British American Tobacco Annual Report 2010 - Financial review

Ben Stevens comments on our financial highlights in 2010.*

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* This video is unaudited content that is not part of the Annual Report.

“With good business momentum, sound financing and the announced share buy-back, shareholders can look forward to continued superior returns.”

Ben Stevens
Finance Director and Chief Information Officer

Profit from operations

The reported Group revenue grew by 5 per cent to £14,883 million. Profit from operations at £4,318 million was also 5 per cent higher.

The growth in Group revenue at constant rates of exchange was slightly up, to £14,263 million but organic revenue growth at constant rates of exchange was 3 per cent higher.

In order to better understand the underlying performance of the business, it is necessary to adjust for a number of items relating, for example, to restructuring costs and impairments. We call the underlying profit after adjusting for these items adjusted profit.

Adjusted profit from operations was £4,984 million, up 12 per cent from £4,461 million in 2009. Adjusted profit from operations translated at constant rates of exchange, was up 6 per cent to £4,745 million.

Percentage increases in revenue and in profit from operations

Foreign currencies

The results of overseas subsidiaries and associates have been translated to sterling at the following exchange rates in respect of principal currencies:

Organic growth

For 2010, revenue growth was enhanced by the full year benefit of the acquisition of PT Bentoel Internasional Investama Tbk in the middle of 2009. On the other hand, the Group revenue was affected by the termination of the Gauloises agreement in Germany at the end of the first quarter and the disposal of the Belgium distribution business, Lyfra NV, on 25 June 2010.

During 2010, we made the decision to withdraw from distributing phone cards in Brazil. Adjusting for these transactions, revenue would have been up 3 per cent to £13,814 million at constant rates of exchange. On the same basis, adjusted profit from operations grew organically by 6 per cent to £4,722 million at constant rates of exchange.

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Operating margin

In 2008, following the success of the previous five year programme of cost savings which ended in 2007, the Group launched a new five year programme – targeting annual savings of £800 million by 2012. It includes areas such as supply chain efficiencies, back office integration and slimmer management structures. During the first three years of the programme the targeted savings of over £800 million were achieved, two years ahead of schedule. The Group will in future focus on an alternative measure, operating margin, with a target, as previously announced, of at least 35 per cent by 2012.

The cost reduction initiatives and the disposal of the Lyfra distribution business resulted in the adjusted profit from operations as a percentage of revenue improving to 33.5 per cent, compared to 31.4 per cent in 2009 and 30.7 per cent in 2008. More details of the Group’s operating performance can be found in the Regional review.

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Adjusting items

The adjustments made to profit from operations are separately disclosed as memorandum information on the face of the income statement and in the segmental analysis.

During 2010, the Group continued to incur costs as a result of restructurings not related to the day-to-day operations of the business.

These initiatives include restructuring the Group’s manufacturing operations, organisation structure and systems and software used. During 2010, we also impaired goodwill and trademarks relating to the acquisition of Tekel by £293 million. The total amount of these adjustments, together with the costs of integrating acquired businesses into existing operations and trademark amortisation, was £666 million for the year ended 31 December 2010, compared to £360 million for 2009.

Restructuring and integration costs in 2010 principally relate to the continuation of factory closure and downsizing activities in Denmark and Australia respectively; the closure of the Jawornik factory in Poland, the Tire factory in Turkey and the Lecce factory in Italy. They also included a voluntary separation scheme and the closure of the printing unit in Argentina and the continued integration of Bentoel into existing operations; as well as combining the Group’s businesses in Belgium, Luxembourg and the Netherlands and some other activities to reduce the overheads of the Group.

Restructuring and integration costs in 2010 also include a payment of US$21 million to Reynolds American relating to the early termination of the Contract Manufacturing Agreement dated 30 July 2004.

Restructuring and integration costs in 2009 principally related to costs in respect of the planned closure of the Soeborg factory in Denmark; the planned downsizing of the manufacturing plant in Australia; and the continued integration of ST, Tekel and Bentoel with existing operations.

The acquisitions of the assets of Tekel and the ST businesses in mid-2008, as well as the Bentoel business in mid-2009, resulted in the capitalisation of trademarks which are amortised over their expected useful lives, which do not exceed 20 years. The 2010 amortisation charge in respect of trademarks amounted to £62 million,while it was £58 million in 2009.

Goodwill and trademarks recognised as a result of the Tekel acquisition in 2008 have been impaired by £249 million and £44 million respectively. Although cost saving initiatives in the acquisition plan have been delivered successfully, the impairment charge arises from intense pricing competition following significant excise increases during 2009 as well as further increases effective from January 2010, which resulted in growth in illicit trade and a loss of volumes and market share. Turkey remains an important market for the Group.

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Net finance costs

Net finance costs at £480 million were £24 million lower than last year. The decrease principally reflects lower net debt and net interest gains on derivative contracts.

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Associates

The Group’s share of the post-tax results of associates, included at the pre-tax profit level under IFRS, increased by £67 million to £550 million, after net adjusting charges of £72 million (2009: £58 million). Excluding the adjusting items in 2009 and 2010, the Group’s share of the post-tax results of associates increased by 15 per cent to £622 million, or 11 per cent at constant rates of exchange. The Group’s share of the net adjusting items from Reynolds American amounted to an expense of £63 million (2009: £58 million) and included trademark amortisation and impairment charges, a Canadian settlement and restructuring charges, and in 2009, a health plan credit. Associates’ income in 2010 also included a £9 million charge from accounting for the dilution in the Group’s interest in ITC as a result of shares issued by the company in respect of its employee stock option scheme.

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Profit before tax

Profit before tax was up £308 million at £4,388 million, reflecting the higher profit from operations, lower interest costs, the increased contribution from associates and favourable exchange rates.

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Effective tax rate

• Underlying tax rate

  

• The tax rates in the Income statement of 28.4 per cent in 2010 and 27.5 per cent in 2009 are affected by the inclusion of the share of associates’ post-tax profit in the Group’s pre-tax results and by the adjusting items.

  The underlying tax rate for subsidiaries, reflected in the adjusted earnings per share below, was 30.2 per cent in 2010 and 30.3 per cent in 2009.

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Earnings per share

Basic earnings per share for 2010 were 145.2p, up 6 per cent (2009: 137.0p). With the distortions that adjusting items can cause in profit, as well as the potentially dilutive effect of employee share schemes, earnings per share are best viewed on the basis of adjusted diluted earnings per share. The calculation of this measure is explained in note 7 of the financial statements.

On this basis, the adjusted diluted earnings per share was 175.7p, a 15 per cent increase over 2009, mainly as a result of the strong operating performance, lower net finance costs, an increased contribution from associates and benefits from foreign exchange movements.

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Dividends

• Dividend per share declared

  

The Group’s guidance is to pay dividends of 65 per cent of long-term sustainable earnings, calculated with reference to the adjusted diluted earnings per share. Interim dividends are calculated as one-third of the total dividends declared for the previous year.

Dividends are declared and payable in sterling except for those shareholders on the branch register in South Africa, whose dividends are payable in rand. A rate of exchange of £:R = 11.54580 as at 22 February 2011, the closing rate for that day as quoted by Bloomberg, results in an equivalent final dividend of 935.20980 SA cents per ordinary share.

With the recommended final dividend of 81.0p, the total dividends per share for 2010 are 114.2p, up 15 per cent on the prior year. Under IFRS, the recommended final dividend in respect of a year is only provided in the accounts of the following year. Therefore, the 2010 accounts reflect the 2009 final dividend and the 2010 interim dividend amounting to 104.8p (£2,093 million) in total (2009: 89.5p – £1,798 million). The table below shows the dividends declared in respect of 2010 and 2009.

Dividends declared

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Treasury operations

Treasury is responsible for raising finance for the Group, managing the Group’s cash resources and managing the financial risks arising from underlying operations. All these activities are carried out under defined policies, procedures and limits.

The Board reviews and agrees the overall treasury policies and procedures, delegating appropriate authority to the Finance Director, the Treasury function and the boards of the central finance companies. The policies include a set of financing principles and key performance indicators.

Clear parameters have been established, including levels of authority, on the type and use of financial instruments to manage the financial risks facing the Group. Such instruments are only used if they relate to an underlying exposure; speculative transactions are expressly forbidden under the Group’s treasury policy. The Group’s treasury position is monitored by the Corporate Finance Committee, which meets regularly throughout the year and is chaired by the Finance Director. Regular reports are provided to senior management and treasury operations are subject to periodic independent reviews and audits, both internal and external.

It is the policy of the Group to maximise financial flexibility and minimise refinancing risk by issuing debt with a range of maturities, generally matching the projected cash flows of the Group and obtaining this financing from a wide range of providers. The Group targets an average centrally managed debt maturity of at least five years with no more than 20 per cent of centrally managed debt maturing in a single rolling 12 months. As at 31 December 2010, the average centrally managed debt maturity was 7.4 years (2009: 6.6 years) and the highest proportion of centrally managed debt maturing in a single rolling 12 month period was 12.5 per cent (2009: 18.4 per cent).

The Group continues to maintain investment-grade credit ratings; as at 31 December 2010 the ratings from Moody’s and S&P were Baa1/BBB+ with a stable outlook (end 2009: Baa1/BBB+). The strength of the ratings has underpinned the debt issuance during 2009 and 2010 and the Group is confident of its ability to successfully access the debt capital markets.

Subsidiary companies are funded by share capital and retained earnings, loans from the central finance companies on commercial terms, or through local borrowings by the subsidiaries in appropriate currencies. All contractual borrowing covenants have been met and none are expected to inhibit the Group’s operations or funding plans.

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Liquidity

It is Group policy that short-term sources of funds (including drawings under the £1 billion euro commercial paper (ECP) programme) are backed by undrawn committed lines of credit and cash.

In the year ended 31 December 2010, the Group continued with transactions in the capital markets. In May 2010, the Group repaid a maturing €525 million bond. The repayment was financed from debt issued in November 2009. On 25 June 2010, the terms of €470 million of the €1 billion bond maturing in 2011 were modified by extending the maturity to 2020; at the same time, the Group issued an additional €130 million bond with a maturity of 2020. In addition, €413 million of the Group’s €750 million bond maturing in 2012 was purchased and cancelled. At the same time, the Group issued a new £275 million bond with a maturity of 2040.

In December 2010, the Group negotiated a new central banking facility of £2 billion with a final maturity date of December 2015. This facility is provided by 22 banks. The existing central banking facility of £1.75 billion, with a final maturity date of March 2012 was cancelled at the same time. The facilities were undrawn as at the end of both years.

In mid-2009, the Group re-established its ECP programme of £1 billion, which was undrawn at 31 December 2010. At 31 December 2009, £187 million of ECP was outstanding.

There were a number of other transactions in the capital markets in 2009 to finance the repayment of bonds, to extend the maturity of other bonds and to finance the repayment of credit facilities used to finance the acquisition of Tekel in 2008. Details of these transactions are provided in notes 24 and 25 on the accounts.

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Capital structure

The Group defines capital as net debt and equity. The only externally imposed capital requirement for the Group is interest cover. The Group targets interest cover, as calculated under its key central banking facilities, of greater than five. For 2010 it is 11.2 times (2009: 9.9 times). The only externally imposed capital requirement the Group has is in respect of its centrally managed banking facilities, which require a gross interest cover of 4.5. The Group assesses its financial capacity by reference to cash flow, net debt and interest cover. Group policies include a set of financing principles and key performance indicators including the monitoring of credit ratings, interest cover and liquidity. These provide a framework within which the Group’s capital base is managed and, in particular, the policies on dividends (as a percentage of long-term sustainable earnings) and share buy-back are decided. The key objective of the financing principles is to appropriately balance the interests of equity and debt holders in driving an efficient financing mix for the Group.

The Group manages its financial risks in line with the classification of its financial assets and liabilities in the Group’s balance sheet and related notes.

Net debt/financing

The Group defines net debt as borrowings, including related derivatives, less cash and cash equivalents and current available-for-sale investments. The maturity profile of net debt is as follows:

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Cash flow

• Free cash flow per share as a ratio of
  adjusted diluted earnings per share

  

The IFRS cash flow statement includes all transactions affecting cash and cash equivalents, including financing. The alternative cash flow statement is presented to illustrate the cash flows before transactions relating to borrowings.

Operating cash flow increased by £584 million or 14 per cent to £4,901 million, reflecting growth in underlying operating performance. Taking into account outflows relating to taxation, which were £83 million higher than last year due to higher taxable profits, an increase in restructuring costs due to the timing of payments and an increase in restructuring activities, as well as an increase in inflows relating to dividends received from associates, the Group’s free cash flow was £610 million, or 23 per cent higher at £3,240 million.

The ratio of free cash flow per share to adjusted diluted earnings per share was 92 per cent (2009: 86 per cent), with free cash flow per share increasing by 23 per cent (2009: increasing by 2 per cent).

Below free cash flow, the principal cash outflows for 2010 comprise the payment of the prior year final dividend and the 2010 interim dividend. Proceeds on disposal of subsidiaries of £12 million which arose from the sale of the Group’s Belgian distribution business, Lyfra NV, have been offset by a cash outflow of £12 million arising from the acquisition of non-controlling interests in subsidiaries.

The year ended 31 December 2009 included a net outflow of £382 million in respect of the purchase of Bentoel and Tekel, the proceeds from the ST trademark disposals and £2 million refunded from the original purchase consideration paid in 2008.

The other net flows principally relate to the impact of the level of shares purchased by the employee share ownership trusts and outflows in respect of certain derivative financial instruments.

The above flows resulted in net cash inflows of £1,070 million (2009: £433 million inflow). After taking account of exchange rate movements, net debt disposed and the change in accrued interest and other, total net debt was £7,841 million at 31 December 2010, down £1,001 million from £8,842 million on 31 December 2009.

Cash flow and net debt movements

* Including movements in respect of debt related derivatives

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Retirement benefit schemes

The Group’s subsidiaries operate around 180 retirement benefit arrangements worldwide. The majority of the scheme members belong to defined benefit schemes, most of which are funded externally and many of which are closed to new entrants. The Group also operates a number of defined contribution schemes.

The present total value of funded scheme liabilities was £5,365 million (2009: £5,250 million), while unfunded scheme liabilities amounted to £337 million (2009: £282 million). The scheme assets increased from £4,634 million in 2009 to £5,134 million in 2010.

After accounting for minimum funding obligations of £29 million (2009: £75 million), excluding unrecognised funded scheme surpluses of £51 million (2009: £52 million) and £1 million for unrecognised past service costs in 2009, the overall net liability for all pension and health care schemes in Group subsidiaries amounted to £648 million at the end of 2010, down from £1,024 million at the end of 2009.

Contributions to the defined benefit schemes are determined after consultation with the respective trustees and actuaries of the individual externally funded schemes, taking into account the regulatory requirements.

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Changes in the Group

In April 2010, the Group announced that it had agreed to sell its Belgium distribution business, Lyfra NV. The transaction was completed on 25 June 2010 for a consideration of €16 million. The disposal will have negligible impact on Group profit, but the company contributed over £400 million to revenue.

In 2009, after the acquisition of Bentoel, BAT Indonesia was merged with the company and from 1 January 2010, is trading under the Bentoel name.

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Share buy-back programme

In 2009, the Board decided to suspend the on-market share buy-back programme that the Group initiated in 2003, in order to preserve the Group’s financial flexibility during the period of economic uncertainty. No shares were bought-back during 2009 and 2010. The Board has approved the resumption of the on-market share buy-back programme in 2011 with a value of up to £750 million.

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Regional structure from 2011

As part of our plans to reduce complexity in our management structure and to achieve a better balance in the scale of our regions, the number of regions will reduce from five to four with effect from 1 January 2011. As a result, the Eastern Europe region will be merged into the Africa and Middle East region and the Western Europe region. The Russia, Ukraine, Moldova, Belarus, Caucasus and Central Asia markets will form part of the new Eastern Europe, Middle East & Africa (EEMEA) region. The Western Europe region will now include the South Eastern Europe (SEE) Area, consisting of Romania, Bulgaria, Serbia, Montenegro, Albania and Kosovo. The Group’s Asia-Pacific and Americas regions will remain unchanged.

The 2010 segmental information has been re-allocated on the basis of the new regional structure and is presented as part of note 2 to the financial statements.

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Non-GAAP measures

In the reporting of financial information, the Group uses certain measures that are not required under International Financial Reporting Standards (IFRS), the generally accepted accounting principles (GAAP) under which the Group reports. The Group believes that these additional measures, which are used internally, are useful to users of the financial information in helping them to understand the underlying business performance.

The principal non-GAAP measures which the Group uses are adjusted profit from operations and adjusted diluted earnings per share, which is reconciled to diluted earnings per share. These measures remove the impact of adjusting items from earnings.

Management reviews current and prior year segmental adjusted profit from operations of subsidiaries and adjusted post-tax results of associates and joint ventures at constant rates of exchange. This allows comparison of the Group’s results had they been translated at last year’s average rate of exchange. Other than in exceptional circumstances, this does not adjust for the normal transactional gains and losses in operations which are generated by exchange movements.

In the presentation of financial information, the Group also uses another measure, organic growth, to analyse the underlying business performance. Organic growth is the growth after adjusting for merger and acquisition and discontinued activities. Adjustments are made to current and prior year numbers, based on the 2010 Group position.

The Group also prepares an alternative cash flow, which includes a measure of ‘free cash flow’, to illustrate the cash flow before transactions relating to borrowings. The Group also provides gross turnover as an additional disclosure to indicate the impact of duty, excise and other taxes.

In accordance with the secondary listing of the ordinary shares of British American Tobacco p.l.c. on the main board of the JSE Limited (‘JSE’) in South Africa, the Group is required to also present headline earnings per share.

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Accounting developments

The Group has prepared its annual consolidated financial statements in accordance with IFRS, as adopted by the EU. During 2010, a number of amended IFRSs and IFRIC interpretations have been adopted by the Group, which had no material effect on reported profit of the Group. IFRS 3 Revised and IAS 27 Revised changed the accounting for business combinations and transactions with non-controlling interests. IAS 27 Revised was applied to the acquisition of certain non-controlling interests in the year with the difference between the fair value of the consideration paid and the carrying value of the non-controlling interest, recognised directly in equity. Annual Improvements to IFRS introduced a number of minor changes, including revised disclosures under IFRS 8 on Operating Segments. As a result of this amendment, the Group no longer presents a measure of total assets for each reportable segment.

The next few years are likely to see more changes in the financial statements given the aims of standard setters and regulators.

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Going concern

Given the Group’s history of growth in profit from operations, the high cash conversion rate from profit into cash, the access to the £2 billion revolving credit facility which is used only as a back stop and the spread of banks providing the facilities, the Group remains confident in its ability to access the debt capital markets.

This, together with the maturity profile of debt, spread over a long period with only limited redemptions scheduled for 2011, provides confidence that the Group has sufficient working capital for the foreseeable future.

After reviewing the Group’s budget, plans and refinancing arrangements, the Directors consider that the Group has adequate resources to continue operating for the foreseeable future. The financial statements have therefore been prepared on a going concern basis. See the Corporate governance statement for full details.

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