure. Carry on. You're on a roll.

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Adrian R. T. Marsh, DS Smith Plc - Group Finance Director & Executive Director [9]

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So in terms of -- the question is how is the Plastics process going? I know we -- yes, I mean, we've had a huge amount of interest as you would expect. I mean, it's a primary carve-out from a major company. It's sweet spot private equity. It's the sort of thing that people get very excited about. And the process is to really start filtering what's excitement because there's just not much activity and people are better for anything, versus what are serious bids, serious players, serious prospects, and what's the best time for the business. Because at the end of the day, we still have a big obligation to make sure that the buyer is appropriate for it. So we're really encouraged so far by the amount of interest. So you would expect that. I mean, it's the right size. It's the right sector. It's cash generative. It's got a good track record. It's scalable. You can see how roll-up strategy -- I mean, there are a number of things that come into play to excite them, so we're quite happy about that. You talked about, if I remember well, looking at the paper portfolio. Well, we always do. I mean, this is something we constantly look around. If at any point in time, there was something -- yes, that would go to leverage for sure. Okay?

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David A. O'Brien, Goodbody Stockbrokers, Research Division - Investment Analyst [10]

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David O'Brien from Goodbody. A couple from me, please. Firstly, on volumes and maybe a little bit on further given it's a fairly healthy number of over 3%. But there is a step-down from the run rate of 5% in last year, which was pretty consistent over the period. So could you give us an indication of where the step-down's coming from, be it by business segment or region or customer? And then you talk about good momentum into the second half. So are we expecting to go back up towards 5% or a continuation of trend, please? And secondly, just on the cost backdrop. There's a lot of talk about paper. But maybe, Adrian, you could take us through what we should expect in terms of the underlying items, transport, chemicals, energy into -- and also what you see in the second half. And finally, if we look at the 1.4 million tonnes that you're short, can you remind us what proportion of that is in kraftliner at the moment and remind us what percentage are integrated? And given your comments around optimizing the asset base, where's the optimum level of integration as you see it going forward.

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Miles W. Roberts, DS Smith Plc - Group Chief Executive & Executive Director [11]

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I'll take the first and the third, and you have to take the second. I'll take volumes and short, and you do the costs.

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Adrian R. T. Marsh, DS Smith Plc - Group Finance Director & Executive Director [12]

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Yes, and then you can pick up, [I presume].

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Miles W. Roberts, DS Smith Plc - Group Chief Executive & Executive Director [13]

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Okay. So with the volumes, 3.2%. It's been pretty consistent during the half year. It's been, I say, pretty consistent. We have found, as I said earlier, in some places, we had -- we basically just -- we've been so busy, we've had a temporary pause. If you look at the U.S., we've just -- we have to get these other assets in and integrate this new business. So there's no doubt we've got ahead of ourselves a little bit back there because the prime thing is you always deliver to the customer what you've said and when you said. And at no price do you take your business where you're not absolutely confident about that. But that's all coming through. So we look at the half year, it was pretty consistent. It is a step-down from last year. When we look at our FMCG business, it's performing pretty well in line. We did have a big boost last year as we took a number of new e-commerce contracts. We took a lot of share there. They absolutely lead this market across Europe. So it's 3.2%. It's actually on last year's 5.2%. So it's 8.4% in a period, so it's -- we don't feel that's too -- that's not too shabby at all. But there's more we can do to liberate some of this volume. There's no doubt in some markets we know we still have 20% of our business that's more exposed to some of those big capital equipment, et cetera, car production lease. We specifically limit ourselves to those [we've captured]. But there's no doubt if you look into the -- places like the U.K., Germany and France, things like car production, it's undoubtedly been lower. Whilst our U.K. business actually grew quite well, we have seen, again in construction and things like that, there has been a slowdown. So that's 20% of our business. So that's sort of in categories. When you look regionally -- regionally, all of our regions are in growth. Some have grown more than others, though none that give us particular cause for concern because people are continuing to consume, to eat and drink. When you look at consumer expenditure on consumption items, this is what we're trying to link our business to. So if you go back over the last 10 or 20 years, even back to the 2007, '08, '09, '10, if you look at consumer consumption expenditure, it is remarkably resilient. That's what we're sort of pinning ourselves against. People stop buying a new car, and they stop moving house, but they don't stop that day-to-day consumption. And that's where 80% of our business is on and what gives us that confidence to say, looking forward, we see ongoing good growth. As against the market, we've done very well because we are less -- we're far more focused on food and drink. So compared to market data, we have taken considerable share in that time, and that's -- and we're very pleased with that.

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Adrian R. T. Marsh, DS Smith Plc - Group Finance Director & Executive Director [14]

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On the cost base, we never normally, with the exception of [selling short], give a breakdown of each item. But I think we can be reasonably confident to say that pretty much every cost is inflationary at the moment. So if you look at energy, if you look at labor, if you look at transport, starch, for that matter, they were in the first half. They will be the same in the second half. I'm not anticipating anything different. But to us, that's the cost of doing business, and what you need to have is measures in place to be able to deal with that. So whether it's the historic capital investment around efficiency projects to give you an insulation against labor, if it's projects around energy, if it's procurement, I mean, we have a very sophisticated procurement function that themselves have what we think is sort of reasonably achievable targets. They always complain they're too stretched, but they have a target of what we're expecting them to recover against. And for us, it's a lot of what we buy. Commodity, a lot of what we buy. There are multiple sellers. It's not a consolidated supply chain, which is a benefit to us. OCC, I mean, for what it's worth, it's been broadly flat. The talk is with it -- I mean, what we're seeing is it's staying pretty flat. What I can't say is what I know because I don't know anything. I mean, it depends what happens global macro, what happens to China. But as it stands, our cost base, excluding anything we actually see, which is flat, is inflation at the moment. I mean, there's no 2 ways about it. And we've got plans and steps in place, as you'd expect, to constantly deal with that. And we do it every year. I mean, it's never not been inflationary, well, 1 year when energy came down 5 years ago. That's about it.

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Miles W. Roberts, DS Smith Plc - Group Chief Executive & Executive Director [15]

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In our short position. So I put up the graph there that we've discussed at the time of the Europac deal, and it shows a substantial short position. And I said, we're very comfortable with having short. We think it's absolutely the right thing for our customers and, therefore, for our shareholders. If you look at the 1.4 million tonnes, this is Europe only. You can probably add on the run rate, by the time Europac closes, it's going to be about another 200,000 tonnes. So we'll be at 1.55 million, 1.6 million on that same basis. The Europac business brings in a net -- because that source have been growing 400,000, 500,000 tonnes. So you can see basically, we end out with about 1 million tonnes short. The Europac deal brings in about 400,000 tonnes of kraft. We don't have any kraft capacity ourselves, and the rest of it is in testliner. So if you look at our relative shorts, we're obviously short in both. We're more short in kraft than we are in test, but we're in short. And that can move around as we sort of -- as we substitute, but you could look at it's going to be about -- probably about 500,000 tonnes short in kraft and around 500,000 short in test, approximately. Going forward, we want to see that -- particularly in and around some markets around Central Europe, where there's always new capacity coming on, we want to see ourselves maintaining a short position. And therefore, as we said on the slide, we said it 6 months ago, we said it 18 months, we have actually divested, sold, closed a number of paper mills over the years. That is always an ongoing piece of work. And we see some opportunities to improve our balance to produce the right return for our shareholders going forward. Not putting any timescale on it, but we constantly review this, and there seems to be some good opportunities there.

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Justin Joseph Jordan, Exane BNP Paribas, Research Division - Analyst [16]

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Justin Jordan from Exane. I've just got a few questions just regarding Slide 17, the technical guidance. Sorry to be geeky for a second. Firstly, on depreciation, your prior guidance of GBP 200 million has come down to circa GBP 185 million to GBP 190 million.

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Adrian R. T. Marsh, DS Smith Plc - Group Finance Director & Executive Director [17]

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It's just plastics, Justin.

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Justin Joseph Jordan, Exane BNP Paribas, Research Division - Analyst [18]

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It's just plastics. Okay, there's no change to the underlying position...

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Adrian R. T. Marsh, DS Smith Plc - Group Finance Director & Executive Director [19]

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What I said is that GBP 10 million is going to -- GBP 10 million is the guidance for all ex Plastics. So...

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Justin Joseph Jordan, Exane BNP Paribas, Research Division - Analyst [20]

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Okay. But just in view of that, then why has the CapEx not come down as well?

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Adrian R. T. Marsh, DS Smith Plc - Group Finance Director & Executive Director [21]

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Because there's not much CapEx in Plastics.

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Justin Joseph Jordan, Exane BNP Paribas, Research Division - Analyst [22]

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Okay, great. Just on -- [you're kind of right]. Okay. So just moving to Slide 14 then on factoring, and thank you for providing additional disclosure here. Can you just explain on -- in '16 at your annual report, you talked about reverse factoring on your supply chain finance program. How much is the balance of that, [I presume] it's nonrecourse also?

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Adrian R. T. Marsh, DS Smith Plc - Group Finance Director & Executive Director [23]

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Well, to the extent that our customers take -- either sell our receivables or [can spread in both], is not something I have any control over. So I don't actually follow it, Justin. What's important to us is what -- if you look at our business model, so we've got a consolidated position. We're a big buyer of paper, probably the -- well, certainly the biggest globally buyer of paper. We put everything through our global paper-sourcing platform. We have a unique position with buying in a commoditized industry with a large number of suppliers. So with that, we take very good payment terms. Now whether someone in that wants to sell it, whether it wants to factor it, whether it wants [us to] factor it upside down, whatever, it's entirely up to them. All I can talk about, and I do as you know, is what we do. We sell it cheaper through that recourse. We describe what it is and why we do it. What I can't talk about is what our customers would do.

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Justin Joseph Jordan, Exane BNP Paribas, Research Division - Analyst [24]

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Okay. Just a point of clarification. The GBP 550 million of factoring, clearly, it's nonrecourse, it's off balance sheet, so that's clearly excluded from the denominator of the 13.9% return on capital employed you report?

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Adrian R. T. Marsh, DS Smith Plc - Group Finance Director & Executive Director [25]

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Correct.

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Justin Joseph Jordan, Exane BNP Paribas, Research Division - Analyst [26]

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Okay. So if I was to add it, the return of capital employed would fall by 160 basis points or so.

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Adrian R. T. Marsh, DS Smith Plc - Group Finance Director & Executive Director [27]

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If that's the math you do. If you add pension deficit, if you add anything that's not on the balance sheet on to balance sheet, it would change the metric you're calculating the balance sheet on. Net-net, you must be right.

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Miles W. Roberts, DS Smith Plc - Group Chief Executive & Executive Director [28]

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And just on -- I think you say if it wasn't there then we'd renegotiate with our customers. So I mean, we don't see it coming back. And when it's...

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Adrian R. T. Marsh, DS Smith Plc - Group Finance Director & Executive Director [29]

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I mean, I've been through that now. Yes, as I said, what we do can't be clearer than that. You can calc whatever, Justin, but the fact of the matter is, it isn't there. It's sold, and we don't take anything into account that we sold.

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Miles W. Roberts, DS Smith Plc - Group Chief Executive & Executive Director [30]

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We've got time for one more question.

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Robert Chantry, Joh. Berenberg, Gossler & Co. KG, Research Division - Analyst [31]

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Rob Chantry, Berenberg. I just wondered if you could give us some thoughts on the U.S. market, specifically regarding to your position of the big [guys] capacity coming into the market, whether that's been delayed and also if you could just give us some thoughts around that on where you're winning, where you're taking share, what is working and how that gets us to the point at which you built it.

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Miles W. Roberts, DS Smith Plc - Group Chief Executive & Executive Director [32]

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Now look -- so it's a great question. Great 2 questions. Just in the U.S. market, you're right. I mean, there have been a number of announcements about some more capacity coming on. And there's been a lot of concerns I think raised to Jim, I mean, on a macro basis about what does this mean for the U.S. market, which is a high-margin business. When we look at the capacity that's been announced, quite a bit of it is actually for export out of the U.S., principally into China. Some of it's for the domestic market, but virtually all of that's been announced actually by integrated players. What, of course, it doesn't say is what about the retirement of assets? And of course, recently we've seen a number of announcements that -- where those same integrated supplies aren't doing that, but of course we've now got to close down this other capacity. The U.S. market overall has moved from a position where packaging volumes, I think, have been pretty flat for a few years. Whereas now, over the last years, they've been increasing. In fact, even if you looked at all of the new capacity, that broadly just matches the forecast increase in demand because of sustainability because of e-commerce, et cetera. In the U.S., about 19% of the market is of goods sold on e-commerce, and that is increasing very rapidly. So U.S. market, concerns about supply, about new capacity coming on, we're saying we think if you look at it, it matches the growth, but actually a lot of it's for China. It doesn't take account of retirements, and there have been new announcements on retirements from those same companies. So our position is and remains that we do have some paid capacity there. I have to say we are very busy. Demand is good. It's strong for the reasons that we've talked about. And going forwards, we see that very positively. In terms our position, as you know, we are a modest player on a national basis. But on the East Coast, particularly in the Southern East Coast, we're very pleased with the performance. The growth in our volumes, in our share, is really around our innovation. So it's around shelf-ready packaging. You had some super, super wins there, where customers want new products. They're coming and talking about it because it's a lot of [feed] to the U.S. market, but I know that we absolutely lead that market across Europe. We've talked about the growth in e-commerce, and again, we're getting some real -- some really wonderful awards and new business coming through there. So we're very focused on the seams of FMCG, consumer expansion of that using our technology, expanding the perimeter of the market, not just going head-to-head with sort of like big American companies, very good companies indeed. Pretty much want to do that, trying to expand the perimeter in our new products, et cetera, that takes Corrugated Packaging further. That's where our customer want us to be. That's where our shareholders wanted to be. And frankly, you can see it in the result. It could be increasing the margin that's coming in that return on capital.

Look, I think we're at the end of our hour now, so I'm going to draw it to a close. But just to say to everybody, thank you very much for joining us today. We are around after if there are more questions. We're pleased, and we look forward to the second half of the year. Thank you very much.

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Adrian R. T. Marsh, DS Smith Plc - Group Finance Director & Executive Director [33]

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Thank you.

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Miles W. Roberts, DS Smith Plc - Group Chief Executive & Executive Director [34]

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Thank you.