an introduction to british american tobacco

Annual Review 2006 British American Tobacco 01Operating and financial review

We produce and market a wide and diverse range of brandsto suit consumers’ preferences, with a particular focuson our four Global Drive Brands (GDBs) – Dunhill, Kent,Lucky Strike and Pall Mall. Offering consumers choice andinnovation in our brands sets us apart from our competitorsand is contributing to the continuing growth of our GDBs.

Our vision is to achieve leadership of the global tobaccoindustry through strategies focused on delivering growth,improving productivity, demonstrating responsibility anddeveloping a winning organisation. These linked strategiesare working well, as we continue to build a business that issustainable and creates long term value for our shareholders.

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BRITISH

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TOBACCO

AN INTRODUCTION TO BRITISH AMERICAN TOBACCO

British American Tobacco was ‘born’international over 100 years ago. We nowemploy over 55,000 people and are thesecond largest stockmarket listed tobaccogroup in the world.

We are also well positioned in all regionsof the world, operating in over 180 markets.This geographical balance provides stability,while our presence in markets where volumesand profits are expected to grow gives usconfidence for the future.

02 British American Tobacco Annual Review 2006Operating and financial review

British American Tobacco has had another good year,with 7 per cent growth in our underlying profit fromoperations and a 10 per cent increase in adjusted dilutedearnings per share. The improvement in profit was drivenby volume growth of 2 per cent and net revenue growthof 5 per cent. The impact of exchange rates for the yearas a whole was not material, although it was significantlynegative in the last six months, especially in the lastquarter, and has continued into the current year.

Our Global Drive Brands were exceptionally successful,growing by 17 per cent. They now represent over21 per cent of the Group’s volume from subsidiaries,while international brands as a whole account for some40 per cent of the total.

Kent volume grew by 16 per cent to 45 billion, whileDunhill improved by 6 per cent, with encouragingperformances both in its new and its existing markets.Lucky Strike grew marginally and the star, once again,was Pall Mall, up 40 per cent.

There were net exceptional charges of £175 million,reflecting the restructuring costs relating to the factoryclosure programme, partly offset by the gains on adisposal of brands. The annual savings from our supplychain programme in 2006 amounted to £148 million,bringing the total to £374 million per year since westarted four years ago.

We also saved a further £99 million from the overheadsand indirects programme, bringing that total over thesame four year period to £355 million on an annualisedbasis. The current overheads and indirects programmewill be completed in 2007. However, we intend to maintainour focus on costs and will be announcing a further fiveyear target, along with the final results from the firstfive years, in March 2008. We will also pursue additionalsupply chain savings over the same five year period.

Our associate companies grew their volume by 4 per cent to241 billion and our share of their post-tax results amountedto £431 million. This represents a 10 per cent increase, if

exceptional items are excluded, reflecting higher profitsfrom Reynolds American and ITC. The contribution fromReynolds American was £285 million, with the earlyresults from the acquisition of the Conwood smokelesstobacco business being distinctly encouraging.

The improvement in profit from both subsidiaries andassociates, together with a lower effective tax rate andthe benefit of the share buy-back programme, morethan offset the impact of higher net finance costs andminorities. As a result, adjusted diluted earnings per sharerose by 10 per cent to 98.12p, just ahead of our longterm goal of achieving, on average, high single figuregrowth in earnings.

By the close of business on 1 March, we expect thatsome 35 million shares will have been bought backsince 1 January 2006 at a cost of £500 million and atan average price of £14.19 per share. Since 2003, whenthe buy-back programme started, around 246 millionshares have been repurchased at a cost of £2,191 million,equivalent to an average price of £8.91 per share. Wecontinue to view the purchase of our own shares as anexcellent investment.

Following a review of the Group’s capital structure,the Board has decided that there is scope to increasesignificantly both the dividend payout ratio and theshare buy-back programme.

The previous policy was to pay out at least 50 per centof long term sustainable earnings in dividends, with thepayout ratio in 2005 being 53 per cent. The Board hasdecided to raise the payout ratio to 65 per cent by 2008in progressive steps and is therefore proposing a finaldividend for 2006 of 40.2p, an increase of 22 per cent.This takes the total for the year to 55.9p, an uplift of19 per cent and raises the dividend payout ratio for2006 to 57 per cent. The dividend will be paid toshareholders on the Register at 9 March 2007. In linewith our current practice, the interim dividend for 2007will be approximately one-third of the total for 2006.

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CHAIRMAN’S STATEMENT AND FINANCIAL HIGHLIGHTS

“These strong results based on excellent organic growthcontinue to provide a solid platform for a sustainable business.Our consistent and balanced approach to the four elementsof our strategy for creating shareholder value is working well.”

Jan du Plessis, Chairman


In addition, the level of the share buy-back will risefrom around £500 million to some £750 million per year,starting in 2007. The increase in the buy-back programmeis likely to mean that, before the Annual General Meetingin 2008, the combined interest of Richemont and Remgro(R&R) will rise above 30 per cent. Not only is this the levelat which, under normal circumstances, an offer wouldhave to be made by R&R for the remaining shares inBritish American Tobacco, but such an outcome is specificallyprohibited by the existing agreement between R&R andthe Company.

Following discussions with both the Takeover Panel andR&R, the Panel has indicated, subject to final approval,that it is prepared to waive the 30 per cent rule, if theindependent shareholders approve such a waiver at theAnnual General Meeting. This will allow the Companyto continue the share buy-back programme, despitethe fact that the R&R shareholding will increase above30 per cent. The existing agreement restricting R&R’svoting rights to 25 per cent will remain in place.

R&R have given their consent to this proposal and in returnhave asked British American Tobacco to obtain a secondarylisting for its ordinary shares on the Johannesburg StockExchange, if and when requested by them. British AmericanTobacco has agreed to this. The proposal will be put tothe Annual General Meeting on 26 April for approval andthe Board recommends the independent shareholders tovote in favour.

The Board does not anticipate that it would continue thebuy-back once R&R’s interest had reached 35 per centof the issued share capital of the Company. At the currentshare price, and at the proposed buy-back levels, thisthreshold is unlikely to be reached in the next seven years.

While the increased level of the share buy-back programmewill create value for shareholders, it continues to preservefinancial flexibility because it can be suspended in the event ofan opportunity to make a significant acquisition that is bothfinancially and strategically attractive in the longer term.

Rupert Pennant-Rea will retire from the Board at the endof the Annual General Meeting. I would like to thank himfor the significant contribution he has made over the last11 years, not only as a Director but also as Chairman ofthe Audit Committee.

2006 has been a good year and I believe we can lookahead with confidence in our ability to achieve furthergrowth and value for shareholders. Over the past fiveyears, British American Tobacco has delivered an averageannual total shareholder return of 26 per cent, comparedto 7 per cent for the FTSE 100.

FINANCIAL HIGHLIGHTS

Profit from operations: like-for-like£ million

Operating profit, excluding exceptional items and the impact arisingfrom the change in terms of trade in Italy, increased from £2,607 millionto £2,797 million.

Adjusted diluted earnings per sharepence

Adjusted diluted earnings per share increased from 89.34 pence to98.12 pence per share.

Group volumesbillions

Group volumes from subsidiaries were 2 per cent higher at 689 billion.

Dividend per share declaredpence

Dividends declared in respect of 2006, were 55.9 pence per share(2005: 47.0 pence), up 19 per cent.

+19%

+2%

+10%

+7%

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2,607

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89.34

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678

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689

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47.0

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55.9

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We have reported another good set of numbers for 2006but what is the state of the tobacco industry and how isBritish American Tobacco expecting to fare in the future?

Before looking forward, it is worth examining our recentpast. Over the last five years we have grown volume,with our four GDBs leading the way, up 57 per centagainst a backdrop of quickening regulatory changes,excise increases and declines in the incidence of smoking.Not all the changes have been external, some areself-imposed. Five years ago we pioneered the industry’sfirst voluntary code, a set of restrictions on our marketingactivity worldwide. The conclusion I’ve drawn is thatit is still possible for us to succeed in an ever tougherenvironment. Whether new challenges come from ourown evolving standards or from regulatory restrictions,we can grow if our positioning and strategy are right.

We have a strong and complete portfolio of brands atdifferent price points. As well as our GDBs, it includes anunrivalled range of regional and local brands which playa vital role in our success in many markets. We have a fullrange of tobacco products and we have a track recordof innovation that our competitors struggle to match.

In addition to the opportunities for top line growth, thereare very significant opportunities to make cost savingsthrough our productivity initiatives. As you can read onpage 14, we are ahead of schedule and the more workwe do in this area the more we identify further savings.

We also believe that we have the right responsibilitystrategy for both the short and the long term and weposition responsibility as a key part of our overall businessstrategy. Consequently, we have invested significantlymore in R&D, particularly around harm reduction.

We agree that risky products such as tobacco should beregulated. Currently, tobacco regulation broadly focuseson three areas: preventing people from starting to smoke,encouraging quitting and protecting people around smokers.

However, we strongly believe that these prevention,cessation and protection efforts are missing an important

‘fourth dimension’, namely, harm reduction, for themillions of adults globally who will continue to betobacco consumers.

Current and future marketCurrently smokers consume over five trillion cigarettesa year globally.

China, the world’s largest cigarette market, makes up35 per cent of global volumes. Outside China, over halfthe global market is held by the six biggest internationalmanufacturers which, in 2006, were: Philip Morris, witha global market share of 18.7 per cent, British AmericanTobacco (including associates’ total volumes) with17.1 per cent, Japan Tobacco with 7.7 per cent, ImperialTobacco with 3.5 per cent, Gallaher with 3.1 per centand Altadis with 2.1 per cent.

Regulation of the industry and its products hasincreased in recent years, including graphic healthwarnings on packs, advertising and promotion restrictionsand, more recently, restrictions on public place smoking.Future regulation will largely be framed by the WorldHealth Organisation’s Framework Convention on TobaccoControl, which entered into force in 2005. Increasesin excise rates in many of the higher-price markets areleading consumers to switch to cheaper brands and thistrend is expected to continue. However, in emergingmarkets, consumers are increasingly trading up, sopremium brands are growing.

Over the next decade, we expect the average dailyconsumption of cigarettes to fall in many of the world’slargest markets. We also expect a declining incidenceof smoking generally, leading to smaller percentagesof populations being smokers, particularly in currentlyhigh margin markets such as Canada, Germany andJapan. However, the number of adults over the ageof 20 in the world is forecast to grow 11 per cent by2015. As a result, although the proportion of adultssmoking will probably decline, global volumes areexpected to be broadly unchanged at some five trillionin 2015. This future market represents a volume and

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“Whether new challenges come from our own evolvingstandards or from regulatory restrictions, we can growif our positioning and strategy are right.”

Paul Adams, Chief Executive


profit pool where, for those who are best positioned,there will still be a great deal to play for.

Unfortunately, the market has also attracted illicitmanufacturers and distributors of tobacco. We estimatethat some 6 per cent of tobacco consumption, about300 billion cigarettes a year, is supplied by smuggledor counterfeit trade. It is a key concern for us. Howmuch of the industry will become illicit in the future?We continue to work proactively with governmentsand customs authorities to try to stem this rising tide.

While volumes are forecast to decline in somemarkets, mainly the current higher margin markets,they are set to grow in others, mainly in lower marginmarkets. Nevertheless, global industry profits are alsoset to increase over the next decade. British AmericanTobacco’s broad geographic base means that we are wellrepresented in many of the lower margin markets wherevolume and profitability are expected to grow, and thatwe are not so reliant on high margin markets, wherevolumes are declining faster than the global average.

So, despite a changing business environment, we areconfident that the tobacco industry has a secure futureand that British American Tobacco has the strategy andproducts to prosper in it.

The evidence of the past decade bears this out. Althoughthe total global volume of cigarettes has been broadlystatic over that time, our global market share has grownsignificantly as a result of both acquisitions and organicgrowth, and our operating profit has increased by over60 per cent.

ConclusionThe tobacco industry is mature and all players, includingus, face some big challenges, but we still have lots ofroom for growth. British American Tobacco’s strong brandportfolio and record of innovation, our trade marketingexpertise, our cost savings potential, the global diversityof our earnings base, our presence in emerging marketsand the future size of those markets: these are all reasonsfor us to believe that our business can continue to grow.

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The following section contains:

06 Our strategy– Growth– Productivity– Responsibility– Winning organisation– Our key performance indicators

10 Our strategy in action10 Growth

– Our approach to marketing– Strategy– GDB strategy is working– Other international brands– Relationships with customers– GDB performance

14 Productivity– Supply chain savings– Overheads and indirects

14 Responsibility– Dow Jones SustainabilityIndexes

– Climate change– Harm reduction

18 Winning organisation– Employees– Employee opinion

GROUP NUMBERS 2006Gross turnover£25,189 million

Revenue after deducting duty, exciseand other taxes£9,762 million

Profit from operations£2,622 million

Net capital expenditure£419million

Research & Development expenditure£76 million

Charitable and community donations£17.6 million

Employees55,145

Global cigarette volumes689 billion


Our vision is to achieve leadership of the global tobaccoindustry, through strategies for creating shareholder valuebased on Growth, Productivity, Responsibility and aWinning Organisation.

We define leadership in both a quantitative and qualitativesense. Quantitatively, we seek volume leadership amongour international competitors. Qualitatively, we aim tolead our industry as the preferred partner of keystakeholders and in demonstrating responsibility.

�See diagram 1

GROWTHWe aim to grow our revenues and profits and to growour share of the global market. We have two routes todo this: organic growth and mergers and acquisitions.Organic growth means increasing our market share inexisting markets and through entering new markets.

To achieve organic growth, we focus on key marketsegments that offer the best long term prospects,including Premium and International Brands. We also aimto optimise the performance of our Global Drive Brandsand to exploit opportunities for profitable volume growthin the Value-for-Money and Low Price segments. We seeinnovative products that offer consumers meaningful,value-added differentiation as key to organic growth.We aim to continue sustaining or developing strongpositions in our largest and most profitable markets.

Strategically important and financially attractivemergers and acquisitions may also provide us withgrowth opportunities.

PRODUCTIVITYOur approach to productivity concentrates on smartcost management, marketing efficiency and capitaleffectiveness; deploying our global resources moreeffectively to increase profits and generate funds toreinvest in our business. This includes ensuring thatwe use our marketing resources and capabilities in themost efficient way, reducing unnecessary complexityand using our cash and other assets effectively. Weare saving money by turning a multinational businessoperating in over 180 markets into an integrated globalenterprise that can really take advantage of its scale.

Greater integration across our supply chain is helping usto reduce costs, increase speed to market and improveeffectiveness. We are also reducing our overheads and

indirect costs (anything we spend money on other thanleaf, wrapping materials, cigarette making machineryand labour costs).

RESPONSIBILITYBecause we manage a product that poses real risksto health, we strongly believe that our business mustdemonstrate responsibility in everything it does. We aimto balance our commercial objectives with stakeholders’changing expectations of a modern tobacco business.Our Business Principles and our Standards of BusinessConduct set out what we require of our companies andemployees in terms of responsible corporate behaviourand personal integrity.

We support tobacco regulation that balances thepreferences of consumers with the interests of society,establishes an open-minded approach to harm reductionas a policy, and enables our businesses to continue tocompete and prosper.

Harm reduction is an important element of our strategy.For more about our approach, see page 17.

WINNING ORGANISATIONTo achieve our vision of industry leadership, we recognisethat we must continue to have the right people and theright working environment. We aim to develop leadersat all levels, to foster a confident culture that embraceschange and innovation, to attract and retain talentedpeople and to ensure continuous improvementthroughout the Group.

OUR KEY PERFORMANCE INDICATORSMeasuring our performanceWe have a wide range of measures and indicators bywhich the Board assesses performance compared tothe Group’s strategy.

The Group’s goal to create shareholder value throughthe strategies of Growth, Productivity, Responsibilityand Winning Organisation is best measured by the mainfinancial drivers of the business. To ensure management’sfocus is aligned with the interests of our shareholders,these measures form the basis upon which the levelsof incentives for the global organisation are decided.They are described below as our seven Key PerformanceIndicators (KPIs). Some of these KPIs are used to set thetargets for the Group’s performance over three years andsome are focused on the short term. These KPIs were chosen

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as they are mainly based on published results or can becalculated from them. They are therefore reliable andare not based on subjective measures or interpretations.

A number of other Business Measures, financial andnon-financial, are monitored and assessed on a frequentbasis to ensure that all the Group’s strategies are delivered.Although all these are not included in management’sincentives, we believe that these Business Measures areall contributing to the success of the Group, particularlyover the longer term.

We have therefore included, in this Review, someadditional Business Measures relating to the Responsibilityand Winning Organisation elements of our strategy. Ourprogress under Productivity is, of course, covered by theinformation we already publish about the Supply Chainand Overheads and Indirects programmes.

These measures and the performance relating to them,are discussed on pages 14 to 19.

The Remuneration Committee sets targets at differentlevels, based on the Group budget approved by theBoard in December. The KPIs used in 2006 have beenretained for 2007.

Measuring short term performanceNet revenue growth

Net revenue for 2006 grew by 5 per cent. The long termgoal is to grow net revenue, on average, by 3-3.5 per centper annum.

The net revenue figure is calculated as the revenue ofthe Group after the deduction of any duties, excise andother taxes, as published in the Group Income Statementon page 42.

Global Drive Brand volumeA key strength of the Group is its diversified Global DriveBrands (GDBs) portfolio. The growth of the four GDBsDunhill, Kent, Lucky Strike and Pall Mall is therefore akey driver of the Group strategy and is measured as oneof the KPIs.

In 2006, GDB overall volume grew by 17 per cent to146 billion compared to 9 per cent growth in 2005. Ourtarget is to achieve high single figure growth.

GDB volumes are calculated as the total volumes of thefour brands sold by our subsidiaries.

More information about the GDBs and their individualperformances, is provided in this Review on pages 12 and 13.

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�Diagram 1: Group strategy

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Achieveleadership

of the globaltobacco industry

Growth Productivity

Winning Organisation

Responsibility

Net revenue growth£ million

Global Drive Brand volumebillions

Long term target, on average

3-3.5%

1

Long term target, on average,high single figures

2

9,301+7%

2005

9,672+5%

2006

124.9+9%

2005

146.1+17%

2006


Share of global volume amongst key playersThe long term goal is to become the leading internationaltobacco company and British American Tobacco iscurrently second.

In 2006, our share of global volumes amongst key playersgrew by 0.2 per cent. Share of global volume is calculatedas the volumes sold by Group subsidiaries as a percentageof the volumes sold by all international players, namelyPhilip Morris International, Japan Tobacco, ImperialGroup, Gallaher and Altadis. The information used tocomplete this calculation is based on publicly availableinformation and internal company analysis.

In our endeavour to grow global volumes, we assess allavailable acquisition opportunities on a frequent basis,but will only make a move when it is both financiallyand strategically attractive.

Organic operating profit growthThe Group’s long term aim is to grow organic underlyingoperating profit by 6 per cent per annum, on average.For 2006, it was 7 per cent and for 2005, it was 9 per cent.

Organic profit used in this assessment is the operatingprofit of the Group’s subsidiaries, excluding any exceptionalitems – the items shown as memorandum information onthe Group Income Statement on page 42.

Cash flowThe Group’s free cash flow in 2006 was £1,541 million,marginally below 2005.

Free cash flow is defined as net cash from operating activities(including dividends from associates, restructuring costsand taxation) less net interest, net capital expenditure anddividends to minorities – the change in free cash flow isdescribed on page 28.

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3 The purpose of this measure is to ensure that the Groupgenerates sufficient cash to fund its operations, paydividends to its shareholders, operate the share buy-backprogramme and undertake other investment opportunitiesthat may arise.

Measuring long term performanceEarnings per share

Adjusted diluted earnings per share (Adjusted EPS)grew at an average of 12.4 per cent per annum since thebeginning of 2004. This compared favourably to the longterm goal of growing at the rate of high single figuresper annum, on average, over the medium to long term.Adjusted EPS grew 10 per cent in 2006 (2005: 17 per cent).

Adjusted diluted EPS is the best measure to assess theunderlying performance of the business, as it excludesall significant distortions (one-off and exceptional itemsthat occur) but includes the potentially dilutive effect ofemployee share schemes. The detail of the calculationand the adjustments made, are explained in note 7 tothe accounts included in the Annual Report and Accounts.This calculation removes the impact of the exceptionalitems shown as memorandum information on the GroupIncome Statement on page 42. These items are therestructuring costs and impairment of a business, offsetby gains on disposal of brands. In addition, the calculationalso adjusts for certain distortions in net finance costsarising under IFRS.

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Total Shareholder ReturnThe Group’s strategy is focused on increasing shareholdervalue which is measured using Total Shareholder Return(TSR), compared to the FTSE 100 Index and also to theFast Moving Consumer Goods (FMCG) peer group. TheGroup has achieved a top quartile performance in boththese categories since 1999. The goal is to be in the topquartile of each of the two comparator groups over athree year average.

Over the past five years, the Group has delivered anaverage TSR of 26 per cent compared to 7 per cent forthe FTSE 100 Index (see page 37 for performance graph).

TSR performance combines both the share price anddividend performance of the Company during theperformance period, as set against the two comparatorgroups. The FMCG comparator group is reviewedannually to ensure that it remains both relevant andrepresentative and to, as far as possible, reflect theCompany’s financial and business trading environment.

TSR is measured according to the return index calculatedby Datastream, on the basis of all companies’ dividendsbeing reinvested in the shares of the companies. Thereturn is the percentage increase in each company’s indexover a three year period. The measures and the outcomefor the current and previous years are explained in theSummary Remuneration Report on page 36, where theGroup’s employee share schemes are described.

7Share of global volume amongst key playerspercentage

Organic operating profit growth£ million

Cash flow£ million

Earnings per sharepence

Long term target

No.1

Specific target set for each year

5

Long term target, on average

6%

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3

6

Long term target, on average,high single figures

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2,607+9%

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2,797+7%

2006

1,582+18%

2005

1,541–3%

2006

89.34+17%

2005

98.20+10%

2006

Total shareholder return (annual %)(1 January 2004 – 31 December 2006) FMCG group

The FMCG comparison is based on three months’ average values.

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Upper QuartileLower Quartile

Median – 15.3% BAT – 32.2% 35

30

25

20

15

10

5

0

–5

Total shareholder return (annual %)(1 January 2004 – 31 December 2006) FTSE 100

The FTSE 100 comparison is based on three months’ average values.

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Upper QuartileLower Quartile

Median – 19.9% BAT – 32.2% 70

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40

30

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17.1%


GROWTHOur approach to marketingWe recognise that our marketing must be conductedresponsibly, ensuring that we communicate our productand brand benefits to adult consumers. In 2001, wedeveloped, along with two major international competitors,the International Marketing Standards (IMS). They setout detailed guidance on all aspects of tobacco marketingfrom print, billboards and electronic media to promotionalevents, packaging and sponsorship. In 2006, in accordancewith the IMS, we ended our sponsorship of Formula 1motor racing.

We want to keep our marketing activity responsive to afast changing world. During 2007, we will therefore berevising our own set of Standards, to include newer medianot captured in the original 2001 version (e.g. internetsales and text messaging), enhanced adult age verificationprocedures and tighter restrictions on promotion andsampling. These and other changes will help ‘raise thebar’ further in terms of addressing what is acceptabletobacco marketing worldwide.

Our marketing approach focuses on using insights intoconsumer lifestyles and values to develop relevant products.These insights drive the development of our product andcommunication campaigns, to differentiate our productsfrom our competitors’ offerings in ways that resonatewith adult consumers. This includes the work of our TradeMarketing & Distribution teams to place and promote theright brands in the right retail outlets for the right consumers.

StrategyCentral to our marketing approach is the premise thatone size does not fit all and we believe a key strength ofBritish American Tobacco is our diversified Global DriveBrands (GDBs) portfolio. These brands deliver rationalchoices such as product, blend and price along withother perceived consumer benefits like strength andtaste. Our growth strategy is built on the success of ourfour GDBs, Dunhill, Kent, Lucky Strike and Pall Mall.We focus our resources to develop these brands in thekey International, Premium, Lights and Adult SmokersUnder 30 (ASU30) marketing segments, where we

expect both current and long term growth opportunities.We also continue to invest in our regional and localbrands, especially where they play a strategic role ina particular market’s portfolio.

We also take opportunities to invest in brands that showspecific promise, particularly in the growing segments,such as Vogue, our premium superslims offer, and Kool,our premium menthol offer.

See chart

GDB strategy is workingOur strategy is working. In 2006, our Premium GDBs alonegrew by 9 per cent. Each of our four GDBs grew in 2006,including Lucky Strike which returned to marginal volumegrowth and continued to improve its share in most of itscore markets. We grew our GDBs in each of our operatingregions, with double digit GDB increases in Asia-Pacific,Europe, Africa and Middle East and Latin America.

The 2 per cent overall volume growth is not concentratedin one country or region. We saw increases in all regionsexcept for America-Pacific, where volume declines inCanada offset gains in Japan.

Our investment in consumer relevant innovation isdelivering results in both volume and value terms. 2006saw a number of highly successful product launches inwhich we offered consumers additional value at a higherprice point. Dunhill Fine Cut cigarettes in numerousmarkets and Pall Mall superslims across key EasternEuropean markets, such as Russia, were just two specificproduct innovations that drove volume and higher netrevenue from our GDBs portfolio. They are concreteexamples of us meeting the preferences of consumerswho, in turn, are choosing to trade up to products thatdeliver higher margins. Innovation is strengthening thefoundations for our future growth.

See chart

Other International BrandsWhile our investment and managerial focus remainsfirmly on our four GDBs, 2006 saw robust growth acrossour broader range of International Brands (IBs), with total

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International Brand growth at 11 per cent for the year.Vogue, our premium superslims offer, led the way withan impressive 32 per cent growth due to excellent resultsin South Korea, Russia, Italy, France and Ukraine. Koolgrew by 16 per cent, as the menthol category continuesto expand worldwide. In addition, we saw robust growthfrom Benson & Hedges, Rothmans and Craven ‘A’. Ourefforts to appeal to consumers who are choosing totrade down in price but still want an international brandsucceeded with Viceroy, which grew by 19 per cent in 2006.

See chart

Relationships with customersThe increasingly restrictive environment in which wecan communicate with consumers means that TradeMarketing & Distribution (TMD) is a key element ofour marketing activity. We recognise the importanceof the retail outlet. That is why we strive to achieve andmaintain benchmark business partnerships with the retailtrade in all the strategic channels where we do business.

To achieve benchmark status, we must operateconsistently in the most effective and efficient mannerto serve our trade customers, both independent outletsas well as our major account customers. We measureour performance in this area extensively and the mostrecent external and independent survey carried out in2006 revealed that, in a majority of countries, retailersperceive British American Tobacco as having the bestTMD organisation compared to other tobacco companies.

The foundation for this success is our ‘Win Win Win’strategy. We recognise that in order for our strategyto succeed, it is imperative that there is a benefit for allthree participants – our customers, ourselves and, aboveall, our consumers. All three must stand to win in someway. This approach resonates with our trade partners,as reflected in our global deal with Shell signed in 2006,the first of its kind within the FMCG sector. Our GDBs,plus two strategic brands in appropriate markets,now have guaranteed, prominent display space in5,500 Shell convenience stores around the world.

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Strategic segment volume in 22 key marketsbillions

Based on data from the 22 markets, our share in each segmentincreased in 2006 to ASU30 (30.2%), Lights (26.6%), IBs (21.8%)and Premium (29.4%).

GDB volume growthbillions

Since 2001, our four GDBs (Dunhill, Kent, Lucky Strike and Pall Mall)have increased combined volume by 57%.

Other International Brands – volume growthbillions

Since 2001, other International Brands (excluding the four GDBs) roseby 3%.

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ASU30

144

199

Lights

208

156

IBs

171150

Premium

153

20052006

100

2002

93

2001

113

2003

114

2004

125

2005

146

2006

116

2002

129

2001

118

2003

122

2004

127

2005

133

2006


GDB performanceDunhillDunhill provides us with a Premium/Super Premiumbrand to meet the needs of consumers at the top endof the tobacco market. In 2006, we extended Dunhill’sgeographic reach, as well as the product segments inwhich Dunhill competes.

2006 saw the successful enhancement of the House ofDunhill via the rapid roll-out of Dunhill Fine Cut cigarettes,the relaunch of Top Leaf and the pilot launches of theEssence (superslims) and Senses (menthol) ranges.These initiatives succeeded in Dunhill’s core marketssuch as Australia, Malaysia, South Korea and Taiwan,where they supplemented existing Dunhill offers, whilestretching the price mix to premium plus levels. Thesedevelopments also helped in the promising launch androll-out of Dunhill in new markets, particularly in WesternEurope and the Middle East. Furthermore, a numberof key product innovations that commanded premiumplus price points were successfully launched. We believethat the equity of the brand, combined with tangibleproduct benefits delivered by these innovations, providesconsumers with what they want.

Manufacture of the Dunhill Signed Range cigarswas moved to Nicaragua in 2006. This change willsignificantly reduce our supply chain complexity, allowus to continue to deliver a premium cigar and invest inthe further growth of the range.

2007 sees the centenary of the Dunhill tobacco brandand several ambitious initiatives will roll-out worldwidein celebration.

KentKent continues to play its key role in our portfolio asthe free standing premium brand for consumers seekinga mild and smooth taste. Kent aims to be the leadingbrand for ASU30 smokers and perceived consistentlyas the brand that delivers ‘the modern way to smoke’.

Kent has continued to demonstrate the innovativenature of a brand designed for the 21st centurythrough a number of linked initiatives. These includethe introduction of a new global pack and the corecharcoal range’s use of 3-Tek filter technology. A newcommunication campaign in Russia, Japan, Romania andChile resulted in accelerated organic growth of the brandin these markets. In Switzerland and the Netherlands,British American Tobacco launched the brand via themigration of Barclay consumers to Kent. Initial results arepromising, with exceptionally strong consumer responsefrom both existing smokers and those switching fromcompetitor brands.

The net result of these initiatives saw Kent become thenumber one brand in Romania, as well as achieving over abillion cigarettes a month in sales in Russia. Kent deliveredthe fastest rate of growth among our premium GDBs,with its fourth consecutive year of double digit growth.

Lucky Strike2006 was a milestone year for the Lucky Strike brand,as it managed to return to volume growth and achievedrecord market share in Germany, Spain, France, Indonesia,Argentina and Italy.

In 2006, Lucky Strike focused on establishing itself as thebrand that provides ‘a rich tobacco experience’ throughthe launch of an innovative pipeline of product andpackaging initiatives.

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OUR STRATEGY IN ACTIONCONTINUED


Lucky Strike’s new premium pack designs add quality,heritage and product expertise cues and further differentiatethe Original Red from the Original Silver variant. The newranges, with Madura, Fireleaf Silver and Mentha Piperitavariants, deliver unique tobaccos to provide a choice ofrich taste and uncompromised smoking pleasure.

Lucky Strike launched new Roll Your Own (RYO) productsin an effort to capitalise on growth without diluting itspremium image. In smokeless products, the market successof Lucky Strike snus in Sweden and the pilot learningsachieved in South Africa, are encouraging signs that thebrand’s equity can be successfully stretched into othertobacco categories.

Pall MallPall Mall aims to redefine consumers’ experience at theValue-for-Money price point by delivering on its promiseof ’imagination in tobacco’ with innovative productand brand attributes. Pall Mall achieved an outstandingperformance in 2006, driven by good organic volume andshare growth in its established markets such as Germany,Poland and Spain, as well as many successful launches inall regions.

Pall Mall’s success is driven by the strong and globallyconsistent brand mix, supported by a solid innovationpipeline, ensuring Pall Mall has a leadership position inresponding to consumer needs in the Value-for-Moneysegment. The launch of House of Pall Mall in Switzerlandincluded the introduction of four different tobaccoproducts (small cigars, RYO, Superslims and Stix) alongwith a range of King Size cigarettes offering more choice.In Germany, Pall Mall successfully captured consumersmoving from Stix to other tobacco products within thebrand family and achieved its highest ever share of theGerman market by the year end, to become the secondlargest tobacco brand.

33 billion cigarettes sold in 20066 per cent increase on 2005


22 billion cigarettes sold in 20060.4 per cent increase on 2005


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PRODUCTIVITYSavings generated by our productivity initiatives are aheadof plan. The substantial efficiencies made in the supplychain, supported by savings through our overheads andindirects programmes, are releasing funds for reinvestmentin research, product innovation and growth, as well asbeing a significant driver of operating profit growth.

Supply chain savingsOur focus on primary supply chain efficiencies hasdelivered benefits of £148 million in 2006, bringing theannual savings for the four years of the programme up to£374 million. These savings are predominantly the resultof efficiencies within our manufacturing and logisticsoperations and initiatives surrounding the specification,purchase and usage of packaging and leaf materials.

There has been further rationalisation of our manufacturingcapacity, with 12 factories closed in the year, includingGuelph in Canada and Southampton in the UK, andcigarette manufacture in Bologna in Italy has ceased. Inaddition, a further four factory closures were announced,including Zevenaar in the Netherlands, and a numberof downsizing exercises have been completed. Theseinitiatives, together with the Group’s ‘Bullseye’ bestpractice audits have increased overall productivity bynearly 10 per cent in the year. We have also redeployed650 individual machinery assets around the Group.

The job losses resulting from closures and downsizings havebeen addressed with care and responsibility. Mitigationactivities have included fair redundancy packages, extensiveoutplacement support and, where appropriate, communitywide initiatives aimed at new job creation. The Company’sMitigation-Plus programme in response to the Darlingtonfactory closure in the north east of England is one of thoseto have received recognition, a best practice award in 2006from the UK-based Management Consultants Association.

The Product Complexity Reduction programme targetsthe elimination of irrelevant complexity across our brandportfolio. Working together, our Operations and Marketingteams have defined standards covering all the key attributesof our brands, from packaging design through to productspecifications and leaf blends. As a result, we have beenable to rationalise and simplify the number of combinationsand specifications we use in our supply chain by morethan 30 per cent. We have also reduced the number ofstock keeping units we sell by 24 per cent, leaving a morefocused, consumer-relevant portfolio.

The productivity, complexity and capacity optimisationprogrammes will continue over the next few years andwill realise significant savings.

In addition, we will establish new capabilities for drivinggrowth through consumer relevant innovations, deliveredthrough an effective and efficient, integrated supply chain.Improvements in global supply chain operations to datewere recognised by a European Supply Chain ExcellenceAward, presented by the magazine ‘Supply Chain Standard’in November 2006.

Overheads and IndirectsThe Overheads and Indirects cost reduction programmeended its fourth year and delivered savings of £99 million.Since its inception in 2003, annualised savings havereached £355 million and are well on the way to reachthe £400 million target by 2007.

Savings are, in part, being driven by the adoption ofsmarter procurement processes around the Group, withprocurement specialists working with key business managersto find mutual benefits. The amount of indirect expenditure(those items that are not involved in cigarette production)that is channelled through procurement has increased toa level that now covers most areas of the business andthe processes established are being embedded withinthe business for sustainable benefit.

The move to shared services in both IT and Finance isgaining momentum and is now delivering real value.

RESPONSIBILITYResponsibility is a key element of our business strategybut how do we measure or assess our performance?We look to external benchmarking to provide us withan objective view on how we are doing and use the DowJones Sustainability Indexes (DJSI) as our primary BusinessMeasure. With regard to our environmental impacts, wehave the data and have been reporting on the trends forseveral years. On pages 15 to 17, we have included someof these measures in a section on the key topic of climatechange. In harm reduction, we can report some encouragingsigns of increasing engagement around an area which iscentral to our business strategy.

Dow Jones Sustainability IndexesIn 2006, we were, for the fifth year running, the onlytobacco company included in the DJSI. Launched in1999, the DJSI are global indices tracking the performanceof the leading companies worldwide. The indices arebased on a detailed assessment of companies’ economic,environmental and social performance, and on how wellthey integrate sustainability strategies into their business.

Externally, these benchmarks are used by asset managersto make investment decisions and by other stakeholderslooking at sustainable businesses. Internally, participation

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Emissionstonnes CO2 per million cigarettes equivalent

Since 2001, our emissions have fallen by 43%.

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1.26

2002

1.38

2001

1.23

2003

1.13

2004

0.83

2005

0.79

2006

Dow Jones Sustainability IndexesWas 2006 score Was scoresame or better higher than

Dow Jones Criteria than 2005? sector average?

Economic Dimension ✖ ✔

Environmental Dimension ✔ ✔

Social Dimension ✔ ✔

Economic Dimension

Corporate Governance ✔ ✔

Risk & Crisis Management ✔ ✔

Codes of Conduct/Compliance/ ✔ ✔Corruption & Bribery

Customer Relationship Management* ✖ ✖

Combat Smuggling ✖ ✔

Environmental Dimension

Environmental Policy/Management ✔ ✔

Environmental Performance (Eco-efficiency) ✔ ✔

Environmental Reporting ✔ ✔

Management of GMO ✔ ✔

Fuels for Tobacco Curing ✔ ✔

Raw Material Sourcing ✔ ✔

Social Dimension

Labour Practice Indicators ✔ ✔

Human Capital Development ✔ ✔

Talent Attraction & Retention ✔ ✔

Social Standards for Suppliers (new) ✔

Corporate Citizenship/Philanthropy ✔ ✔

Social Reporting ✔ ✔

Responsible Marketing Policies ✔ ✔

Occupational Health & Safety ✔ ✔

**TARGET reached ✔

*We were previously sector leaders in this category but a change in the scoringsystem resulted in a significant fall in our score in 2006.

**Our target is to record a higher score than the sector average in a minimumof 15 out of 19 categories.

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in the indices gives us an objective third party perspectiveon how we are managing the business and allows us tobenchmark our performance against the best in the sectorand the sector averages.

The tobacco sector group is based upon an assessmentof 10 tobacco companies, although the names of all thecompanies are not publicly disclosed. In 2006, our overallscore remained equal to last year’s at 79 per cent againsta sector average that increased significantly to 66 per cent.We achieved the top score in 13 out of 19 categories,improved our score in 16 and scored better than the sectoraverage in 18. We shall continue to submit ourselves forconsideration, with the aim of maintaining our position inthe indices. However, because inclusion is determined bya third party, we have chosen not to regard inclusion itselfas a Business Measure. Chart 4 shows how we report ourperformance in the DJSI. Our annual target is to recorda higher score than the sector average in a minimum of15 out of 19 categories.

See chart

Climate changeWe consider it to be part of our responsibility to measure,monitor and reduce our energy use and greenhouse gas(GHG) emissions and report on our global performance inaccordance with Global Reporting Initiative (GRI) guidelines,publicly on an annual basis.

We view reductions in emissions as being the top priority,followed by mitigation. Where no further reduction ormitigation is possible, we will look to offsetting.

Reduction – our performance on reducing emissionsWe have reduced both the absolute amount and intensity(per unit production) of our CO2 emissions in recent years.This has been achieved by energy conservation initiatives,investment in energy efficient technologies, use of renewablefuels and through consolidation of our manufacturingfootprint. We also work to reduce waste sent to landfilland increase the amount of waste recycled.

EmissionsCO2 is a GHG, a major contributor to climate change.

In 2000, the Group committed to reducing CO2 emissionsby 5.2 per cent by 2008, in line with the Kyoto protocol.This was achieved by 2004. We have set progressively morestretching targets each year since 2004. In 2006, the targetwas 0.78 tonnes CO2 per million cigarettes equivalent andwe achieved 0.79 tonnes, a reduction of 5 per cent over2005. Over the last five years, our emissions have reducedby 43 per cent.

See chart 5

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Waste to landfillWaste sent to landfill creates methane, which is 21 timesmore potent as a GHG than CO2.

By reducing the amount of total waste generated andincreasing recycling rates, we have reduced waste sentto landfill by 59 per cent since 2001.

See chart

RecyclingIncreasing recycling rates reduces the amount of wastethat is sent to landfill. Our 2006 global recycling ratewas 81.2 per cent.

Through proactively seeking new partners and destinationsfor recycling, we have increased our recycling rates overthe last five years. There are now 10 companies withinthe Group achieving 95 per cent recycling rates.

See chart

Working with our Supply ChainSuppliers are increasingly seen as a critically importantstakeholder group and there are growing expectationsthat businesses should use their influence to encouragegood standards of corporate responsibility in their supplychains. We accept this responsibility and work not onlyto set high standards for our suppliers but to supportthem in achieving continuous improvement.

We see this as particularly important for a very largebusiness such as ours, with a primary supply chain thatincludes some 250,000 farmers who grow tobacco leafand other international suppliers from whom we buyother raw materials such as packaging and paper.

Our major supply chain programmes include our BusinessEnabler Survey Tool (BEST), which sets out in detail thestandards we expect of the suppliers from whom we buyraw materials other than leaf. BEST assesses suppliers across102 performance criteria, covering, for example, suppliers’business ethics; environment, occupational health andsafety management; employee rights and the supplier’sability to trace the sources of raw materials, includingsourcing wood from sustainably managed forestry.

Social Responsibility in Tobacco Production (SRTP) is asignificant programme that aims to ensure that we onlypurchase tobacco leaf from responsible and sustainablesources, by working to address the social and environmentalissues associated with tobacco leaf growing and processing.

We have also encouraged other manufacturers to adopt asimilar approach, an initiative that is gaining considerablesupport. Our supplier review methodology has beenadopted by a number of tobacco manufacturers, whileothers have adopted similar programmes of their own.

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In terms of reducing GHG emissions, we are workingwith leaf and material suppliers, through both the SRTPand BEST programmes, to achieve further improvementand we will be establishing minimum environmentalperformance criteria for suppliers during 2007.

Mitigation activities – The British American TobaccoBiodiversity PartnershipWe are also working with our Non-GovernmentalOrganisation partners (Earthwatch Institute (Europe),Fauna & Flora International, the Royal Botanic Gardens,Kew and the Tropical Biology Association) within theBiodiversity Partnership to avoid, minimise and mitigateour impacts on biodiversity and minimise the use ofecosystem services, such as soil, water and wood.

We have categorised our projects in accordance withdefinitions from the Intergovernmental Panel on ClimateChange (IPCC), splitting the contribution to the ClimateChange agenda into the following:

• Understanding impacts, adaptation and vulnerability• Mitigation

Of the current 43 projects within the partnershipprogramme portfolio, 25 address understanding impacts,adaptation and vulnerability, and 17 address the mitigationpart of the IPCC definitions. 14 of the projects addressboth and 15 are relevant to neither aspects of climatechange but are relevant to biodiversity conservation.

Water useIn many areas where we operate, climatic variationsmay cause water to become a scarce resource. In 2006,we have reduced our water use by 7 per cent and overthe last five years it has come down by 41 per cent.

See chart

OffsettingWe do not use the information below to formally offsetour CO2 emissions, as many of the trees that we sponsorare not owned by us.

However, since the 1970s, Group companies havepromoted forestry programmes to ensure a source ofwood fuel for tobacco growers. The Edinburgh Centre forCarbon Management has helped the Group to quantifythe CO2 take-up and storage by these forests since 1998.At the end of 2005, the carbon storage associated withthe programmes in Brazil, Kenya, Pakistan and Ugandawas estimated at 400,000 tonnes of carbon, equivalentto 1.46 million tonnes of CO2. This compared to the0.85 million tonnes of CO2 emitted from Group companies’operations in 2005. This study will be updated in 2007.

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During 2007, we will investigate potential ways to offsetour emissions, although our first priority will always beto reduce them as far as possible.

Harm reductionWe believe that harm reduction, which is a key element ofour business strategy, ought to be able to find commonground with the goals of public health policy.

We agree that risky products such as tobacco should beregulated. Currently, tobacco regulation broadly focuseson three areas: preventing people from starting to smoke,encouraging quitting and protecting people around smokers.

However, we strongly believe that these prevention,cessation and protection efforts are missing an important‘fourth dimension’, namely, harm reduction, for themillions of adults globally who will continue to betobacco consumers.

The World Health Organisation predicts that, evenwith increasingly strict regulation, there will be as manyor more smokers globally in 10 years’ time as there aretoday, as falling tobacco consumption is offset by astrongly rising world adult population.

In public policy, harm reduction is an established concept.It recognises that positive health outcomes can be achievedin ways other than through disincentives, punitive measuresor the prohibition of certain lifestyle choices.

Smoking poses real and serious health risks, but nicotine,at the levels smokers take, does not. If smokers could takenicotine from pleasurable tobacco products with far lowerrisks than smoking, we believe that tobacco related harmto health would reduce far faster than current publichealth efforts can achieve alone.

We believe we can contribute to reducing the harm oftobacco use through innovative products, while alsosupporting the long term sustainability of our business.

What we are doingEncouraged by public health stakeholders, we haveextended some major cigarette brands to Swedish-stylesnus, a smokeless tobacco product mainly sold in Swedenand recognised by health experts, such as the UK’s RoyalCollege of Physicians, to be much less harmful than smoking.We are marketing snus in Sweden, have started sales inNorway and, building on our experience in South Africa,have begun a pilot in Japan. We plan to extend theseinitiatives elsewhere in due course.

We are planning to lobby for an amendment to the EU banon snus sales in the EU except for Sweden. We believe thereis no rational justification for continuing to bar smokersfrom choosing a less hazardous alternative to cigarettes.

Waste to landfilltonnes per million cigarettes equivalent

Since 2001, we have reduced our waste to landfill by 59%.

Recyclingpercentage of waste recycled

Since 2001, we have increased our recycling by 24%.

Water usecubic metres per million cigarettes equivalent

Since 2001, our water usage has decreased by 41%.

*For comparison purposes, the 2004 figure excludes data from Peru relating to the useof irrigation water by farms owned by a company we acquired in late 2003. It is unusualfor the Group to own farms. The 2004 figure, including Peru, is 8.01.

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0.050

2002

0.056

2001

0.042

2003

0.036

2004

0.035

2005

0.023

2006

63.6

2002

57.3

2001

69.4

2003

72.3

2004

72.5

2005

81.2

2006

8.01

2002

8.73

2001

7.84

2003

6.61*

2004

5.58

2005

5.18

2006


We are also developing a scientific framework forevaluating the relative risks of different tobacco products,both combustible and non-combustible. Currently, there isno accepted approach to measuring tobacco consumers’exposure to the toxicants believed relevant to tobaccorelated disease. This is vital to enable development oflower risk tobacco products. However, we cannot developa framework alone. To ensure that the work and supportingresearch are robust, we are expanding our engagementwith external scientists.

Research and developmentOur research and development activities are focused ondeveloping new products and new processes, as well asmaintaining and improving the quality of existing products.Research is also carried out on risk characterisation,building a framework to assess the relative risk of noveland conventional products and a better understandingof how consumers use them. Risk reduction, such asdeveloping technologies that have the potential to lowerexposure to toxicants in smoke, is also a central part ofthe research and development programme. Research isalso undertaken into aspects of the science and behaviouralscience related to smoking and we continue to providefunding for independent studies.

WINNING ORGANISATIONBritish American Tobacco will be a winning organisationwhen it is recognised by its employees as being a greatplace to work, where outstanding people are attracted,challenged and have the opportunity to grow.

EmployeesCreating a safe place to work has to be our primaryconsideration for employees. We measure and trackperformance using a measure of the Lost WorkdayCase Incident Rate (LWCIR).

Over recent years, the rate has been reducing, althoughthe acquisition of ETI in Italy in late 2003 had a negativeeffect on safety performance in 2004. As British AmericanTobacco’s standards for safety were adopted, performancein Italy has improved. In 2006, we aimed to achieve afurther 10 per cent reduction to a rate of 0.44. In fact,the rate fell to 0.42 from 0.49. Positive as this trendis, we continue to aspire to achieve a rate of 0.1-0.2,considered to be a best practice standard for comparablemultinational organisations.

We are committed to providing a work environmentthat is free from harassment, bullying and discrimination.There is no discrimination against people with disabilitieswho apply to join the Group and those with a disability

are afforded the same opportunities for promotion, trainingand career development as other staff. Our EmploymentPrinciples are available to all staff on the Group’s intranet.

The Group continues to encourage employee ownershipthrough its provision of employee share plans, including thePartnership Share Scheme and the Share Reward Scheme.

In addition to the global survey (see below), we encourageemployee engagement through individual discussions, teambriefings, local surveys, publications and regular meetingswith recognised employee representatives.

See chart

Employee opinionThe extent to which our employees, at every level ofthe business, feel engaged and committed to deliveringsuperior results is key to delivering our leadership vision.

The most authentic way to measure progress is to collectviews from employees themselves. The best judge (andindeed the best influencer) of the extent to which we aremaking tangible progress in what underpins our WinningOrganisation strategy has to be our employees, at everylevel and in every part of the business. We therefore workto create an environment where employees feel that theycan speak honestly about their company and the issuesof importance to them, placing emphasis on the role ofemployee opinion research.

Our international employee opinion survey, ‘Your Voice’,is run by ISR (International Survey Research), a leadingglobal employee research organisation, to gather detailedviews from employees to enable regional, functional andlocal action planning. Your Voice was conducted as a globalcensus for the first time in October 2005, in over 70 markets,followed by a further census in November 2006, capturingthe feedback from over 38,000 employees. The surveycovers all levels of employees and will now be run attwo yearly intervals.

BenchmarkingTo establish how employee opinion within British AmericanTobacco compares with other organisations, our globalemployee opinion survey data is compared with ISR’sglobal FMCG companies norm.

Many of these companies (e.g. Diageo, Nestlé,Coca-Cola and Unilever) also appear in the peer groupof FMCG companies used to assess our performancein the Long Term Incentive Plan (LTIP) – see page 37.

2006 survey resultsThe overall response rate for the survey in 2006 improvedover the previous year to reach 89 per cent.

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In all of the 15 categories in the 2006 survey, employeeopinion in British American Tobacco is significantly morepositive than in the FMCGs benchmarked by ISR.

There were also significant improvements in most of thecategories compared to the previous survey.

See chart

Using the survey resultsOf course, it is positive for us to know that our employees,for example, understand our global vision and are proudto be associated with the Company, but how can thesurvey be used to improve performance?

ISR research shows that employee attitudes aboutleading indicators (e.g. strategic direction, leadership,talent, customer focus) tend to be significantly morefavourable in high performing organisations. The laggingindicators (e.g. morale, efficiency, commitment) tendto follow naturally. As the leading indicators tend to bethe key drivers of improved organisational performance,we concentrate our efforts on these particular areas.

A number of the indicators (e.g. strategic direction,morale) are drawn from a range of the categories shownin Chart 10 and do not correspond directly to a singlecategory heading.

We are performing well in terms of many of the leadingindicators, including strategic direction and customerfocus. In response to scores that were less positive, wehave committed to put more focus on leading indicatorssuch as leadership and talent. Recent actions includesetting clear targets for local representation on top teamsand in succession plans.

The survey results are used at global, regional, local andfunctional levels, while the learning from companies withgood results is captured and shared around the Group.

The survey results also provide detailed informationabout any areas of concern. If issues have been raised,the companies work with employees on action plansto improve in the highlighted areas.

The Your Voice survey is a major undertaking across theGroup and is key to the way we measure our performancecompared to the Group strategy. We will continue to seekand respond to our employees’ opinions.

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Lost Workday Case Incident Rate (LWCIR)LWCIR = No. of lost workday cases through injury or occupational illnessto employees x 200,000 ÷ total hours worked by all employees

Since 2001, the LWCIR has decreased by 42%.

*For comparison purposes, the 2004 figure excludes new companies acquired. If theseacquisitions are included, the 2004 figure is 0.64.

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Your Voice survey 2006British American Tobacco vs. ISR global FMCG companies norm

Favourable scores Differences from benchmark

Survey follow up75 8

Pay and benefits55 8

Information andcommunication 77 7

Leadership72 6

Respect for ouremployees 69 6

Learning64 6

Talent60 6

Team working79 5

Alignment76 5

Structure68 5

Corporateresponsibility 80 4

Culture79 4

Freedom throughresponsibility 71 2

Enterprising spirit67 2

Open minded57 2

0 20 40 60 80 100 0 10

10

0.63

2002

0.72

2001

0.55

2003

0.48*

2004

0.49

2005

0.42

2006


REGIONAL DATAVolumes Revenue Operating profit

2006 2005 2006 2005 2006 2005bns bns £m £m £m £m

Europe 247.7 244.0 3,545 3,497 781 784Asia-Pacific 141.9 137.1 1,839 1,758 616 531Latin America 152.6 149.3 1,791 1,555 611 530Africa and Middle East 103.3 102.6 1,489 1,405 468 434America-Pacific 43.8 45.0 1,098 1,110 424 436

689.3 678.0 9,762 9,325 2,900 2,715

Unallocated costs (103) (96)

Operating profit before exceptional items page 26 2,797 2,619

Revenue and operating profit, beforeexceptional items, restated at comparablerates of exchange page 26 9,774 9,325 2,799 2,619

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REGIONAL REVIEW

■ Europe■ Asia-Pacific■ Latin America■ Africa and Middle East■ America-Pacific

■ Associates


REGIONAL SUMMARYThe reported Group profit from operations was 8 per centhigher at £2,622 million or, as explained on page 26,7 per cent higher on a like-for-like basis, with Asia-Pacific,Latin America and the Africa and Middle East regionscontributing to this good result.

Group volumes from subsidiaries increased by 2 per centto 689 billion on both a reported and like-for-like basis.The reported Group revenue rose by 5 per cent to£9,762 million and also increased by 5 per cent ona like-for-like basis. This excellent volume and revenuegrowth was achieved across a broad spread of markets.

The four Global Drive Brands continued their impressiveperformance and achieved overall volume growth of17 per cent.

Kent volume grew by 16 per cent with significantincreases in Russia, Romania, Ukraine and Chile, andshare growth was also achieved in its major market,Japan. Dunhill rose by 6 per cent, driven by strongperformances in South Korea, Taiwan, Australia, SouthAfrica and the Middle East, although it was lower inMalaysia due to a reduced total market.

Lucky Strike volumes rose marginally as the growth inSpain, France, Italy and Indonesia was largely offset bydeclines as a result of lower industry volumes in Germanyand Japan. Pall Mall continued its exceptional growthand achieved an increase of 40 per cent, driven bySpain, Greece, Poland, Russia and Bangladesh.

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The following section contains:

21 Regional review– Europe– Asia-Pacific– Latin America– Africa and Middle East– America-Pacific– Unallocated costs– Results of associates

26 Financial review– Profit from operations– Interest cover– Effective tax rate – subsidiaries– Adjusted diluted earningsper share

– Dividends per share declared– Cash flow– Treasury options– Changes in the Group– Changes in accounting policies– Share buy-back programme

30 Key Group risk factors– Litigation– Regulation– Operations– Excise and sales tax– Illicit trade and intellectualproperty

– Information technology– Financial


EuropeIn Europe, profit at £781 million was slightly lower mainlyas a result of very competitive trading conditions in anumber of markets and the inclusion in the comparativeperiod of a one-off benefit in Italy, resulting from thechange in terms of trade following the sale of Etinera.Excluding this benefit, profit increased by £9 million,with strong growth from Russia, Hungary, Italy andFrance, largely offset by declines in Spain, Poland,Germany, the Netherlands and Ukraine. Regional volumeson a like-for-like basis were 2 per cent higher at 248 billion,with growth in Russia, France, Spain and Hungary partlyoffset by declines in Ukraine, Italy and Germany.

In Italy, profit grew strongly driven by improved marginsafter industry price increases and a successful productivityprogramme which has considerably reduced the overallcost base. The growth in Global Drive Brands’ market sharewas more than offset by the decline in domestic brands.

Profit in Germany was slightly down due to excise drivenvolume declines in the overall market and down-tradingto lower price and margin products after the end ofStix production. These factors were partly offset by costreductions and the good cigarette market share growthof Pall Mall and Lucky Strike, which led to a higher overallcigarette market share.

Profit in France grew strongly, benefiting from highervolumes, an improved product mix and lower costs.In Switzerland, profit was higher due to the inclusionof the vending machine business acquired last yearand despite price competition. The continued growthof Parisienne volume and share was offset by the declinein other brands, resulting in overall volumes the sameas last year and a lower market share.

In the Netherlands, profit was lower due to higherexcise levels and an adverse product mix, partly offsetby cost savings, while cigarette market share increased.Profit in Belgium was affected by intense price competition

in the other tobacco segments, although overall cigarettemarket share increased as Pall Mall and Winfield performedwell. In Spain, despite strong growth in volumes and amuch higher share, the results were adversely affectedby the significantly reduced market profitability resultingfrom intense price competition.

The impressive performance in Russia continued throughstrong volume and profit increases, with an improvedproduct mix and lower production costs. A higher overallmarket share resulted from significantly increased volumesof Kent and Vogue, supported by good Pall Mall growth.In Romania, the Group continued to grow volumes andprofit, consolidating its leadership position in a reducedmarket, affected by substantial excise increases.Volume performance was driven by its premium brands,particularly by Kent, which is now the largest sellingbrand, as well as Dunhill and Vogue.

In Ukraine, profitability was adversely affected bythe considerable decline in volumes. However, Kent,Lucky Strike and Pall Mall grew market share. Profit grewsignificantly in Hungary, benefiting from the recovery ofthe legal market after improved border controls, efficiencyprogrammes and the strong volume growth from Viceroyand Pall Mall. In Poland, industry profitability was severelyaffected by increased excise rates and aggressive pricecompetition. Volumes were down, although Pall Malland Vogue grew both share and volume.

See chart

Asia-PacificIn Asia-Pacific, regional profit rose by £85 million to£616 million, mainly attributable to good performances inAustralasia, Malaysia, South Korea and Pakistan. Volumesat 142 billion were 4 per cent higher as strong increasesin Pakistan, Bangladesh, South Korea and Vietnam werepartially offset by declines in Malaysia and Indonesia.

Profit grew strongly in Australia, as a result of improvedmargins from a combination of product cost reductions,

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price increases and a substantial reduction in overheads.Good performances from Winfield and Dunhill, andthe launch of Pall Mall, contributed to a higher overallmarket share in a reduced total market. New Zealandalso showed strong profit growth in local currency asmargins increased but this was eroded by the weakeningof the currency. Volumes were in line with last yeardespite the growth of Dunhill and Pall Mall and marketshare was slightly down.

In Malaysia, profit increased strongly due to productivityinitiatives and higher margins, as well as the absence ofone-off costs which reduced profit in 2005. Dunhill andPall Mall grew market share but total volumes declineddue to reduced industry volumes as a result of the growthof illicit trade and the impact of significant excise increasesin the past two years. In Vietnam, volumes increaseddespite the higher prevalence of illicit brands. Pall Mallgrew strongly following its launch in the middle of theyear and Craven ‘A’ continued its growth. However, profitwas lower as a result of increased marketing investment.

In South Korea, impressive profit growth was achievedfrom higher volumes and strong market share gains byDunhill and Vogue, helped by supply chain cost reductions.Industry volumes increased, reflecting volume distortionslast year as a result of the excise increases at the end of2004. Volumes and market share grew in Taiwan, but profitwas adversely impacted by higher marketing investmentand down-trading after manufacturers’ price increases.

In Pakistan, market leadership was strengthened withexcellent performances by Gold Flake and Capstan,resulting in a strong market share increase. Profit wasup significantly with strong volume growth and highermargins. In Bangladesh, volumes and market share werehigher while profit significantly increased, with improvedmargins after industry-wide price increases. In Sri Lanka,good profit growth was achieved with higher marginsand an improved product mix.

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Europelike-for-like information

Asia-Pacificlike-for-like information

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242

Volume(billions)

248 3,473

Revenue(£ million)

3,545

772

Operating profit(£ million)

78120052006

137

Volume(billions)

142

1,758

Revenue(£ million)

1,839

531


616

20052006


Latin AmericaProfit in Latin America increased by £81 million to£611 million due to good performances across theregion, coupled with a stronger average exchange ratein Brazil. Volumes grew in many of the markets whichled to an overall increase of 2 per cent to 153 billion.

In Brazil, volume and market share increased, benefitingfrom marketing initiatives and continuing anti-illicittrade operations by the government. Profit increasedsubstantially as a result of higher volumes, improvedmargins and the appreciation of the local currency.

The strong profit growth in Mexico was driven byhigher margins, efficiency programmes and synergybenefits from the contract manufacturing agreementwith Canada. Volumes were slightly down as the growthin international brands, notably Pall Mall, was morethan offset by the decline of local low-price brands. InArgentina, strong volume growth was achieved throughan excellent performance by Viceroy and a reduction inillicit competition. However, profit was lower due tosevere price competition.

In Chile, profit grew strongly as volumes and pricesincreased, the product mix improved and the currencystrengthened. GDBs, Kent, Lucky Strike and Pall Mall,led the volume and share increases. In Venezuela, highermargins and increased volumes, led by Belmont andConsul, resulted in an excellent increase in profit andmarket share. The Central America and Caribbean areashowed a significant profit increase as a result of highervolumes and margins, an improved product mix, supplychain savings and the benefits from productivity initiatives.

See chart

Africa and Middle EastProfit in the Africa and Middle East region grew by£34 million to £468 million, mainly driven by SouthAfrica, Nigeria, the Middle East and Egypt. Volumes wereslightly higher at 103 billion, as a result of Nigeria, Egyptand the Middle East, partly offset by decreases in Turkey.

In South Africa, despite the weaker average randexchange rate, good profit growth was achieved as a

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result of an improved product mix and higher margins.Peter Stuyvesant’s volumes were in line with last year,while both Rothmans and Dunhill continued their stronggrowth, with Dunhill recording its highest ever sales.However, reduced volumes for other brands resulted in alower market share. In Nigeria, volumes and market sharegrew with strong performances by Benson & Hedges andPall Mall. Improved margins and volumes resulted in ahigher profit.

In the Middle East, volume and profit continued to growwith good results from Iran, Iraq and the Arabian Gulf,partly offset by the Levant. Dunhill was the main driverfor the good performances in the Middle East. Profit inEgypt benefited significantly from higher volumes anda reduction in costs.

In Turkey, industry price increases led to higher margins,which, together with lower production costs, ensureda continued reduction in underlying operating losses.However, the move to direct distribution in this marketresulted in one-off costs which, together with lowervolumes, adversely impacted profitability.

See chart

America-PacificThe profit from the America-Pacific region decreasedby £12 million to £424 million, while volumes weredown 3 per cent to 44 billion. The increases in profitand volumes from Japan were more than offset bylower contributions from Canada.

Profit in Canada was down £39 million to £280 million,largely due to lower volumes following the growth ofillicit product and a shift to low-priced brands, as wellas the costs incurred in the move to direct distribution.This was partially offset by the impact of efficiency savings,with the move of production to Mexico, and the strongerCanadian dollar. The premium segment now represents53 per cent of the total market compared with 57 per centlast year. Imperial Tobacco Canada’s total cigarette marketshare was down 1 share point to 53 per cent.

In Japan, volume, market share and profit grew stronglydespite the decline in the total market. Market share

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growth accelerated during the second half of the yearwith strong performances from Kent and Kool. Profitrose significantly due to the increased volumes, thebenefit of the manufacturers’ price increase and theabsence of one-off costs, which more than offset theimpact of exchange.

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Unallocated costsUnallocated costs, which are net corporate costs notdirectly attributable to individual regions, were £7 millionhigher at £103 million, mainly as a result of increasedpension costs.

The above regional profits were achieved before accountingfor restructuring costs and losses/gains on disposal of abusiness, brands and joint venture, as explained on page 26.

Results of associatesThe Group’s share of the post-tax results of associatesincreased by £39 million to £431 million. Excluding theexceptional items explained on page 26, the Group’sshare of the post-tax results of associates increased by£38 million to £427 million.

The contribution from Reynolds American, excludingbrand impairment charges and the benefit from thefavourable resolution of certain tax matters in bothyears, as well as other exceptional charges in 2005,was £18 million higher at £285 million. This was mainlydue to improved pricing and cost reductions, partiallyoffset by lower volumes. As explained on page 29,Reynolds American acquired Conwood on 31 May 2006.Reynolds American reported that on a US GAAP pro formabasis, as if it had been owned since the beginning of2005, Conwood increased margins and profits for theyear to December 2006.

The Group’s associate in India, ITC, continued its stronggrowth and, excluding the one-off items in 2005, itscontribution to Group profit rose by £11 million to£91 million.

Associates’ volumes increased by 4 per cent to 241 billion,and with the inclusion of these, total Group volumes were930 billion (2005: 910 billion).

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Latin Americalike-for-like information

Africa and Middle Eastlike-for-like information

America-Pacificlike-for-like information

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4

3

149

Volume(billions)

153

1,555

Revenue(£ million)

1,791

530


611

20052006

103

Volume(billions)

103

1,405

Revenue(£ million)

1,489

434


468

20052006

45

Volume(billions)

44

1,110

Revenue(£ million)

1,098

436


424

20052006


From 1 January 2005, the Group is reporting underInternational Financial Reporting Standards (IFRS). Themove to IFRS has made the reporting of performancemore complex.

However, the changes in IFRS during 2006 have nothad a material impact on the Group’s results. The onlychange to impact the income statement is an amendmentto IFRS in respect of foreign exchange. This required arestatement of the 2005 results to increase net financecosts by £4 million, with a compensating adjustmentreflected directly in changes in total equity.

Profit from operations like-for-likeThe reported Group profit from operations was 8 per centhigher at £2,622 million. The table below shows like-for-likeoperating profit after excluding exceptional items and theimpact arising from the change in terms of trade in Italyfollowing the sale of Etinera in December 2004.

2006 2005£m £m

As reported (page 42) 2,622 2,420Restructuring costs (page 42) 216 271Losses/(gains) on impairment of abusiness and disposal of brands andjoint venture (page 42) (41) (72)

2,7972,619Etinera – change in terms of trade (12)

Like-for-like 2,797 2,607

On this basis, the operating profit for 2006 of £2,797 millionwould represent growth of 7 per cent. The overall impact offoreign exchange for the year as a whole was not material.

See chart

Details of the Group’s operating performance excludingexceptional items can be found on pages 20 to 25.

The Group continued its review of manufacturingoperations and organisational structure, including theinitiative to reduce overheads and indirect costs. Furtherrestructurings continued in 2006 and on 22 Septemberagreement was reached on the closure of the plant atZevenaar in the Netherlands. The plant will close by theend of 2008 with the production being transferred toBayreuth in Germany and Augustow in Poland. The totalrestructuring costs of £216 million for 2006 principallycomprise costs in respect of Zevenaar and further costs forthe UK and Canadian restructurings announced in 2005.

The agreement to sell the Italian cigar business described onpage 29 resulted in the recognition of a loss of £19 million,including an impairment charge of £15 million.

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In 2006, the Group sold its Muratti Ambassador brandin certain markets, as well as the L&M and Chesterfieldtrademarks in Hong Kong and Macao, while acquiring theBenson & Hedges trademark in certain African countries.The transactions resulted in a gain of £60 million.

Profit from operations in 2005 benefited from a£72 million gain, principally in respect of the disposalof certain trademarks in Malta, Cyprus and Lithuania.

Below profit from operations, net finance costs at£289 million were £61 million higher than last year,principally reflecting the impact of higher interestrates as well as derivatives.

Interest coverThe Group assesses its financial capacity by reference tocash flow and interest cover. Interest cover is distortedby the pre-tax impact of the exceptional items and netfinance cost distortions reflected in the adjusted earningsper share as explained below. The chart shows the cover,adjusting for these items, on the basis of profit beforeinterest payable over interest payable. The interest coverremains strong at 8.1x (2005: 8.8x), with the lower coverreflecting higher interest costs.

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At 31 December 2006, the ratio of floating to fixed ratefinancial liabilities was 58:42 (2005: 55:45).

As explained on page 25, the Group’s share of thepost-tax results of associates, included at the pre-tax levelunder IFRS, increased by £39 million to £431 million, afterexceptional net income of £4 million (2005: £3 million).The exceptional items are shown as memoranduminformation on the Group Income Statement (page 42).

Profit before tax was up £180 million at £2,764 million,principally reflecting the higher profit from operations.

Effective tax rate – subsidiariesThe tax rates in the income statement of 25.9 per centin 2006 and 26.7 per cent in 2005 are affected by theinclusion of the share of associates’ post-tax profit inthe Group’s pre-tax results.

The underlying tax rate for subsidiaries, adjusted toremove the distortions as reflected in the adjustedearnings per share below, was 29.6 per cent in 2006and 31.4 per cent in 2005; the decrease reflects theinclusion of a tax credit in Canada in respect of prioryears and changes in the mix of profits.

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Adjusted diluted earnings per shareBasic earnings per share for 2006 were 92.08p (2005: 84.34p).

With the distortions that can occur in profit over theyears, as well as the potential dilutive effect of employeeshare schemes, earnings per share is best viewed onthe basis of adjusted diluted earnings per share. Thisremoves the impact of exceptional items which areshown as memorandum information in the GroupIncome Statement on page 42. The main items arerestructuring costs, loss on impairment of a businessand gains on disposal of brands and a joint venture.In addition, the calculation adjusts for certain distortionsin net finance costs arising under IFRS in 2005, as well asreflecting the impact of the potential conversion of shares.

On this basis, the earnings per share are 98.12p,a 10 per cent increase over 2005, as the higher netfinance costs and minority interests were more thanoffset by the improvement in profit from operations,the share of associates’ post-tax results, a lower tax rateand the benefit from the share buy-back programme.

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Dividends per share declaredWith the recommended final dividend of 40.2p,the total dividends per share declared for 2006 are55.9p, up 19 per cent on the prior year. Under IFRS,the recommended final dividend in respect of a yearis only provided in the accounts of the following year.Therefore, the 2006 accounts reflect the 2005 final dividendand the 2006 interim dividend amounting to 48.7p(£1,008 million) in total (2005: 43.2p – £910 million).The table on page 28 shows the dividends declared inrespect of 2006 and 2005.

As explained in the Chairman’s Statement, the previouspolicy was to pay out as dividends at least 50 per cent oflong term sustainable earnings but the Board has decidedto raise the ratio to 65 per cent by 2008 in progressivesteps. Dividends per share declared for 2006 represent57.0 per cent of adjusted fully diluted earnings per share(2005: 52.6 per cent).

See charts and

Total equity was £189 million lower at £6,688 million.The profit retained after payment of dividends exceededthe impact of the share buy-back by £388 million. However,this was more than offset by a £580 million adverse impactfrom exchange movements, reflecting the general strengthof sterling.

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Profit from operations like-for-like£ million

Interest covertimes

Underlying tax rate – subsidiariespercentage

Adjusted diluted earnings per sharepence

Dividends per share declaredpence

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+19%

+10%

29.6%

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8.1x

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31.4

2005

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2006

89.34

2005

98.12

2006

47.0

2005

55.9

2006

2,607

2005

2,797

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Cash flow2006 2005£m £m

Net cash from operating activitiesbefore restructuring costs and taxation 3,295 3,229Restructuring costs (220) (143)Taxation (713) (762)

Net cash from operating activities 2,362 2,324Net interest (263) (231)Net capital expenditure (419) (378)Dividends to minority interests (139) (133)

Free cash flow 1,541 1,582Dividends paid to shareholders (1,008) (910)Share buy-back (500) (501)Other net flows (5) (49)

Net cash flows 28 122

IFRS cash flowNet cash from operating activities 2,362 2,324Net cash from investing activities (315) (292)Net cash from financing activities (2,339) (2,147)

Net cash flows (292) (115)

The IFRS cash flow includes all transactions affecting cashand cash equivalents, including financing. The alternativecash flow above is presented to illustrate the cash flowsbefore transactions relating to borrowings.

The Group’s net cash flow from operating activities at£2,362 million was £38 million higher. The growth inunderlying operating performance was offset by thetiming of working capital movements. However, a£49 million fall in tax outflows, reflecting the timing ofpayments, as well as £66 million higher dividends fromassociates more than offset the higher restructuring flows.

After higher net capital expenditure and net interestflows, with similar levels of dividends to minority interests,the free cash flow is £41 million lower than in 2005 at£1,541 million. This inflow exceeds the total cash outlayon dividends to shareholders and share buy-back by£33 million.

The other net flows in 2006 principally reflect the purchaseof minority interests in Chile and shares for the Group’sshare-based compensation plans, largely offset by the saleof Toscano in Italy and the sale of brands. The other netflows in 2005 mainly arise from the acquisition of furthershares in the Group’s Danish associate and the acquisitionof Restomat AG in Switzerland, partly offset by theproceeds of the brand sale to Gallaher.

The above flows resulted in net cash inflows of £28 millioncompared to £122 million in 2005. After taking accountof transactions related to borrowings, especially the netrepayment of borrowings, the above flows resulted in anet decrease of cash and cash equivalents of £292 millioncompared to a net decrease of £115 million in 2005, asshown in the IFRS cash flow above.

These cash flows, after an adverse exchange impactof £96 million, resulted in cash and cash equivalents,net of overdrafts, decreasing by £388 million in 2006(2005: £66 million).

Borrowings, excluding overdrafts but taking into accountderivatives relating to borrowings, were £6,401 millioncompared to £7,117 million as at 31 December 2005.The decrease in this figure principally reflected the netrepayment of borrowings and the impact of exchangemovements.

Current available-for-sale investments at 31 December 2006were £128 million (31 December 2005: £96 million).

As a result of the above borrowings, net of cash, cashequivalents and current available-for-sale investments,were £4,996 million (31 December 2005: £5,357 million).

Treasury operationsTreasury is tasked with raising finance for the Group,managing the financial risks arising from underlyingoperations and managing the Group's cash resources.All these activities are carried out under defined policies,procedures and limits.

The Board reviews and agrees the overall treasury policiesand procedures, delegating appropriate authority to the

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Dividends declared2006 2005

Pence Penceper share £m per share £m

Ordinary sharesInterim 2006 paid 13 September 2006 (see page 45) 15.7 323 14.0 293Final 2006 payable 3 May 2007 40.2 821 33.0 685

55.9 1,144 47.0 978


Finance Director, the Treasury function and the boards ofthe central finance companies. The Finance Director chairsthe boards of the major central finance companies. Anysignificant departure from agreed policies is subject to theprior approval of the Board.

Clear parameters have been established, including levelsof authority, on the type and use of financial instrumentsto manage the financial risks facing the Group. Suchinstruments are only used if they relate to an underlyingexposure; speculative transactions are expressly forbiddenunder the Group’s treasury policy. The Group’s treasuryposition is monitored by the Group Treasury Committee,which meets seven times a year and is chaired by theFinance Director. Regular reports are provided to seniormanagement, and treasury operations are subject to periodicindependent reviews and audits, both internal and external.

One of the principal responsibilities of Treasury is tomanage the financial risk arising from the Group’sunderlying operations. Specifically, Treasury manages,within an overall policy framework, the Group's exposureto funding and liquidity, interest rate, foreign exchangeand counterparty risks. Derivative contracts are onlyentered into to facilitate the management of these risks.

During 2005, the Group issued one further bond maturingin 2012, which raised €750 million; the proceeds wereused to refinance maturing bond issues. In addition,the Group’s central banking facility was renewed for anincreased amount of £1.75 billion for a term of five years(with two additional one year extension options) and onsignificantly improved terms.

During 2006, the Group issued three bonds (€525 millionmaturing in 2010, €600 million maturing in 2014 and£325 million maturing in 2016) and the proceeds wereused to refinance maturing bond issues. In addition, theGroup’s central banking facility was extended on existingterms under the first extension option to a term of fiveyears (plus one remaining one year extension).

The Group continues to target investment-grade creditratings; as at 31 December 2006 the ratings fromMoody’sand S&P were Baa1/BBB+ (end 2005: Baa1/BBB+). Thestrength of the ratings has underpinned the debt issuanceduring 2005 and 2006 and the Group continues to enjoyfull access to the debt capital markets.

Changes in the GroupThe Group ceased to be the controlling company ofBritish American Racing (Holdings) Limited (BAR) on8 December 2004, when BAR went into administration.The Group consequently ceased to consolidate BAR fromthat date. On 7 January 2005, BARH Ltd. (BARH), a newly

formed joint venture between British American Tobaccoand Honda Motor Co. Ltd, acquired the BAR business.On 4 October 2005, the Group announced that it hadagreed the sale of its 55 per cent shareholding in BARHto Honda and the sale was completed on 20 December2005. As a result of these transactions, a gain of £5 millionwas included in profit from operations. For the period7 January 2005 to 20 December 2005, BARH was equityaccounted reflecting shared control with Honda.

On 21 October 2005, the Group announced the exerciseof its pre-emption rights over shares in SkandinaviskTobakskompagni AS, its Danish associate company, andthe transaction was completed on 12 December 2005.This increased the Group’s holding from 26.6 per centto 32.3 per cent at a cost of £95 million, resulting ingoodwill of £69 million.

On 25 November 2005, the Group acquired RestomatAG, the largest operator of cigarette vending machines inSwitzerland, at a cost of £25 million, resulting in goodwillof £7 million.

On 10 March 2006, the Group’s Italian subsidiarysigned an agreement to sell its cigar business, Toscano,to Maccaferri for €95 million. The sale was subjectto regulatory and governmental approval and wascompleted on 19 July 2006. This agreement resulted inthe recognition of an impairment charge of £15 million.

From August 2006, the Group purchased minorityinterests in its subsidiary in Chile for a cost of £91 million,raising the Group shareholding from 70.4 per cent to96.5 per cent. The goodwill arising on these transactionswas £80 million and the minority interests in Group equitywere reduced by £11 million.

On 31 May 2006, the Group’s associate, Reynolds American,completed the acquisition of Conwood, the second largestmanufacturer of smokeless tobacco products in the US,for US$3.5 billion. The acquisition was funded principallywith debt, and the fair value of assets acquired and liabilitiesassumed was US$4.1 billion and US$0.6 billion respectively.

Changes in accounting policiesIn December 2005, the International Accounting StandardsBoard issued an amendment to IAS21 on foreign exchangerates. The amendment to IAS21 allowed inter companybalances that form part of a reporting entity’s net investmentin a foreign operation to be denominated in a currencyother than the functional currency of either the ultimateparent or the foreign operation itself. This means thatcertain exchange differences previously taken to theincome statement are instead reflected directly in changesin total equity. However, as this amendment was only

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adopted by the EU in 2006, the interim report to 30 June2006 contained the first published results to reflect thischange. The previously published results have been restatedaccordingly, which has resulted in an increase in net financecosts of £4 million for the year ended 31 December 2005.

While this amendment was not applicable for Groupreporting until it was endorsed by the EU, as this wasexpected in 2006 it was allowed for in the adjustedearnings per share calculations in the published resultsfor the year ended 31 December 2005.

The International Accounting Standards Board issued IFRICInterpretation 4 which is applicable for annual reportingperiods beginning on or after 1 January 2006. Thisinterpretation is to determine whether an arrangement,which is not in the legal form of a lease, is in substancea lease and should be accounted for in accordance withIAS17 (Leases). This has resulted in the recognition ofcertain arrangements as leases. The previously publishedbalance sheet for 2005 has been restated in respect offinance leases to increase property, plant and equipmentby £4 million and borrowings by a similar amount butthere was no impact on the Group’s reported profit.

In 2005, IAS32 and IAS39 on financial instruments wereapplied from 1 January 2005. This resulted in a £42 millionreduction in the Group equity at that date, which is shownas the change in accounting policy on page 44.

Share buy-back programmeThe Group initiated an on-market share buy-backprogramme at the end of February 2003. By the close ofbusiness on 1 March 2007, we expect that some 35 millionshares will have been bought back since 1 January 2006at a cost of £500 million (see page 45). During 2005,45 million shares were bought at a cost of £501 million.

IntroductionA description of the key risk factors that may affect theBritish American Tobacco Group’s business is outlinedbelow. Not all of these factors are within the control ofBritish American Tobacco and other factors besides thoselisted below may affect the performance of its business.This section highlights some of these particular risks butit is not intended to be an extensive analysis of all risksaffecting the Group. Some risks may be unknown atpresent and other risks, currently regarded as immaterial,could turn out to be material in the future. All of theserisks have the potential to have an adverse impact on theGroup’s business; its revenues, profits, assets, liquidity andcapital resources. These risks should be considered withreference to the statement on internal control on page 71of the Annual Report and Accounts (the main aspects ofwhich are summarised below) and the cautionary statementregarding forward-looking statements on page 32.

Risk management in summaryThe Company maintains a sound system of internalcontrol with a view to safeguarding shareholders’investment and the Company’s assets. It is designed tomanage risks that may impede the achievement of theCompany’s business objectives rather than to eliminatethese risks and can therefore provide only reasonable, notabsolute, assurance against material misstatement or loss.

The Group uses audit committees at both regional andend market levels to support the Audit Committee (seepage 33) in monitoring risks and control. This frameworkprovides a continuing process for identifying, evaluatingand managing the significant risks faced by the Companyand its subsidiaries. The Group’s regional audit committees(which are all chaired by an Executive Director) focuson risks and the control environment within each regionand are in turn supported by end market or area auditcommittees. The regional audit committees’ reviewsinclude consideration of the effectiveness of the processfor identifying, evaluating and managing the risks of thebusiness and the assessments of internal control andbusiness risks completed by operating companies.

In addition, the Corporate Social Responsibility (CSR)Committee (see page 33) is responsible for identifyingand assessing, in conjunction with management,the significant social, environmental and reputationalrisks facing the Group’s business and for evaluatingmanagement’s handling of such risks. In this, it is similarlysupported by a framework of regional and end marketCSR committees.

LitigationThe Group is involved in a number of legal andregulatory court proceedings in a number of countries.

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These proceedings may be characterised as coveringsmoking and health issues and include claims for personalinjury and claims for economic loss arising from thetreatment of smoking and health related diseases. Regulatoryproceedings may result in a challenge to new regulations.In addition, there are legal proceedings and a governmentalinvestigation in Canada arising from alleged past smugglingactivities with consequent claims for unpaid excise tax.A fuller analysis of current legal proceedings to whichthe Group is subject is set out on pages 130 to 136 ofthe Annual Report and Accounts and pages 45 to 47of the Annual Review.

While it is impossible to be certain of the outcome ofany particular case or of the amount of any possibleadverse verdict, the Company believes that the defencesof the Group companies to all these various claims aremeritorious both on the law and the facts. Nevertheless,it is not impossible that the results of operations or cashflows of the Group could be materially affected by thefinal outcome of any particular litigation.

RegulationThe Group’s businesses operate under increasinglystringent regulatory regimes around the world. Furtherregulation is expected, particularly as a result of theWorld Health Organisation’s Framework Convention onTobacco Control (FCTC) and increasingly active tobaccocontrol activities outside the FCTC. It is not possible topredict where, when and in what form regulations willbe enacted, but regulation of the tobacco industrygenerally covers:• Product: product design and attributes (e.g. ‘lowignition propensity paper’) as well as product disclosures(e.g. ingredients, additives, emissions);

• Packaging: pictorial warnings, rotating warnings,use of colours and size;

• Promotion: communications regarding the Group’sproducts at both retail and trade levels;

• Purchase: the manner in which cigarettes are sold, suchas type of outlet (e.g. supermarkets, vending machines)and how they are sold (e.g. above the counter versusbeneath the counter);

• Place: regulations as to the places where adults canand cannot smoke tobacco products;

• Price: regulations as to the price the Group can chargefor its products (e.g. by excise or minimum prices).

These regulations may have an impact on volumes (e.g. asa result of restrictions on where cigarettes may be smoked)and profits (e.g. as a result of diminution of brand equityleading consumers away from premium brands, throughexcise increases and/or through increased cost of complyingwith product design, disclosure or packaging requirements).

Further, taking into account the significant number ofregulations applying to the Group’s businesses acrossthe world, it is possible that there may be allegations ofbreaches of regulations. Even when such allegations areproven untrue, there is often a reputational impact anda financial cost in defending such allegations.

OperationsThe Group has substantial operations in over 180 countries.The Group’s results are influenced by the economic,regulatory and political situations in the countries andregions in which it has operations. Some countries inwhich the Group operates face the threat of increasingcivil unrest and can be subject to frequent changes inregime. In others, terrorism, conflict and the threat of warmay have a significant impact on the business environment.Some countries maintain trade barriers or adopt policiesthat favour domestic producers, preventing or restrictingsales by the Group. There can be no assurance that political,social, legal, economic, trade or other developments, aswell as theft and fraud, will not have an adverse impacton the Group’s investments and businesses or on theGroup’s consolidated results of operations.

Severe disruption to any aspect of the Group’s supplychain or suppliers’ operations could have an adverseimpact on the Group’s ability to produce and deliver tocustomer demands. In certain markets, the distributionof Group products is through channels managed bythird parties, and often licensed by governments. Inthese instances, loss of distribution, and therefore areduction in sales volumes and revenues, is a possibility.

The raw materials used in the Group’s business arecommodities that are subject to price volatility caused byfactors such as weather conditions, growing conditions,local planting decisions, market fluctuations and changesin agricultural regulations. Commodity price changes thatare beyond the Group’s control may result in unexpectedincreases in raw materials and packaging costs for theGroup’s products.

The Group operates in highly competitive businesses andgeographical markets. To maintain a competitive advantage,it must anticipate and respond to new consumer trendsthrough continuous innovation. The Group also seeksto develop and market new products, packaging andtechnologies, including products with potentially reducedharm. Development of these products is an expensive andlengthy process, but there are anticipated advantages forany manufacturer who introduces these products to themarket first. Competitors’ speed-to-market in brandingchanges, new product launches, or changes in productmix, could have an adverse effect on the Group’s operations.

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In tough competitive environments, where the price burdenon consumers is high because of taxation or limitedpurchasing power, the Group is vulnerable to competitorsaggressively taking market share through price repositioning,which generally has the impact of reducing the overallprofit pool of the market and, ultimately, Group profits.

Excise and sales taxTobacco products are subject to substantial excise andsales taxes in most countries in which the Group operates.In many of these countries, taxes are generally increasingbut the rate of increase varies between countries andbetween different types of tobacco products. Increasedtobacco taxes, or changes in relative tax rates for differenttobacco products, or adjustments to excise structures,may result in a decline in overall sales volume for theGroup’s products or may alter the Group’s sales mix infavour of Value-for-Money brands. Increases in tobaccotaxes can also lead to consumers rejecting the Group’slegitimate tax-paid products for products from illicit sources.

Illicit trade and intellectual propertyIllicit trade in the form of counterfeit products, smuggledgenuine products and locally manufactured product onwhich applicable taxes are evaded, represents a significantand growing threat to the legitimate tobacco industry.Increasing excise rates are encouraging more consumersto switch to illegal cheaper tobacco products and providinggreater rewards for smugglers. Illicit trade can have anadverse effect on Group volumes, restrict the ability toincrease selling prices and damage brand equity.

The brand names under which the Group’s productsare sold are key assets. Investments over a period of timehave led to many of the Group’s brands having significantbrand equity and global appeal to consumers, essentialfor delivering sustainable profit growth into the future.The protection and maintenance of the reputation ofthese brands is important to the success of the Group.In a number of countries around the world, the risk ofintellectual property rights’ infringement remains highas a result of limitations in judicial protection and/orinadequate enforceability. Any substantial erosion inthe value of the brands could have an adverse effecton the Group.

Information TechnologyThe Group is increasingly reliant on informationtechnology systems for its internal communications,controls, reporting and relations with customers andsuppliers. A significant disruption due to computerviruses, malicious intrusions, the setting up of sharedservices centres or the installation of new systems couldaffect the Group’s communications and operations.

FinancialThe Group’s subsidiary undertakings operate over120 active retirement benefit arrangements worldwide.These arrangements have been developed in accordancewith local practices in the countries concerned. Themajority of employees belong to defined benefit schemes,most of which are funded externally, although the Groupoperates a number of defined contribution schemes. Thecontributions to the Group’s defined benefit schemes andtheir valuations are determined in accordance with theadvice of independent, professionally qualified actuaries.Changes in asset returns, salary increases, inflation, longterm interest rates and other actuarial assumptions couldhave an adverse impact on the Group.

Funding and liquidity risks expose the Group to shortages ofcash and cash equivalents needed in the Group’s operationsand for refinancing of existing debt. The Group cannot becertain that it will at all times have access to the bank andcapital markets and that the failure to achieve such accesswill not have an adverse effect on the Group’s fundingand liquidity position and on its credit ratings.

The Group is exposed to changes in currency rates onthe translation of the net assets of overseas subsidiaries intothe Group’s reporting currency, sterling. The Group is alsoexposed to currency changes from the translation of profitsearned in overseas subsidiaries; these exposures are notnormally hedged. Exposures also arise from the foreigncurrency denominated trading transactions undertakenby subsidiaries and dividend flows. The Group maintainsboth floating and fixed rate debt. Where appropriate, theGroup also uses derivatives, primarily interest rate swaps,to vary the fixed to floating mix. Changes in currencyvalues and interest rates could have an adverse impacton the financial condition or operations of the Group.

Cash deposits and other financial instruments give riseto credit risk on the amounts due from counterparties.The failure of any counterparty to meet its obligations tothe Group could have an adverse effect on the financialcondition or operations of the Group.

Further details on the Group’s financial managementand treasury operations are on page 28.

REG

IONALAND

FINANCIALREV

IEWKEY

GROUPRISK

FACTORS

KEY GROUP RISK FACTORSCONTINUED

Cautionary Statement: the Operating and Financial Review and certainother sections of this document contain forward looking statementswhich are subject to risk factors associated with, among other things,the economic and business circumstances occurring from time to timein the countries and markets in which the Group operates. It is believedthat the expectations reflected in these statements are reasonable butthey may be affected by a wide range of variables which could causeactual results to differ materially from those currently anticipated.

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