FINANCIAL REVIEW

PAGE Finance Director’s overview 52 Ben Stevens, Finance Director, reviews the Group’s financial performance and activities.

Interest cover 53 Interest cover remains strong at 8.6 times, reflecting the increase in the Group’s profit, cash generation and the contributions of acquisitions in 2008 and 2009, offset by the associated increase in interest costs.

Dividends 54 The total dividends per share increased by 19 per cent, in line with the Group’s policy to pay dividends of 65 per cent of long-term sustainable earnings.

Cash flow 56 Free cash flow – the cash flow before dividends, share buy-backs and investing activities – grew by 1 per cent and exceeded the total cash outlay on dividends to shareholders by £832 million.

50 British American Tobacco Annual Report 2009 Directors’ report: Business review From the Chairman www.bat.com/annualreport2009 Performance and strategy Regional review Financial review Governance Group financial statements financial statements Parent Company Shareholder information

Directors’ report: Business review British American Tobacco Annual Report 2009 51 FINANCIAL REVIEW

Our history of consistent profit growth and “high cash conversion, provides confidence in our ability to continue building a highly successful and competitive business.” Ben Stevens Finance Director

Profit from operations Tobakskompagni (ST) and the purchase HIGHLIGHTS The reported Group revenue at £14,208 million of the cigarette assets of Tekel, the Turkish grew by 17 per cent and profit from operations state tobacco company. During 2009, the ■ Revenue grew by 17 per cent. at £4,101 million grew by 15 per cent. Group also acquired PT Bentoel Internasional Investama Tbk, which contributed to the ■ Adjusted profit from operations increased The growth in Group revenue would have second half of the year’s results. by 20 per cent. been 10 per cent, to £13,280 million, at

■ Adjusted diluted earnings per share up constant rates of exchange. In 2008, it was announced that the Group wanted to continue the success of the previous by 19 per cent. In order to better understand the underlying five year programme of cost savings which ■ Total dividends per share for 2009 performance of the business, it is necessary ended in 2007, by launching a new five year of 99.5p, up 19 per cent on 2008. to adjust for a number of items relating, for programme – to achieve annual savings of example, to restructuring costs. We call the ■ Strong cash flow, with free cash flow £800 million by 2012. It includes areas such as underlying profit after adjusting for these at 86 per cent of adjusted earnings supply chain efficiencies, back office integration items, adjusted profit. These adjustments are per share. and slimmer management structures. During described further below. Adjusted profit from ■ Interest cover remains strong with interest the first two years of the programme, savings operations was £4,461 million, up 20 per cent payable covered 8.6x (2008: 8.5x). of over £484 million were delivered. from £3,717 million in 2008. ■ Committed long-term facilities of These cost reduction initiatives resulted in the Adjusted profit from operations translated £1.75 billion were undrawn at year end. adjusted profit from operations, as a percentage at constant rates of exchange, was up ■ Operating margin increased by of net revenue, improving to 31.4 per cent 10 per cent to £4,106 million. 0.7 percentage points to 31.4 per cent. compared to 30.7 per cent in 2008 and For 2009, revenue growth was enhanced by 30.0 per cent in 2007. More details of the the full year benefits of the acquisitions of the Group’s adjusted operating performance cigarette and snus businesses of Skandinavisk can be found in the Regional review.

Percentage increases in revenue and in profit from operations Revenue Profit growth growth As reported +17% +15% Excluding adjusting items +17% +20% Excluding adjusting items at constant rates +10% +10%

52 British American Tobacco Annual Report 2009 Directors’ report: Business review From the Chairman www.bat.com/annualreport2009 Performance and strategy

Adjusting items Imperial Tobacco Canada paid a fine of Adjusted profit from operations

The adjusting items below included in the £102 million which was expensed in 2008 £ MILLION profit from operations, are separately disclosed and treated as an adjusting item. as memorandum information on the face of 07 3,002 +7% The acquisitions of the assets of Tekel and the income statement and in the segmental 08 3,717 +24% the ST businesses in mid-2008, as well as analysis. Excluding them from the reported 09 4,461 +20% the Bentoel business in mid-2009, resulted profit from operations helps to provide a in the capitalisation of trademarks which are Regional review better understanding of the Group’s underlying amortised over their expected useful lives, IN 2009 financial performance and is referred to as +20% which do not exceed 20 years. The 2009 adjusted profit from operations. amortisation charge in respect of trademarks During 2009, the Group incurred costs as a amounted to £58 million, while it was result of initiatives to improve the effectiveness £24 million in 2008. Gross interest cover and the efficiency of the Group as a globally As part of the ST transaction, the Group TIMES integrated enterprise. These initiatives include a realised a gain of £139 million in 2008 with review of the Group’s manufacturing operations, 07 9.4 the disposal of its 32.35 per cent holding in overheads and indirect costs, organisational 08 8.5 Financial review the non-cigarette and snus businesses of ST. structure and systems and software used. 09 8.6 The acquisition was subject to regulatory The costs of these initiatives plus the costs of approval which was received on the condition integrating acquired businesses into existing that the Group divest a small number of local TIMES IN 2009 operations were £304 million for the year 8.6 trademarks, primarily in Norway. The disposal ended 31 December 2009, compared to of the trademarks was dealt with in two £160 million for 2008. packages, which were completed in February Restructuring and integration costs principally and May 2009. The total proceeds from the relate to costs in respect of the planned two packages resulted in a gain of £2 million. closure of the Soeborg factory in Denmark, Governance Net finance costs the planned downsizing of the manufacturing Net finance costs at £504 million were plant in Australia, the continued integration £113 million higher than last year. The of ST and Tekel and the merger of Bentoel increase principally reflects the full year with existing Indonesian operations, as well impact of the costs of financing the two as other restructuring initiatives. The costs for acquisitions made during 2008 and the these other initiatives include redundancies, acquisition of Bentoel in the middle of principally in respect of activities in the Group’s 2009, as well as exchange rate movements. subsidiary in Canada, and impairment charges Group financial

for certain software assets where developing Interest cover statements global software solutions has resulted in these The Group assesses, as two principal measures assets having minimal or limited future of its financial capacity, cash flow and interest economic benefits. cover. Interest cover is distorted by the pre-tax impact of adjusting items. The chart shows On 31 July 2008, the Group’s subsidiary, gross interest cover, excluding adjusting Imperial Tobacco Canada, announced that items, on the basis of profit before interest it had reached a resolution with the federal payable over interest payable. The interest and provincial governments with regard to cover remains strong at 8.6x (2008: 8.5x), financial statements the investigation related to the export to the Parent Company with the higher cover reflecting the Group’s United States of Imperial Tobacco Canada increased profit and the contribution of products in the late 1980s and early 1990s. ST and Tekel since the middle of 2008 and The subsidiary entered a plea of guilty to Bentoel since the middle of 2009, offset by a regulatory violation of a single count of the increase in interest costs as a result of the Section 240(i)(a) of the Excise Act and financing arrangements for the acquisitions. Shareholder information

Directors’ report: Business review British American Tobacco Annual Report 2009 53 FINANCIAL REVIEW CONTINUED

Adjusted diluted EPS Associates Earnings per share

PENCE The Group’s share of the post-tax results Basic earnings per share for 2009 were of associates, included at the pre-tax profit 137.0p, up 11 per cent (2008: 123.3p). 07 108.5 +11% level under IFRS, decreased by £20 million With the distortions that adjusting items 08 128.8 +19% to £483 million, after net adjusting charges can cause in profit, as well as the potential 09 153.0 +19% of £58 million (2008: £26 million income). dilutive effect of employee share schemes, Excluding the adjusting items in 2008 and earnings per share are best viewed on the 2009, the Group’s share of the post-tax basis of adjusted diluted earnings per share. IN 2009 +19% results of associates increased by 13 per cent The calculation of this measure is explained to £541 million, with a decline of 1 per cent in note 7 of the financial statements. Profit at constant rates of exchange as a result of for the year is adjusted by the adjusting items accounting for ST as a subsidiary from July explained above, as well as for distortions in Dividend per share declared 2008. The Group’s share of the net adjusting net finance costs and one-off adjustments in PENCE items from Reynolds American amounted to taxation in 2008. an expense of £58 million (2008: £13 million of 07 66.2 +18% On this basis, the adjusted diluted earnings income) and included trademark impairment 08 83.7 +26% per share were 153.0p, a 19 per cent increase charges, restructuring charges, a health plan 09 99.5 +19% over 2008, mainly as a result of the strong credit and in 2008, a benefit from the operating performance and benefits from termination of a joint venture agreement. foreign exchange movements. IN 2009 +19% Associates’ income in 2008 also included a Dividends £13 million benefit from accounting for an The Group’s policy is to pay dividends of additional quarter’s income of the ST group 65 per cent of long-term sustainable earnings, during 2008, prior to the acquisition of the Underlying tax rate calculated with reference to the adjusted cigarette and snus businesses on 2 July 2008. PERCENTAGE diluted earnings per share. Interim dividends This was treated as an adjusting item in 2008. are calculated as one-third of the total 07 29.6 Profit before tax dividends declared for the previous year. 08 30.8 Profit before tax was up £396 million at With the recommended final dividend of 09 30.3 £4,080 million, principally reflecting the 71.6p, the total dividends per share for 2009 higher profit from operations and favourable are 99.5p, up 19 per cent on the prior year. exchange rates, partially offset by the rise in IN 2009 Under IFRS, the recommended final dividend 30.3% interest costs and the decreased contribution in respect of a year is only provided in the from associates. accounts of the following year. Therefore, the Effective tax rate 2009 accounts reflect the 2008 final dividend The tax rates in the Group income statement and the 2009 interim dividend amounting to of 27.5 per cent in 2009 and 27.8 per cent in 89.5p (£1,798 million) in total (2008: 69.7p – 2008 are affected by the inclusion of the share £1,393 million). The table below shows the of associates’ post-tax profit in the Group’s dividends declared in respect of 2009 and 2008. pre-tax results and by the adjusting items. Treasury operations The underlying tax rate for subsidiaries, Treasury is responsible for raising finance reflected in the adjusted earnings per for the Group, managing the Group’s cash share below, was 30.3 per cent in 2009 resources and managing the financial risks and 30.8 per cent in 2008. The decrease arising from underlying operations. All these arose mainly from a favourable change in activities are carried out under defined policies, the mix of profits and a reduction in tax procedures and limits. rates in several countries.

54 British American Tobacco Annual Report 2009 Directors’ report: Business review From the Chairman www.bat.com/annualreport2009 Performance and strategy

The Board reviews and agrees the overall The Group continues to maintain investment- treasury policies and procedures, delegating grade credit ratings; as at 31 December 2009, appropriate authority to the Finance Director, the ratings from Moody’s and S&P were the Treasury function and the boards of Baa1/BBB+ with a stable outlook (end 2008: the central finance companies. The policies Baa1/BBB+). The strength of the ratings has include a set of financing principles including underpinned the debt issuance during 2008 the monitoring of credit ratings, interest cover and 2009 and, despite the impact of the Regional review and liquidity. These provide a framework turbulence in financial markets, the Group is within which the Group’s capital, including confident of its ability to successfully access debt, is managed. the debt capital markets.

Clear parameters have been established, Subsidiary companies are funded by share including levels of authority, on the type capital and retained earnings, loans from the and use of financial instruments to manage central finance companies on commercial the financial risks facing the Group. Such terms, or through local borrowings by the instruments are only used if they relate to an subsidiaries in appropriate currencies. All underlying exposure; speculative transactions contractual borrowing covenants have been Financial review are expressly forbidden under the Group’s met and none of them is expected to inhibit treasury policy. the Group’s operations or funding plans.

It is the policy of the Group to maximise Liquidity financial flexibility and minimise refinancing In the year ended 31 December 2009, the risk by issuing debt with a range of maturities, Group entered into a number of transactions generally matching the projected cash flows in the capital markets. The first was the of the Group, and obtaining this financing repayment of the €900 million maturing from a wide range of providers. The Group debt at the end of February 2009. This was targets an average centrally managed debt financed from bond issues during 2008 and Governance maturity of at least five years with no more from cash generated from operations. In May, than 20 per cent of centrally managed debt there was the repayment of a MYR100 million maturing in a single year. As at 31 December bond, which was subsequently replaced in 2009, the average centrally managed debt August by a new MYR250 million bond due maturity was seven years (2008: five years) 2014. The additional proceeds were used for and the highest proportion of centrally the repayment of a MYR150 million bond managed debt maturing in a single year which matured in November 2009. was 18 per cent (2008: 18 per cent). Group financial statements

Dividends declared 2009 2008 Pence Pence per share £m per share £m financial statements

Ordinary shares Parent Company Interim 27.9 557 22.1 440 Final 71.6 1,418 61.6 1,241 99.5 1,975 83.7 1,681 Shareholder information

Directors’ report: Business review British American Tobacco Annual Report 2009 55 FINANCIAL REVIEW CONTINUED

Cash flow and net debt movements 2009 2008 £m £m Net cash from operating activities excluding restructuring costs and taxation 5,160 4,692 Restructuring costs (187) (210) Taxation (1,095) (943) Net cash from operating activities 3,878 3,539 Net interest (499) (280) Net capital expenditure (515) (482) Dividends paid to minority interests (234) (173) Free cash flow 2,630 2,604 Dividends paid to shareholders (1,798) (1,393) Share buy-back (400) Purchase of Bentoel (370) Purchase of Tekel cigarette assets (12) (873) Proceeds from ST trademark disposals and purchase of ST businesses 187 (1,243) Purchases of other subsidiaries, associates and minority interests (1) (9) Other net flows (203) (218) Net cash flows 433 (1,532)

Opening net debt (9,891) (5,581) Exchange rate effects 672 (2,622) Acquired debt (84) Accrued interest and other 28 (156) Closing net debt (8,842) (9,891)

In June, the Group issued a £250 million bond €700 million term loan facility with a maturity with maturity of June 2022. In November 2009, date of 31 October 2012 with an option to the terms of €481 million of the €1.0 billion extend it to October 2013, at the discretion of bond maturing in 2013 were modified the banking participants in the syndicated facility. by extending the maturity to 2021. At the In mid-2009, the Group also re-established its same time, the Group issued an additional euro commercial paper (ECP) programme of €169 million bond with a maturity of 2021. £1 billion. In addition, £199 million of the £350 million bond maturing in 2013 was purchased and At year end 2009, the £1.75 billion revolving cancelled; at the same time, the Group issued a credit facility described below, was undrawn. new £500 million bond with a maturity of 2034. The revolving credit facility acts as a backstop for the ECP programme and £187 million of On 13 February 2008, the Group entered ECP was outstanding at year end. into an acquisition credit facility whereby lenders agreed to make available an amount In the year ended 31 December 2008, the of US$2 billion. On 1 May 2008, this facility €1.8 billion revolving acquisition credit facility was syndicated in the market and was arranged in December 2007 was cancelled redenominated into two euro facilities of and replaced with the issue of €1.25 billion €420 million and €860 million; €395 million and £500 million bonds maturing in 2015 and €759 million were outstanding as at and 2024 respectively. In addition to this, the 31 December 2008 respectively. The Group increased its €1 billion (5.375 per cent, €395 million was repaid in September 2009 maturity 2017) bond by an additional and €759 million was repaid in October 2009. €250 million, bringing the total size of the The €759 million was refinanced by a new bond to €1.25 billion.

56 British American Tobacco Annual Report 2009 Directors’ report: Business review From the Chairman www.bat.com/annualreport2009 Performance and strategy

During 2008, the Group also issued investing activities. Although net interest US$300 million and US$700 million bonds, payments, capital expenditure and dividends maturing in 2013 and 2018 respectively, paid to minorities increased, the free cash pursuant to Rule 144A and RegS under flow was £26 million higher than 2008 at the US Securities Act. The Group also repaid £2,630 million. The free cash flow exceeded US$330 million and £217 million bonds upon the total cash outlay on dividends to maturity in May and November respectively. shareholders by £832 million. Regional review In addition, on 22 September 2008, the The ratio of free cash flow per share to adjusted Group repurchased its maturing Mexican diluted earnings per share was 86 per cent 2011 MXN1,055 million UDI bond and (2008: 101 per cent), with free cash flow per refinanced it with a floating rate borrowing share increasing by 2 per cent. of MXN1,444 million. During 2009, the cash outflows of Cash flow £370 million on the purchase of Bentoel The IFRS cash flow includes all transactions comprise the purchase price, together with affecting cash and cash equivalents, including the related acquisition costs and the acquired financing. The alternative cash flow shown Financial review net cash and cash equivalents and overdrafts. above is presented to illustrate the cash flows There was also an outflow of £12 million in before transactions relating to borrowings. 2009 in respect of the acquisition of the Tekel The growth in underlying operating performance, assets, and a net cash inflow of £187 million partially offset by the timing of working capital from the disposal of ST trademarks. For 2008, movements, resulted in a £468 million increase the cash outflows of £873 million and in cash flow before restructuring costs and £1,243 million respectively, on the purchase taxation, to £5,160 million. Although there of Tekel assets and ST businesses, comprise was a £152 million increase in tax outflows, the purchase price, the acquisition costs reflecting higher profits and the timing of less acquired net cash and cash equivalents Governance payments, with the improved operating cash and overdrafts. flow and lower restructuring costs, the Group’s The other net flows principally reflect the net cash flow from operating activities was impact of the level of shares purchased by £339 million higher at £3,878 million. the employee share ownership trusts, together Free cash flow is the Group’s cash flow with the impact of flows in respect of certain before dividends, share buy-backs and derivative financial instruments. Group financial statements Net debt/financing The Group defines net debt as borrowings, including related derivatives, less cash and cash equivalents and current available-for-sale investments. The maturity profile of net debt is as follows: 2009 2008 £m £m Net debt due within one year Borrowings (1,370) (2,724)

Related derivatives 33 (91) financial statements Parent Company Cash and cash equivalents 2,161 2,309 Current available-for-sale investments 57 79 881 (427) Net debt due beyond one year Borrowings (9,712) (9,437) Related derivatives (11) (27) (9,723) (9,464) Total net debt (8,842) (9,891) Shareholder information

Directors’ report: Business review British American Tobacco Annual Report 2009 57 FINANCIAL REVIEW CONTINUED

The above flows resulted in a net cash inflow Regional structure from 2009 of £433 million compared to an outflow of The Group’s regional structure was realigned £1,532 million in 2008. After taking account from 1 January 2009 after the acquisitions of exchange rate movements of £672 million, of ST and the cigarette assets of Tekel. The acquired debt of £84 million with the Bentoel Europe region was divided into Eastern Europe acquisition and changes in accrued interest and Western Europe, the Americas region now and other, total net debt was £8,842 million includes Latin America, the Caribbean and at 31 December 2009, down £1,049 million Canada, while Asia-Pacific now includes from £9,891 million on 31 December 2008. Japan. The 2008 segmental information has been re-allocated on the basis of the Retirement benefit schemes new regional structure. The Group’s subsidiaries operate around 160 retirement benefit arrangements globally. Non-GAAP measures The majority of the scheme members belong In the reporting of financial information, the to defined benefit schemes, most of which are Group uses certain measures that are not funded externally and many are closed to new required under IFRS, the generally accepted entrants. The Group also operates a number accounting principles (GAAP) under which the of defined contribution schemes. Group reports. The Group believes that these additional measures, which are used internally, The overall net liability for all pension and are useful to users of the financial information healthcare schemes in Group subsidiaries in helping them to understand the underlying amounted to £1,024 million at the end of 2009, business performance. up from £773 million at the end of 2008. The present total value of funded scheme liabilities The principal non-GAAP measures which the was £5,250 million (2008: £4,647 million), Group use are adjusted profit from operations while unfunded scheme liabilities amounted and adjusted diluted earnings per share, to £282 million (2008: £248 million). which is reconciled to diluted earnings per share. These measures remove the impact The increase in the scheme liabilities and deficits of adjusting items from earnings. in the schemes were largely due to changes in assumptions, including lower discount rates Management reviews current and prior year for liabilities and higher expected inflation. segmental adjusted profit from operations of subsidiaries and adjusted post-tax results Contributions to the defined benefit schemes of associates and joint ventures at constant are determined after consultation with the rates of exchange. This allows comparison of respective trustees and actuaries of the the Group’s results had they been translated individual externally funded schemes, taking at last year’s rate of exchange. This does not into account the regulatory environment. adjust for the normal transactional gains and Changes in the Group losses in operations which are generated by The Group acquired Bentoel during 2009 and exchange movements. from 1 January 2010 BAT Indonesia was merged The Group also prepares an alternative into Bentoel. There were a number of changes cash flow, which includes a measure of in the Group in 2008, described under adjusting ‘free cash flow’, to illustrate the cash flow items above. In January 2010, the Group before transactions relating to borrowings, announced the planned closure of the Tire and provides gross turnover as an additional factory in Turkey and the consolidation of all disclosure to indicate the impact of duty, manufacturing in Turkey in the Samsum factory. excise and other taxes. Share buy-back programme In accordance with the secondary listing In 2008, the Board decided to suspend of the ordinary shares of British American the on-market share buy-back programme Tobacco p.l.c. on the main board of the JSE that the Group initiated in 2003, in order Limited (JSE) in South Africa, the Group to preserve the Group’s financial flexibility is required to also present headline earnings during the period of economic uncertainty. per share. No shares were bought back during 2009.

58 British American Tobacco Annual Report 2009 Directors’ report: Business review From the Chairman www.bat.com/annualreport2009 Performance and strategy

Accounting developments borrowing costs for acquisitions, construction The Group has prepared its annual consolidated or longer-term projects and the additional financial statements in accordance with disclosures regarding fair value measurements International Financial Reporting Standards and liquidity risks. (IFRS), as endorsed by the EU. Generally, the During 2008, the Group amended its move to IFRS has made the reporting of accounting policy in respect of the recognition performance more complex. of actuarial gains and losses under IAS 19 and Regional review The disclosure of segmental information has adopted IFRIC 14. been updated to meet the requirements of The next few years are likely to see more IFRS 8 on Operating Segments. This standard, changes in the financial statements given which requires segmental reporting to be the aims of standard setters and regulators. on the same basis as is used for internal management reporting to the chief operating Going concern decision maker, has not required any changes Given the Group’s history of growth in profit to the segments reported. However, it has from operations, the high cash conversion resulted in certain changes to the disclosures. rate from profit into cash, the access to the Financial review £1.75 billion revolving credit facility which The Group has also amended the format is used only as a back stop and the spread of its financial statements in accordance of banks providing the facilities, the Group with IAS1 Revised (Presentation of Financial remains confident in its ability to access the Statements) and Improvements to IFRSs debt capital markets. (issued in May 2008). These amendments have required certain changes in the format of This, together with the maturity profile of debt, the financial statements and a reclassification spread over a long period with only limited of derivatives held for trading from current to redemptions scheduled for 2010, provides non-current on the balance sheet. The effect confidence that the Group has sufficient Governance at 31 December 2008 has been to increase working capital for the foreseeable future. non-current assets and decrease current assets After reviewing the Group’s budget, plans by £3 million, while increasing non-current and refinancing arrangements, the Directors liabilities and decreasing current liabilities by consider that the Group has adequate £23 million. resources to continue operating for the Other changes in accounting requirements forseeable future. The financial statements that were implemented but had limited or have therefore been prepared on a going no material impact on the results, are the concern basis. See the Corporate governance Group financial clarification of vesting conditions in respect of statement for full details. statements share-based payments, the capitalisation of

Foreign currencies The results of overseas subsidiaries and associates have been translated to sterling at the following exchange rates in respect of principal currencies: Average Closing financial statements 2009 2008 2009 2008 Parent Company US dollar 1.566 1.852 1.615 1.438 Canadian dollar 1.779 1.961 1.693 1.775 Euro 1.123 1.257 1.126 1.034 South African rand 13.091 15.132 11.891 13.292 Brazilian real 3.108 3.355 2.815 3.353 Australian dollar 1.990 2.187 1.796 2.062 Russian rouble 49.535 45.810 48.952 43.902 Shareholder information

Directors’ report: Business review British American Tobacco Annual Report 2009 59