As explained in the Summary Financial Statement, from 1 January 2005 the Group is reporting under International Financial Reporting Standards (IFRS). The changes in presentation required by IFRS have made the reporting of performance more complex and have been complicated still further by important changes in the Group that took place in 2004.
Profit from operations like-for-like
The reported Group profit from operations was 36 per cent lower at £2,420 million, due to a number of distorting factors but principally the gain on the Reynolds American transaction in 2004. The table below shows like-for-like operating profit after excluding restructuring costs, investment costs written off and gains on disposal of subsidiaries, joint ventures, non-current investments and brands, as well as the Brown & Williamson (B&W), Lane and Etinera operating profit, and the resultant change in terms of trade in Italy.
|Profit from operations (see the Group Income Statement)||2,420||3,760|
|Exceptional items see the Group Income Statement)||199||(1,171)|
|B&W and Lane||(149)|
On this basis, the operating profit for 2005 of £2,607 million would represent growth of 9 per cent. The results benefited from the weakness of sterling against many currencies and profit at constant rates of exchange would have risen by 5 per cent.
Details of the Group's operating performance can be found in the regional summary.
The principal distortion in the headline profit from operations was due to the agreement to combine the Group's US domestic businesses with R.J. Reynolds at the end of July 2004, which resulted in a gain of £1,389 million on the partial disposal of the US business and was included in the profit from operations. The 2004 profit from operations also included a contribution from the US businesses of £149 million for the period to July 2004.
In December 2004, the Group sold Etinera, the distribution business of the Italian subsidiary. Although there was no gain on the disposal, the Group profit from operations in 2004 is estimated to include £42 million from the Etinera operations.
The Group continued its review of manufacturing operations and organisational structure, including the initiative to reduce overheads and indirect costs. Major announcements in 2005 covered the cessation of production in the UK, Ireland and Canada, with production to be transferred elsewhere. Restructuring charges in total for 2005 were £271 million compared to £206 million in 2004.
Profit from operations in 2005 also benefited from a £72 million gain, principally in respect of the disposal of certain trademarks in Malta, Cyprus and Lithuania. In 2004, there was a gain of £38 million on the disposal of non-current investments and a £50 million cost for writing off costs previously capitalised on a project to establish a major strategic investment in China.
Below profit from operations, net finance costs at £224 million were £32 million lower than last year, principally reflecting the impact of derivatives and exchange differences under IFRS, together with the benefit of the Group's improved cash flow.
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 above shows the cover, adjusting for these items, on the basis of profit before interest payable over interest payable. The interest cover remains strong at 8.8x (2004: 7.9x), with the higher cover reflecting the increase in underlying profit.
At 31 December 2005, the ratio of floating to fixed rate financial liabilities was 55:45 (2004: 52:48).
As explained in the Regional Summary, the Group's share of post-tax results of associates, included at the pre-tax level under IFRS, increased by £266 million to £392 million, after exceptional net income of £3 million (2004: £63 million expense). The exceptional items are shown as memorandum information on the Group income statement (Regional Summary).
Despite the good underlying performance, profit before tax was down £1,042 million at £2,588 million, principally reflecting the gain on the disposal of subsidiaries in the 2004 comparative.
Effective tax rate - subsidiaries
The tax rates in the income statement of 26.7 per cent in 2005 and 18.5 per cent in 2004 are affected by the inclusion of the share of associates' post-tax profit in the Group's pre-tax results and the significant gain on the Reynolds American transaction in 2004. The underlying tax rate for subsidiaries, adjusted to remove the distortions as reflected in the adjusted earnings per share below, was 31.4 per cent in 2005 and 31.7 per cent in 2004, and the decrease reflects changes in the mix of profits.
Adjusted diluted earnings per share
Basic earnings per share for 2005 were 84.53p (2004: 133.43p).
With the distortions that can occur in profit over the years, as well as the potential dilutive effect of employee share schemes and the convertible redeemable preference shares (in 2004), 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 . The main items are gains in respect of disposals of subsidiaries and brands, partly offset by restructuring costs. In addition, the calculation adjusts for certain distortions in net finance costs arising under IFRS, as well as reflecting the impact of the potential conversion of shares.
On this basis, the earnings per share are 89.34p, a 17 per cent increase over 2004, benefiting from the improved underlying operating profit and reduced net finance costs, as well as the impact of the Reynolds American transaction and the share buy-back programme.
Dividends per share declared
With the recommended final dividend of 33.0p, the total dividends per share declared for 2005 are 47.0p, up 12 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 2005 accounts reflect the 2004 final dividend and the 2005 interim dividend amounting to 43.2p (£910 million) in total (2004: 39.7p - £856 million). The table below shows the dividends declared in respect of 2005 and 2004.
Our policy is to pay out as dividends at least 50 per cent of long term sustainable earnings. Dividends per share declared for 2005 represent 52.6 per cent of adjusted fully-diluted earnings per share (2004: 54.7 per cent).
Total equity was £760 million higher at £6,877 million. This reflected the profit retained after payment of dividends, which more than offset the impact of the share buy-back programme. In addition, exchange movements had a £421 million positive impact on shareholders' funds, reflecting the general weakness of sterling. The adoption of IFRS for financial instruments from 1 January 2005 reduced the total equity at that date by £42 million.
|Interim 2005 paid 14 September 2005||14.0||293||12.7||271|
|Final 2005 payable 4 May 2006||33.0||684||29.2||617|
Convertible redeemable preference shares
|Amortisation of discount||8|
|Net cash from operating activities before restructuring costs||2,467||2,194|
|Net cash from operating activities||2,324||1,980|
|Net capital expenditure||(378)||(306)|
|Dividends to minority interests||(133)||(123)|
|Free cash flow||1,582||1,336|
|Dividends paid to shareholders||(910)||(856)|
|Other net flows||(49)||109|
|Net cash flows||122||97|
IFRS Cash flow
|Net cash from operating activities||2,324||1,980|
|Net cash from investing activities||(292)||(29)|
|Net cash from financing activities||(2,147)||(2,193)|
|Net cash flows||(115)||(242)|
The IFRS cash flow includes all transactions affecting cash and cash equivalents, including financing. The alternative cash flow above is presented to illustrate the cash flows before transactions relating to borrowings.
The Group's net cash flow from operating activities at £2,324 million was £344 million higher, with the growth in underlying operating performance. Cash flows also benefited from timing of working capital while, with £112 million additional dividends from associates following the Reynolds American transaction, the disposal of subsidiaries in 2004 did not materially affect operating flows. The reduced restructuring flows were offset by a £59 million rise in tax outflows reflecting higher profits and the timing of payments. After higher net interest, net capital expenditure and dividends paid to minorities, the free cash flow is £1,582 million, up £246 million on 2004. This inflow exceeds the total cash outlay on dividends to shareholders and share buy-back by £171 million.
The other net flows in 2005 mainly arise from the acquisition of further shares in the Group's Danish associate and the acquisition of Restomat AG in Switzerland, partly offset by the proceeds of the brand sale to Gallaher. The other net flows in 2004 principally reflect the sale of Etinera in Italy and the disposal of non-current investments, partly offset by the outflow in respect of the Reynolds American transaction.
The above flows resulted in net cash flows of £122 million compared to £97 million in 2004. After taking account of transactions related to borrowings, especially the net repayment of borrowings, the above flows resulted in a net decrease of cash and cash equivalents of £115 million, compared to a net decrease of £242 million in 2004.
These cash flows, after an exchange benefit of £49 million, resulted in cash and cash equivalents, net of overdrafts, decreasing by £66 million in 2005.
Borrowings, excluding overdrafts but taking into account derivatives relating to borrowings, were £6,985 million at 31 December 2004. The adoption of IAS32 and IAS39 on financial instruments from 1 January 2005 resulted in a £121 million increase in this figure to £7,106 million, principally due to the reclassification of interest accruals to borrowings from elsewhere in the balance sheet. The marginal increase in this figure during the year to £7,113 million at 31 December 2005 principally reflected a net repayment of borrowings of £136 million offset by the impact of exchange.
Current available-for-sale investments at 31 December 2005 were £96 million (31 December 2004: £86 million).
Treasury is tasked with raising finance for the Group, managing the financial risks arising from underlying operations and managing the Group's cash resources. All these activities are carried out under defined policies, procedures and limits.
The Board reviews and agrees the overall treasury policies and procedures, delegating appropriate authority to the 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.
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 transacted 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 eight 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.
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.
In 2004, the Group issued one bond maturing in 2011, which raised €1 billion; the proceeds were used to refinance maturing bond issues. In addition, the Group's central banking facility was renewed for an increased amount of £1.5 billion and on improved terms. In particular, £1.0 billion of the facility was renewed for an extended term of five years, with £500 million continuing with a one year term.
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.
The Group continues to target investment-grade credit ratings; as at the end of 2005, the ratings from Moody's and S&P were Baa 1/BBB+ (end 2004: Baa 1/BBB+). The strength of the ratings has underpinned the success of the debt issuance during 2004 and 2005 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) Ltd. (BAR) on 8 December 2004, when BAR went into administration. The Group consequently ceased to consolidate BAR from that date. On 7 January 2005, a joint venture (BARH) 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. For the period 7 January 2005 to 20 December 2005, BARH has been equity accounted, reflecting shared control with Honda.
On 21 October 2005, the Group announced the exercise of its pre-emption rights over shares in STK, its Danish associated 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.
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.
Share buy-back programme
The Group initiated an on-market share buy-back programme at the end of February 2003. During 2005, 45 million shares were bought at a cost of £501 million (2004: 59 million shares at a cost of £492 million).
International Financial Reporting Standards (IFRS)
As noted in the Summary Financial Statement, with the transition to IFRS the comparative figures for 2004 have been restated to IFRS. In the Report and Accounts for 2004 the impact of this change to IFRS on the 2004 results was explained. This explanation was based on IFRS expected, at that date, to apply for Group reporting in 2005. Subsequent IFRS changes have only had a minor impact on the restatement of the 2004 figures.
The effect on the profit for the year to 31 December 2004 was an increase of £1,733 million to £2,957 million. This was principally due to £1,262 million in respect of disposal of subsidiaries, £918 million of which was recognised outside of the income statement under UK GAAP and £344 million of which arose from applying IFRS to the transactions. In addition, goodwill is not amortised under IFRS, which added £491 million to the profit.
The effect on shareholders' funds as at 31 December 2004 was an increase of £699 million. This principally arose from the non-accrual of the final dividend (£617 million) and non-amortisation of goodwill (£473 million), partly offset by the recognition of post-retirement benefit liabilities (£237 million), the impact of IFRS on associates (£84 million) and higher deferred tax (£65 million).