British American Tabacco Df 2006

Review 06 Annual Review and Summary Financial Statement 2006

About this Review The format of our reporting has been changed to accommodate the inclusion, for the first time, of an Operating and Financial Review (OFR). In preparing the OFR, we have sought to take into account, when considered appropriate, the best practice set out in the UK Accounting Standards Board’s ‘Reporting Statement: Operating and Financial Review’. We have responded to the spirit of the OFR by offering shareholders a balanced and comprehensive analysis of our current business and describing the significant industry trends that are likely to influence our future prospects. For the first time, we have published our Key Performance Indicators, some other important Business Measures and the Group’s Key Risk Factors. We have also attempted to avoid having too much information in one publication. Our corporate website bat.com has a wealth of material about the Group and, in May 2007, we plan to publish our latest Social Report, detailing progress during 2006 on a range of commitments and actions. We will carefully consider the structure and content of our future reporting in the light of developments in the field and the advice and comments we receive about this publication.



The full content of this Review is under this flap. Leave it open as a reference to find your way to the different topics covered.

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

OPERATING AND FINANCIAL REVIEW

SUMMARY CORPORATE GOVERNANCE AND SUMMARY FINANCIAL STATEMENT

Overview

Summary corporate governance

01 An introduction to British American Tobacco 02 Chairman’s statement and financial highlights

33 34 35 36

Business and strategic review 04 Chief Executive’s industry overview 06 Our strategy (including Key Performance Indicators) 10 Our strategy in action (including Business Measures)

Regional and financial review 20 Regional review 26 Financial review 26 Profit from operations 26 Interest cover 26 Effective tax rate 27 Adjusted diluted earnings per share 27 Dividends per share 28 Cash flow 28 Treasury operations 29 Changes in the Group 29 Changes in accounting policies 30 Share buy-back programme

30 Key Group risk factors

Summary corporate governance Board of Directors Management Board Summary remuneration report

Summary financial statement 41 42 43 44 45

Independent auditors’ statement Group income statement Group balance sheet Group statement of changes in total equity Summary financial statement and notes

Additional information 48 Shareholder information ibc Contact information

Review 06 Annual Review and Summary Financial Statement 2006

Founded in 1903 by Albino Souza Cruz with just 16 employees, Souza Cruz is today the undisputed leader in the Brazilian cigarette market and is among the largest companies in the country. Souza Cruz employs around 6,000 people and sells over 78 billion cigarettes a year. It also provides more than 117,000 tons of tobacco leaf for export to more than 50 countries on five continents. This special feature focuses on how our global strategy of Growth, Productivity, Responsibility and Winning Organisation is working in Souza Cruz, a company contributing significantly to the success of British American Tobacco.

Brazil Special feature

Annual Report and Accounts 06 Annual Review and Summary Financial Statement and Directors’ Report and Accounts 2006

ABOUT THIS REVIEW This Annual Review and Summary Financial Statement for the year ended 31 December 2006 is intended for investors who do not require the full detail of the Directors’ Report and Accounts, which is produced as Part 2 of a combined report (see ‘About the Combined Report’ below). The Annual Review comprises an Operating and Financial Review (OFR) and a Summary Corporate Governance Report, a Summary Remuneration Report and a Summary Financial Statement. The OFR has been prepared to a standard which fulfils the requirements for a business review in accordance with section 234ZZB of the Companies Act 1985, taking into account, where considered appropriate, the best practice set out in the UK Accounting Standards Board’s ‘Reporting Statement: Operating and Financial Review’. The Annual Review does not contain sufficient information to allow for a full understanding of the results of the Group and of the state of affairs of the Company or of the Group. For further information, reference should be made to the Directors’ Report and Accounts 2006, which incorporates the full accounts, the Report of the independent auditors on those accounts, the Directors’ Report, the Remuneration Report and the Corporate Governance Statement. The Annual Review is issued to all shareholders. Special feature As part of the OFR, we have produced a special feature on our Brazilian subsidiary, Souza Cruz, to highlight how our strategy is working in a key market.

ABOUT THE COMBINED REPORT This year, for the first time, British American Tobacco has produced a combined report which amalgamates in one bound document, the Annual Review and Summary Financial Statement together with the Directors’ Report and Accounts of British American Tobacco p.l.c. for the year ended 31 December 2006. The combined report is bound together as the ‘Annual Report and Accounts 06’. The Directors’ Report and Accounts is produced as Part 2 of that combined report. By reference to the Annual Review above, it incorporates the OFR as part of the Directors’ Report on page 49. The Directors’ Report and Accounts is issued, as part of the combined report, to shareholders who elected to receive it together with the Annual Review.

Annual Review 2006 British American Tobacco 01 Operating and financial review

AN INTRODUCTION TO BRITISH AMERICAN TOBACCO

British American Tobacco was ‘born’ international over 100 years ago. We now employ over 55,000 people and are the second largest stockmarket listed tobacco group in the world.

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

AN INTRODUCTION TO BRITISH AMERICAN TOBACCO

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

OVERVIEW

We are also well positioned in all regions of the world, operating in over 180 markets. This geographical balance provides stability, while our presence in markets where volumes and profits are expected to grow gives us confidence for the future.

02 British American Tobacco Annual Review 2006 Operating and financial review

CHAIRMAN’S STATEMENT AND FINANCIAL HIGHLIGHTS

“These strong results based on excellent organic growth continue to provide a solid platform for a sustainable business. Our consistent and balanced approach to the four elements of our strategy for creating shareholder value is working well.” Jan du Plessis, Chairman

OVERVIEW

British American Tobacco has had another good year, with 7 per cent growth in our underlying profit from operations and a 10 per cent increase in adjusted diluted earnings per share. The improvement in profit was driven by volume growth of 2 per cent and net revenue growth of 5 per cent. The impact of exchange rates for the year as a whole was not material, although it was significantly negative in the last six months, especially in the last quarter, and has continued into the current year. Our Global Drive Brands were exceptionally successful, growing by 17 per cent. They now represent over 21 per cent of the Group’s volume from subsidiaries, while international brands as a whole account for some 40 per cent of the total.

CHAIRMAN’S STATEMENT AND FINANCIAL HIGHLIGHTS

Kent volume grew by 16 per cent to 45 billion, while Dunhill improved by 6 per cent, with encouraging performances 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 factory closure programme, partly offset by the gains on a disposal of brands. The annual savings from our supply chain programme in 2006 amounted to £148 million, bringing the total to £374 million per year since we started four years ago. We also saved a further £99 million from the overheads and indirects programme, bringing that total over the same four year period to £355 million on an annualised basis. The current overheads and indirects programme will be completed in 2007. However, we intend to maintain our focus on costs and will be announcing a further five year target, along with the final results from the first five years, in March 2008. We will also pursue additional supply chain savings over the same five year period. Our associate companies grew their volume by 4 per cent to 241 billion and our share of their post-tax results amounted to £431 million. This represents a 10 per cent increase, if

exceptional items are excluded, reflecting higher profits from Reynolds American and ITC. The contribution from Reynolds American was £285 million, with the early results from the acquisition of the Conwood smokeless tobacco business being distinctly encouraging. The improvement in profit from both subsidiaries and associates, together with a lower effective tax rate and the benefit of the share buy-back programme, more than offset the impact of higher net finance costs and minorities. As a result, adjusted diluted earnings per share rose by 10 per cent to 98.12p, just ahead of our long term goal of achieving, on average, high single figure growth in earnings. By the close of business on 1 March, we expect that some 35 million shares will have been bought back since 1 January 2006 at a cost of £500 million and at an average price of £14.19 per share. Since 2003, when the buy-back programme started, around 246 million shares have been repurchased at a cost of £2,191 million, equivalent to an average price of £8.91 per share. We continue to view the purchase of our own shares as an excellent investment. Following a review of the Group’s capital structure, the Board has decided that there is scope to increase significantly both the dividend payout ratio and the share buy-back programme. The previous policy was to pay out at least 50 per cent of long term sustainable earnings in dividends, with the payout ratio in 2005 being 53 per cent. The Board has decided to raise the payout ratio to 65 per cent by 2008 in progressive steps and is therefore proposing a final dividend for 2006 of 40.2p, an increase of 22 per cent. This takes the total for the year to 55.9p, an uplift of 19 per cent and raises the dividend payout ratio for 2006 to 57 per cent. The dividend will be paid to shareholders on the Register at 9 March 2007. In line with our current practice, the interim dividend for 2007 will be approximately one-third of the total for 2006.

Annual Review 2006 British American Tobacco 03 Operating and financial review

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

R&R have given their consent to this proposal and in return have asked British American Tobacco to obtain a secondary listing for its ordinary shares on the Johannesburg Stock Exchange, if and when requested by them. British American Tobacco has agreed to this. The proposal will be put to the Annual General Meeting on 26 April for approval and the Board recommends the independent shareholders to vote in favour.

While the increased level of the share buy-back programme will create value for shareholders, it continues to preserve financial flexibility because it can be suspended in the event of an opportunity to make a significant acquisition that is both financially and strategically attractive in the longer term. Rupert Pennant-Rea will retire from the Board at the end of the Annual General Meeting. I would like to thank him for the significant contribution he has made over the last 11 years, not only as a Director but also as Chairman of the Audit Committee. 2006 has been a good year and I believe we can look ahead with confidence in our ability to achieve further growth and value for shareholders. Over the past five years, British American Tobacco has delivered an average annual total shareholder return of 26 per cent, compared to 7 per cent for the FTSE 100.

£ million 2,607

2005

2,797

+7%

2006

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

Adjusted diluted earnings per share pence 89.34

2005

98.12

+10%

2006

Adjusted diluted earnings per share increased from 89.34 pence to 98.12 pence per share.

Group volumes billions 678

689

2005

2006

+2%

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

Dividend per share declared pence 55.9 47.0

2005

+19%

2006

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

CHAIRMAN’S STATEMENT AND FINANCIAL HIGHLIGHTS

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

Profit from operations: like-for-like

OVERVIEW

Following discussions with both the Takeover Panel and R&R, the Panel has indicated, subject to final approval, that it is prepared to waive the 30 per cent rule, if the independent shareholders approve such a waiver at the Annual General Meeting. This will allow the Company to continue the share buy-back programme, despite the fact that the R&R shareholding will increase above 30 per cent. The existing agreement restricting R&R’s voting rights to 25 per cent will remain in place.

FINANCIAL HIGHLIGHTS

04 British American Tobacco Annual Review 2006 Operating and financial review

CHIEF EXECUTIVE’S INDUSTRY OVERVIEW

“Whether new challenges come from our own evolving standards or from regulatory restrictions, we can grow if our positioning and strategy are right.” Paul Adams, Chief Executive BUSINESS AND STRATEGIC REVIEW

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

‘fourth dimension’, namely, harm reduction, for the millions of adults globally who will continue to be tobacco consumers.

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

Current and future market Currently smokers consume over five trillion cigarettes a year globally.

CHIEF EXECUTIVE’S INDUSTRY OVERVIEW

We have a strong and complete portfolio of brands at different price points. As well as our GDBs, it includes an unrivalled range of regional and local brands which play a vital role in our success in many markets. We have a full range of tobacco products and we have a track record of innovation that our competitors struggle to match. In addition to the opportunities for top line growth, there are very significant opportunities to make cost savings through our productivity initiatives. As you can read on page 14, we are ahead of schedule and the more work we do in this area the more we identify further savings. We also believe that we have the right responsibility strategy for both the short and the long term and we position responsibility as a key part of our overall business strategy. Consequently, we have invested significantly more in R&D, particularly around harm reduction. We agree that risky products such as tobacco should be regulated. Currently, tobacco regulation broadly focuses on 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

China, the world’s largest cigarette market, makes up 35 per cent of global volumes. Outside China, over half the global market is held by the six biggest international manufacturers which, in 2006, were: Philip Morris, with a global market share of 18.7 per cent, British American Tobacco (including associates’ total volumes) with 17.1 per cent, Japan Tobacco with 7.7 per cent, Imperial Tobacco with 3.5 per cent, Gallaher with 3.1 per cent and Altadis with 2.1 per cent. Regulation of the industry and its products has increased in recent years, including graphic health warnings on packs, advertising and promotion restrictions and, more recently, restrictions on public place smoking. Future regulation will largely be framed by the World Health Organisation’s Framework Convention on Tobacco Control, which entered into force in 2005. Increases in excise rates in many of the higher-price markets are leading consumers to switch to cheaper brands and this trend is expected to continue. However, in emerging markets, consumers are increasingly trading up, so premium brands are growing. Over the next decade, we expect the average daily consumption of cigarettes to fall in many of the world’s largest markets. We also expect a declining incidence of smoking generally, leading to smaller percentages of populations being smokers, particularly in currently high margin markets such as Canada, Germany and Japan. However, the number of adults over the age of 20 in the world is forecast to grow 11 per cent by 2015. As a result, although the proportion of adults smoking will probably decline, global volumes are expected to be broadly unchanged at some five trillion in 2015. This future market represents a volume and

Annual Review 2006 British American Tobacco 05 Operating and financial review

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

While volumes are forecast to decline in some markets, mainly the current higher margin markets, they are set to grow in others, mainly in lower margin markets. Nevertheless, global industry profits are also set to increase over the next decade. British American Tobacco’s broad geographic base means that we are well represented in many of the lower margin markets where volume and profitability are expected to grow, and that we are not so reliant on high margin markets, where volumes are declining faster than the global average. So, despite a changing business environment, we are confident that the tobacco industry has a secure future and that British American Tobacco has the strategy and products to prosper in it.

Conclusion The tobacco industry is mature and all players, including us, face some big challenges, but we still have lots of room for growth. British American Tobacco’s strong brand portfolio and record of innovation, our trade marketing expertise, our cost savings potential, the global diversity of our earnings base, our presence in emerging markets and the future size of those markets: these are all reasons for us to believe that our business can continue to grow.

10 Our strategy in action 10 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 Sustainability Indexes – Climate change – Harm reduction 18 Winning organisation – Employees – Employee opinion GROUP NUMBERS 2006 Gross turnover

£25,189 million Revenue after deducting duty, excise and other taxes

£9,762 million Profit from operations

£2,622 million Net capital expenditure

£419 million Research & Development expenditure

£76 million Charitable and community donations

£17.6 million Employees

55,145 Global cigarette volumes

689 billion

CHIEF EXECUTIVE’S INDUSTRY OVERVIEW

The evidence of the past decade bears this out. Although the total global volume of cigarettes has been broadly static over that time, our global market share has grown significantly as a result of both acquisitions and organic growth, and our operating profit has increased by over 60 per cent.

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

BUSINESS AND STRATEGIC REVIEW

Unfortunately, the market has also attracted illicit manufacturers and distributors of tobacco. We estimate that some 6 per cent of tobacco consumption, about 300 billion cigarettes a year, is supplied by smuggled or counterfeit trade. It is a key concern for us. How much of the industry will become illicit in the future? We continue to work proactively with governments and customs authorities to try to stem this rising tide.

The following section contains:

06 British American Tobacco Annual Review 2006 Operating and financial review

OUR STRATEGY

BUSINESS AND STRATEGIC REVIEW

Our vision is to achieve leadership of the global tobacco industry, through strategies for creating shareholder value based on Growth, Productivity, Responsibility and a Winning Organisation.

indirect costs (anything we spend money on other than leaf, wrapping materials, cigarette making machinery and labour costs).

We define leadership in both a quantitative and qualitative sense. Quantitatively, we seek volume leadership among our international competitors. Qualitatively, we aim to lead our industry as the preferred partner of key stakeholders and in demonstrating responsibility.

RESPONSIBILITY Because we manage a product that poses real risks to health, we strongly believe that our business must demonstrate responsibility in everything it does. We aim to balance our commercial objectives with stakeholders’ changing expectations of a modern tobacco business. Our Business Principles and our Standards of Business Conduct set out what we require of our companies and employees in terms of responsible corporate behaviour and personal integrity.

See diagram 1 GROWTH We aim to grow our revenues and profits and to grow our share of the global market. We have two routes to do this: organic growth and mergers and acquisitions. Organic growth means increasing our market share in existing markets and through entering new markets. To achieve organic growth, we focus on key market segments that offer the best long term prospects, including Premium and International Brands. We also aim to optimise the performance of our Global Drive Brands and to exploit opportunities for profitable volume growth in the Value-for-Money and Low Price segments. We see innovative products that offer consumers meaningful, value-added differentiation as key to organic growth. We aim to continue sustaining or developing strong positions in our largest and most profitable markets.

OUR STRATEGY

Strategically important and financially attractive mergers and acquisitions may also provide us with growth opportunities. PRODUCTIVITY Our approach to productivity concentrates on smart cost management, marketing efficiency and capital effectiveness; deploying our global resources more effectively to increase profits and generate funds to reinvest in our business. This includes ensuring that we use our marketing resources and capabilities in the most efficient way, reducing unnecessary complexity and using our cash and other assets effectively. We are saving money by turning a multinational business operating in over 180 markets into an integrated global enterprise that can really take advantage of its scale. Greater integration across our supply chain is helping us to reduce costs, increase speed to market and improve effectiveness. We are also reducing our overheads and

We support tobacco regulation that balances the preferences of consumers with the interests of society, establishes an open-minded approach to harm reduction as a policy, and enables our businesses to continue to compete and prosper. Harm reduction is an important element of our strategy. For more about our approach, see page 17. WINNING ORGANISATION To achieve our vision of industry leadership, we recognise that we must continue to have the right people and the right working environment. We aim to develop leaders at all levels, to foster a confident culture that embraces change and innovation, to attract and retain talented people and to ensure continuous improvement throughout the Group. OUR KEY PERFORMANCE INDICATORS Measuring our performance We have a wide range of measures and indicators by which the Board assesses performance compared to the Group’s strategy. The Group’s goal to create shareholder value through the strategies of Growth, Productivity, Responsibility and Winning Organisation is best measured by the main financial drivers of the business. To ensure management’s focus is aligned with the interests of our shareholders, these measures form the basis upon which the levels of incentives for the global organisation are decided. They are described below as our seven Key Performance Indicators (KPIs). Some of these KPIs are used to set the targets for the Group’s performance over three years and some are focused on the short term. These KPIs were chosen

Annual Review 2006 British American Tobacco 07 Operating and financial review

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

Diagram 1: Group strategy

Achieve leadership of the global tobacco industry

We have therefore included, in this Review, some additional Business Measures relating to the Responsibility and Winning Organisation elements of our strategy. Our progress under Productivity is, of course, covered by the information we already publish about the Supply Chain and Overheads and Indirects programmes.

Growth

Productivity

Responsibility

Winning Organisation

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

BUSINESS AND STRATEGIC REVIEW

A number of other Business Measures, financial and non-financial, are monitored and assessed on a frequent basis to ensure that all the Group’s strategies are delivered. Although all these are not included in management’s incentives, we believe that these Business Measures are all contributing to the success of the Group, particularly over the longer term.

The Remuneration Committee sets targets at different levels, based on the Group budget approved by the Board in December. The KPIs used in 2006 have been retained for 2007. Measuring short term performance 1 Net revenue growth Net revenue for 2006 grew by 5 per cent. The long term goal is to grow net revenue, on average, by 3-3.5 per cent per annum.

Global Drive Brand volume A key strength of the Group is its diversified Global Drive Brands (GDBs) portfolio. The growth of the four GDBs Dunhill, Kent, Lucky Strike and Pall Mall is therefore a key driver of the Group strategy and is measured as one of the KPIs.

Net revenue growth £ million 9,301 +7%

9,672 +5%

2005

2006

2

In 2006, GDB overall volume grew by 17 per cent to 146 billion compared to 9 per cent growth in 2005. Our target is to achieve high single figure growth.

2

3-3.5%

Global Drive Brand volume billions 124.9 +9%

146.1 +17%

GDB volumes are calculated as the total volumes of the four brands sold by our subsidiaries. More information about the GDBs and their individual performances, is provided in this Review on pages 12 and 13.

Long term target, on average

2005

2006

Long term target, on average, high single figures

OUR STRATEGY

1

The net revenue figure is calculated as the revenue of the Group after the deduction of any duties, excise and other taxes, as published in the Group Income Statement on page 42.

08 British American Tobacco Annual Review 2006 Operating and financial review

OUR STRATEGY

Share of global volume amongst key players The long term goal is to become the leading international tobacco company and British American Tobacco is currently second. 3

BUSINESS AND STRATEGIC REVIEW

In 2006, our share of global volumes amongst key players grew by 0.2 per cent. Share of global volume is calculated as the volumes sold by Group subsidiaries as a percentage of the volumes sold by all international players, namely Philip Morris International, Japan Tobacco, Imperial Group, Gallaher and Altadis. The information used to complete this calculation is based on publicly available information and internal company analysis. In our endeavour to grow global volumes, we assess all available acquisition opportunities on a frequent basis, but will only make a move when it is both financially and strategically attractive. 4 Organic operating profit growth The Group’s long term aim is to grow organic underlying operating 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 operating profit of the Group’s subsidiaries, excluding any exceptional items – the items shown as memorandum information on the Group Income Statement on page 42. 5 Cash flow The Group’s free cash flow in 2006 was £1,541 million, marginally below 2005.

OUR STRATEGY

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

The purpose of this measure is to ensure that the Group generates sufficient cash to fund its operations, pay dividends to its shareholders, operate the share buy-back programme and undertake other investment opportunities that may arise. Measuring long term performance 6 Earnings per share Adjusted diluted earnings per share (Adjusted EPS) grew at an average of 12.4 per cent per annum since the beginning of 2004. This compared favourably to the long term goal of growing at the rate of high single figures per 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 the underlying performance of the business, as it excludes all significant distortions (one-off and exceptional items that occur) but includes the potentially dilutive effect of employee share schemes. The detail of the calculation and the adjustments made, are explained in note 7 to the accounts included in the Annual Report and Accounts. This calculation removes the impact of the exceptional items shown as memorandum information on the Group Income Statement on page 42. These items are the restructuring costs and impairment of a business, offset by gains on disposal of brands. In addition, the calculation also adjusts for certain distortions in net finance costs arising under IFRS.

Annual Review 2006 British American Tobacco 09 Operating and financial review

Total Shareholder Return The Group’s strategy is focused on increasing shareholder value which is measured using Total Shareholder Return (TSR), compared to the FTSE 100 Index and also to the Fast Moving Consumer Goods (FMCG) peer group. The Group has achieved a top quartile performance in both these categories since 1999. The goal is to be in the top quartile of each of the two comparator groups over a three year average. 7

3

Share of global volume amongst key players percentage Long term target 17.1%

BUSINESS AND STRATEGIC REVIEW

4

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

No.1

Organic operating profit growth £ million 2,607 +9%

TSR performance combines both the share price and dividend performance of the Company during the performance period, as set against the two comparator groups. The FMCG comparator group is reviewed annually to ensure that it remains both relevant and representative and to, as far as possible, reflect the Company’s financial and business trading environment.

2005

5

2,797 +7%

Long term target, on average

6%

2006

Cash flow £ million

TSR is measured according to the return index calculated by Datastream, on the basis of all companies’ dividends being reinvested in the shares of the companies. The return is the percentage increase in each company’s index over a three year period. The measures and the outcome for the current and previous years are explained in the Summary Remuneration Report on page 36, where the Group’s employee share schemes are described. 6

1,582 +18%

1,541 –3%

2005

2006

Specific target set for each year

Earnings per share 89.34 +17%

2005

7

Total shareholder return (annual %)

7

(1 January 2004 – 31 December 2006) FMCG group Upper Quartile Lower Quartile

Median – 15.3%

98.20 +10%

OUR STRATEGY

pence Long term target, on average, high single figures

2006

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

BAT – 32.2%

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

35 30

Upper Quartile Lower Quartile

Median – 19.9%

BAT – 32.2%

70 60

25

50

20

40

15

30

10

20

5

10

0

0

–5

– 10

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

10 British American Tobacco Annual Review 2006 Operating and financial review

OUR STRATEGY IN ACTION

BUSINESS AND STRATEGIC REVIEW

GROWTH Our approach to marketing We recognise that our marketing must be conducted responsibly, ensuring that we communicate our product and brand benefits to adult consumers. In 2001, we developed, along with two major international competitors, the International Marketing Standards (IMS). They set out detailed guidance on all aspects of tobacco marketing from print, billboards and electronic media to promotional events, packaging and sponsorship. In 2006, in accordance with the IMS, we ended our sponsorship of Formula 1 motor racing. We want to keep our marketing activity responsive to a fast changing world. During 2007, we will therefore be revising our own set of Standards, to include newer media not captured in the original 2001 version (e.g. internet sales and text messaging), enhanced adult age verification procedures and tighter restrictions on promotion and sampling. These and other changes will help ‘raise the bar’ further in terms of addressing what is acceptable tobacco marketing worldwide.

OUR STRATEGY IN ACTION

Our marketing approach focuses on using insights into consumer lifestyles and values to develop relevant products. These insights drive the development of our product and communication campaigns, to differentiate our products from our competitors’ offerings in ways that resonate with adult consumers. This includes the work of our Trade Marketing & Distribution teams to place and promote the right brands in the right retail outlets for the right consumers. Strategy Central to our marketing approach is the premise that one size does not fit all and we believe a key strength of British American Tobacco is our diversified Global Drive Brands (GDBs) portfolio. These brands deliver rational choices such as product, blend and price along with other perceived consumer benefits like strength and taste. Our growth strategy is built on the success of our four GDBs, Dunhill, Kent, Lucky Strike and Pall Mall. We focus our resources to develop these brands in the key International, Premium, Lights and Adult Smokers Under 30 (ASU30) marketing segments, where we

expect both current and long term growth opportunities. We also continue to invest in our regional and local brands, especially where they play a strategic role in a particular market’s portfolio. We also take opportunities to invest in brands that show specific promise, particularly in the growing segments, such as Vogue, our premium superslims offer, and Kool, our premium menthol offer. See chart

1

GDB strategy is working Our strategy is working. In 2006, our Premium GDBs alone grew by 9 per cent. Each of our four GDBs grew in 2006, including Lucky Strike which returned to marginal volume growth and continued to improve its share in most of its core markets. We grew our GDBs in each of our operating regions, 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 concentrated in one country or region. We saw increases in all regions except for America-Pacific, where volume declines in Canada offset gains in Japan. Our investment in consumer relevant innovation is delivering results in both volume and value terms. 2006 saw a number of highly successful product launches in which we offered consumers additional value at a higher price point. Dunhill Fine Cut cigarettes in numerous markets and Pall Mall superslims across key Eastern European markets, such as Russia, were just two specific product innovations that drove volume and higher net revenue from our GDBs portfolio. They are concrete examples of us meeting the preferences of consumers who, in turn, are choosing to trade up to products that deliver higher margins. Innovation is strengthening the foundations for our future growth. See chart

2

Other International Brands While our investment and managerial focus remains firmly on our four GDBs, 2006 saw robust growth across our broader range of International Brands (IBs), with total

Annual Review 2006 British American Tobacco 11 Operating and financial review

See chart

1

billions 199 208

To achieve benchmark status, we must operate consistently in the most effective and efficient manner to serve our trade customers, both independent outlets as well as our major account customers. We measure our performance in this area extensively and the most recent external and independent survey carried out in 2006 revealed that, in a majority of countries, retailers perceive British American Tobacco as having the best TMD organisation compared to other tobacco companies.

171

150 153

2005 2006 ASU30

Lights

IBs

Premium

Based on data from the 22 markets, our share in each segment increased in 2006 to ASU30 (30.2%), Lights (26.6%), IBs (21.8%) and Premium (29.4%). 2

GDB volume growth billions 146 93

100

2001

2002

113

114

2003

2004

125

2005

2006

Since 2001, our four GDBs (Dunhill, Kent, Lucky Strike and Pall Mall) have increased combined volume by 57%. 3

Other International Brands – volume growth billions 129

2001

118

122

127

133

116

2002

2003

2004

2005

2006

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

OUR STRATEGY IN ACTION

The foundation for this success is our ‘Win Win Win’ strategy. We recognise that in order for our strategy to succeed, it is imperative that there is a benefit for all three participants – our customers, ourselves and, above all, our consumers. All three must stand to win in some way. 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 in 5,500 Shell convenience stores around the world.

156

139 144

3

Relationships with customers The increasingly restrictive environment in which we can communicate with consumers means that Trade Marketing & Distribution (TMD) is a key element of our marketing activity. We recognise the importance of the retail outlet. That is why we strive to achieve and maintain benchmark business partnerships with the retail trade in all the strategic channels where we do business.

Strategic segment volume in 22 key markets

BUSINESS AND STRATEGIC REVIEW

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

12 British American Tobacco Annual Review 2006 Operating and financial review

OUR STRATEGY IN ACTION CONTINUED

BUSINESS AND STRATEGIC REVIEW

GDB performance Dunhill Dunhill provides us with a Premium/Super Premium brand to meet the needs of consumers at the top end of the tobacco market. In 2006, we extended Dunhill’s geographic reach, as well as the product segments in which Dunhill competes. 2006 saw the successful enhancement of the House of Dunhill via the rapid roll-out of Dunhill Fine Cut cigarettes, the relaunch of Top Leaf and the pilot launches of the Essence (superslims) and Senses (menthol) ranges. These initiatives succeeded in Dunhill’s core markets such as Australia, Malaysia, South Korea and Taiwan, where they supplemented existing Dunhill offers, while stretching the price mix to premium plus levels. These developments also helped in the promising launch and roll-out of Dunhill in new markets, particularly in Western Europe and the Middle East. Furthermore, a number of key product innovations that commanded premium plus price points were successfully launched. We believe that the equity of the brand, combined with tangible product benefits delivered by these innovations, provides consumers with what they want. Manufacture of the Dunhill Signed Range cigars was moved to Nicaragua in 2006. This change will significantly reduce our supply chain complexity, allow us to continue to deliver a premium cigar and invest in the further growth of the range.

OUR STRATEGY IN ACTION

2007 sees the centenary of the Dunhill tobacco brand and several ambitious initiatives will roll-out worldwide in celebration.

Kent Kent continues to play its key role in our portfolio as the free standing premium brand for consumers seeking a mild and smooth taste. Kent aims to be the leading brand for ASU30 smokers and perceived consistently as the brand that delivers ‘the modern way to smoke’. Kent has continued to demonstrate the innovative nature of a brand designed for the 21st century through a number of linked initiatives. These include the introduction of a new global pack and the core charcoal range’s use of 3-Tek filter technology. A new communication campaign in Russia, Japan, Romania and Chile resulted in accelerated organic growth of the brand in these markets. In Switzerland and the Netherlands, British American Tobacco launched the brand via the migration of Barclay consumers to Kent. Initial results are promising, with exceptionally strong consumer response from both existing smokers and those switching from competitor brands. The net result of these initiatives saw Kent become the number one brand in Romania, as well as achieving over a billion cigarettes a month in sales in Russia. Kent delivered the fastest rate of growth among our premium GDBs, with its fourth consecutive year of double digit growth. Lucky Strike 2006 was a milestone year for the Lucky Strike brand, as it managed to return to volume growth and achieved record market share in Germany, Spain, France, Indonesia, Argentina and Italy. In 2006, Lucky Strike focused on establishing itself as the brand that provides ‘a rich tobacco experience’ through the launch of an innovative pipeline of product and packaging initiatives.

Annual Review 2006 British American Tobacco 13 Operating and financial review

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

Pall Mall Pall Mall aims to redefine consumers’ experience at the Value-for-Money price point by delivering on its promise of ’imagination in tobacco’ with innovative product and brand attributes. Pall Mall achieved an outstanding performance in 2006, driven by good organic volume and share growth in its established markets such as Germany, Poland and Spain, as well as many successful launches in all regions.

45 billion cigarettes sold in 2006 16 per cent increase on 2005

22 billion cigarettes sold in 2006 0.4 per cent increase on 2005

46 billion cigarettes sold in 2006 40 per cent increase on 2005

OUR STRATEGY IN ACTION

Pall Mall’s success is driven by the strong and globally consistent brand mix, supported by a solid innovation pipeline, ensuring Pall Mall has a leadership position in responding to consumer needs in the Value-for-Money segment. The launch of House of Pall Mall in Switzerland included the introduction of four different tobacco products (small cigars, RYO, Superslims and Stix) along with a range of King Size cigarettes offering more choice. In Germany, Pall Mall successfully captured consumers moving from Stix to other tobacco products within the brand family and achieved its highest ever share of the German market by the year end, to become the second largest tobacco brand.

33 billion cigarettes sold in 2006 6 per cent increase on 2005

BUSINESS AND STRATEGIC REVIEW

Lucky Strike launched new Roll Your Own (RYO) products in an effort to capitalise on growth without diluting its premium image. In smokeless products, the market success of Lucky Strike snus in Sweden and the pilot learnings achieved in South Africa, are encouraging signs that the brand’s equity can be successfully stretched into other tobacco categories.

14 British American Tobacco Annual Review 2006 Operating and financial review

OUR STRATEGY IN ACTION CONTINUED

BUSINESS AND STRATEGIC REVIEW

PRODUCTIVITY Savings generated by our productivity initiatives are ahead of plan. The substantial efficiencies made in the supply chain, supported by savings through our overheads and indirects programmes, are releasing funds for reinvestment in research, product innovation and growth, as well as being a significant driver of operating profit growth.

In addition, we will establish new capabilities for driving growth through consumer relevant innovations, delivered through an effective and efficient, integrated supply chain. Improvements in global supply chain operations to date were recognised by a European Supply Chain Excellence Award, presented by the magazine ‘Supply Chain Standard’ in November 2006.

Supply chain savings Our focus on primary supply chain efficiencies has delivered benefits of £148 million in 2006, bringing the annual savings for the four years of the programme up to £374 million. These savings are predominantly the result of efficiencies within our manufacturing and logistics operations and initiatives surrounding the specification, purchase and usage of packaging and leaf materials.

Overheads and Indirects The Overheads and Indirects cost reduction programme ended its fourth year and delivered savings of £99 million. Since its inception in 2003, annualised savings have reached £355 million and are well on the way to reach the £400 million target by 2007.

There has been further rationalisation of our manufacturing capacity, with 12 factories closed in the year, including Guelph in Canada and Southampton in the UK, and cigarette manufacture in Bologna in Italy has ceased. In addition, a further four factory closures were announced, including Zevenaar in the Netherlands, and a number of downsizing exercises have been completed. These initiatives, together with the Group’s ‘Bullseye’ best practice audits have increased overall productivity by nearly 10 per cent in the year. We have also redeployed 650 individual machinery assets around the Group.

OUR STRATEGY IN ACTION

The job losses resulting from closures and downsizings have been addressed with care and responsibility. Mitigation activities have included fair redundancy packages, extensive outplacement support and, where appropriate, community wide initiatives aimed at new job creation. The Company’s Mitigation-Plus programme in response to the Darlington factory closure in the north east of England is one of those to have received recognition, a best practice award in 2006 from the UK-based Management Consultants Association. The Product Complexity Reduction programme targets the elimination of irrelevant complexity across our brand portfolio. Working together, our Operations and Marketing teams have defined standards covering all the key attributes of our brands, from packaging design through to product specifications and leaf blends. As a result, we have been able to rationalise and simplify the number of combinations and specifications we use in our supply chain by more than 30 per cent. We have also reduced the number of stock keeping units we sell by 24 per cent, leaving a more focused, consumer-relevant portfolio. The productivity, complexity and capacity optimisation programmes will continue over the next few years and will realise significant savings.

Savings are, in part, being driven by the adoption of smarter procurement processes around the Group, with procurement specialists working with key business managers to find mutual benefits. The amount of indirect expenditure (those items that are not involved in cigarette production) that is channelled through procurement has increased to a level that now covers most areas of the business and the processes established are being embedded within the business for sustainable benefit. The move to shared services in both IT and Finance is gaining momentum and is now delivering real value. RESPONSIBILITY Responsibility is a key element of our business strategy but how do we measure or assess our performance? We look to external benchmarking to provide us with an objective view on how we are doing and use the Dow Jones Sustainability Indexes (DJSI) as our primary Business Measure. With regard to our environmental impacts, we have the data and have been reporting on the trends for several years. On pages 15 to 17, we have included some of these measures in a section on the key topic of climate change. In harm reduction, we can report some encouraging signs of increasing engagement around an area which is central to our business strategy. Dow Jones Sustainability Indexes In 2006, we were, for the fifth year running, the only tobacco company included in the DJSI. Launched in 1999, the DJSI are global indices tracking the performance of the leading companies worldwide. The indices are based on a detailed assessment of companies’ economic, environmental and social performance, and on how well they integrate sustainability strategies into their business. Externally, these benchmarks are used by asset managers to make investment decisions and by other stakeholders looking at sustainable businesses. Internally, participation

Annual Review 2006 British American Tobacco 15 Operating and financial review

in the indices gives us an objective third party perspective on how we are managing the business and allows us to benchmark our performance against the best in the sector and the sector averages.

See chart

Dow Jones Criteria

Was 2006 score same or better than 2005?

Was score higher than 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

✖

✔

✔ ✔ ✔ ✔ ✔ ✔

✔ ✔ ✔ ✔ ✔ ✔

Talent Attraction & Retention

✔ ✔ ✔

Social Standards for Suppliers

(new)

Corporate Citizenship/Philanthropy

✔ ✔ ✔ ✔

✔ ✔ ✔ ✔ ✔ ✔ ✔ ✔ ✔

Environmental Dimension Environmental Policy/Management Environmental Performance (Eco-efficiency) Environmental Reporting Management of GMO Fuels for Tobacco Curing Raw Material Sourcing

4

Climate change We 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 in accordance with Global Reporting Initiative (GRI) guidelines, publicly on an annual basis.

Reduction – our performance on reducing emissions We 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 renewable fuels and through consolidation of our manufacturing footprint. We also work to reduce waste sent to landfill and increase the amount of waste recycled. Emissions CO2 is a GHG, a major contributor to climate change. In 2000, the Group committed to reducing CO2 emissions by 5.2 per cent by 2008, in line with the Kyoto protocol. This was achieved by 2004. We have set progressively more stretching targets each year since 2004. In 2006, the target was 0.78 tonnes CO2 per million cigarettes equivalent and we achieved 0.79 tonnes, a reduction of 5 per cent over 2005. Over the last five years, our emissions have reduced by 43 per cent. 5

Social Dimension Labour Practice Indicators Human Capital Development

Social Reporting Responsible Marketing Policies Occupational Health & Safety **TARGET reached

*We were previously sector leaders in this category but a change in the scoring system resulted in a significant fall in our score in 2006. **Our target is to record a higher score than the sector average in a minimum of 15 out of 19 categories.

5

Emissions tonnes CO2 per million cigarettes equivalent 1.38

2001

1.26

2002

1.23

2003

1.13

2004

0.83

0.79

2005

2006

Since 2001, our emissions have fallen by 43%.

OUR STRATEGY IN ACTION

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

See chart

Dow Jones Sustainability Indexes

BUSINESS AND STRATEGIC REVIEW

The tobacco sector group is based upon an assessment of 10 tobacco companies, although the names of all the companies are not publicly disclosed. In 2006, our overall score remained equal to last year’s at 79 per cent against a 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 sector average in 18. We shall continue to submit ourselves for consideration, with the aim of maintaining our position in the indices. However, because inclusion is determined by a third party, we have chosen not to regard inclusion itself as a Business Measure. Chart 4 shows how we report our performance in the DJSI. Our annual target is to record a higher score than the sector average in a minimum of 15 out of 19 categories.

4

16 British American Tobacco Annual Review 2006 Operating and financial review

OUR STRATEGY IN ACTION CONTINUED

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

BUSINESS AND STRATEGIC REVIEW

By reducing the amount of total waste generated and increasing recycling rates, we have reduced waste sent to landfill by 59 per cent since 2001. See chart

6

Recycling Increasing recycling rates reduces the amount of waste that is sent to landfill. Our 2006 global recycling rate was 81.2 per cent. Through proactively seeking new partners and destinations for recycling, we have increased our recycling rates over the last five years. There are now 10 companies within the Group achieving 95 per cent recycling rates. See chart

7

Working with our Supply Chain Suppliers are increasingly seen as a critically important stakeholder group and there are growing expectations that businesses should use their influence to encourage good standards of corporate responsibility in their supply chains. We accept this responsibility and work not only to set high standards for our suppliers but to support them in achieving continuous improvement.

OUR STRATEGY IN ACTION

We see this as particularly important for a very large business such as ours, with a primary supply chain that includes some 250,000 farmers who grow tobacco leaf and other international suppliers from whom we buy other raw materials such as packaging and paper. Our major supply chain programmes include our Business Enabler Survey Tool (BEST), which sets out in detail the standards we expect of the suppliers from whom we buy raw materials other than leaf. BEST assesses suppliers across 102 performance criteria, covering, for example, suppliers’ business ethics; environment, occupational health and safety management; employee rights and the supplier’s ability to trace the sources of raw materials, including sourcing wood from sustainably managed forestry. Social Responsibility in Tobacco Production (SRTP) is a significant programme that aims to ensure that we only purchase tobacco leaf from responsible and sustainable sources, by working to address the social and environmental issues associated with tobacco leaf growing and processing. We have also encouraged other manufacturers to adopt a similar approach, an initiative that is gaining considerable support. Our supplier review methodology has been adopted by a number of tobacco manufacturers, while others have adopted similar programmes of their own.

In terms of reducing GHG emissions, we are working with leaf and material suppliers, through both the SRTP and BEST programmes, to achieve further improvement and we will be establishing minimum environmental performance criteria for suppliers during 2007. Mitigation activities – The British American Tobacco Biodiversity Partnership We are also working with our Non-Governmental Organisation partners (Earthwatch Institute (Europe), Fauna & Flora International, the Royal Botanic Gardens, Kew and the Tropical Biology Association) within the Biodiversity Partnership to avoid, minimise and mitigate our impacts on biodiversity and minimise the use of ecosystem services, such as soil, water and wood. We have categorised our projects in accordance with definitions from the Intergovernmental Panel on Climate Change (IPCC), splitting the contribution to the Climate Change agenda into the following: • Understanding impacts, adaptation and vulnerability • Mitigation Of the current 43 projects within the partnership programme portfolio, 25 address understanding impacts, adaptation and vulnerability, and 17 address the mitigation part of the IPCC definitions. 14 of the projects address both and 15 are relevant to neither aspects of climate change but are relevant to biodiversity conservation. Water use In many areas where we operate, climatic variations may cause water to become a scarce resource. In 2006, we have reduced our water use by 7 per cent and over the last five years it has come down by 41 per cent. See chart

8

Offsetting We do not use the information below to formally offset our CO2 emissions, as many of the trees that we sponsor are not owned by us. However, since the 1970s, Group companies have promoted forestry programmes to ensure a source of wood fuel for tobacco growers. The Edinburgh Centre for Carbon Management has helped the Group to quantify the CO2 take-up and storage by these forests since 1998. At the end of 2005, the carbon storage associated with the programmes in Brazil, Kenya, Pakistan and Uganda was estimated at 400,000 tonnes of carbon, equivalent to 1.46 million tonnes of CO2. This compared to the 0.85 million tonnes of CO2 emitted from Group companies’ operations in 2005. This study will be updated in 2007.

Annual Review 2006 British American Tobacco 17 Operating and financial review

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

6

Waste to landfill tonnes per million cigarettes equivalent 0.056

Harm reduction We believe that harm reduction, which is a key element of our business strategy, ought to be able to find common ground with the goals of public health policy.

0.042

0.036 0.035 0.023

2001

2002

2003

2004

2005

2006

Since 2001, we have reduced our waste to landfill by 59%. 7

Recycling percentage of waste recycled

However, we strongly believe that these prevention, cessation and protection efforts are missing an important ‘fourth dimension’, namely, harm reduction, for the millions of adults globally who will continue to be tobacco consumers. The World Health Organisation predicts that, even with increasingly strict regulation, there will be as many or more smokers globally in 10 years’ time as there are today, as falling tobacco consumption is offset by a strongly rising world adult population. In public policy, harm reduction is an established concept. It recognises that positive health outcomes can be achieved in ways other than through disincentives, punitive measures or the prohibition of certain lifestyle choices.

We believe we can contribute to reducing the harm of tobacco use through innovative products, while also supporting the long term sustainability of our business. What we are doing Encouraged by public health stakeholders, we have extended some major cigarette brands to Swedish-style snus, a smokeless tobacco product mainly sold in Sweden and recognised by health experts, such as the UK’s Royal College of Physicians, to be much less harmful than smoking. We are marketing snus in Sweden, have started sales in Norway and, building on our experience in South Africa, have begun a pilot in Japan. We plan to extend these initiatives elsewhere in due course. We are planning to lobby for an amendment to the EU ban on snus sales in the EU except for Sweden. We believe there is no rational justification for continuing to bar smokers from choosing a less hazardous alternative to cigarettes.

2001

2002

69.4

72.3

72.5

2003

2004

2005

81.2

2006

Since 2001, we have increased our recycling by 24%. 8

Water use cubic metres per million cigarettes equivalent 8.73

8.01

7.84 6.61*

2001

2002

2003

2004

5.58

5.18

2005

2006

Since 2001, our water usage has decreased by 41%. *For comparison purposes, the 2004 figure excludes data from Peru relating to the use of irrigation water by farms owned by a company we acquired in late 2003. It is unusual for the Group to own farms. The 2004 figure, including Peru, is 8.01.

OUR STRATEGY IN ACTION

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

57.3

63.6

BUSINESS AND STRATEGIC REVIEW

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

0.050

18 British American Tobacco Annual Review 2006 Operating and financial review

OUR STRATEGY IN ACTION CONTINUED

BUSINESS AND STRATEGIC REVIEW

We are also developing a scientific framework for evaluating the relative risks of different tobacco products, both combustible and non-combustible. Currently, there is no accepted approach to measuring tobacco consumers’ exposure to the toxicants believed relevant to tobacco related disease. This is vital to enable development of lower risk tobacco products. However, we cannot develop a framework alone. To ensure that the work and supporting research are robust, we are expanding our engagement with external scientists. Research and development Our research and development activities are focused on developing new products and new processes, as well as maintaining and improving the quality of existing products. Research is also carried out on risk characterisation, building a framework to assess the relative risk of novel and conventional products and a better understanding of how consumers use them. Risk reduction, such as developing technologies that have the potential to lower exposure to toxicants in smoke, is also a central part of the research and development programme. Research is also undertaken into aspects of the science and behavioural science related to smoking and we continue to provide funding for independent studies.

OUR STRATEGY IN ACTION

WINNING ORGANISATION British American Tobacco will be a winning organisation when it is recognised by its employees as being a great place to work, where outstanding people are attracted, challenged and have the opportunity to grow. Employees Creating a safe place to work has to be our primary consideration for employees. We measure and track performance using a measure of the Lost Workday Case Incident Rate (LWCIR). Over recent years, the rate has been reducing, although the acquisition of ETI in Italy in late 2003 had a negative effect on safety performance in 2004. As British American Tobacco’s standards for safety were adopted, performance in Italy has improved. In 2006, we aimed to achieve a further 10 per cent reduction to a rate of 0.44. In fact, the rate fell to 0.42 from 0.49. Positive as this trend is, we continue to aspire to achieve a rate of 0.1-0.2, considered to be a best practice standard for comparable multinational organisations. We are committed to providing a work environment that is free from harassment, bullying and discrimination. There is no discrimination against people with disabilities who apply to join the Group and those with a disability

are afforded the same opportunities for promotion, training and career development as other staff. Our Employment Principles are available to all staff on the Group’s intranet. The Group continues to encourage employee ownership through its provision of employee share plans, including the Partnership Share Scheme and the Share Reward Scheme. In addition to the global survey (see below), we encourage employee engagement through individual discussions, team briefings, local surveys, publications and regular meetings with recognised employee representatives. See chart

9

Employee opinion The extent to which our employees, at every level of the business, feel engaged and committed to delivering superior results is key to delivering our leadership vision. The most authentic way to measure progress is to collect views from employees themselves. The best judge (and indeed the best influencer) of the extent to which we are making tangible progress in what underpins our Winning Organisation strategy has to be our employees, at every level and in every part of the business. We therefore work to create an environment where employees feel that they can speak honestly about their company and the issues of importance to them, placing emphasis on the role of employee opinion research. Our international employee opinion survey, ‘Your Voice’, is run by ISR (International Survey Research), a leading global employee research organisation, to gather detailed views from employees to enable regional, functional and local action planning. Your Voice was conducted as a global census for the first time in October 2005, in over 70 markets, followed by a further census in November 2006, capturing the feedback from over 38,000 employees. The survey covers all levels of employees and will now be run at two yearly intervals. Benchmarking To establish how employee opinion within British American Tobacco compares with other organisations, our global employee opinion survey data is compared with ISR’s global FMCG companies norm. Many of these companies (e.g. Diageo, Nestlé, Coca-Cola and Unilever) also appear in the peer group of FMCG companies used to assess our performance in the Long Term Incentive Plan (LTIP) – see page 37. 2006 survey results The overall response rate for the survey in 2006 improved over the previous year to reach 89 per cent.

Annual Review 2006 British American Tobacco 19 Operating and financial review

In all of the 15 categories in the 2006 survey, employee opinion in British American Tobacco is significantly more positive than in the FMCGs benchmarked by ISR.

9

Lost Workday Case Incident Rate (LWCIR) LWCIR = No. of lost workday cases through injury or occupational illness to employees x 200,000 ÷ total hours worked by all employees 0.72

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

0.55

0.48* 0.49

0.42

10

Using the survey results Of course, it is positive for us to know that our employees, for example, understand our global vision and are proud to be associated with the Company, but how can the survey be used to improve performance? ISR research shows that employee attitudes about leading indicators (e.g. strategic direction, leadership, talent, customer focus) tend to be significantly more favourable in high performing organisations. The lagging indicators (e.g. morale, efficiency, commitment) tend to follow naturally. As the leading indicators tend to be the 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 shown in Chart 10 and do not correspond directly to a single category heading.

The survey results are used at global, regional, local and functional levels, while the learning from companies with good results is captured and shared around the Group. The survey results also provide detailed information about any areas of concern. If issues have been raised, the companies work with employees on action plans to improve in the highlighted areas. The Your Voice survey is a major undertaking across the Group and is key to the way we measure our performance compared to the Group strategy. We will continue to seek and respond to our employees’ opinions.

2002

2003

2004

2005

2006

Since 2001, the LWCIR has decreased by 42%. *For comparison purposes, the 2004 figure excludes new companies acquired. If these acquisitions are included, the 2004 figure is 0.64.

10

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

Differences from benchmark

75

8

55

8

77

7

72

6

69

6

64

6

60

6

79

5

76

5

68

5

80

4

79

4

71

2

67

2

57

2

Survey follow up Pay and benefits Information and communication Leadership Respect for our employees Learning

OUR STRATEGY IN ACTION

We are performing well in terms of many of the leading indicators, including strategic direction and customer focus. In response to scores that were less positive, we have committed to put more focus on leading indicators such as leadership and talent. Recent actions include setting clear targets for local representation on top teams and in succession plans.

2001

BUSINESS AND STRATEGIC REVIEW

See chart

0.63

Talent Team working Alignment Structure Corporate responsibility Culture Freedom through responsibility Enterprising spirit Open minded

0

20

40

60

80

100

0

10

20 British American Tobacco Annual Review 2006 Operating and financial review

REGIONAL REVIEW

REGIONAL AND FINANCIAL REVIEW

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

REGIONAL REVIEW

REGIONAL DATA Volumes

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

Revenue

2005 bns

2006 £m

2005 £m

2006 £m

2005 £m

247.7 141.9 152.6 103.3 43.8

244.0 137.1 149.3 102.6 45.0

3,545 1,839 1,791 1,489 1,098

3,497 1,758 1,555 1,405 1,110

781 616 611 468 424

784 531 530 434 436

689.3

678.0

9,762

9,325

2,900

2,715

Unallocated costs

(103)

Operating profit before exceptional items page 26 Revenue and operating profit, before exceptional items, restated at comparable rates of exchange page 26

Operating profit

2006 bns

9,774

9,325

(96)

2,797

2,619

2,799

2,619

Annual Review 2006 British American Tobacco 21 Operating and financial review

REGIONAL SUMMARY The reported Group profit from operations was 8 per cent higher 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 regions contributing to this good result.

The four Global Drive Brands continued their impressive performance and achieved overall volume growth of 17 per cent. Kent volume grew by 16 per cent with significant increases in Russia, Romania, Ukraine and Chile, and share growth was also achieved in its major market, Japan. Dunhill rose by 6 per cent, driven by strong performances in South Korea, Taiwan, Australia, South Africa and the Middle East, although it was lower in Malaysia due to a reduced total market.

26 Financial review – Profit from operations – Interest cover – Effective tax rate – subsidiaries – Adjusted diluted earnings per 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 intellectual property – Information technology – Financial

REGIONAL REVIEW

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

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

REGIONAL AND FINANCIAL REVIEW

Group volumes from subsidiaries increased by 2 per cent to 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 on a like-for-like basis. This excellent volume and revenue growth was achieved across a broad spread of markets.

The following section contains:

22 British American Tobacco Annual Review 2006 Operating and financial review

REGIONAL REVIEW CONTINUED

REGIONAL AND FINANCIAL REVIEW

Europe In Europe, profit at £781 million was slightly lower mainly as a result of very competitive trading conditions in a number of markets and the inclusion in the comparative period of a one-off benefit in Italy, resulting from the change in terms of trade following the sale of Etinera. Excluding this benefit, profit increased by £9 million, with strong growth from Russia, Hungary, Italy and France, largely offset by declines in Spain, Poland, Germany, the Netherlands and Ukraine. Regional volumes on a like-for-like basis were 2 per cent higher at 248 billion, with growth in Russia, France, Spain and Hungary partly offset by declines in Ukraine, Italy and Germany. In Italy, profit grew strongly driven by improved margins after industry price increases and a successful productivity programme which has considerably reduced the overall cost base. The growth in Global Drive Brands’ market share was more than offset by the decline in domestic brands. Profit in Germany was slightly down due to excise driven volume declines in the overall market and down-trading to lower price and margin products after the end of Stix production. These factors were partly offset by cost reductions and the good cigarette market share growth of Pall Mall and Lucky Strike, which led to a higher overall cigarette market share.

REGIONAL REVIEW

Profit in France grew strongly, benefiting from higher volumes, an improved product mix and lower costs. In Switzerland, profit was higher due to the inclusion of the vending machine business acquired last year and despite price competition. The continued growth of Parisienne volume and share was offset by the decline in other brands, resulting in overall volumes the same as last year and a lower market share. In the Netherlands, profit was lower due to higher excise levels and an adverse product mix, partly offset by cost savings, while cigarette market share increased. Profit in Belgium was affected by intense price competition

in the other tobacco segments, although overall cigarette market share increased as Pall Mall and Winfield performed well. In Spain, despite strong growth in volumes and a much higher share, the results were adversely affected by the significantly reduced market profitability resulting from intense price competition. The impressive performance in Russia continued through strong volume and profit increases, with an improved product mix and lower production costs. A higher overall market share resulted from significantly increased volumes of Kent and Vogue, supported by good Pall Mall growth. In Romania, the Group continued to grow volumes and profit, consolidating its leadership position in a reduced market, affected by substantial excise increases. Volume performance was driven by its premium brands, particularly by Kent, which is now the largest selling brand, as well as Dunhill and Vogue. In Ukraine, profitability was adversely affected by the considerable decline in volumes. However, Kent, Lucky Strike and Pall Mall grew market share. Profit grew significantly in Hungary, benefiting from the recovery of the legal market after improved border controls, efficiency programmes and the strong volume growth from Viceroy and Pall Mall. In Poland, industry profitability was severely affected by increased excise rates and aggressive price competition. Volumes were down, although Pall Mall and Vogue grew both share and volume. See chart

1

Asia-Pacific In Asia-Pacific, regional profit rose by £85 million to £616 million, mainly attributable to good performances in Australasia, Malaysia, South Korea and Pakistan. Volumes at 142 billion were 4 per cent higher as strong increases in Pakistan, Bangladesh, South Korea and Vietnam were partially offset by declines in Malaysia and Indonesia. Profit grew strongly in Australia, as a result of improved margins from a combination of product cost reductions,

Annual Review 2006 British American Tobacco 23 Operating and financial review

In Malaysia, profit increased strongly due to productivity initiatives and higher margins, as well as the absence of one-off costs which reduced profit in 2005. Dunhill and Pall Mall grew market share but total volumes declined due to reduced industry volumes as a result of the growth of illicit trade and the impact of significant excise increases in the past two years. In Vietnam, volumes increased despite the higher prevalence of illicit brands. Pall Mall grew strongly following its launch in the middle of the year and Craven ‘A’ continued its growth. However, profit was lower as a result of increased marketing investment.

1

Europe like-for-like information 242

248

3,473 3,545

772

781 2005 2006

Volume (billions)

2

Revenue (£ million)

Operating profit (£ million)

Asia-Pacific like-for-like information 1,758 1,839 137

142 531

616 2005 2006

Volume (billions)

Revenue (£ million)

REGIONAL AND FINANCIAL REVIEW

price increases and a substantial reduction in overheads. Good performances from Winfield and Dunhill, and the launch of Pall Mall, contributed to a higher overall market share in a reduced total market. New Zealand also showed strong profit growth in local currency as margins increased but this was eroded by the weakening of the currency. Volumes were in line with last year despite the growth of Dunhill and Pall Mall and market share was slightly down.

Operating profit (£ million)

In South Korea, impressive profit growth was achieved from higher volumes and strong market share gains by Dunhill and Vogue, helped by supply chain cost reductions. Industry volumes increased, reflecting volume distortions last year as a result of the excise increases at the end of 2004. Volumes and market share grew in Taiwan, but profit was adversely impacted by higher marketing investment and down-trading after manufacturers’ price increases.

See chart

2

REGIONAL REVIEW

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

24 British American Tobacco Annual Review 2006 Operating and financial review

REGIONAL REVIEW CONTINUED

Latin America Profit in Latin America increased by £81 million to £611 million due to good performances across the region, coupled with a stronger average exchange rate in Brazil. Volumes grew in many of the markets which led to an overall increase of 2 per cent to 153 billion. REGIONAL AND FINANCIAL REVIEW

In Brazil, volume and market share increased, benefiting from marketing initiatives and continuing anti-illicit trade operations by the government. Profit increased substantially as a result of higher volumes, improved margins and the appreciation of the local currency. The strong profit growth in Mexico was driven by higher margins, efficiency programmes and synergy benefits from the contract manufacturing agreement with Canada. Volumes were slightly down as the growth in international brands, notably Pall Mall, was more than offset by the decline of local low-price brands. In Argentina, strong volume growth was achieved through an excellent performance by Viceroy and a reduction in illicit competition. However, profit was lower due to severe price competition.

REGIONAL REVIEW

In Chile, profit grew strongly as volumes and prices increased, the product mix improved and the currency strengthened. GDBs, Kent, Lucky Strike and Pall Mall, led the volume and share increases. In Venezuela, higher margins and increased volumes, led by Belmont and Consul, resulted in an excellent increase in profit and market share. The Central America and Caribbean area showed a significant profit increase as a result of higher volumes and margins, an improved product mix, supply chain savings and the benefits from productivity initiatives.

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 strong growth, with Dunhill recording its highest ever sales. However, reduced volumes for other brands resulted in a lower market share. In Nigeria, volumes and market share grew with strong performances by Benson & Hedges and Pall Mall. Improved margins and volumes resulted in a higher profit. In the Middle East, volume and profit continued to grow with good results from Iran, Iraq and the Arabian Gulf, partly offset by the Levant. Dunhill was the main driver for the good performances in the Middle East. Profit in Egypt benefited significantly from higher volumes and a reduction in costs. In Turkey, industry price increases led to higher margins, which, together with lower production costs, ensured a continued reduction in underlying operating losses. However, the move to direct distribution in this market resulted in one-off costs which, together with lower volumes, adversely impacted profitability. See chart

4

America-Pacific The profit from the America-Pacific region decreased by £12 million to £424 million, while volumes were down 3 per cent to 44 billion. The increases in profit and volumes from Japan were more than offset by lower contributions from Canada.

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

Profit in Canada was down £39 million to £280 million, largely due to lower volumes following the growth of illicit product and a shift to low-priced brands, as well as 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 stronger Canadian dollar. The premium segment now represents 53 per cent of the total market compared with 57 per cent last year. Imperial Tobacco Canada’s total cigarette market share was down 1 share point to 53 per cent.

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

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

See chart

3

Founded in 1903 by Albino Souza Cruz with just 16 employees, Souza Cruz is today the undisputed leader in the Brazilian cigarette market and is among the largest companies in the country. Souza Cruz employs around 6,000 people and sells over 78 billion cigarettes a year. It also provides more than 117,000 tons of tobacco leaf for export to more than 50 countries on five continents. This special feature focuses on how our global strategy of Growth, Productivity, Responsibility and Winning Organisation is working in Souza Cruz, a company contributing significantly to the success of British American Tobacco.

Special feature

Home to nearly 30 million smokers, Brazil is the sixth largest cigarette market in the world. Brazil produces around 10 per cent of the world’s tobacco and is the largest exporter of tobacco leaf.

Spanning the full production cycle from ‘seed to smoke’, Souza Cruz runs three processing plants, two factories and an internationally acknowledged R&D centre. An outstanding distribution operation results in 80 per cent of volumes being delivered in less than 24 hours. Processing plant, Santa Cruz do Sul

Innovation and creativity remained key to the company’s early success.

Heritage

Albino Souza Cruz – founder of Souza Cruz

In 1903, at the age of just 32, Portuguese immigrant Albino Souza Cruz and 16 employees began to produce cigarettes using an innovative rolling machine based in a house in the heart of Rio de Janeiro. The machine was the first of its kind in Brazil and was able to roll five cigarettes simultaneously producing Dalila, the first brand from Souza Cruz & Cia. As demand for this initial product rapidly grew, it soon became necessary for production to move to larger premises and in 1910, Souza Cruz purchased a snuff plant in the Rue Conde de Bonfim, with snuff manufacture gradually replaced by cigarettes. In order to grow his company still further, Albino Souza Cruz transferred stock control to the British American Tobacco Group in 1914, a move

Packaging from an early Souza Cruz brand

that resulted in greater output and further rapid development. Innovation and creativity remained key to the company’s early success, with Dalila the first of a series of brands based on women’s names. The welfare of his workers was of paramount importance to Albino Souza Cruz. In 1910, he introduced the coffee break to provide a dedicated rest period for employees and, in 1951, another trail-blazing initiative was launched in the form of medical care for staff at the Bonfim factory. Souza Cruz was listed on the Rio de Janeiro and São Paolo Stock Exchanges in 1946 and 1957 respectively and Albino Souza Cruz continued to chair the company until 1962. Two years later, he passed away in Lisbon, leaving behind him a lasting legacy of one of Brazil’s most successful business groups and top-performing companies within British American Tobacco.

Piola restaurant, São Paulo

Cinema foyer – Reserva Cultural, São Paulo

Hollywood – one of Souza Cruz’s leading brands

Souza Cruz leads the Brazilian cigarette market.

72%

Souza Cruz has over 70 per cent of the legal cigarette market

32%

Derby accounts for one out of every three cigarettes sold legally in Brazil

Growth Local brand strength Souza Cruz leads the Brazilian cigarette market, with six of the country’s top-selling brands and a share of over 70 per cent of the legal market. Its best-selling brand is Derby, which became a market leader in just three months when it was launched in 1993 and now has a share of around 32 per cent. In total, Souza Cruz sells 16 brands in Brazil including Capri, Charm, Hilton, Plaza and Ritz, with more than 30 variants. Leading brands include Hollywood, Souza Cruz’s oldest brand, which became Brazil’s best-selling cigarette during the 1980s. Launched in 1984, Free was the first Souza Cruz brand to disclose full lists of ingredients and smoke constituents, an initiative that was subsequently adopted by all Souza Cruz brands. Carlton is the market leader in the premium segment. It was the first to launch a range of flavoured new variants in 2003.

Global Drive Brands Although the leading cigarette brands in Brazil are local brands produced by Souza Cruz, British American Tobacco’s Global Drive Brands also have a growing presence in the market. Kent’s launch in 2002 focused on brand innovation and was based around its activated charcoal filter technology – a first in the Brazilian cigarette market. In 2005, the 3-Tek charcoal filter was introduced, again highlighting Kent’s commitment to using new technology to deliver unique flavour. Lucky Strike continues to develop its market share through blend and flavour and packaging innovations.

Agrega’s volume-based purchasing power gives it a keen competitive edge in negotiations with suppliers.

£6m

Savings on indirect purchases in 2006

£3m

Savings of over £3 million in supply chain management

Productivity Reducing complexity and costs All British American Tobacco Group companies aim to reduce supply chain complexity and save costs, with Souza Cruz being no exception. In 2006, the company delivered savings of £6 million on indirect purchases (anything other than leaf, wrapping materials, cigarette making machinery and labour). Souza Cruz also achieved savings of over £3 million in its supply chain management through closer alignment of leaf purchasing, procurement negotiation, manufacturing and waste reduction. Agrega Souza Cruz has pioneered an innovative and collaborative approach to delivering competitive advantage through reducing the cost of indirects. In 2001, the company formed a joint venture called Agrega, with leading brewer AmBev, to identify potential reductions in spending on 44 common product groups in areas such as office materials and travel. Using economies of scale and mainly in-house expertise, Agrega soon became a benchmark for procurement practice in Brazil, attracting major clients including Nestlé, Pfizer and Unibanco.

Agrega’s volume-based purchasing power gives it a keen competitive edge in negotiations with suppliers and today, it encompasses over 80 groups of materials and services such as IT, fuel and medical services. Other British American Tobacco companies have used Agrega’s success as a template for establishing their own versions. In Argentina, Nobleza Piccardo has worked with Quilmes, the country’s biggest brewer, to set up a joint venture to reduce indirect costs and the business model has also been rolled out to Cigarrera Bigott in Venezuela. In 2006, Agrega moved into Canada and Mexico. Efficient distribution The comprehensive Souza Cruz distribution network directly services more than 200,000 points of sale. At the heart of the system is the São Paulo facility, the largest and most modern cigarette distribution hub in Latin America. With around 1,000 vehicles and some 2,000 sales and delivery staff, Souza Cruz guarantees delivery periods of no more than 24 hours between ordering and receipt of the product almost everywhere in Brazil. Souza Cruz has been acknowledged as a model supplier and an international benchmark for FMCG logistical operations.

Distribution Centre, São Paulo

Distribution Centre, São Paulo

Tobacco field, Santa Cruz do Sul

‘Available Here’ campaign at Varanda das Frutas, São Paulo

Souza Cruz remains committed to reducing its environmental impacts and preserving the biodiversity of native forests.

Responsibility Responsibility takes many forms at Souza Cruz, from youth smoking prevention programmes to extensive environmental commitment and efforts to tackle illicit trade. Examples include the ‘Available Here’ Social Responsibility Programme, which aims to ensure that retailers comply with national legislation and do not sell tobacco products to people under 18 years of age. The initiative encourages retailers to think of the wider benefits to their own communities, rather than profit from tobacco sales to the underaged. In 2006, more than 210,000 retailers took part in the programme and activities are set to expand in 2007. Environment Souza Cruz remains committed to reducing its environmental impacts and preserving the biodiversity of native forests. In southern Brazil, it owns two reforestation areas that together cover over 5,000 hectares and enable the company to be self-sufficient in wood fuel, a source of cleaner renewable energy for its factories and leaf processing plants. The company

has been recognised by the RainForest Alliance for managing these areas in line with the stringent standards defined by the Forest Stewardship Council and for its efforts to preserve the environment. Tackling illicit trade Illicit trade is a major problem in Brazil, negatively affecting many sectors of industry. Only recently it accounted for around a third of the total cigarette market. Souza Cruz has been working with the authorities and other industries faced with similar problems to tackle the issue and these combined endeavours are beginning to achieve results. During 2006, smuggling was down 7 per cent and counterfeit dropped 45 per cent, bringing the share of the total market attributable to illicit trade below the 30 per cent level.

210,000 5,000

Retailers in the ‘Available Here’ youth smoking prevention programme

Hectares of forest land enabling Souza Cruz to be self-sufficient in wood fuel

The programme recognises projects that represent good examples of leadership and adding value to the business.

Winning Organisation

Andrew Gray – General Manager, Souza Cruz

Recruiting and developing talented managers at all levels remains central to the continuing success of Souza Cruz. The company runs a development programme involving academic centres of excellence in Brazil and also places staff on secondment in other British American Tobacco companies, with around 40 managers working abroad at any one time. Initiatives such as the Souza Cruz Golden Leaf Acknowledgement Programme aim to motivate employees and create a working environment that fosters and encourages high performance by teams. The programme recognises projects that represent good examples of leadership and adding value to the business, replicating a similar awards scheme held for senior management across British American Tobacco. Souza Cruz is committed to building a diverse workforce. For example, the leaf processing plant at Santa Cruz do Sul launched a pioneering campaign in 2005 to further the recruitment of people with special needs who apply for seasonal work. All facilities at the

Staff welfare is of key importance at Souza Cruz

plant are regularly updated to respond to the needs of the new recruits and the campaign has involved raising extensive awareness among employees of the relevance of a socially inclusive working environment. Staff welfare is of key importance at Souza Cruz and the company was one of the first in Brazil to offer supplementary pension funds before national private pension legislation came into place. The Albino Souza Cruz Pension Foundation has continued to evolve to offer greater security and better benefits to its members, making a real contribution to employee satisfaction in the process. Corporate social investment Many community-based projects are run by the Institute of Souza Cruz, set up in 2000, with a particular focus on education and training for young people in rural areas. Its core activity is the Rural Youth Entrepreneurship Programme, which operates in the three southernmost states of Brazil and trains young people to manage their own lives and businesses.

40

Managers working outside Brazil, sharing their knowledge and experience

Distribution in action in São Paulo

Visitors to the sense garden for the visually impaired at Cachoeirnha

Souza Cruz is one of the most successful companies within the British American Tobacco Group and the following awards and achievements reflect some of the passion, talent and commitment of its employees. 2006 awards

2006 achievements

• In its tenth year, the corporate category • For the second year in succession, Souza of the Hummingbird (Beija-Flor) Trophy, Cruz was rated the best company in the was awarded to Souza Cruz. The award Foods, Beverages and Tobacco sector was presented by the RioVoluntário by the latest Biggest and Best Yearbook, non-governmental organisation in which offers the most wide-ranging and recognition of the Souza Cruz Volunteers accurate analysis of business in Brazil. Programme, which involved most of the • Souza Cruz was rated the best company company’s members of staff and benefited in the Foods, Beverages and Tobacco more than 5,000 people across Brazil. segment by the Agri-Business Yearbook. • Souza Cruz was awarded the Sustainable • Souza Cruz was voted the Best Company Enterprise Prize by Meio-Ambiente in Brazil’s leaf sector by the editors of Industrial magazine. The criteria for Global Finance magazine. entry included meeting standards such as ISO 14001 (Environment), SA 8000 (Social Responsibility) and OHSAS 18001 (Occupational Health and Safety), as well as carrying out environmental and social reporting audits. • For the fifth year, Souza Cruz won the Prize for Excellence in Customer Services, awarded by Consumidor Moderno magazine.

Annual Review 2006 British American Tobacco 25 Operating and financial review

growth accelerated during the second half of the year with strong performances from Kent and Kool. Profit rose significantly due to the increased volumes, the benefit of the manufacturers’ price increase and the absence of one-off costs, which more than offset the impact of exchange.

3

Latin America like-for-like information 1,791 1,555 149

153 611

5

Unallocated costs Unallocated costs, which are net corporate costs not directly attributable to individual regions, were £7 million higher at £103 million, mainly as a result of increased pension costs.

2005 2006 Volume (billions)

4

The Group’s associate in India, ITC, continued its strong growth and, excluding the one-off items in 2005, its contribution 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 were 930 billion (2005: 910 billion).

Africa and Middle East 1,405 1,489

103

103 434

468 2005 2006

Volume (billions)

5

Revenue (£ million)

Operating profit (£ million)

America-Pacific like-for-like information 1,110 1,098

436 45

424

44 2005 2006

Volume (billions)

Revenue (£ million)

Operating profit (£ million)

REGIONAL REVIEW

The contribution from Reynolds American, excluding brand impairment charges and the benefit from the favourable resolution of certain tax matters in both years, as well as other exceptional charges in 2005, was £18 million higher at £285 million. This was mainly due to improved pricing and cost reductions, partially offset 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 forma basis, as if it had been owned since the beginning of 2005, Conwood increased margins and profits for the year to December 2006.

Operating profit (£ million)

like-for-like information

The above regional profits were achieved before accounting for restructuring costs and losses/gains on disposal of a business, brands and joint venture, as explained on page 26. Results of associates The Group’s share of the post-tax results of associates increased by £39 million to £431 million. Excluding the exceptional items explained on page 26, the Group’s share of the post-tax results of associates increased by £38 million to £427 million.

Revenue (£ million)

REGIONAL AND FINANCIAL REVIEW

530

See chart

26 British American Tobacco Annual Review 2006 Operating and financial review

FINANCIAL REVIEW

From 1 January 2005, the Group is reporting under International Financial Reporting Standards (IFRS). The move to IFRS has made the reporting of performance more complex.

REGIONAL AND FINANCIAL REVIEW

However, the changes in IFRS during 2006 have not had a material impact on the Group’s results. The only change to impact the income statement is an amendment to IFRS in respect of foreign exchange. This required a restatement of the 2005 results to increase net finance costs by £4 million, with a compensating adjustment reflected directly in changes in total equity. Profit from operations like-for-like The reported Group profit from operations was 8 per cent higher at £2,622 million. The table below shows like-for-like operating profit after excluding exceptional items and the impact arising from the change in terms of trade in Italy following the sale of Etinera in December 2004.

As reported (page 42) Restructuring costs (page 42) Losses/(gains) on impairment of a business and disposal of brands and joint venture (page 42)

2006 £m

2005 £m

2,622 216

2,420 271

(41) 2,797

Etinera – change in terms of trade Like-for-like

2,797

Profit from operations in 2005 benefited from a £72 million gain, principally in respect of the disposal of 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 interest rates as well as derivatives. Interest cover The Group assesses its financial capacity by reference to cash flow and interest cover. Interest cover is distorted by the pre-tax impact of the exceptional items and net finance cost distortions reflected in the adjusted earnings per share as explained below. The chart shows the cover, adjusting for these items, on the basis of profit before interest payable over interest payable. The interest cover remains strong at 8.1x (2005: 8.8x), with the lower cover reflecting higher interest costs.

(72) See chart

2

2,619 At 31 December 2006, the ratio of floating to fixed rate (12) financial liabilities was 58:42 (2005: 55:45). 2,607 As explained on page 25, the Group’s share of the

FINANCIAL REVIEW

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

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

1

post-tax results of associates, included at the pre-tax level under IFRS, increased by £39 million to £431 million, after exceptional net income of £4 million (2005: £3 million). The exceptional items are shown as memorandum information on the Group Income Statement (page 42).

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

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

The Group continued its review of manufacturing operations and organisational structure, including the initiative to reduce overheads and indirect costs. Further restructurings continued in 2006 and on 22 September agreement was reached on the closure of the plant at Zevenaar in the Netherlands. The plant will close by the end of 2008 with the production being transferred to Bayreuth in Germany and Augustow in Poland. The total restructuring costs of £216 million for 2006 principally comprise costs in respect of Zevenaar and further costs for the UK and Canadian restructurings announced in 2005.

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

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

The underlying tax rate for subsidiaries, adjusted to remove the distortions as reflected in the adjusted earnings per share below, was 29.6 per cent in 2006 and 31.4 per cent in 2005; the decrease reflects the inclusion of a tax credit in Canada in respect of prior years and changes in the mix of profits. See chart

3

Annual Review 2006 British American Tobacco 27 Operating and financial review

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

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

£ million 2,607

2005

2

and

2006

8.8x

2005

3

8.1x

2006

Underlying tax rate – subsidiaries percentage

2005

4

29.6

29.6%

2006

Adjusted diluted earnings per share pence 89.34

2005

5

98.12

+10%

2006

Dividends per share declared pence 55.9 47.0

5

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

8.1x

2005

2006

+19%

FINANCIAL REVIEW

4

+7%

Interest cover

31.4

As explained in the Chairman’s Statement, the previous policy was to pay out as dividends at least 50 per cent of long term sustainable earnings but the Board has decided to raise the ratio to 65 per cent by 2008 in progressive steps. Dividends per share declared for 2006 represent 57.0 per cent of adjusted fully diluted earnings per share (2005: 52.6 per cent).

2,797

times

4

Dividends per share declared With the recommended final dividend of 40.2p, the total dividends per share declared for 2006 are 55.9p, up 19 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 2006 accounts reflect the 2005 final dividend and 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 in respect of 2006 and 2005.

See charts

Profit from operations like-for-like

REGIONAL AND FINANCIAL REVIEW

With the distortions that can occur in profit over the years, as well as the potential dilutive effect of employee share schemes, earnings per share is best viewed on the basis of adjusted diluted earnings per share. This removes the impact of exceptional items which are shown as memorandum information in the Group Income Statement on page 42. The main items are restructuring costs, loss on impairment of a business and gains on disposal of brands and a joint venture. In addition, the calculation adjusts for certain distortions in net finance costs arising under IFRS in 2005, as well as reflecting the impact of the potential conversion of shares.

1

28 British American Tobacco Annual Review 2006 Operating and financial review

FINANCIAL REVIEW CONTINUED

Cash flow 2006 £m

REGIONAL AND FINANCIAL REVIEW

Net cash from operating activities before restructuring costs and taxation 3,295 Restructuring costs (220) Taxation (713) Net cash from operating activities Net interest Net capital expenditure Dividends to minority interests Free cash flow Dividends paid to shareholders Share buy-back Other net flows Net cash flows IFRS cash flow Net cash from operating activities Net cash from investing activities Net cash from financing activities

2,362 (263) (419) (139) 1,541 (1,008) (500) (5) 28 2,362 (315) (2,339)

The other net flows in 2006 principally reflect the purchase of minority interests in Chile and shares for the Group’s share-based compensation plans, largely offset by the sale of Toscano in Italy and the sale of brands. The other net 3,229 flows in 2005 mainly arise from the acquisition of further (143) shares in the Group’s Danish associate and the acquisition (762) of Restomat AG in Switzerland, partly offset by the 2,324 proceeds of the brand sale to Gallaher. (231) (378) The above flows resulted in net cash inflows of £28 million (133) compared to £122 million in 2005. After taking account of transactions related to borrowings, especially the net 1,582 repayment of borrowings, the above flows resulted in a (910) net decrease of cash and cash equivalents of £292 million (501) compared to a net decrease of £115 million in 2005, as (49) shown in the IFRS cash flow above. 122 These cash flows, after an adverse exchange impact of £96 million, resulted in cash and cash equivalents, net of overdrafts, decreasing by £388 million in 2006 2,324 £66 million). (2005: (292) 2005 £m

FINANCIAL REVIEW

(2,147) Borrowings, excluding overdrafts but taking into account Net cash flows (292) (115) derivatives relating to borrowings, were £6,401 million compared to £7,117 million as at 31 December 2005. The decrease in this figure principally reflected the net The IFRS cash flow includes all transactions affecting cash repayment of borrowings and the impact of exchange and cash equivalents, including financing. The alternative movements. cash flow above is presented to illustrate the cash flows before transactions relating to borrowings. Current available-for-sale investments at 31 December 2006 were £128 million (31 December 2005: £96 million). The Group’s net cash flow from operating activities at £2,362 million was £38 million higher. The growth in As a result of the above borrowings, net of cash, cash underlying operating performance was offset by the equivalents and current available-for-sale investments, timing of working capital movements. However, a were £4,996 million (31 December 2005: £5,357 million). £49 million fall in tax outflows, reflecting the timing of Treasury operations payments, as well as £66 million higher dividends from associates more than offset the higher restructuring flows. Treasury is tasked with raising finance for the Group, managing the financial risks arising from underlying After higher net capital expenditure and net interest operations and managing the Group's cash resources. flows, with similar levels of dividends to minority interests, All these activities are carried out under defined policies, the free cash flow is £41 million lower than in 2005 at procedures and limits. £1,541 million. This inflow exceeds the total cash outlay The Board reviews and agrees the overall treasury policies on dividends to shareholders and share buy-back by and procedures, delegating appropriate authority to the £33 million.

Dividends declared 2006

Ordinary shares Interim 2006 paid 13 September 2006 (see page 45) Final 2006 payable 3 May 2007

Pence per share

2005

£m

Pence per share

£m

15.7 40.2

323 821

14.0 33.0

293 685

55.9

1,144

47.0

978

Annual Review 2006 British American Tobacco 29 Operating and financial review

Finance Director, the Treasury function and the boards of the central finance companies. The Finance Director chairs the boards of the major central finance companies. Any significant departure from agreed policies is subject to the prior approval of the Board.

One of the principal responsibilities of Treasury is to manage the financial risk arising from the Group’s underlying operations. Specifically, Treasury manages, within an overall policy framework, the Group's exposure to funding and liquidity, interest rate, foreign exchange and counterparty risks. Derivative contracts are only entered into to facilitate the management of these risks.

During 2006, the Group issued three bonds (€525 million maturing in 2010, €600 million maturing in 2014 and £325 million maturing in 2016) and the proceeds were used to refinance maturing bond issues. In addition, the Group’s central banking facility was extended on existing terms under the first extension option to a term of five years (plus one remaining one year extension). The Group continues to target investment-grade credit ratings; as at 31 December 2006 the ratings from Moody’s and S&P were Baa1/BBB+ (end 2005: Baa1/BBB+). The strength of the ratings has underpinned the debt issuance during 2005 and 2006 and the Group continues to enjoy full access to the debt capital markets. Changes in the Group The Group ceased to be the controlling company of British American Racing (Holdings) Limited (BAR) on 8 December 2004, when BAR went into administration. The Group consequently ceased to consolidate BAR from that date. On 7 January 2005, BARH Ltd. (BARH), a newly

On 25 November 2005, the Group acquired Restomat AG, the largest operator of cigarette vending machines in Switzerland, at a cost of £25 million, resulting in goodwill of £7 million. On 10 March 2006, the Group’s Italian subsidiary signed an agreement to sell its cigar business, Toscano, to Maccaferri for €95 million. The sale was subject to regulatory and governmental approval and was completed on 19 July 2006. This agreement resulted in the recognition of an impairment charge of £15 million. From August 2006, the Group purchased minority interests in its subsidiary in Chile for a cost of £91 million, raising the Group shareholding from 70.4 per cent to 96.5 per cent. The goodwill arising on these transactions was £80 million and the minority interests in Group equity were reduced by £11 million. On 31 May 2006, the Group’s associate, Reynolds American, completed the acquisition of Conwood, the second largest manufacturer of smokeless tobacco products in the US, for US$3.5 billion. The acquisition was funded principally with debt, and the fair value of assets acquired and liabilities assumed was US$4.1 billion and US$0.6 billion respectively. Changes in accounting policies In December 2005, the International Accounting Standards Board issued an amendment to IAS21 on foreign exchange rates. The amendment to IAS21 allowed inter company balances that form part of a reporting entity’s net investment in a foreign operation to be denominated in a currency other than the functional currency of either the ultimate parent or the foreign operation itself. This means that certain exchange differences previously taken to the income statement are instead reflected directly in changes in total equity. However, as this amendment was only

FINANCIAL REVIEW

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

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

REGIONAL AND FINANCIAL REVIEW

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 Group Treasury Committee, which meets seven times a 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.

formed joint venture between British American Tobacco and Honda Motor Co. Ltd, acquired the BAR business. On 4 October 2005, the Group announced that it had agreed the sale of its 55 per cent shareholding in BARH to Honda and the sale was completed on 20 December 2005. As a result of these transactions, a gain of £5 million was included in profit from operations. For the period 7 January 2005 to 20 December 2005, BARH was equity accounted reflecting shared control with Honda.

30 British American Tobacco Annual Review 2006 Operating and financial review

FINANCIAL REVIEW

KEY GROUP RISK FACTORS

CONTINUED

adopted by the EU in 2006, the interim report to 30 June 2006 contained the first published results to reflect this change. The previously published results have been restated accordingly, which has resulted in an increase in net finance costs of £4 million for the year ended 31 December 2005. REGIONAL AND FINANCIAL REVIEW

While this amendment was not applicable for Group reporting until it was endorsed by the EU, as this was expected in 2006 it was allowed for in the adjusted earnings per share calculations in the published results for the year ended 31 December 2005. The International Accounting Standards Board issued IFRIC Interpretation 4 which is applicable for annual reporting periods beginning on or after 1 January 2006. This interpretation is to determine whether an arrangement, which is not in the legal form of a lease, is in substance a lease and should be accounted for in accordance with IAS17 (Leases). This has resulted in the recognition of certain arrangements as leases. The previously published balance sheet for 2005 has been restated in respect of finance leases to increase property, plant and equipment by £4 million and borrowings by a similar amount but there was no impact on the Group’s reported profit. In 2005, IAS32 and IAS39 on financial instruments were applied from 1 January 2005. This resulted in a £42 million reduction in the Group equity at that date, which is shown as the change in accounting policy on page 44.

FINANCIAL REVIEW / KEY GROUP RISK FACTORS

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

Introduction A description of the key risk factors that may affect the British American Tobacco Group’s business is outlined below. Not all of these factors are within the control of British American Tobacco and other factors besides those listed below may affect the performance of its business. This section highlights some of these particular risks but it is not intended to be an extensive analysis of all risks affecting the Group. Some risks may be unknown at present and other risks, currently regarded as immaterial, could turn out to be material in the future. All of these risks have the potential to have an adverse impact on the Group’s business; its revenues, profits, assets, liquidity and capital resources. These risks should be considered with reference to the statement on internal control on page 71 of the Annual Report and Accounts (the main aspects of which are summarised below) and the cautionary statement regarding forward-looking statements on page 32. Risk management in summary The Company maintains a sound system of internal control with a view to safeguarding shareholders’ investment and the Company’s assets. It is designed to manage risks that may impede the achievement of the Company’s business objectives rather than to eliminate these risks and can therefore provide only reasonable, not absolute, assurance against material misstatement or loss. The Group uses audit committees at both regional and end market levels to support the Audit Committee (see page 33) in monitoring risks and control. This framework provides a continuing process for identifying, evaluating and managing the significant risks faced by the Company and its subsidiaries. The Group’s regional audit committees (which are all chaired by an Executive Director) focus on risks and the control environment within each region and are in turn supported by end market or area audit committees. The regional audit committees’ reviews include consideration of the effectiveness of the process for identifying, evaluating and managing the risks of the business and the assessments of internal control and business risks completed by operating companies. In addition, the Corporate Social Responsibility (CSR) Committee (see page 33) is responsible for identifying and assessing, in conjunction with management, the significant social, environmental and reputational risks facing the Group’s business and for evaluating management’s handling of such risks. In this, it is similarly supported by a framework of regional and end market CSR committees. Litigation The Group is involved in a number of legal and regulatory court proceedings in a number of countries.

Annual Review 2006 British American Tobacco 31 Operating and financial review

While it is impossible to be certain of the outcome of any particular case or of the amount of any possible adverse verdict, the Company believes that the defences of the Group companies to all these various claims are meritorious both on the law and the facts. Nevertheless, it is not impossible that the results of operations or cash flows of the Group could be materially affected by the final outcome of any particular litigation.

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

Operations The Group has substantial operations in over 180 countries. The Group’s results are influenced by the economic, regulatory and political situations in the countries and regions in which it has operations. Some countries in which the Group operates face the threat of increasing civil unrest and can be subject to frequent changes in regime. In others, terrorism, conflict and the threat of war may have a significant impact on the business environment. Some countries maintain trade barriers or adopt policies that favour domestic producers, preventing or restricting sales by the Group. There can be no assurance that political, social, legal, economic, trade or other developments, as well as theft and fraud, will not have an adverse impact on the Group’s investments and businesses or on the Group’s consolidated results of operations. Severe disruption to any aspect of the Group’s supply chain or suppliers’ operations could have an adverse impact on the Group’s ability to produce and deliver to customer demands. In certain markets, the distribution of Group products is through channels managed by third parties, and often licensed by governments. In these instances, loss of distribution, and therefore a reduction in sales volumes and revenues, is a possibility. The raw materials used in the Group’s business are commodities that are subject to price volatility caused by factors such as weather conditions, growing conditions, local planting decisions, market fluctuations and changes in agricultural regulations. Commodity price changes that are beyond the Group’s control may result in unexpected increases in raw materials and packaging costs for the Group’s products. The Group operates in highly competitive businesses and geographical markets. To maintain a competitive advantage, it must anticipate and respond to new consumer trends through continuous innovation. The Group also seeks to develop and market new products, packaging and technologies, including products with potentially reduced harm. Development of these products is an expensive and lengthy process, but there are anticipated advantages for any manufacturer who introduces these products to the market first. Competitors’ speed-to-market in branding changes, new product launches, or changes in product mix, could have an adverse effect on the Group’s operations.

KEY GROUP RISK FACTORS

Regulation The Group’s businesses operate under increasingly stringent regulatory regimes around the world. Further regulation is expected, particularly as a result of the World Health Organisation’s Framework Convention on Tobacco Control (FCTC) and increasingly active tobacco control activities outside the FCTC. It is not possible to predict where, when and in what form regulations will be enacted, but regulation of the tobacco industry generally covers: • Product: product design and attributes (e.g. ‘low ignition 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’s products at both retail and trade levels; • Purchase: the manner in which cigarettes are sold, such as type of outlet (e.g. supermarkets, vending machines) and how they are sold (e.g. above the counter versus beneath the counter); • Place: regulations as to the places where adults can and cannot smoke tobacco products; • Price: regulations as to the price the Group can charge for its products (e.g. by excise or minimum prices).

Further, taking into account the significant number of regulations applying to the Group’s businesses across the world, it is possible that there may be allegations of breaches of regulations. Even when such allegations are proven untrue, there is often a reputational impact and a financial cost in defending such allegations. REGIONAL AND FINANCIAL REVIEW

These proceedings may be characterised as covering smoking and health issues and include claims for personal injury and claims for economic loss arising from the treatment of smoking and health related diseases. Regulatory proceedings may result in a challenge to new regulations. In addition, there are legal proceedings and a governmental investigation in Canada arising from alleged past smuggling activities with consequent claims for unpaid excise tax. A fuller analysis of current legal proceedings to which the Group is subject is set out on pages 130 to 136 of the Annual Report and Accounts and pages 45 to 47 of the Annual Review.

32 British American Tobacco Annual Review 2006 Operating and financial review

KEY GROUP RISK FACTORS CONTINUED

In tough competitive environments, where the price burden on consumers is high because of taxation or limited purchasing power, the Group is vulnerable to competitors aggressively taking market share through price repositioning, which generally has the impact of reducing the overall profit pool of the market and, ultimately, Group profits. REGIONAL AND FINANCIAL REVIEW

Excise and sales tax Tobacco products are subject to substantial excise and sales taxes in most countries in which the Group operates. In many of these countries, taxes are generally increasing but the rate of increase varies between countries and between different types of tobacco products. Increased tobacco taxes, or changes in relative tax rates for different tobacco products, or adjustments to excise structures, may result in a decline in overall sales volume for the Group’s products or may alter the Group’s sales mix in favour of Value-for-Money brands. Increases in tobacco taxes can also lead to consumers rejecting the Group’s legitimate tax-paid products for products from illicit sources.

KEY GROUP RISK FACTORS

Illicit trade and intellectual property Illicit trade in the form of counterfeit products, smuggled genuine products and locally manufactured product on which applicable taxes are evaded, represents a significant and growing threat to the legitimate tobacco industry. Increasing excise rates are encouraging more consumers to switch to illegal cheaper tobacco products and providing greater rewards for smugglers. Illicit trade can have an adverse effect on Group volumes, restrict the ability to increase selling prices and damage brand equity. The brand names under which the Group’s products are sold are key assets. Investments over a period of time have led to many of the Group’s brands having significant brand equity and global appeal to consumers, essential for delivering sustainable profit growth into the future. The protection and maintenance of the reputation of these brands is important to the success of the Group. In a number of countries around the world, the risk of intellectual property rights’ infringement remains high as a result of limitations in judicial protection and/or inadequate enforceability. Any substantial erosion in the value of the brands could have an adverse effect on the Group. Information Technology The Group is increasingly reliant on information technology systems for its internal communications, controls, reporting and relations with customers and suppliers. A significant disruption due to computer viruses, malicious intrusions, the setting up of shared services centres or the installation of new systems could affect the Group’s communications and operations.

Financial The Group’s subsidiary undertakings operate over 120 active retirement benefit arrangements worldwide. These arrangements have been developed in accordance with local practices in the countries concerned. The majority of employees belong to defined benefit schemes, most of which are funded externally, although the Group operates a number of defined contribution schemes. The contributions to the Group’s defined benefit schemes and their valuations are determined in accordance with the advice of independent, professionally qualified actuaries. Changes in asset returns, salary increases, inflation, long term interest rates and other actuarial assumptions could have an adverse impact on the Group. Funding and liquidity risks expose the Group to shortages of cash and cash equivalents needed in the Group’s operations and for refinancing of existing debt. The Group cannot be certain that it will at all times have access to the bank and capital markets and that the failure to achieve such access will not have an adverse effect on the Group’s funding and liquidity position and on its credit ratings. The Group is exposed to changes in currency rates on the translation of the net assets of overseas subsidiaries into the Group’s reporting currency, sterling. The Group is also exposed to currency changes from the translation of profits earned in overseas subsidiaries; these exposures are not normally hedged. Exposures also arise from the foreign currency denominated trading transactions undertaken by subsidiaries and dividend flows. The Group maintains both floating and fixed rate debt. Where appropriate, the Group also uses derivatives, primarily interest rate swaps, to vary the fixed to floating mix. Changes in currency values and interest rates could have an adverse impact on the financial condition or operations of the Group. Cash deposits and other financial instruments give rise to credit risk on the amounts due from counterparties. The failure of any counterparty to meet its obligations to the Group could have an adverse effect on the financial condition or operations of the Group. Further details on the Group’s financial management and treasury operations are on page 28.

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

Annual Review 2006 British American Tobacco 33 Summary Corporate Governance and Summary Financial Statement

SUMMARY CORPORATE GOVERNANCE

The principal governance rules applying to UK companies listed on the London Stock Exchange are contained in the Combined Code on Corporate Governance adopted by the Financial Reporting Council in July 2003 (the Code). The Company has either complied with the Provisions of the Code throughout the year or else a full explanation (in the case of the continuing appointment of Rupert Pennant-Rea) has been provided in the Corporate Governance Statement at pages 67 to 72 of the Annual Report and Accounts where it has not. The Board therefore considers that the Company has satisfied its obligations under the Code.

The Board is also responsible for the overall system of internal control for the Company and its subsidiaries and for reviewing the effectiveness of the system. It carries out such a review at least annually, covering all material controls including financial, operational and compliance controls and risk management systems, and reports to shareholders that it has done so. The system is designed to manage risk that may impede the achievement of the

The Audit Committee is chaired by Robert Lerwill. Its role is to monitor the integrity of the financial statements of the Company, review and, where appropriate, make representations to the Board on business risks, internal control and compliance. The Corporate Social Responsibility Committee is chaired by Kenneth Clarke and its role is to help identify and assess, with management, those significant social, environmental and reputational risks that might impair the Company’s strategic objective to be recognised as a responsible company in a controversial industry. The Committee also evaluates the adequacy of the Company’s policies in this area and makes recommendations for change. The Nominations Committee is chaired by Jan du Plessis. Its role is to make recommendations to the Board on suitable candidates for appointment to the Board and Management Board, ensuring that both boards have an appropriate balance of expertise and ability. In addition, it is responsible for reviewing the succession plans for the Executive Directors and members of the Management Board. The Remuneration Committee is chaired by Kenneth Clarke and the summary remuneration report below sets out its role, responsibilities and policies during 2006.

SUMMARY CORPORATE GOVERNANCE

The Board and its Committees The Board is responsible to the Company’s shareholders for the success of the Group and for its overall strategic direction, its values and its governance. Among the key matters on which the Board alone may make decisions are the Group’s business strategy, its annual budget, dividends and major corporate activities. It is also responsible for reviewing the Company’s internal control and governance system and for approving our Standards of Business Conduct. It held seven scheduled meetings in 2006. Responsibility for implementing the Group’s strategy and for creating the conditions for the Group’s successful day-to-day operation is delegated to the Management Board, which met nine times in 2006.

Company’s business objectives rather than to eliminate these risks. The internal control system can therefore only provide reasonable, not absolute, assurance against material misstatement or loss. SUMMARY CORPORATE GOVERNANCE

Corporate governance British American Tobacco is committed to maintaining high standards of corporate governance. Our corporate governance framework is directed towards achieving our business objectives in a manner which is responsible and in accordance with high standards of honesty, transparency and accountability. These principles are reflected in our Standards of Business Conduct, which have been in place for many years and are kept under continual review in order to ensure that they remain at the forefront of best business practice. Every Group company and every employee worldwide is expected to live up to them. In addition, the principles set out within our Statement of Business Principles are designed to help meet the expectations placed on us by our various stakeholders. Both documents are available from the Company Secretary and through our bat.com website.

34 British American Tobacco Annual Review 2006 Summary Corporate Governance and Summary Financial Statement

BOARD OF DIRECTORS

SUMMARY CORPORATE GOVERNANCE BOARD OF DIRECTORS

Jan du Plessis (British/South African) Chairman ▲ Appointed Chairman in July 2004, having been a Non-Executive Director since his appointment to the Board in 1999. He was previously Group Finance Director of Richemont. He is Chairman of the Nominations Committee. He is Chairman of RHM plc and a Non-Executive Director of Lloyds TSB Group plc. (53)

The Rt. Hon. Kenneth Clarke QC MP (British) Deputy Chairman and Senior Independent Non-Executive Director ▲■●◆ Appointed a Director in 1998. He is Chairman of the Remuneration and Corporate Social Responsibility Committees. He is Non-Executive Director of Foreign & Colonial Investment Trust PLC and Independent News & Media (UK) Limited. (66)

Paul Adams (British) Chief Executive Appointed a Director in March 2001 and Chief Executive in January 2004. He joined British American Tobacco in July 1991 and held senior appointments as Regional Director, Asia-Pacific and Regional Director, Europe prior to becoming Deputy Managing Director in June 2001 and Managing Director in January 2002. (53)

Paul Rayner (Australian) Finance Director Joined Rothmans Holdings Limited in Australia in 1991. He held senior executive positions with Rothmans before becoming Chief Operating Officer of British American Tobacco Australasia Limited in September 1999. He became Finance Director in January 2002. He has been a Non-Executive Director of Centrica plc since September 2004. (52)

Antonio Monteiro de Castro (Brazilian) Chief Operating Officer and Director, America-Pacific Appointed a Director in March 2002 and Chief Operating Officer in January 2004. He is President of the administrative council of Souza Cruz SA and a member of the board of the Getulio Vargas Foundation. He has been a Director of Reynolds American Inc. since July 2004. (61)

Piet Beyers (South African) Non-Executive Director▲ ◆ Appointed a Director in June 2004. He is an Executive Director of Richemont and a Non-Executive Director of Distell Group Limited and Remgro Limited where he was previously Marketing Strategy Director. (57)

Robert Lerwill (British) Non-Executive Director ▲ ■ ● ◆ Appointed a Director in 2005, he is Chairman of the Audit Committee. He has been Chief Executive of Aegis Group plc since 2005 and was formerly a Director of Cable & Wireless plc and WPP Group PLC. He is Non-Executive Director of Synergy Healthcare plc and a Director of The Anthony Nolan Trust. (55)

Dr Ana Maria Llopis (Spanish) Non-Executive Director ▲ ■ ● ◆ Appointed a Director in 2003. She is Executive Deputy Chairman of the J F Llopis Foundation and a member of the Good Governance Working Group for Spanish listed companies. Previously she was Executive VicePresident at Indra and Chief Executive of Openbank, the Santander Group online bank. (56)

Rupert Pennant-Rea (British) Non-Executive Director ▲ ■ ● ◆ Appointed Non-Executive Director of B.A.T Industries p.l.c. in 1995, becoming a Director of British American Tobacco in 1998. He will retire at the conclusion of this year’s Annual General Meeting. Formerly Editor of The Economist and Deputy Governor of the Bank of England. He is Chairman of Henderson Group plc and Electra Kingsway VCT plc. (59)

Anthony Ruys (Dutch) Non-Executive Director ▲ ■ ● ◆ A Director from March 2006. He joined Heineken N.V. in 1993 becoming Chairman in 2002. He is a member of the Supervisory Boards of ABN AMRO Bank and Sara Lee International B.V. and a director of Lottomatica S.p.A. (Italy). He was appointed an Officer in the Order of Orange-Nassau in 2005. (59)

Sir Nicholas Scheele (British/US) Non-Executive Director ▲ ■ ● ◆ Appointed a Director in 2005. Formerly President and Chief Operating Officer of Ford Motor Company. He is Chancellor of the University of Warwick. He is Chairman of The Cambridge-MIT Institute and Director of Pegasus Holdings Group (USA), Grupo Proeza (Mexico) and Caparo plc. (63)

Thys Visser (South African) Non-Executive Director ▲ ◆ A Director since 2001. He is CEO of Remgro Limited, having held senior management positions with Rembrandt Group since 1980. He is Chairman of Rainbow Chicken Ltd and is a NonExecutive Director of Medi-Clinic Corporation Limited, Nampak Limited and Distell Group Limited. (52)

Annual Review 2006 British American Tobacco 35 Summary Corporate Governance and Summary Financial Statement

MANAGEMENT BOARD

Nicandro Durante (Italian) Director, Africa and Middle East Appointed Regional Director for Africa and Middle East and appointed to the Management Board in March 2006. He previously held senior financial and general management roles in Brazil (including President of Souza Cruz) and also in the UK and Hong Kong. (50)

Rudi Kindts (Belgian) Director, Human Resources Joined British American Tobacco in 1988. He has held a number of senior human resources roles across the Group (including Europe, Africa, the Middle East and Central and South Asia). He has been Director, Human Resources since July 2004. (49)

Michael Prideaux (British) Director, Corporate and Regulatory Affairs Appointed Director, Corporate and Regulatory Affairs in 1998 following the demerger of B.A.T Industries. He had previously joined B.A.T Industries in 1989 from Charles Barker, a leading financial and corporate public relations, advertising and design agency, where he was Chief Executive. (56)

Jimmi Rembiszewski (German) Director, Marketing Joined the Group as a Marketing Director and as a Territorial Director in 1991, having had various senior marketing and business appointments in Procter & Gamble and Jacobs Suchard. He has been a member of the Management Board since 1996. (56)

Ben Stevens (British) Director, Europe Appointed Director, Europe in January 2004 having previously joined the Management Board in 2001 as Development Director. Since joining British American Tobacco in 1989, he has covered a number of senior marketing, finance and management roles particularly in Europe, South Asia and Russia. (47)

Peter Taylor (British) Director, Operations and IT Joined British American Tobacco in 1980 and worked in a variety of operational and general management roles across the Group. He was appointed Global Operations Director in 2003. (54)

Neil Withington (British) Director, Legal and General Counsel Appointed Director, Legal and Security and General Counsel of British American Tobacco in 2000, having previously been the Group’s Deputy General Counsel. He joined the Group in 1993 after a career at the Bar and in the chemical and pharmaceutical industries. He has been a Director of Reynolds American Inc. since July 2004. (50)

The role of the Management Board The Management Board, chaired by the Chief Executive, comprises the Executive Directors of British American Tobacco p.l.c. together with the executives shown on this page. The Management Board has delegated responsibility for overseeing the implementation by the Group’s operating subsidiaries of the policies and strategy set by the Board of Directors, and for creating the conditions for their successful day-to-day operation. Board Committees Committee membership is indicated by the following symbols: ▲ Nominations Committee ■ Audit Committee ● Remuneration Committee ◆ Corporate Social Responsibility Committee

MANAGEMENT BOARD

John Daly (Irish) Director, Asia-Pacific Joined the Management Board as Regional Director for Asia-Pacific in October 2004. He held a number of senior management roles for Rothmans International in Europe and the Far East before becoming Area Director for the Middle East and North Africa in 2001. (50)

SUMMARY CORPORATE GOVERNANCE

Flavio de Andrade (Brazilian) Director, Latin America and Caribbean Joined the Management Board as Regional Director for Latin America and Caribbean in January 2004, following a long career in Brazil with Souza Cruz SA, assuming a variety of senior management roles (including President of Souza Cruz) before being appointed to his current position. (58)

36 British American Tobacco Annual Review 2006 Summary Corporate Governance and Summary Financial Statement

SUMMARY REMUNERATION REPORT

This report is extracted from the full Remuneration Report set out in the Directors’ Report and Accounts 2006 (a copy of which is available on request and can be found on our website, bat.com). SUMMARY CORPORATE GOVERNANCE

The role of the Remuneration Committee and Executive remuneration policy The Remuneration Committee determines the framework and policy on the terms of engagement (including remuneration) for the Chairman, the Executive Directors and the members of the Management Board. The Remuneration Committee also decides their specific remuneration, including awards under the share incentive schemes and pension schemes.

SUMMARY REMUNERATION REPORT

The overriding objective of the British American Tobacco remuneration policy is to reward the achievement of corporate and individual goals by linking success in those areas to the Group strategy: a balanced approach to achieving growth, improving productivity, managing the business in a responsible manner and developing a winning organisation. The delivery of strategy is measured by the Key Performance Indicators (KPIs) and Business Measures set out and described on pages 6 to 9 of this Annual Review. The continued focus by the Executive Directors of British American Tobacco and the members of its Management Board in driving all four elements of the strategy will continue to build a sustainable business. This methodology is supported by a competitively positioned and integrated pay and benefits structure which reflects the nature of the Group’s worldwide operations and the need to attract, motivate and retain high-quality executives. In order to strengthen the alignment of executive remuneration to the generation of shareholder value, a balance is maintained between the short and the long term elements of the structure. The application of this policy will continue during 2007, with performance based variable rewards (cash and share-based performance related annual bonus plans; and a Long Term Incentive Plan – the LTIP) comprising about 56 per cent of total remuneration with the balance of core fixed elements covering base salary, pension and other benefits.

Remuneration – key components Table 1 Executive Directors’ remuneration policy summary Table 2 Directors’ remuneration Table 3 Summary of share interests including long term incentives Review of incentive arrangements and proposed new Long Term Incentive Plan The Company’s current LTIP (the Current LTIP) will expire in April 2008. The Remuneration Committee undertook a comprehensive review of the current incentive arrangements for the senior executive team with a view to advising the Board on possible replacement incentive arrangements to support the executive remuneration policy and its embedded link with the Group strategy (the Review). As a result of the Review, shareholder approval is being sought for a new Long Term Incentive Plan (the New LTIP). Details of the New LTIP will be set out in the notice for the 2007 Annual General Meeting and its accompanying letter from the Chairman of the Remuneration Committee. The proposed new plan, in which all Executive Directors and members of the Management Board would participate, is, in many respects, very similar to the existing arrangements and the key points and differences (including proposed award levels) are noted in Table 1 on page 38. Awards under the New LTIP would deliver shares subject to stretching performance conditions over three years. These performance conditions for the awards would continue to be based on Total Shareholder Return (TSR) and earnings per share (EPS) measures. Participants would continue to receive the LTIP Dividend Equivalent. In order to provide flexibility and sufficient capacity for future awards over the life of the Plan, the individual limit would be increased to 300 per cent of salary. The Remuneration Committee does not anticipate that awards will be made up to this limit in normal circumstances and there is no current intention to utilise this limit by making awards in excess of the proposed levels referred to in Table 1 on page 38. The Remuneration Committee will advise shareholders in advance of any change in the current proposed award levels, and any such change will be disclosed in the Remuneration Report.

Annual Review 2006 British American Tobacco 37 Summary Corporate Governance and Summary Financial Statement

The members of the FMCG group for the 2004 award vesting in March 2007 were: Imperial Tobacco Group InBev Johnson & Johnson Kellogg Kimberly-Clark LVMH Moët Hennessy Nestlé Pepsico Procter & Gamble Reckitt Benckiser SABMiller Sara Lee Scottish & Newcastle Unilever

Performance graph Schedule 7A to the Companies Act requires that the Company must provide a graph comparing the TSR performance of a hypothetical holding of shares in the Company with a broad equity market index over a five year period – the performance graph. This illustrates the performance of TSR against the FTSE 100 Index over a five year period commencing on 1 January 2002. In the opinion of the Directors, the FTSE 100 Index is the most appropriate index against which TSR should be measured because it is a widely used and understood index of broadly similar-sized UK companies to the Company. In addition to the performance graph, illustrative graphs show the relative position on the TSR measures for the LTIP award vesting in March 2007.

growth in the value of a hypothetical £100 holding over five years 350

British American Tobacco FTSE 100

300 250 200 150 100 50 Dec 2001

Dec 2002

Dec 2003

Dec 2004

Dec 2005

Dec 2006

FTSE 100 comparison based on 30 trading day average values.

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

Median – 15.3%

BAT – 32.2%

35 30 25 20 15 10 5 0 –5

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

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

Median – 19.9%

BAT – 32.2%

70 60 50 40 30 20 10 0 – 10

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

SUMMARY REMUNERATION REPORT

Altadis Altria Group Anheuser-Busch Cadbury Schweppes Campbell Soup Carlsberg Coca-Cola Colgate-Palmolive Danone Diageo Gallaher Group Heineken HJ Heinz The Hershey Company

Historical TSR performance

SUMMARY CORPORATE GOVERNANCE

Long Term Incentive Plan: vesting of 2004 award As reported last year, 77.1 per cent of the 2003 LTIP award vested on 19 March 2006. The sixth LTIP award was made in 2004, with the performance period being completed at 31 December 2006. The Remuneration Committee has assessed the performance of British American Tobacco against the two performance conditions outlined in Table 1 and has determined that 100 per cent of the award will vest. On the TSR measure, the Company ranked tenth out of the FTSE 100 group of companies, giving a vesting of 25 per cent for performance at the upper quartile. A vesting of 25 per cent was achieved for ranking second out of the peer group of international FMCG companies, this being upper quartile. Earnings per share growth was 8.98 per cent per annum in excess of inflation, resulting in a vesting of 50 per cent.

38 British American Tobacco Annual Review 2006 Summary Corporate Governance and Summary Financial Statement

SUMMARY REMUNERATION REPORT CONTINUED

Table 1. Executive Directors’ remuneration policy summary Remuneration constituents SUMMARY CORPORATE GOVERNANCE

Base salary

Rationale

Delivery

Policy summary

– competitively reward corporate and individual performance – reflect skills and experience

– cash – monthly

– annual review with changes effective from April – benchmarked against a mid-market level of main board directors from a UK comparator group with a mainly international consumer goods focus chosen from the FTSE 100 Index – additional reference to published salary data with reference to companies in the UK comparator group

– UK management level benefit – car or car allowance – private medical and personal – Executive Directors receive the benefit of the use of a driver accident insurance

Benefits in kind

Performance related bonus

– incentivise the attainment of corporate targets on an annual basis

– five common measures: underlying operating profit, – International Executive market share of key players, Global Drive Brand Incentive Scheme (IEIS) volume, net revenue and cash flow – 50 per cent cash – 50 per cent shares (Deferred – for an ‘on target’ performance, the cash and shares elements of the IEIS together carry a value Share Bonus Scheme - DSBS) of 100 per cent of the base salary with an overall – DSBS shares held in trust for maximum of 150 per cent three years and participants receive cash sum equivalent to the dividend on the after tax position of all unvested shares held in the DSBS at the dividend record date

SUMMARY REMUNERATION REPORT

Long term incentives – alignment of executive (Long Term Incentive remuneration with the Plan or LTIP); new Long generation of shareholder Term Incentive Plan or value New LTIP proposed for – incentivise growth in shareholder approval at earnings per share and Total Annual General Meeting Shareholder Return (TSR) on 26 April 2007 over a three year period

– shares – discretionary annual award – LTIP dividend equivalent as cash at time of vesting – the proportion of shares awarded under an LTIP grant which later lapse upon the vesting of an award do not attract the LTIP dividend equivalent

– maximum awards under the New LTIP will be increased from 175 per cent of salary to 250 per cent for the Chief Executive, and from 125 per cent to 200 per cent of salary for the Finance Director and Chief Operating Officer – cash LTIP dividend equivalent to the dividends that participants would have received as shareholders from the date of the LTIP award to the award’s vesting date – the value of the LTIP dividend equivalent is taken into account when considering awards – three year performance period – TSR performance (50 per cent of the total award) combines both the share price and dividend performance during the three year performance period as against two comparator groups: (1) the constituents of the FTSE 100 Index; and (2) a peer group of FMCG companies (25 per cent for each measure) – earnings per share measure (50 per cent of the total award) relates to earnings per share growth (on an adjusted diluted basis) relative to inflation

Pension

– British American Tobacco UK Pension Fund; defined benefit plan – benefit paid as on-going pension

– pension accrues at 1/40 of annual basic salary – UK Pension Fund normal retirement age of 60 – maximum pension payable will not exceed 2/3 of base salary averaged over the preceding 12 months – Paul Adams and Paul Rayner are both members of the UK Pension Fund – UK Pension Fund retains a scheme-specific cap following the introduction of the new UK pension regime in April 2006 – excess benefits continue to be accrued within an unfunded unapproved retirement benefits scheme (UURBS) – benefits for Antonio Monteiro de Castro are all accrued in the UURBS, offset by his entitlements under the defined benefit plan of Souza Cruz of Brazil

– provision of competitive post-retirement benefits

Annual Review 2006 British American Tobacco 39 Summary Corporate Governance and Summary Financial Statement

Non-Executive Directors’ terms of appointment and remuneration policy The Non-Executive Directors do not have service contracts with the Company but instead have letters of appointment. The terms of appointment provide that a new Director is appointed for a specified term, being an initial period to the next Annual General Meeting after appointment and, subject to reappointment at that meeting, for a further period ending at the Annual General Meeting held three years thereafter. Subsequent reappointment is subject to endorsement by the Board and the approval of shareholders. Fees for Non-Executive Directors are determined by the Board with reference to the time commitment and responsibilities associated with the roles. Under the terms of their letters of appointment, on termination (at any time), a Non-Executive Director is entitled to any accrued but unpaid Director’s fees but not to any other compensation.

SUMMARY CORPORATE GOVERNANCE

Executive Directors’ service contracts The Remuneration Committee continues to operate a policy of one year rolling contracts for Executive Directors; these contracts incorporate a provision for a termination or compensation payment in lieu of notice. This will comprise: (1) 12 months’ salary at his then current base pay; and (2) a cash payment in respect of other benefits under the contract such as medical insurance, or the Company may at its option continue those benefits for a 12 month period. In addition, the Committee also maintains discretion in respect of this policy for those Executive Directors who may be recruited externally or from overseas, when it may be appropriate to offer a contract with an initial period of longer than one year, reducing to a one year rolling contract after the expiry of the initial period.

Table 2. Directors’ remuneration Performancerelated pay: deferred share bonus2, 3 £

520,000 150,000 984,896 608,646 835,956 60,000 75,000 60,000 60,000 50,000 60,000 60,000

– – 710,000 436,650 482,800 – – – – – – –

– – 745,425 460,512 504,779 – – – – – – –

–

–

3,524,498

1,629,450

Salary/fees £

J P du Plessis K H Clarke P N Adams P A Rayner 5 A Monteiro de Castro 6 P E Beyers R E Lerwill A M Llopis R L Pennant-Rea A Ruys1 Sir Nicholas Scheele M H Visser Former Director K S Wong (deceased)1 Total remuneration

Benefits in kind4 £

2006 Total £

2005 Total £

68,524 593 132,397 232,642 213,176 9,735 403 – – 831 8,739 6,584

588,524 150,593 2,572,718 1,738,450 2,036,711 69,735 75,403 60,000 60,000 50,831 68,739 66,584

533,743 154,237 2,118,457 1,443,800 1,803,123 60,000 79,664 60,000 68,750 – 50,860 82,588

–

–

–

10,000

1,710,716

673,624

7,538,288

6,465,222

Notes: 1 K S Wong died on 16 February 2005; Anthony Ruys was appointed a Director on 1 March 2006. 2 The Remuneration Committee, following its usual procedures, agreed that the performance targets for the year ended 31 December 2006 have been met (subject to confirmation of a figure yet to be published). The Committee agreed that the performance-related bonus payments shown above could, as a consequence, increase or decrease by approximately 1.5 per cent following the publication of the outstanding information which would enable the relevant calculations to be finalised after 1 March 2007. Such changes, if any, will be reported in the Remuneration Report for the year ending 31 December 2007. 3 The deferred share bonus payments include cash sums equivalent to the dividend on the after tax position on all unvested ordinary shares comprised in the awards held by participants (including Executive Directors) in the Deferred Share Bonus Scheme at each dividend record date. For the year ended 31 December 2006, these payments for Executive Directors were as follows: Paul Adams £35,425 (2005: £29,374); Paul Rayner £23,862 (2005: £19,750); and Antonio Monteiro de Castro £21,979 (2005: £18,376). 4 Benefits in kind include: (a) a car or a car allowance; (b) use of a driver; (c) spouse travel and associated expenses for business-related purposes. For Non-Executive Directors these benefits relate to spouse travel only. 5 Paul Rayner’s benefits in kind included payments in respect of family education (£56,344) which followed his relocation to the UK from Australia. 6 Antonio Monteiro de Castro’s benefits in kind included tax advice of £65,424 in respect of his former contractual arrangements up to 1 January 2004 prior to which date he derived his emoluments in both the UK and Brazil. 7 The Directors’ remuneration shown above does not include the illustrative value (as at 23 February 2007) of the Executive Directors’ Long Term Incentive Plan awards made in March 2004 which will vest on 17 March 2007. Reference should be made to Table 3 on page 40 note 5.

SUMMARY REMUNERATION REPORT

Performancerelated pay: annual cash bonus2 £

40 British American Tobacco Annual Review 2006 Summary Corporate Governance and Summary Financial Statement

SUMMARY REMUNERATION REPORT CONTINUED

SUMMARY CORPORATE GOVERNANCE

Chairman’s terms of appointment and remuneration Jan du Plessis’s terms of appointment provide that he will hold the office of Chairman with effect from 1 July 2004 for a period of three years unless terminated earlier by: (1) the Company giving three months’ notice or a discretionary compensation payment in lieu of notice; or (2) by the Chairman giving one month’s written notice with the Company having discretion to make a compensation payment in lieu of such notice. This is limited to any fees which are payable for such part of the

relevant notice period as the Board does not require the Chairman to perform his duties. The Chairman is subject to the reappointment of Directors’ provisions contained in the Company’s articles of association; he will therefore not ordinarily serve as a Director for more than two years before seeking reappointment. In common with the Non-Executive Directors, he does not participate in the Company’s share schemes, bonus schemes or incentive plans and is not a member of any Group pension plan.

Table 3. Summary of share interests including long term incentives Ordinary shares at 1 Jan 2006 or date of Ordinary shares appointment at 31 Dec 2006

P N Adams Sharesave Scheme LTIP P A Rayner Share Option and Sharesave Schemes LTIP A Monteiro de Castro Sharesave Scheme LTIP

SUMMARY REMUNERATION REPORT

J P du Plessis K H Clarke P E Beyers R E Lerwill A M Llopis R L Pennant-Rea A Ruys1 Sir Nicholas Scheele M H Visser

143,051 143,394 – – – –

Ordinary shares Ordinary shares (Deferred Scheme) (Deferred Scheme) at 1 Jan 2006 at 31 Dec 2006

Options and Options and awards over awards over ordinary shares ordinary shares at 1 Jan 2006 at 31 Dec 2006

Share options exercisable from/to LTIP awards initial vesting date

125,517 – –

118,611 – – – – 2,492 2,492 Jan 10-Jun 10 – 341,383 362,067 Mar 07-Mar 09

83,558 – –

83,155 – –

82,821 – – – – 6,777 6,266 Sep 02-Jun 12 – 200,511 177,490 Mar 07-Mar 09

179,564 179,844 – – – –

76,784 – –

75,889 – – – – 957 957 Jan 09-Jun 09 – 229,480 266,273 Mar 06-Mar 09

83,228 – –

50,000 4,459 – 3,000 2,200 3,295 – – –

50,000 4,611 – 3,000 2,200 3,407 3,000 – –

– – – – – – – – –

– – – – – – – – –

– – – – – – – – –

– – – – – – – – –

Notes: 1 Anthony Ruys was appointed a Director on 1 March 2006. 2 No Director had a non-beneficial interest in the shares of the Company at the dates stated above. 3 Share options granted under the Share Option Scheme are not normally granted in any year to Executive Directors who receive an award under the LTIP; no options were granted in the year ended 31 December 2006. The aggregate gains on share options exercised by Executive Directors during the year ended 31 December 2006 were £17,562 (2005: £423,516). Options granted under the Share Option Scheme are exercisable subject to a performance condition based on earnings per share growth; the Company’s published adjusted earnings per share growth has to exceed inflation by an average of 3 per cent per annum over any consecutive three year period during the 10 year life of the options. 4 The value of LTIP awards which vested to Executive Directors during the year ended 31 December 2006 was £2,783,533 (2005: £1,300,628). 5 The March 2004 LTIP award will vest on 17 March 2007 at 100 per cent in the manner described on page 37. For illustrative purposes only, the aggregate value of the vesting awards for the Executive Directors was £3,820,370 based on a share price on 23 February 2007 (being the latest practicable date prior to publication) of 1,584p per ordinary share.

– – – – – – – – –

Annual Review 2006 British American Tobacco 41 Summary Corporate Governance and Summary Financial Statement

INDEPENDENT AUDITORS’ STATEMENT TO THE MEMBERS OF BRITISH AMERICAN TOBACCO P.L.C.

We have examined the Summary Financial Statement on pages 42 to 47, including the Summary Remuneration Report (pages 36 to 40) of British American Tobacco p.l.c. for the year ended 31 December 2006.

SUMMARY FINANCIAL STATEMENT

Respective responsibilities of Directors and auditors The Directors are responsible for preparing the Summary Corporate Governance and Summary Financial Statement in accordance with United Kingdom law. Our responsibility is to report to you our opinion on the consistency of the Summary Financial Statement (including the Summary Remuneration Report) within the Summary Corporate Governance and Summary Financial Statement with the full annual financial statements, the Directors’ Report and the Remuneration Report and its compliance with the relevant requirements of Section 251 of the Companies Act 1985 and the regulations made thereunder. We also read the other information contained in the Annual Review and consider the implications for our report if we become aware of any apparent misstatements or material inconsistencies with the Summary Financial Statement. This statement, including the opinion, has been prepared for and only for the Company’s members as a body in accordance with Section 251 of the Companies Act 1985 and for no other purpose. We do not, in giving this opinion, accept or assume responsibility for any other purpose or to any other person to whom this statement is shown or into whose hands it may come save where expressly agreed by our prior consent in writing.

Opinion In our opinion the Summary Financial Statement is consistent with the full annual financial statements, the Directors’ Report and the Remuneration Report of British American Tobacco p.l.c. for the year ended 31 December 2006 and complies with the applicable requirements of Section 251 of the Companies Act 1985, and the regulations made thereunder. PricewaterhouseCoopers LLP Chartered Accountants and Registered Auditors 1 Embankment Place, London 1 March 2007

INDEPENDENT AUDITORS’ STATEMENT

Basis of opinion We conducted our work in accordance with Bulletin 1999/6, ‘The Auditors’ Statement on The Summary Financial Statement’ issued by the Auditing Practices Board. Our reports on the Company’s full annual financial statements describe the basis for our audit opinions on those financial statements and the Directors’ Report and the Remuneration Report.

42 British American Tobacco Annual Review 2006 Summary Corporate Governance and Summary Financial Statement

GROUP INCOME STATEMENT FOR THE YEAR ENDED 31 DECEMBER

2006

SUMMARY FINANCIAL STATEMENT

£m

2005 Restated £m

Gross turnover (including duty, excise and other taxes of £15,427m (2005: £14,659m))

25,189

23,984

Revenue Raw materials and consumables used Changes in inventories of finished goods and work in progress Employee benefit costs Depreciation and amortisation costs Other operating income Other operating expenses

9,762 (2,861) (11) (1,554) (401) 181 (2,494)

9,325 (2,760) (2) (1,557) (383) 179 (2,382)

2,622

2,420

Profit from operations after (charging)/crediting – restructuring costs – (losses)/gains on disposal of a business, brands and joint venture

(216) 41

(271) 72

Finance income Finance costs

110 (399)

118 (346)

Net finance costs Share of post-tax results of associates and joint ventures

(289) 431

(228) 392

(13) 17

(13) (12) (29) 57

Profit before taxation Taxation on ordinary activities

2,764 (716)

2,584 (690)

Profit for the year

2,048

1,894

Attributable to: Shareholders’ equity

1,896

1,767

152

127

Earnings per share Basic

92.08p

84.34p

Diluted

91.33p

83.66p

after (charging)/crediting – restructuring costs – US Federal tobacco buy-out – brand impairments – exceptional tax credits and other impairments

GROUP INCOME STATEMENT

Minority interests

Annual Review 2006 British American Tobacco 43 Summary Corporate Governance and Summary Financial Statement

GROUP BALANCE SHEET AT 31 DECEMBER

2006

7,476 2,207 2,108 29 273 192 24 76

7,987 2,331 2,193 35 290 197 27 87

12,385

13,147

Current assets Inventories Income tax receivable Trade and other receivables Available-for-sale investments Derivative financial instruments Cash and cash equivalents

2,056 59 1,568 128 124 1,456

2,274 81 1,577 96 86 1,790

Total current assets

5,391

5,904

Total assets

17,776

19,051

Equity Total equity

6,688

6,877

Liabilities Non-current liabilities Borrowings Retirement benefit liabilities Deferred tax liabilities Other provisions for liabilities and charges Trade and other payables Derivative financial instruments

5,568 435 296 161 146 29

5,058 543 277 261 180 19

Total non-current liabilities

6,635

6,338

Current liabilities Borrowings Income tax payable Other provisions for liabilities and charges Trade and other payables Derivative financial instruments

1,058 292 253 2,766 84

2,202 374 234 2,883 143

Total current liabilities

4,453

5,836

17,776

19,051

Assets Non-current assets Intangible assets Property, plant and equipment Investments in associates and joint ventures Retirement benefit assets Deferred tax assets Trade and other receivables Available-for-sale investments Derivative financial instruments Total non-current assets

Total equity and liabilities

This Summary Financial Statement was approved by the Board of Directors on 1 March 2007 and signed on its behalf by Jan du Plessis, Chairman.

GROUP BALANCE SHEET

2005 Restated £m

SUMMARY FINANCIAL STATEMENT

£m

44 British American Tobacco Annual Review 2006 Summary Corporate Governance and Summary Financial Statement

GROUP STATEMENT OF CHANGES IN TOTAL EQUITY FOR THE YEAR ENDED 31 DECEMBER

2006 £m

SUMMARY FINANCIAL STATEMENT

Differences on exchange Cash flow hedges Available-for-sale investments Net investment hedges Tax on items recognised directly in equity

2005 Restated £m

(685) (2) (2) 117 (12)

425 58

Net (losses)/gains recognised directly in equity Profit for the year page 42

(584) 2,048

390 1,894

Total recognised income for the year

1,464

2,284

– shareholders’ equity – minority interests

1,334 130

2,128 156

69

72

Employee share options Dividends and other appropriations – to British American Tobacco shareholders – to minority interests Purchase of own shares – held in Employee Share Ownership Trusts – share buy-back programme Other movements Balance 1 January page 43 Change in accounting policy page 29 Balance 31 December

(52) (41)

(1,008) (137)

(910) (112)

(77) (500)

(48) (501) 17

(189) 6,877

802 6,117 (42)

6,688

6,877

GROUP STATEMENT OF CHANGES IN TOTAL EQUITY

Total equity comprised £6,461 million of shareholders’ funds (2005: £6,630 million), after deducting cost of own shares held in Employee Share Ownership Trusts of £197 million (2005: £182 million), and minority interests of £227 million (2005: £247 million).

Annual Review 2006 British American Tobacco 45 Summary Corporate Governance and Summary Financial Statement

SUMMARY FINANCIAL STATEMENT AND NOTES

The Summary Financial Statement on pages 42 to 47 is a summary of information in the Annual Report and Accounts and should be read with the reviews on pages 1 to 32. Reference should also be made to the Summary Remuneration Report on pages 36 to 40.

Contingent liabilities There are contingent liabilities in respect of litigation, overseas taxes and guarantees in various countries. Product liability litigation Group companies, notably Brown & Williamson Holdings, Inc. (B&W), as well as other leading cigarette manufacturers, are defendants, principally in the US, in a number of product liability cases. In a number of these cases, the amounts of compensatory and punitive damages sought are significant.

SUMMARY FINANCIAL STATEMENT AND NOTES

Report of the auditors The auditors’ report on the full annual accounts of the Group Indemnity for the year ended 31 December 2006 is unqualified and does not contain any statement concerning accounting records On 30 July 2004, B&W completed transactions combining or failure to obtain necessary information and explanations. its US tobacco business assets, liabilities and operations with R.J. Reynolds Tobacco Company. A new company Going concern called R.J. Reynolds Tobacco Company (RJRT) was created After reviewing the Group’s annual budget and plans, the as a result of the combination transactions. As a result of Directors consider that the Group has adequate resources these transactions: (a) B&W discontinued the active conduct to continue in operational existence for the foreseeable of any tobacco business in the US; (b) B&W contributed future and that it is therefore appropriate to continue to to RJRT all of its assets other than the capital stock of adopt the going concern basis in preparing the accounts. certain subsidiaries engaged in non-US businesses and other limited categories of assets; (c) RJRT assumed all Accounting policies liabilities of B&W (except liabilities to the extent relating From 1 January 2005, the Group has prepared its annual to businesses and assets not contributed by B&W to RJRT consolidated financial statements in accordance with and other limited categories of liabilities) and contributed International Financial Reporting Standards (IFRS) as adopted subsidiaries or otherwise to the extent related to B&W’s by the European Union and implemented in the UK. tobacco business as conducted in the US on or prior to Changes in accounting policies are as described on page 29. 30 July 2004; and, (d) RJRT agreed to indemnify B&W and each of its affiliates (other than Reynolds American Inc. Dividends and share buy-back and its subsidiaries) against, among other matters, all The dividends are as described on pages 27 and 28. losses, liabilities, damages, expenses, judgments, attorneys’ For the first time the Company needed to file interim fees, etc, to the extent relating to or arising from such accounts which were prepared to recognise additional assumed liabilities or the assets contributed by B&W to dividend income during 2006. As a result of the Company RJRT (the RJRT Indemnification). The scope of the RJRT not doing so, the interim dividend of £323 million paid Indemnification includes all expenses and contingent on 13 September 2006 did not comply with the technical liabilities in connection with litigation to the extent relating requirements of the Companies Act 1985. It is proposed to or arising from B&W’s US tobacco business as conducted that the appropriation of distributable profits to the payment on or prior to 30 July 2004, including smoking and health of the interim dividend will be ratified by shareholders by tobacco litigation, whether the litigation is commenced way of a special resolution at the Annual General Meeting. before or after 30 July 2004 (the tobacco litigation). Accordingly, the payment has been presented as a dividend Pursuant to the terms of the RJRT Indemnification, RJRT payment on page 44. is liable for any possible judgments, the posting of appeal Between 22 September 2006 and 4 December 2006, bonds or security, and all other expenses of and responsibility the Company sought to repurchase 6,927,790 shares for managing the defence of the tobacco litigation. RJRT for an aggregate consideration of £100 million, which has assumed control of the defence of the tobacco litigation are included in the purchase of own shares on page 44. involving B&W. Affiliates of B&W have retained control of

SUMMARY FINANCIAL STATEMENT

The Annual Review and Summary Financial Statement does not contain sufficient information to allow for as full an understanding of the results of the Group and the state of affairs of the Company, or of the Group, and their policies and arrangements concerning Directors’ remuneration, as would be provided by the full Annual Report and Accounts. Shareholders requiring more detailed information have the right to obtain, free of charge, a copy of the full Annual Report and Accounts for 2006, or for future years, by contacting British American Tobacco Publications as set out on the inside back cover.

However, as a result of the technical infringement of the Companies Act 1985, the repurchase and cancellation of these shares was invalid and accordingly, their nominal value is included within the Company's share capital as at 31 December 2006. These shares will be repurchased on 1 March 2007 from their present holders, the Company's brokers, at the same prices agreed between 22 September 2006 and 4 December 2006.

46 British American Tobacco Annual Review 2006 Summary Corporate Governance and Summary Financial Statement

SUMMARY FINANCIAL STATEMENT AND NOTES CONTINUED

the defence in certain tobacco litigation cases with respect to which such affiliates are entitled to indemnification.

SUMMARY FINANCIAL STATEMENT

US litigation 1. Medical reimbursement cases These civil actions seek to recover amounts spent by government entities and other third party providers on healthcare and welfare costs claimed to result from illnesses associated with smoking. As at 31 December 2006, a reimbursement suit brought by an Indian tribe and two non-governmental reimbursement suits were pending against B&W. The vast majority of other such claims have been dismissed on legal grounds. As at 31 December 2006, B&W was named as defendant in two US cases brought by foreign government entities (São Paulo and Panama) seeking reimbursement of medical costs. In July 2006, the Delaware Superior Court granted defendants’ motion to dismiss these cases. Plaintiffs appealed to the Supreme Court of Delaware, which heard oral argument in December 2006 and reserved decision.

SUMMARY FINANCIAL STATEMENT AND NOTES

2. Class actions As at 31 December 2006, B&W was named as a defendant in some 15 separate actions attempting to assert claims on behalf of classes of persons allegedly injured by smoking. In the Engle case (Florida), one jury awarded compensatory damages totalling US$12.7 million and assessed US$17.6 billion in punitive damages against B&W. The intermediate appellate court reversed the trial court’s judgment. In July 2006, the Florida Supreme Court upheld the intermediate appellate court’s decision to decertify the class, and vacated the jury’s punitive damages award. In Scott, the jury returned a verdict of US$591 million on the class’s claim for a smoking cessation programme. Defendants’ appeal to the Louisiana Fourth Circuit Court of Appeal resulted in the reduction of the award by US$312 million. In the Schwab class action complaint, the court granted plaintiffs’ motion for class certification. By order in November 2006, the Second Circuit Court of Appeals granted defendants’ motion to stay proceedings in this case, and further granted defendants’ petition for leave to appeal the class certification order. 3. Individual cases Approximately 3,471 cases were pending against B&W at 31 December 2006, filed by or on behalf of individuals in which it is contended that diseases or deaths have been caused by cigarette smoking or by exposure to environmental tobacco smoke (ETS). 4. Consolidated claims In the West Virginia consolidated smoking and health cases, the court so-ordered the parties' stipulation dismissing B.A.T Industries p.l.c. from the action, with prejudice, on 12 December 2006. This is a significant decision

as B.A.T Industries p.l.c. was previously a defendant in around 1,000 consolidated individual cases in West Virginia. British American Tobacco (Investments) Limited has been dismissed from those West Virginia consolidated smoking and health cases in which it was a defendant. 5. Conduct-based claims In 1999, the US Department of Justice brought an action against various industry members, including RJRT and B&W. British American Tobacco (Investments) Limited is a co-defendant in the action. The trial of this claim was completed in June 2005. In August 2006, the District Court issued its final judgment, finding in favour of the Government, and against certain defendants, including B&W and British American Tobacco (Investments) Limited. The court also ordered a wide array of injunctive relief, including a ban on the use of ‘lights’ and other similar descriptors. Defendants filed a motion to stay enforcement of the judgment shortly after the judgment was issued. The court denied the stay motion, but defendants filed a notice of appeal and an emergency motion to stay the judgment before the Washington DC Circuit Court of Appeals in September 2006. In October 2006, the Court of Appeals granted defendants’ motion to stay enforcement of the judgment pending the outcome of the appeal. 6. Settlement of State Health Care Reimbursement Cases After an Independent Auditor found that the terms of the Master Settlement Agreement (MSA) were a ‘significant factor’ in market share losses experienced by signatories to the MSA in 2003, several US tobacco companies asserted their rights under the MSA to recover a payment credit or offset for MSA payments made in April 2004. The amount at stake exceeds US$1 billion. The settling states have filed motions seeking enforcement of certain MSA provisions and defendants have opposed these motions, arguing instead for arbitration. 7. Other claims The Flintkote Company (Flintkote), a US asbestos production and sales company, was included in the acquisition of Genstar Corporation by Imasco Limited (now Imperial Tobacco Canada Limited (Imperial)) in 1986 and became a Group subsidiary following the restructuring of Imasco in 2000. In 2003, Imperial divested Flintkote and then, in 2004, Flintkote filed for bankruptcy in the US. In 2006, Flintkote, certain representatives of both the present and future asbestos claimants as well as certain individual asbestos claimants were permitted by the bankruptcy court to file a complaint against Imperial and other defendants for the recovery of dividends paid and other compensation under various legal theories. The parties are presently engaged in case management discussions to establish the scope and manner of discovery in this case. This litigation is expected to take several years to proceed to trial.

Annual Review 2006 British American Tobacco 47 Summary Corporate Governance and Summary Financial Statement

Imperial is currently being investigated by the Royal Canadian Mounted Police relating to its business records and sales of products exported from Canada between 1989 and 1994. No action has been commenced against Imperial. Imperial believes that it has conducted itself appropriately at all times, but cannot predict the outcome of any such investigation, or whether additional investigations will occur. Two actions have been started in Russia by a minority shareholder in OJSC Company British American TobaccoYava (BAT-Yava), a Russian incorporated subsidiary of British American Tobacco Holdings (Russia) B.V. The minority shareholder, Branston Holdings, issued a claim in Moscow seeking to have a contract between BAT-Yava and its sister company invalidated, and issued another claim in the Stavropol region alleging that certain of the directors of BAT-Yava, and other parties, took various unlawful steps. The Moscow Court has dismissed the claim and the Stavropol Court has ordered the transfer of the case filed there to Moscow. An appeal of the dismissed Moscow case has been sent to the Moscow Appellate Court. Branston has also threatened actions in the Netherlands and England but has not yet commenced these. The Company considers these actions to be without merit and will defend the claims strenuously.

Conclusion While it is impossible to be certain of the outcome of any particular case or of the amount of any possible adverse verdict, the Company believes that the defences of the Group companies to all these various claims are meritorious both on the law and the facts, and a vigorous defence is being made everywhere. If an adverse judgment were entered against any of the Group companies in any case, an appeal will be made. Such appeals could require the The Supreme Court of Canada has upheld the constitutionality appellants to post appeal bonds or substitute security of the British Columbian Tobacco Damages and Health Care in amounts which could in some cases equal or exceed Costs Recovery Act. Non-Canadian defendants challenged the amount of the judgment. In any event, with regard the personal jurisdiction of the British Columbia Court but to US litigation, the Group has the benefit of the RJRT these motions were dismissed. The Court found a ‘real and Indemnification. At least in the aggregate and despite substantial connection’ between British Columbia and the the quality of defences available to the Group, it is not foreign defendants. Defendants’ appeal to this decision impossible that the results of operations or cash flows of was dismissed in September 2006. Defendants then filed the Group in particular quarterly or annual periods could leave to appeal to the Supreme Court in November 2006. be materially affected by this and by the final outcome of In addition, there are five class actions and four individual any particular litigation. cases in Canada. In the Knight class action, the Supreme Having regard to these matters, the Directors (i) do not Court of British Columbia certified a class of all consumers consider it appropriate to make any provision in respect of Imperial manufactured cigarettes in British Columbia, not of any pending litigation and (ii) do not believe that the just British Columbia residents. Defendant’s appeal was ultimate outcome of all this litigation will significantly heard in February 2006, and the Appeal Court confirmed impair the financial condition of the Group.

SUMMARY FINANCIAL STATEMENT AND NOTES

Other foreign litigation At 31 December 2006, active claims against Group companies existed in 18 countries outside the United States but the only countries with more than five active claims were Argentina, Brazil, Canada, Chile, Italy and the Republic of Ireland. As at 31 December 2006, there were some 1,142 pending individual cases in Italy. 1,113 cases are pending before the Justice of the Peace Courts, the majority of which relate to claims of alleged fraud in connection with ‘light’ cigarettes. Because of the type of court involved, the most an individual plaintiff can recover is €1,033. There are around 27 smoking and health cases filed by or on behalf of individuals. There are also two labour cases for alleged occupational exposure pending in Italy.

the certification of the class but limited any liability, if proved, to the period from 1997. In Quebec, in February 2005, two smoking and health class actions were certified. There is no right of appeal against class certification.

SUMMARY FINANCIAL STATEMENT

In Wisconsin, the Authorities have identified potentially responsible parties to fund the clean up of the Fox River after pollution from paper mills operating nearby, a task currently estimated to cost in the order of US$600m. Among the potentially liable parties are NCR Corporation and Appleton Papers Inc. B.A.T Industries p.l.c. purchased what was then NCR’s Appleton Papers Division from NCR Corporation, and B.A.T Industries p.l.c. spun off the Appleton Paper business in 1990 having obtained full indemnities from Appleton Papers Inc. for past and future environmental claims. Disputes have arisen between NCR Corporation and B.A.T Industries p.l.c. as to the indemnities given and received under the purchase agreement in 1978 which disputes have been the subject of arbitration in 1998 and 2006. Under the terms of the arbitration awards B.A.T Industries p.l.c. has an obligation to share the costs of environmental claims with NCR Corporation, although it has never been required to do this because Appleton Papers Inc. has paid any sums demanded. It is our belief that all future environmental liabilities will continue to be met directly by Appleton Papers Inc. by self funding or insurance cover and no demand will be made upon B.A.T Industries p.l.c. by NCR Corporation.

48 British American Tobacco Annual Review 2006 Summary Corporate Governance and Summary Financial Statement

SHAREHOLDER INFORMATION

Registrar Enquiries concerning your shareholding, mandating your dividends (including consolidated dividend tax vouchers) and notifying changes in your personal details should be directed to Computershare Investor Services PLC, PO Box 82, The Pavilions, Bridgwater Road, Bristol BS99 7NH, tel: 0800 408 0094 (UK); +44 870 889 3159 ADDITIONAL INFORMATION

Online www.bat.com Access comprehensive information about British American Tobacco and download shareholder publications at the corporate website; visit the Investor Centre for valuation and charting tools and dividend and share price data; and subscribe to the e-mail and SMS alert services for key financial events in the British American Tobacco financial calendar www.computershare.com/uk/investor/bri Access the web-based enquiry service for shareholders operated by Computershare Investor Services; view details of your British American Tobacco shareholding and recent dividend payments and register for shareholder electronic communications to receive notification of British American Tobacco shareholder mailings by e-mail www.computershare.com/dealing/UK Go online or telephone 0870 703 0084 (UK) to buy or sell British American Tobacco shares [email protected] Contact Computershare Investor Services by e-mail

SHAREHOLDER INFORMATION

Publications Copies of current and past Annual Report and Accounts and Annual Reviews are available on request. Copies of the Group corporate descriptive booklet About Us and past Quarterly Reports are also available. Highlights from these publications can be produced in alternative formats such as Braille, audio tape and large print. Contact British American Tobacco Publications, Unit 80, London Industrial Park, Roding Road, London E6 6LS tel: +44 (0)20 7511 7797, facsimile: +44 (0)20 7540 4326, e-mail: [email protected] Dividend Reinvestment Plan A straightforward and economic way of utilising your dividends to build up your shareholding in British American Tobacco; contact Computershare Investor Services for details American Depositary Receipts British American Tobacco sponsors an American Depositary Receipt (ADR) programme in the United States. Enquiries regarding ADR holder accounts and payment of dividends should be directed to Shareholder Relations, The Bank of New York, PO Box 11258,

Church Street Station, New York, NY 10286-1258, USA, tel: +1 888 BNY ADRS (toll-free) or +1 212 815 3700, e-mail: [email protected] website: www.adrbny.com Individual Savings Accounts (ISAs) A British American Tobacco sponsored ISA; contact The Share Centre, PO Box 2000, Aylesbury, Bucks, HP21 8ZB, tel: 0800 800 008 (UK); +44 (0)1296 414 141, e-mail: [email protected]; website: www.share.co.uk Capital gains tax Fact sheet for British American Tobacco historical capital gains tax information; contact the British American Tobacco Company Secretarial Department, tel: +44 (0)20 7845 1000 or access the Investor Centre at www.bat.com/investorcentre/cgt Final dividend 2006 Ex-dividend date – 7 March 2007 Record date – 9 March 2007 Payment date – 3 May 2007 Annual General Meeting Thursday, 26 April 2007 at 11.30am, The Mermaid Conference & Events Centre, Puddle Dock, Blackfriars, London EC4V 3DB Financial results 2007 First quarter – 3 May Interim – 26 July Third quarter – 1 November Analyses of shareholders At 31 December 2006, there were 2,068,803,944 ordinary shares in issue held by 60,226 shareholders. These shareholdings are analysed as follows by category of shareholder and size of shareholding: Category of shareholder

Number of holders

Individuals 53,283 Financial institutions/ pension funds 273 Nominee companies 6,162 Other corporate holders 507 R&R Holdings S.A. 1

Size of shareholding

1 – 1,999 2,000 – 9,999 10,000 – 199,999 200,000 – 499,999 500,000 and over

Percentage of issued Number of ordinary ordinary shares share capital

Percentage of total holders

88.47

77,196,613

3.74

0.46 10.23 0.84 –

5,913,028 1,356,353,424 25,004,252 604,336,627

0.29 65.56 1.21 29.20

60,226 100.00

2,068,803,944

100.00

Number of holders

Percentage of issued ordinary share capital

48,232 9,852 1,609 215 318

1.26 1.79 3.24 3.33 90.38

60,226

100.00

CONTACT INFORMATION

Registered office Globe House, 4 Temple Place, London WC2R 2PG tel: +44 (0)20 7845 1000, facsimile: +44 (0)20 7240 0555 Incorporated in England and Wales No. 3407696 Secretary Nicola Snook General Counsel Neil Withington Investor relations Enquiries should be directed to Ralph Edmondson or Rachael Brierley, tel: +44 (0)20 7845 1180 Press office Enquiries should be directed to Fran Morrison or David Betteridge, tel: +44 (0)20 7845 2888, e-mail: press_offi[email protected] Auditors PricewaterhouseCoopers LLP, 1 Embankment Place, London WC2N 6RH Registrar Enquiries concerning your shareholding, mandating your dividends (including consolidated dividend tax vouchers) and notifying changes in your personal details Contact Computershare Investor Services PLC, PO Box 82, The Pavilions, Bridgwater Road, Bristol BS99 7NH, tel: 0800 408 0094 (UK); +44 870 889 3159 (International)

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