British American Tobacco - 20-F annual report 2017

Quarterly dividends

The dividend in respect of 2017 is 195.2p, being an increase over 2016 of 15.2% (2016: 169.4p).

As announced in April 2017, the Group has moved to quarterly dividends with effect from 1 January 2018. In order to effect the transition to quarterly dividends, we committed to ensuring shareholders would receive an equivalent cash amount in 2018 under the quarterly dividend approach as they would have done under the previous methodology.

As part of this process, a second interim dividend of 43.6p (equivalent to 25% of the cash dividend paid in 2017) was declared in December 2017 and paid in February 2018. The Board has declared an interim dividend of 195.2p per ordinary share, payable in four equal dividend payments of 48.8p per ordinary share, to shareholders registered on the UK main register or the South Africa branch register and to ADS holders, each on the applicable record dates. The dividends receivable by ADS holders in US dollars will be calculated based on the exchange rate on the applicable payment dates.

Further information on dividends can be found on page 37 of the Financial Review and page 241 in the Shareholder information section.

Board changes

We were very pleased to welcome Lionel Nowell, III, Holly Keller Koeppel and Luc Jobin who joined our Board as Non-Executive Directors from Reynolds American and I look forward to the insights that they will provide to the Board.

I would like to thank Ann Godbehere and Dr Pedro Malan, who will be retiring from the Board at the conclusion of the forthcoming AGM on 25 April 2018. Ms Godbehere has served as a Non-Executive Director since October 2011 and Dr Malan has served as a Non-Executive Director since February 2015.

Our mission

Delivering our commitments

to society, while championing

informed consumer choice.

We have long known that, as a major international business, we have a responsibility to address societal issues with our tobacco products, and that, as our business continues to grow, so does our influence and the responsibility that comes with it.

We are also clear that we have a duty to our shareholders to ensure we continue to deliver today and invest for a sustainable future and to our consumers to provide, in addition to our combustible products, a range of potentially reduced-risk products such as NGPs and oral tobacco products.

Our transforming tobacco ambition, with its core objective of providing consumers with more choice, more innovation and less risk will allow us to: satisfy these consumers; address societal concerns at large through the growth of multiple categories of potentially reduced-risk tobacco and nicotine products; and provide a sustainable, profitable future for our shareholders.

From 2018, the Group will introduce a new metric called Revenue Growth of our Strategic Portfolio, replacing the Global Drive Brand (GDB) & Key Strategic Brand (KSB) volume growth metric. To provide the comparator against which 2018 will be measured, Revenue of our Strategic Portfolio in 2017 would have been £16,711 million assuming we had consolidated RAI for a full 12 months and after recognising the impact of implementing the new accounting requirements of IFRS 15.

Strong results across our portfolio of products

Notwithstanding the good progress we are making with our potentially reduced-risk products, combustible cigarette products remain at the core of our business – delivering growth today and providing the funds required for investing in the future. I am therefore pleased that 2017 saw the Group yet again deliver another good performance.

The Group’s cigarette market share in its Key Markets continued to grow strongly (up 40 bps). This was powered by another excellent performance by our GDBs, which grew 110 bps (ex US) and now account for more than 50% of Group cigarette and THP volume outside the US. Over the year, market share in the US also grew strongly and was up 20 bps, with the RAI Strategic Brands growing 40 bps.

Total Group cigarette and THP volume grew 3.2% to 686 billion, or on an organic basis fell 2.6%, outperforming the industry, which was estimated to have declined by around 3.5%.

In 2017, we also made excellent progress with our NGP business. Our flagship THP, glo, first launched in Japan in December 2016, reached 3.6% market share by the end of 2017 – having been rolled out nationally from October 2017. Since then, 50% of the overall category growth in Japan has been from glo – demonstrating its strong consumer appeal in a very short period. Good initial progress is also being made in our other launch markets of South Korea, Russia, Canada, Romania and Switzerland.

In the vapour category, Vype is now present in nine markets and we remain the market leader in the UK, with Vype and Ten Motives combined delivering around 40% share of measured retail in December 2017. We also lead the vapour category in Poland. In the US, the Vuse range of products continues to have a significant presence in the market. We see the rapidly developing vapour category, as a whole, contributing significantly to our long-term growth ambitions in NGPs.

The Group’s financial performance was positively impacted by the accounting for the acquisition of RAI and the subsequent US tax reforms. These drove diluted earnings per share up by over 600% to 1,830.0p.

In Americas, adjusted profit from operations was up as growth in Canada, Chile and Mexico more than offset the continued economic challenges in Brazil. Transactional foreign exchange headwinds and difficult trading in Russia, GCC and South Africa led to adjusted profit from operations in EEMEA being marginally lower than prior year. In Western Europe, adjusted profit from operations was up driven by Romania and Germany.

Operating margin increasing,

with net finance costs and tax

impacted by the RAI transaction

Our operating margin increased by 270 bps, driven by the performance of the organic business and by RAI, which had a positive mix effect on margin, and partly due to the US$70 million synergies achieved by the year end. Organic adjusted operating margin increased by 40 bps.

Net finance costs grew as the Group incurred an increase in borrowings to support the acquisition of RAI. Our banking facilities require a gross interest cover of at least 4.5 times. In 2017 this was 7.8 times (2016: 12.2 times).

Due to the change in reporting of RAI as a wholly owned subsidiary following the acquisition, the Group recognised a deemed gain of £23,288 million on the deemed disposal of RAI as an associate. Our other material associate, ITC, continued to perform well.

Due to the impact of the deferred tax credit (£9.6 billion) arising from the US tax reforms, our tax charge was a net credit of £8,113 million, being a tax rate of 27.4% (credit) compared to 22.5% (charge) in 2016. This is also affected the inclusion of associates post-tax income, in ourpre-tax profits. On an underlying basis, excluding such impacts and the affect of adjusting items, the tax rate was a charge of 29.7%, a marginal decrease on 2016 (29.8%).

US cigarette brands

In the period since acquisition, RAI Companies’ cigarette volume in the US was 36 billion, outperforming the industry with total cigarette market share at 34.7%, up 20 bps on 2016.

Newport and Natural American Spirit continued to grow market share driven by the investment into the trade and, together, they are the fastest growing premium brands on the market. Camel market share increased due to the performance of the menthol range. Pall Mall market share was lower due to price competition in the value for money category.

Local and international

cigarette brands

We have many other international and local cigarette brands including Vogue, Viceroy, Kool, Peter Stuyvesant, Craven A, Benson & Hedges, John Player Gold Leaf, State Express 555 and Shuang Xi.

Although experiencing a slow overall decline, our local and international brands continue to play an important role in delivering the Group’s Strategy in several Key Markets, including Brazil, South Africa, Vietnam, Pakistan, Bangladesh and Japan.

Other international brands declined by 13.4%, as growth in State Express 555 and B&H was more than offset by lower volume from Craven A, Viceroy, Peter Stuyvesant, John Player Gold Leaf, and Vogue.

Combustible product

Innovations¹

In addition to innovations in our NGP portfolio, innovations in our combustible tobacco portfolio remain an important part of our strategy to provide consumers with a range of exciting and differentiated products from which to choose.

Innovations volume grew by 11.6%, driven by the continued growth of tube filters and capsules which now account for 37% of our cigarette volume.

Change to performance measure

Revenue Growth from the Strategic Portfolio – effective 2018

The Group continuously assesses the performance metrics to ensure they remain relevant to reflect the Group’s short- and long-term delivery in line with the strategic vision. To that end, from 2018, the Group will introduce a new measure called Revenue Growth from the Strategic Portfolio, as part of the short-term incentive scheme. This will have a 30% weighting, with the Strategic Portfolio reflecting the focus of the Group’s investment activity, and defined as:

The new metric will replace the Global Drive Brand (GDB) & Key Strategic Brand (KSB) volume growth metric. The volume share metric of key markets is retained with a weighting reduced from 20% to 10%.

In 2017, while not part of the Group’s KPIs, to provide the comparator against which 2018 will be measured, Revenue from the Strategic Portfolio was £16,711 million assuming we had owned RAI for the full 12 months and after the implementation of the new accounting requirements of IFRS 15.

Continued optimisation of manufacturing locations and leaf growing

In 2017, we continued to optimise our manufacturing footprint and at the end of the year had 45 cigarette factories in 42 countries. In addition, the acquisition of Reynolds American added a further six manufacturing facilities to the Group.

The Malaysia factory was closed this year and the German factory was refocused on OTP, Dry Ice Expanded Tobacco (DIET) and Casing/ Flavours Manufacture – with the ending of cigarette manufacture planned for early 2018. This factory reduction is balanced against continued strategic acquisitions to support the Growth Agenda.

Factory expansions in Romania and South Korea to accommodate new opportunities in NGPs, specifically consumables production for glo, show how our sourcing is responsive to innovative growth demands while remaining cost effective. This complements substantial investment in device capacity, which is also taking place in response to increased consumer demand for glo.

We are continually looking to improve the efficiency of our entire supply chain with the opportunities to improve our manufacturing operations being a focus in 2017, continuing into 2018. We are realising the benefits of our Integrated Work Systems, a programme that is designed to maximise equipment efficiency while ensuring we maintain high standards of product quality.

The improved equipment efficiency is delivering real benefits through improved productivity and lower maintenance costs together with reduced waste. An additional positive by-product is the release of capital expenditure which can be used to invest in further innovation.

While the Group does not own tobacco farms or directly employ farmers, it sources over 400,000 tons of tobacco leaf each year directly from over 90,000 contracted farmers and through third-party suppliers mainly in developing countries and emerging markets in Africa, Asia and Latin America. The Group also purchases tobacco leaf from India where the tobacco is bought over an auction floor. The price of tobacco in US dollars varies from year-to-year driven by domestic inflationary pressures, supply, demand and quality. The Group believes there is an adequate supply of tobacco leaf in the world markets to satisfy its current and anticipated production requirements.

Attracting the best talent

When we do recruit externally, we actively seek those who will provide additional knowledge and skills that will strengthen our teams and ultimately make us a stronger business. In 2017, we continued to enhance our internal capabilities to engage and recruit those people who will help us win in growth markets and growth categories including Next Generation Products.

We continued the digital growth of our employer brand – ‘Bring your Difference’ – across core social media channels. We have more than doubled our followership on Facebook and increased followership by 20% on LinkedIn. We are leading the industry in social media engagement and have moved ahead of several top FMCG companies.

As competition for talented employees intensifies, people increasingly want to work for businesses with a good corporate reputation, so we are proud to have been ranked among the top employers around the world and have been named as a Top Employer for Europe, Africa and Asia-Pacific by the Top Employer Institute, an independent global certification company. We also received similar accolades in many of the countries in which we operate.

Growth through diversity

Diversity matters to the Group because it makes good commercial sense – having a diverse workforce means we are better able to understand and meet the varied preferences of our global consumers. Our efforts to drive diversity are built on three pillars of driving ownership and accountability, building diverse talent pools and creating enablers; all of which are underpinned by an inclusive culture.

The vast majority of all Group accidents are in Trade Marketing & Distribution (TM&D), where we have over 29,800 vehicles and motorcycles out on the road every day. Many of these are in challenging parts of the world with high levels of road traffic accidents and armed robberies.

Our driver safety and security programme continues to focus on addressing these risks, such as through the use ofin-vehicle ‘telematics’ monitoring systems to analyse driver behaviour data, insights from which are used to tailor our training programmes to improve driving skills and hazard perception. Since 2014, all our vehicles are required to meet strict safety specifications, and we also continually assess threat levels to enhance security protocols and escorts in high-risk locations.

In 2017, accidents across the Group increased significantly, from 182 in 2016**, up to 217. Sadly, this included an increase in fatalities, with the death of a contracting electrician in our factory in Bangladesh from contact with electricity; two TM&D contractors who died in road traffic accidents in Brazil; and one TM&D employee and eight TM&D security contractors who died in violent attacks in Brazil and South Africa. Eleven members of the public also lost their lives in road traffic accidents involving BAT vehicles in eight countries.

We deeply regret this loss of life and the suffering caused to friends, family and colleagues. We liaise closely with the relevant authorities and conduct our own detailed investigations to determine the root cause of each accident, identify any lessons that can be learned and implement action plans, the outcomes of which are reviewed at Board-level.

Overall, our driver and vehicle safety programmes have led to a decline in road traffic accidents in 2017 involving cars or vans, but this was offset by a rise in accidents involving motorcycles, which we have increased the use of in markets where the high density of traffic means they are a more practical option. To address the increased risks, we have put in place motorcycle training programmes in all markets, where motorcycles have been recently introduced, to provide practical techniques for different road conditions and types of traffic, safe speeds and distances, and how to spot a potential problem and take action to deal with it safely.

Equal opportunities for all

We are committed to providing equal opportunities to all employees. We do not discriminate when making decisions on hiring, promotion or retirement on the grounds of race, colour, gender, age, social class, religion, smoking habits, sexual orientation, politics or disability, subject to the inherent requirements of the role to be performed. We are committed to providing training and development for employees with disabilities.

suppliers (covering nearly 80% of our total tobacco leaf purchases). We are now using the results to inform our approach to selecting and developing new partnerships and community-based projects that will have a demonstrably positive impact for farmers and their communities.

Human rights in tobacco growing

Agricultural supply chains are particularly susceptible to the risks of child labour and, in 2000, as part of our long running commitment to end the practice within tobacco farming, we became a founding board member of the Eliminating Child Labour in Tobacco Growing (ECLT) Foundation. We remain active members today, alongside other major tobacco companies and leaf suppliers. ECLT helps to strengthen communities and bring together key stakeholders to develop and implement local and national approaches to tackle child labour.

We provide training and communications to farmers and rural community members to raise awareness of human rights issues, which reached over 67,000 beneficiaries in 2017. We also run on-the-ground projects in farming communities to address root causes, such as rural poverty, in collaboration with local partners.

In 2017, we developed a new operational standard on child labour prevention, with inputs from the ECLT and the International Labour Organization. This complements our long-standing Child Labour Policy and includes detailed standards, guidance and processes for our leaf operations to ensure it is effectively applied in a robust and globally consistent way.

Corporate behaviour

Our actions and behaviour impact all areas of our business – which is why corporate behaviour is such an important focus for our long-term sustainability strategy.

Our commitment to good corporate behaviour is underpinned by our Group Standards of Business Conduct (SoBC), or localised equivalent, which require all our staff worldwide to act with a high degree of business integrity, comply with applicable laws and regulations, and ensure that our standards are not compromised for the sake of results.

Delivery with integrity

In 2017, we introduced the Group’s updated compliance programme, ‘Delivery with Integrity’, focused on strengthening and driving a globally consistent approach to compliance across the Group. The programme is led by our Business Conduct & Compliance department, reporting directly to the Group Legal and External Affairs Director.

All these suppliers are now assessed according to independent human rights indices and those with the highest risk exposure are prioritised for enhanced due diligence.

In 2017, independenton-site audits were conducted on 65 direct suppliers in 29 countries, representing 20% of our total direct procurement spend. For our indirect suppliers, 102 suppliers in 16 countries were identified as high risk and required to undergo a self-assessment in 2017.

With the majority of our employees working in business areas where we have robust oversight and control, human rights risks in our own operations are substantially avoided. The risks that do exist are also mitigated as a result of the suite of robust policies, practices, compliance and governance procedures that we have in place across all Group companies.

However, we recognise that we need to continually work to ensure these are effectively applied and that we carefully monitor the situation in high-risk countries. So, in 2017, we further strengthened our approach with enhanced monitoring for our operations in countries identified by independent indices as high-risk.

		Further details of our approach to human rights and our Modern Slavery Act statement can be found at www.bat.com/humanrights

Marketing responsibly

We are committed to ensuring all our product marketing complies with local legislation and we have voluntary Marketing Principles in place for our different product categories to govern our approach to responsible marketing to adult consumers only.

In light of our shift to being a multi-category business, we are now developing, as part of NGP integration, a new set of consolidated Marketing Principles to cover all our product categories, including combustible cigarettes, smokeless oral tobacco and NGPs.

In 2017, we revised and strengthened our long-standing approach to youth smoking prevention with the launch of our new Youth Access Prevention (YAP) guidelines. This now covers all our different product categories – from conventional cigarettes to NGPs. We have also broadened the scope to include markets where our products are distributed through third parties, and strengthened the governance process for ensuring compliance.

for many years and is based on international standards, including ISO 14001.

Each of our Group companies has an EHS Steering Committee, with overall environmental responsibility held by the applicable General Manager or site manager. EHS is also a standing agenda item for management meetings and governance committees at area, regional and global levels. Our governance structures raise awareness of environmental risks across our business and our aim is to create a consistent approach across our Group to manage them.

The primary environmental focus areas for our business include energy use and carbon dioxide (CO₂) emissions, water use and availability, and waste and recycling. In our supply chain, the primary focus areas relate to the environmental impacts of tobacco farming.

Our approach to reducing the environmental impacts of our operations is long established and we have an internal reporting system in place for monitoring Group-wide environmental performance. Please refer to pages 27 to 29 for details of our approach to environmental management and progress against key performance indicators.

Community and social initiatives

As an international business, we play an important role in countries around the world and have built close ties with local communities. We encourage our employees

Our key performance indicators in this area focus on the number, and results, of reviews and audits conducted as part of our due diligence processes for our suppliers and business operations. In 2017:

Anti-bribery and corruption

Corrupt practices are illegal, cause distortion in markets and harm economic, social and political development, particularly in developing countries.

Our SoBC makes it clear that it is wholly unacceptable for Group companies, our employees or our business partners to be involved or implicated, in any way, in corrupt practices. Our SoBC is fully aligned with the provisions of the UK Bribery Act and is designed to meet the standards of the OECD Convention on Combating Bribery of Foreign Public Officials in International Business Transactions.

Our policies are continually kept under review and, on the acquisition of RAI in 2017, we updated our SoBC to reflect the requirements of the US Foreign and Corrupt Practices Act, and other relevant US law and regulation. In 2017, we also updated our SoBC to take account of the requirements of the UK Criminal Finances Act.

We also developed a new e-learning course on anti-bribery and corruption in 2017, targeted specifically at employees who conduct external engagement with key stakeholders, governments and regulators. This will be completed by over 3,000 employees in 2018. Alongside this, a new mobile app will be launched in 2018 to provide employees with ‘on-the-go’ guidance on how to act in specific situations.

  Revenue

  (£m)

In 2017, revenue was 37.6% higher at £20,292 million. This was driven by the inclusion of RAI since the acquisition date, pricing, the growth of the NGP portfolio and the translational foreign exchange tailwind on the reported results, partially offset by negative geographic and portfolio mix of 1%. Revenue also grew due to the sale of products bought-in on short-term contract manufacturing arrangements inclusive of excise. After adjusting for the revenue from acquisitions, including RAI, the short-term uplift to revenue due to the treatment of excise on bought-in goods and the effect of exchange on the reported result, on an organic, adjusted constant currency basis, revenue was up by 2.9%.

Depreciation, amortisation and impairment costs increased by £295 million to £902 million in 2017 and by £179 million in 2016. This was due to the amortisation and impairment charges of £393 million (2016: £166 million, 2015: £72 million) largely related to the trademarks and similar intangibles capitalised following the acquisitions (including RAI, Ten Motives, CHIC Group, TDR, Bentoel, Tekel and Skandinavisk Tobakskompagni A/S (ST)). The increase in 2017 was also driven by higher depreciation charges due to the consolidation of RAI, with depreciation higher in 2016 due to the investment in the Group’s manufacturing infrastructure.

Other operating expenses increased by £1,688 million to £5,346 million in 2017 (2016 up by £386 million) due to the impact of higher overhead costs, foreign exchange in 2017 and 2016 and the acquisition of RAI in 2017.

Expenditure on research and development was approximately £191 million in 2017 (2016: £144 million, 2015: £148 million) with a focus on products that could potentially reduce the risk associated with smoking conventional cigarettes.

Included in profit from operations are a number of adjusting items related to restructuring and integration costs and one-off charges, provisions and income. Adjusted items are defined in note 1 in the Notes on the Accounts.

Total adjusting items were £1,517 million in 2017 (2016: £825 million, 2015: £435 million), including the charges related to trademark amortisation and impairment (discussed above), and £600 million (2016: £603 million,

Adjusted operating margin

(%)

Net finance costs

In 2017, net finance costs increased by £457 million to £1,094 million, largely due to the additional finance, including pre-financing charges of £153 million, required to acquire RAI and the finance costs associated with the RAI debt now consolidated within the Group. In 2016, net finance costs were £637 million compared to net finance income of £62 million in 2015. This was principally due to the impact of adjusting items in net finance costs, including one-off costs of £101 million related to the early settlement of a bond (described on page 39), while 2015 included a deemed gain (£601 million) related to the investment in that year in RAI associated with RAI’s acquisition of Lorillard. In 2017 and 2016 the Group recognised interest of £25 million and £25 million respectively in related to FII GLO. 2016 also benefited from an £18 million hedge ineffectiveness gain, which partially reversed in 2017 (£9 million charge), following the market volatility due to Brexit, which is not in the normal course of business.

The publication of this strategy is considered to constitute compliance with the duty under paragraph 16(c) Schedule 19 Part 2 of the UK Finance Act 2016.

The taxation on ordinary activities for 2017 was a credit of £8.1 billion against a charge of £1.4 billion in 2016 and £1.3 billion in 2015, with tax paid (due to the timing of corporation tax instalment payments which straddle different financial years) of £1.7 billion (2016: £1.2 billion, 2015: £1.3 billion).

Our tax footprint extends beyond corporation tax, including significant payment of employment taxes and other indirect taxes including customs and import duties. The Group also collects taxes on behalf of governments (including tobacco excise, employee taxes, VAT and other sales taxes). The total tax contribution in 2017 of £37.4 billion (2016: £33.2 billion, 2015: £29.6 billion) therefore consists of both taxes borne and taxes collected as shown in the table provided.

In addition to the major taxes, there are a host of other taxes the Group bears and collects such as transport taxes, energy and environmental taxes, and banking and insurance taxes.

As part of the acquisition of RAI, the Group acquired the assets and liabilities of the RAI Companies. These are required to be fair valued at the date of acquisition, as disclosed in note 24 on the accounts, on page 165. The value of the net assets acquired created a deferred tax liability, valued within the purchase price allocation process at the prevailing rate of corporation tax at the date of acquisition, being 25 July 2017. Subsequently, on 22 December 2017, the US federal corporate tax rate was changed to 21%, effective from 1 January 2018. This revised rate has been used to value the deferred tax liability at the balance sheet date, reducing the liability and providing a credit to the income statement in 2017 of £9.6 billion. Due to the scale of the impact, this credit has been treated as an adjusting item.