DrKW Equity research Tobacco | United Kingdom

Reviewing the margin opportunity 14 September 2005

Buy
Unchanged

BAT
A lot of flex
Despite the well-recognised cost-saving story, we estimate the current BAT share price discounts no improvement from the current 27% margin. Indicative of BATs opportunity is that its closest rival, PMI, delivers 40% margins on the same unit revenue. We increase our DCF-based target for BAT from 1,250p to 1,350p on the basis that over time it should manage to get halfway to the PMI benchmark.
Two margin drivers, efficiency and mix: We have BATs EBITA margin plateauing at
1,250p

Current 1,170p Target 1,350p

Previous
Current price equivalent

17.38
ADR

US$42.69
Market cap

24,646m 36,613m
52-week high/low

1,170p / 797p
Price performance 1M 3M 12M

Price (p) Absolute Rel market (%) Rel sector (%)

1,103 1,092 6.0 6.5 1.4 7.1 -0.2 3.3

809 44.5 19.9 5.3

Source: DrKW Equity research Reuters Bloomberg

31% but the risk is on the upside. While its rival, PMI, delivers 40% margins, BAT is on 27%. BAT management has previously said that its cost saving process should take its efficiency level to that of PMI. The two companies already have the same unit revenue. We estimate cost savings could add 300-500bp to BAT margins. On top of efficiency gains, we see a top-line opportunity to raise margins. We estimate that BATs 2001-04 top-line growth was driven entirely by positive mix. Even assuming a much more diluted mix dynamic can still suggest a further possible 250bp margin gain from this avenue, we believe.
Dollar risk: BATs sector relative tracks the USD/GBP exchange rate. If dollar weakness

BATS.L

BATS LN Equity

were to return materially, this could temper the BAT investment case.
Valuation: We raise our DCF-based target from 1,250p to 1,350p on the basis of 3% top-

line growth, terminal EBITA margin of 33%, a WACC of 7.9% and terminal growth of -1%. The implied target 2006 P/E is 14.2x and the target 2006E FCF yield is 6.7%.

Price relative
1200 1100 1000 900 800 700 O ct Nov Dec Jan Feb Mar Apr M ay Jun Jul Aug Sep Bat relative to Dj Stoxx 600 Bat

Source: RIMES

Dil EPS excl Year to end Dec 2004 Sales m 10,768 9,268 9,529 9,760 EBITA m 2,589 2,525 2,669 2,838 except, gw p 76.5 84.7 95.2 103.6 DPS p 41.9 45.3 48.9 55.4 EV/ EBITA x 8.4 10.1 9.1 8.5 P/E x 10.8 13.8 12.3 11.3 Yield % 3.6 3.9 4.2 4.7 FCF Yield % 5.0 7.5 8.0 9.0

Research Analysts Charles Manso de Zuniga +44 (0)20 7475 2336 chas.manso@drkw.com

2005E 2006E 2007E

Source: Company data, DrKW Equity research estimates

Online research: www.drkwresearch.com Bloomberg: DRKW<GO>

Please refer to the Disclosure Appendix at the end of this report for all relevant disclosures and our disclaimer. In respect of any compendium report covering six or more companies, all relevant disclosures are available on our website www.drkwresearch.com/disclosures or by contacting the DrKW Research Department at the address below.
Dresdner Kleinwort Wasserstein Securities Limited, Authorised and regulated by the Financial Services Authority and a Member Firm of the London Stock Exchange PO Box 560, 20 Fenchurch Street, London EC3P 3DB. Telephone: +44 20 7623 8000 Telex: 916486 Registered in England No. 1767419 Registered Office: 20 Fenchurch Street, London EC3P 3DB. A Member of the Dresdner Bank Group.

BAT

14 September 2005

Contents
Contents......................................................................................................................2 Investment summary .................................................................................................3 Valuation .....................................................................................................................4 The potential five-year return .......................................................................................5 Dollar risk .....................................................................................................................6 Cost savings: The flex in the model ........................................................................7 Cost savings revisited: Kicking the bucket(s) ..............................................................9 Top-line growth: All in the mix ...............................................................................13 Top 24 markets.........................................................................................................17 Financials..................................................................................................................19 Disclosure appendix................................................................................................21 Disclosures under US regulations..............................................................................21 Additional disclosures under other non-US regulations.............................................21 Disclaimer ..................................................................................................................22 Summary financials and key valuations................................................................24

BAT

14 September 2005

Investment summary
Cost-savings in consensus thinking, not in consensus modelling

Despite the strong run in its share price so far this year, in our view BAT continues to be significantly undervalued by the stock market. While the cost-saving potential is well recognised, we believe it is not adequately reflected in consensus estimates. We believe there is vast upside to BATs current EBITA margin of 27% (cf PMIs H1 2005 margin of 40%). Currently, comments from BATs management arguably suggest a total savings target of 640m by 2007. If BAT can emulate PMIs current unit cost level then 1bn is not out of the question, even if it takes a few extra years to get there. After some reinvestment, the implied net incremental savings could add 500bp to the group margin. Furthermore, top-line growth of 2.4% could contribute another 250bp to the margin over ten years, we believe, assuming price/mix contributes at least 1% CAGR to sales (historically price/mix has contributed more). BAT has a positive top-line mix story through its renewed focus on rolling out its Global Drive Brands (GDBs) in which the group is currently under-represented versus its peers. BAT needs to gain scale economies in marketing, otherwise why be global? It is rolling out its four GDBs (Dunhill, Kent, Lucky Strike and Pall Mall), across all of Europe (among other territories) over the next 18-24 months. Benefits are already rolling in. In Q2 2005 its GDB growth accelerated from 2% to 9% with Kent and Pall Mall up 13% and 28% respectively. In our valuation section, our baseline DCF, where we assume a terminal EBITA margin of 31%, suggests fair value at 1,287p. We show a sensitivity analysis where the groups implied value is practically 1,350p on a 33% margin and reaches 1,418p on a 35% margin. A different analysis, based on 5-year cash returns to investors, reinforces the view that BAT should be worth between 1,300-1,400p.

Global drive brands are the mix opportunity, currently only 17-18% of BAT volume

Watch the dollar

On the risk side, we show just how close BATs share price trades with the USD/GBP exchange rate. We raise our DCF-based target price on BAT from 1,250p to 1,350p. We feel that in ten years time, BATs EBITA margin could comfortably exceed the 33% level that suggests a value today of 1,350p, but we temper the target slightly on currency grounds. The implied 2006 P/E on 95.3p earnings would be 14.2x, a level, for example, somewhat below the 15x that the European Beverage sector currently trades on. Yet we believe BAT can deliver earnings growth in line with that of the Beverages sector with the higher returns one might expect from Tobacco.

New target: 1350p

BAT

14 September 2005

Valuation
DCF assumptions: Topline +2.4% CAGR Terminal EBITA margin 31% WACC 7.9% Terminal growth -1%

Our primary valuation methodology for BAT is a discounted cash flow (DCF) analysis of the subsidiary businesses with the associate businesses included at their current market value. Our BAT projections assume 2.4% CAGR top-line growth and 4% CAGR EBITA growth over the explicit ten-year period, followed by our standard negative perpetuity growth rate of -1%. The explicit EBITA growth assumption is below corporate guidance of around 6% growth. We calculate our tobacco WACCs on a geographically-weighted basis. However, emerging market risk should be fairly diversified away across BATs widespread portfolio. We attempt to factor this risk diversification into our WACC by applying a relatively modest general country risk premium of 1.5 points over a mature risk-free rate of 5% and equity risk premium of 3.5%. Our WACC for BAT is 7.9%.

DCF on BAT subsidiary businesses

Year-End 31 Dec (m) Sales Growth (%) EBITA Margin (%) Growth (%) Tax on EBITA EBITA after tax (NOPAT) Depreciation Working capital Net Capex Capex/sales (%) Capex/depreciation (%) Free cash flow (FCF) FCF growth (%) Terminal Value FCF to be discounted WACC Terminal Growth Subsidiaries NPV 7.9% (1.0%) 28,367 1,899 2,054 2,145 2,134 2,200 2,250 2,322 2,391 2,459 2005E 9,268 (25.3) 2,525 27.2 (10.8) (795) 1,730 277 174 (280) 3.0 101 1,901 (1.9) 2006E 9,529 2.8 2,669 28.0 5.7 (841) 1,828 285 44 (258) 2.7 90 1,899 (0.1) 2007E 9,760 2.4 2,838 29.1 6.3 (894) 1,944 292 46 (229) 2.3 78 2,054 8.1 2008E 9,991 2.4 3,009 30.1 6.0 (948) 2,061 299 19 (234) 2.3 78 2,145 4.4 2009E 10,240 2.5 3,107 30.3 3.3 (979) 2,128 293 (21) (265) 2.6 91 2,134 (0.5) 2010E 10,504 2.6 3,208 30.5 3.3 (1,010) 2,197 297 (23) (272) 2.6 92 2,200 3.1 2011E 10,777 2.6 3,311 30.7 3.2 (1,043) 2,268 302 (24) (297) 2.8 98 2,250 2.3 2012E 11,016 2.2 3,409 30.9 3.0 (1,074) 2,335 307 (24) (296) 2.7 96 2,322 3.2 2013E 11,261 2.2 3,507 31.1 2.9 (1,105) 2,403 314 (3) (323) 2.9 103 2,391 3.0 2014E 11,513 2.2 3,607 31.3 2.8 (1,136) 2,471 321 (3) (330) 2.9 103 2,459 2.9 29,018 31,559 2,541 2.9 2,541 4.0 Terminal 05-14E CAGR (%) 2.4

Source: DrKW Equity research estimates

Base DCF value of 1,287p

To the estimated subsidiary value of 28.4bn we add BATs share of the current market value of Reynolds American (RAI) and ITC (BATs main Indian associate). The European associate, STK, (26%-owned by BAT) is not listed, so we simply put a 12x multiple on its estimated earnings contribution to the group. The biggest minorities are Souza Cruz in Brazil and BAT Malaysia. Minorities represent 6% of BATs earnings so we simply strip out from the valuation that percentage from the implied group enterprise value. After stripping out 2006E net debt of 4.96bn, we arrive at our estimated equity value of 26.5bn: 1,287p per share.
BAT valuation summary: Equity value 1,287p
Value (m) Subsidiaries Associates Group RAI India STK Implied EV, pre-minorities Minority adjustment Implied EV, post minorities Net debt Implied equity value Shares in issue (m)
Source: DrKW Equity research estimates

Per share () 13.77 1.37 0.92 0.25 16.3 1.03 15.28 2.41 12.87 2,061

Method DCF Actual Actual 12x 05 Percent of DCF 2006E 2006E

Discount (%)

28,367 2,824 1,896 520 33,606 2,129 31,477 4,963 26,514

0 0 0

Group Group Group

BAT

14 September 2005

As the DCF table shows, our model assumes a terminal EBITA margin of 31.3%, a 406bp build in nine years (45bp per year) from the 27.2% margin we are forecasting for 2005E. We suggest in the next section that prospective cost savings alone could account for nearly 500bp of margin-build to 32%. Additionally, annual compound top-line growth of 2.4% could contribute perhaps another 250bp to margin over the explicit period, assuming price/mix contributes at least 1% CAGR to sales. This margin contribution could be higher if the price/mix driver to revenue turns out to be higher. To put this into perspective, a potential 35% EBITA terminal margin for BAT by 2014E would still be significantly weaker than the 40.5% margin PMI recorded in H1 2005. Regionally, the only BAT divisions generating a margin below 32% this year should be Europe and Africa & Middle East, the two areas identified by management as containing the greatest scope for cost reduction.
Sensitivity analysis on terminal EBITA margin and WACC
Terminal EBITA margin Value Subsidiary NPV (m) Subsidiary NPV (m) Subsidiary NPV (m) Equity value per share () Equity value per share () Equity value per share () Implied 2006 P/E on 95.3p EPS Implied 2006 P/E on 95.3p EPS Implied 2006 P/E on 95.3p EPS
Source: DrKW Equity research estimates

WACC (%) 7.5 7.9 8.5 7.5 7.9 8.5 7.5 7.9 8.5

31.3% 29,879 28,367 26,459 13.55 12.87 12.00 14.2 13.5 12.6

33.0% 31,293 29,682 27,650 14.20 13.46 12.54 14.9 14.1 13.2

35.0% 32,982 31,253 29,073 14.96 14.18 13.19 15.7 14.9 13.8

37.0% 34,693 32,842 30,512 15.74 14.90 13.84 16.5 15.6 14.5

Sensitivity analysis suggests value range of 1,300-1,500p... ...top-end of that range if BAT achieves objective of 6% EBITA CAGR long-term... ...we settle for 1,350p partly to recognise some currency risk

On our estimated WACC of 7.9% for BAT, the sensitivity analysis outputs a value range for the group from nearly 13 per share to 15. The range we have circled in the sensitivity table on average suggests a value of 1420p. Some investors may baulk at the implied 2006E P/E of 14.9x although this would only take the rating to current trading multiples of the European beverage sector. We settle on a new DCF-based target price of 1,350p, (implied 2006 P/E of 14.2x) at the low-end of what we have circled, implicitly assuming BATs margin plateaus at 33%. Though we suspect BAT can justify an even higher price level, our target is partly set to recognise the groups currency risk as described below. BATs objective of delivering high-single-digit EPS growth on average over the long-term includes a 6% EBITA growth objective. Our model grows EBITA by 4% CAGR. If BAT were to achieve its 6% target, this would equate to the 37% margin column in the sensitivity table, ie almost 15 per share on a 7.9% WACC.

The potential five-year return

A five-year cash return analysis implies IRR of over 12%...

On our estimates, by 2010E BATs EPS could reach 122p. This is broadly in line with management guidance of high-single digit earnings growth over the long term. In our model it is front-end loaded, that is, we have double-digit growth in 2005 and 2006 driven by cost savings, but by 2009-10 we have earnings growth slowing down to 4-5% per annum. At present, we do not continue to include the share buyback in our model after next year, by which time BATs largest shareholder, R&R, should have attained the magic 30% holding level (the ceiling level in their shareholder agreement and possibly a trigger level for a full takeover bid). However, without a buyback keeping BATs balance sheet reasonably tight, its net debt/EBITDA multiple (one principal cover looked at by the credit agencies) may reduce from 1.8x down to just 0.2x. Assuming the issues surrounding the R&R stake can be sorted out (eg R&R sells into the buyback) then we believe that in the absence of major acquisitions, BAT could at least maintain its current net debt/EBITDA multiple without unduly ruffling the credit agencies feathers. A 5% annual buyback from 2007 onwards would seem to us to be the ticket as it would take

BAT

14 September 2005

BATs net debt/EBITDA to 1.9x by 2010E, close to this years level and within the range to maintain a BBB debt rating. Because of the low cost of debt, this would raise the estimated 2010E EPS to 136p, a 9.9% 2005-10E CAGR. Now, the implied annual return to an investor buying the stock today could be a very attractive 12.4% assuming BAT could trade on 12.5x earnings in 2010 (around todays 2006E sector average P/E of 12.6x) and taking into account accumulated dividends that could exceed 300p per share over the next five years.
...assuming a 7-9% IRR is acceptable, the share price could reach 1,300-1,370p

At what share price does BAT trade before its earnings and dividend stream cease to be attractive? Well, in our view in the current environment a 7-9% return should be viewed as quite reasonable (and is around most investors views of cost of capital). At a BAT share price of 1,250p, the implied return would be 9.9%, at 1,300p 9.1%, and at 1,370p investors could still receive a 7.9% return. So on this analysis BAT could justify a share price today of 1,300-1,370p.

Dollar risk
BAT sector relative versus USD/GBP
110 105 100 95 90 85 80 75 2001 2002 2003 2004 /$ exchange rate British American Tobacco relative to FTSE Europe Tobacco 2005
Engle decertification Reynolds American announcement Reynolds American announcement

Engle decertification

Source: RIMES

Close linkage between BAT performance and USD/GBP

BATs sector relative performance tends to track the USD/GBP exchange rate. The graph above illustrates a remarkably close correlation, we think, outside the period circled. In late 2003 and into early 2004, BAT broke away from the weakening dollar and outperformed its European peers. This corresponds to the period when the Florida Third District Court of Appeals decertified the infamous Engle case (21 May 2003) and when BAT announced the prospective merger between its US asset, Brown & Williamson, and RJR to form Reynolds American (27 October 2003 and subsequent debate surrounding deal closure and potential synergies). From the graph, one could arguably ascribe most of BATs outperformance this year simply to the firmer dollar. Clearly therefore, if dollar weakness were to return, this could temper the BAT investment case.

BAT

14 September 2005

Cost savings: The flex in the model

BATs oft-stated objective, especially since Jan du Plessis became chairman last summer, is to grow earnings on average by a high single-digit rate over the long-term. It seems logical to us that presently, when the benefits of its cost-saving programmes are beginning to dash up the J-curve, that BAT should deliver above-average growth. However logical our argument may be, some doubt was cast against it at BATs investor trip to Italy, earlier this year.
Headwind markets: not hitting the fan so much?

Paul Adams, BATs CEO, noted that in any truly global portfolio there will always be some markets that are struggling (!*it happens), dragging back earnings growth. In BATs case, the key headwind markets are: Canada, Malaysia and Japan, where we pencil in constant currency EBITA declines of 18-20% for BAT in each market this year. In total, these three markets accounted for an estimated 22.5% of H1 2005 subsidiary profit and 20% on a FY 2005 basis. The combined estimated profit decline this year amounts to about a 4% drag to group 2005 EBITA growth. The good news is that in Q2, at least, the force of the headwinds abated somewhat (see table) allowing group EBITA growth to reach +10%. The non-headwind markets are improving profit strongly through pricing (Europe, Africa and Latam) and not least cost savings. Throwing in financial leverage, the buyback, the Reynolds American enhancements and a more favourable FX environment, BAT seems well on track to exceed its earnings objective this year (and next) and deliver double-digit earnings growth.
Headwind markets less of a drag in Q2 2005 ...
Headwind markets (m) Canada Japan/Other Am-Pac Malaysia Sub-total Headwind mkts Rest of subsidiaries BAT subsidiaries H1 2004 169 76 85 330 794 1,124 H1 2005 150 56 67 273 938 1,211 % change (11) (26) (21) (17) 18 8

Headwind markets (m) Canada Japan/Other Am-Pac Malaysia Sub-total Headwind mkts Rest of subsidiaries BAT subsidiaries

Q2 2004 86 37 43 166 429 595

Q22005 86 32 33 151 501 652

% change 0 (14) (24) (9) 17 10

Headwind markets (m) Canada Japan/Other Am-Pac Malaysia Sub-total Headwind mkts Rest of subsidiaries BAT subsidiaries
Source: BAT; DrKW Equity research estimates

Q1 2004 83 39 42 164 365 529

Q1 2005 64 24 34 122 437 559 (23) (38) (18) (25) 20 6

BAT

14 September 2005

... leading to an (estimated) improving organic profit momentum, before cost savings
BAT Base EBITA FX (%) M&A (%) Restructuring (%) Organic (%) End EBITA Growth (%) 2003 2,681 0.8 0.0 3.4 (0.5) 2,781 3.7 22 0 91 (13) 100 m 2004 2,781 (5.4) 5.6 6.5 (5.0) 2,830 1.8 (151) 157 182 (139) 49 m H1 2005 1,124 1 0 4 3 1,211 7.7 8 0 40 39 87 m

Source: BAT; DrKW Equity research estimates

Cost savings buffer BAT from headwinds...

Paul Adams noted that going forward, the groups still not-totally quantified cost saving programmes should buffer the company from headwind markets and allow high-singledigit EPS growth. In some years, he said, the headwinds may be lighter, such that more can flow down to the bottom line. He stressed that cost savings would not stop in 2007 (the deadline for the current programmes) and he would not be surprised if there were further significant savings. However cost reduction is not everything: brands are important too. BAT says it has learnt from its Canadian experience. It cannot afford to have un-segmented (all premium) under-invested brands in any of its markets. Value brands without equity are vulnerable. Brand equity provides relative stability and support when price dynamics change. So BAT will continue to invest behind its brands. BAT has no issue with some peoples view of tobacco: flat to declining volumes offset by price/mix. But BAT believes that view is not the whole picture. It sees volume as an important part of the revenue growth equation and that organic volume growth should be viewed by the market as an important measure of the companys dynamic.
BAT: Cost savings the flex in the model
Investment Investment in in brand brands

...and fund brand reinvestment

!*it !*it happens happens

Buffers Cost savings Cost savings

Funds

In good year increases

Earnings Earnings growth growth

Source: BAT; DrKW Equity research estimates

Difficult to gauge return on marketing spend

So cost savings are there not only to buffer headwind markets and help deliver target earnings growth but also to fund reinvestment in brands. The difficulty for investors here is gauging a reasonable return on incremental marketing spend. The benchmark against which companies measure the success of their A&P spend is what they think would happen to volume, sales and profits without such A&P, and of course these may decline without support. So a large part of incremental marketing may simply be necessary to provide sustainability. For new brand launches we guess the hurdle rates could be around a five-year payback, i.e. eventually a 20% IRR, though BAT does not give guidance itself on this subject. One clear message from Italy was that BAT stands at the cusp of larger, more coordinated launches of its Global Drive Brands across wider regions: eg Pall Mall to be launched right across Western Europe this year, Dunhill is being rolled out across Europe, Kent will probably be pushed across Europe next year. BAT will accelerate its efforts to migrate its more minor brands to GDBs: all of which costs.
8

BAT

14 September 2005

A fair question therefore is whether BAT will ever deliver bottom line growth much above its high-single digit objective but rather redirect surplus funds into marketing instead, where returns are harder to predict. One thing is for sure. The more mature tobacco markets are at best a zero-sum game. Pricing is arguably getting tougher and the onus on taking market share is increasing. BAT is now working hard to get into good condition as previous cosy oligopolies become more competitive.

Cost savings revisited: Kicking the bucket(s)

Opening gambit: 640m of gross savings

Let us take another stab at gauging the flex in BATs machine: how high can those cost savings reach? BAT doesnt really help itself. It refuses to give clear guidance on the total savings its cost reduction programmes are expected to deliver. It confuses matters by having two programmes. BAT is willing to quantify the first bucket of savings, Overheads & Indirects: it is currently budgeted to save 320m by end 2007 (although the total level of Overheads & Indirect costs is not disclosed). The second bucket, Supply Chain costs, BAT does not externally quantify apart from indicating that savings here should be at least as large as those garnered from Overheads & Indirects. So as an opening gambit we simply double the 320m to arrive at a total gross savings target from subsidiaries of 640m. Some of these gross savings will be reinvested into the business. BAT believes it should retain almost all the Overheads & Indirect savings but reinvest about half of the Supply Chain savings. This implies about a 75% retention ratio on the estimated 640m of total savings, i.e. 480m dropping down to the bottom line. The larger the Supply Chain savings (and this is where we see scope for much higher numbers) presumably the lower the retention ratio.
BAT savings to-date and to 2007: 300m of net savings to come?
BAT (m) Gross savings, annual - of which: overheads & indirects - of which supply chain savings Gross savings, cumulative Reinvested, cumulative Retention ratio (%) EBITA benefit, cumulative
Source: BAT, DrKW Equity research estimates

2003 91 64 27

2004 182 89 93 273 100 63 173

2005E

2006E

2007E

2004-07E

640 160 75 480

367 60 84 307

Is there much upside to the potential gross savings of 640m? Paul Raynor, BAT CFO, presented the following chart comparing operating costs per 1000 cigarettes in the recent Italian investor trip, suggesting this is the key efficiency metric focused on by BAT management. According to the chart, BAT has unit costs of ca 9.4 per 1000, surprisingly close to Imperial Tobacco, less surprisingly close to JTI, with Philip Morris International at around 7.8 per 1000 and Gallaher enjoying low cost manufacturer status at around 5.0 per 1000.

BAT BAT: 1bn of savings?

(/1000 units) 10.0 9.0 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 BAT
Source: BAT

14 September 2005

9.4

9.2

9.0 7.8

5.0

Imperial

JTI

PMI

Gallaher

BAT views PMIs unit cost as its objective

In the past BATs management has commented that it sees no reason why at the end of its cost saving process that it should not be as efficient as PMI. A reduction of 1.5/1000 on subsidiary volumes of some 680bn sticks implies savings of about 1bn of potential gross savings. (Indeed, one could argue it implies 1bn of net savings!). Of course all players, including PMI, are working hard to tighten their cost bases so the benchmark should improve over time as well. Taking 1bn as a guideline for what BAT might achieve overall, and assuming that Supply Chain savings are the major source of the uplift from our current 640m estimate, then we estimate perhaps 660m might drop to profits of which perhaps 437m would be incremental to 2005E results (see table). The implied 5 point margin build would take BATs operating margin to 32.0%, compared to PMIs margin of ca 40%. BATs margin should also benefit from operational leverage to top-line growth (see next section).
Sensitivity analysis of potential gross savings
Total gross savings (m) As percent of sales (%) As percent of EBITA (%) As percent of costs (%) Overheads/Indirects Supply Chain Reinvestment Retention ratio (%) Gross savings booked by 2005E Net savings booked by 2005E, say Incremental gross savings Incremental net savings As percent of sales (%) As percent of EBITA (%) As percent of costs (%) Implied impact of savings Sales Implied costs Implied EBITA Implied margin (%)
Source: DrKW Equity research estimates

500 5.4 19.8 7.4 320 180 90 82 373 223 127 187 2.0 7.4 2.8 187 9,253 6,734 2,520 27.2 9,253 6,547 2,707 29.3

640 6.9 25.4 9.5 320 320 160 75 373 223 267 257 2.8 10.2 3.8 257 9,253 6,477 2,777 30.0

800 8.6 31.7 11.9 320 480 240 70 373 223 427 337 3.6 13.4 5.0 337 9,253 6,397 2,857 30.9

1000 10.8 39.7 14.9 320 680 340 66 373 223 627 437 4.7 17.3 6.5 437 9,253 6,297 2,957 32.0

BATs subsidiaries operate some 66 cigarette factories across the globe. Regionally BAT sees the greatest scope for factory footprint rationalisation in Europe and Africa-Middle East where the unit volume per plant ranks among the lowest in the group (see table).

10

BAT Average factory throughput is low versus peers

Subsidiary volume BAT Europe Asia-Pacific Latin America Africa & ME America-Pacific BAT Group (bn units) 244 131 150 113 44 681 Subsidiary plants 22 15 9 19 1 66

14 September 2005

Volume/plant (bn units) 11 9 17 6 44 10

European volume Gallaher Altadis Imperial 157 103 130

European plants 8 6 9

Volume/plant 20 17 14

Source: Company data, DrKW Equity research estimates

BATs European production footprint could more than halve...

...helped by increasing capacity from low-cost areas like Russia...

We believe the groups level of overcapacity is very front-of-mind at BAT and that the European plant footprint could be substantially below the current level of 22. After the recent announcement of two UK closures saving ca 40m, we expect further newsflow of this nature. For example BAT has already signalled it is looking to close at least two Italian plants after the loss of the PMI contract manufacturing agreement last year. Although we do not explicitly model in this way, we think it reasonable that BAT could halve its European factory numbers over time, taking its volume per plant to some 2022bn, in line with the current Gallaher level. Given the differences in size of the two companies, economies of scale should argue for even greater potential at BAT-Europe. We believe it is possible for BAT to be targeting a more aggressive reduction to 5-6 plants across wider Europe. We understand some US$200m is to be spent on the two existing Russian factories to increase exports for the rest of the group. West European factory footprint may reduce to as low as three plants and 1-2 plants in Eastern Europe. It makes sense to us that at least one of the Eastern European plants is in Russia. In Africa the story is similar. Average factory output is the lowest in the group at six billion sticks. Despite closing nine factories in the region since 2000 and having downsized 11, BAT still has 19 plants in AME. BAT continues to transfer volume from high cost to low cost countries in the region, in 2004 to the tune of 12bn sticks. South Africa is a major beneficiary, with the groups plant capacity there growing rapidly as volume is shifted inwards. BATs South African plant now exports to 29 markets and is currently in the middle of the regions supply chain reorganisation, which should be executed by Q1 2006. BATSA capacity should grow from 30bn to 60bn stick equivalents (cf domestic market of 24bn). We believe it should be possible for BAT to halve the number of its plants in Africa & Middle East.

...and South Africa

11

BAT

14 September 2005

BAT has nearly 40% overcapacity in the EU

Cigarette volume (bns p.a.) 250
EU Capacity The Gap The Gap

200 44 54 150 32 28 37 44 60

15

100

50
Demand Demand

0
Source: BAT

1998

1999

2000

2001

2002

2003

2004

2005

The average saving per plant from BATs two closure announcements (UK & Canada in 2003 and the two proposed UK closures announced this year) is running at around 26m. Even if this falls to the industry average saving of 10m, we still believe BAT could save some 250m from this route alone. But production costs are perhaps one-third of a tobacco companys cost of sales. BAT believes there are considerable opportunities to increase efficiency in logistics and reduce complexity. We are entering the phase where BAT is getting ruthless with nonconsumer relevant complexity. It is also introducing new systems to track leaf inventories globally, increasing visibility and transparency, which should enable the group to deliver substantially reduced leaf costs. In the valuation section we go through the value implications of various net savings scenarios. Essentially we feel that every additional 100m of post-tax savings adds around 60p to the share value.

12

BAT

14 September 2005

Top-line growth: All in the mix

Historical top-line performance of current subsidiaries driven by mix

It is no secret that BATs historical top-line momentum has been somewhat lacklustre. Reported group volumes and revenues have been at best flat if not declining (exacquisitions) over the 2001-04 period. The groups reporting structure has now changed, however, and so to gauge how its current subsidiary businesses have fared we have analyzed below its underlying top-line momentum under the new operational reporting structure, excluding associates and the US business. Organic subsidiary volumes (exUS) declined some -1.4% CAGR between 2001 and 2004. Its estimated organic sales momentum was similar, slipping -1.3% CAGR. It is clear that BAT has suffered from its significant exposure to the US dollar and dollar-related currencies, we estimate by -3.5%. On a constant currency basis we estimate BATs organic subsidiary sales have risen +2.1% CAGR over 2001-04 and therefore that the price/mix dynamic has actually been pretty good at +3.6% CAGR. In comparison, over the same period, Philip Morris International (PMI) has grown dollar sales by +8.6% largely thanks to a +4.9% FX benefit and an estimated M&A contribution of ca 1.1%, leaving constant currency organic sales growth of 2.6%. In its annual reports, PMIs parent, Altria, discusses the isolated price element and we estimate this to have increased +2.8% CAGR for PMI with a broadly flat contribution from volume/mix. Although it is not always easy to separate acquired volumes from the PMI data, we believe organic volume progression might be ca 1.7% which implies a rather uninspiring price/mix of 0.9%. PMIs portfolio is weighted towards Europe where downtrading is a major issue, so despite decent price inflation, PMI appears to be suffering significantly from negative mix.
Historical top-line growth analysis of BATs current subsidiary operations
BAT Group volume (bn units) Associate volume (bn units) US B&W volume (bn units) M&A contribution (bn units) Organic subsidiary volume (bn units) Revenue (m) Reported group revenue Revenue share of associates & JVs Subsidiary revenue M&A contribution B&W contribution Subsidiary organic revenue ex-US Cumulative FX impact (est.) Subsidiary organic revenue ex-US (constant FX) 8,662 12,039 668 11,371 0 2,709 8,662 12,410 1,646 10,764 1,451 960 8,324 (907) 9,231 2.1 (29.2) (1.3) 1.0 35.1 (1.8) 2001 807 110 44 0 653 2004 853 167 34 26 625 CAGR 2001-04 (%) 1.8 14.9 (8.2) Na (1.4)

In contrast, PMI underlying top-line more volume driven

BAT versus PMI, CAGR 2001-04 Organic volume growth

BAT (1.4) 3.6 2.1 (3.5) (1.3) 1.4 0.1

PMI 1.7 0.9 2.6 4.9 7.5 1.1 8.6

Note difference between growth drivers: PMI weighted towards Europe where negative mix is an issue For BAT M&A contribution CAGR, we have stripped out Etinera, now disposed

Organic price/mix Organic sales growth (constant FX) FX impact Organic sales growth (current FX) M&A contribution Subsidiary sales growth (BAT in , PMI in $)
Source: DrKW Equity research estimates

13

BAT

14 September 2005

It should be noted that in 2002 BAT significantly cut back the number of distributors, particularly those to the duty-free channel, in order to reduce the level of fraud. That year, group volumes (including associates) fell by 30bn sticks or -3.7%, the only year volumes have declined. Over half of the decline may have been due to the specific action on trade channels. Arguably, therefore, BATs underlying volume growth trend could be more like -0.5% CAGR 2001-04 rather than the -1.4% we have used in the table.
BATs market share in key segments (key markets ex-China): Weak in GDBs
Segment share (%) 40 35 30 25 20 15 10 5 0 Total 2003 2004 24.1 25.8 Total NTO 24 25.2

Premium 29.9 28.4

IB's 19.5 19.9

GDB's 14.9 15.1

ASU 30 27.9 29

Lights 24.1 24.4

Charcoal 15.8 17.2

Menthol 22.8 21.1

Source: BAT

Low level of GDBs is both a boon and a bane

BAT needs to gain scale economies in marketing otherwise why be global? The weight of BATs global drive brands (GDBs) in its portfolio is much lower than its peers. GDBs only represent 17-18% of BATs subsidiary volume, compared to PMIs 64% and JTIs 62%. Consequently, BATs share of the global drive brand segment, at 15%, is below its corporate total volume share of 25.8% in its key markets ex-China. BATs relatively low level of brand concentration in its portfolio is both a boon and a bane. It is a bane because it fosters cost inefficiencies both in production and marketing. It is a boon because steady improvement in GDB from its low base provides substantial scope for BAT to improve its mix, to decrease operational cost complexity and to market efficiently across regions. The chart below shows that BAT has indeed been able to grow the volume of its focus brands while its peers PMI and JTI broadly have not. This should continue to drive a positive mix dynamic for the group.
Global drive brand performance of major tobacco companies, volume indexed
Index v 1997 150 140 130 120 110 100 90 1997 1998 1999 2000 BAT(Lucky Strike, Kent, Dunhill, Pall Mall) JTI(Mild 7, Camel, Salem, Winston) 2001 2002 2003 PMI(Marlboro, L+M, Parliament, Philip Morris) 2004

Source: BAT

14

BAT

14 September 2005

That said, the historical differences between BATs and PMIs top-line growth drivers have largely disappeared so far in 2005 (see table). While BATs overall rate of organic sales growth (constant FX) has materially improved, from 2.1% to 2.9%, this has been driven by a return to volume growth, put down to market share gains in various markets such as Russia, Turkey, Nigeria, Pakistan, Iran and Vietnam. The lower level of positive mix (1% versus 3.6%) we think is due to much of the volume growth now occurring in low-price markets. Management is hoping for FY 2005 volume growth of 1.5-2% and for the sustainable rate to be at the lower end of that range.
BAT and PMI volume and price/mix drivers currently very similar
2001-04 (%) Volume Price/mix Organic sales (constant FX) FX impact Organic sales growth (current FX) M&A contribution Subsidiary sales growth (BAT in , PMI in $)
Source: DrKW Equity research estimates

H1 2005 vs H1 2004 BAT 1.9 1.0 2.9 2.0 4.9 0 4.9 PMI 1.8 1.1 2.9 5.1 7.9 4.0 11.9

BAT (1.4) 3.6 2.1 (3.5) (1.3) 1.4 0.1

PMI 1.7 0.9 2.6 4.9 7.5 1.1 8.6

Importantly, BATs positive mix could well start to climb back to its previous highs. BAT is investing behind brand innovation (eg in Kent with charcoal filters and menthol) and generally a more aggressive marketing of the GDBs including an increasing level of GDB launches across Europe and elsewhere.
In Europe, BATs global drive brands have grown 10% CAGR since 2001
70 60 50 40 30 20 10 0 2001 Viceroy
Source: BAT

2002 Vogue Pall Mall

2003 Lucky

Kent

Dunhill

2004

GDB roll-outs (hopefully) to accelerate volume and mix dynamics

Since 2001 BAT has grown its GDB by 10% CAGR in Europe but BATs European brand footprint remains very fragmented. The target is to grow its top six brands (the four GDBs plus Viceroy and Vogue) in Europe by 12-13% in 2005 and even faster going forward. However, even if the group is successful at this, the total European portfolio should only grow by +1-2% as there is such a large tail with 77% of its portfolio outside the top-6 brands perhaps declining at 2% per annum.
The group is re-launching Dunhill across Europe this year with the target of rolling out

across 12 countries by year-end. This is a premium brand selling at a premium to Marlboro. Early results are encouraging in Russia, Germany and Italy.
Pall Mall is beginning to be relaunched right across Europe by Q1 2006 with new

bevelled edge packaging.

15

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14 September 2005

The Kent brand is very weak in Western Europe but stronger in Eastern Europe. In

Russia, it outsells Marlboro at a 125% price premium. BAT is now launching Kent at parity to Marlboro in Italy and we imagine other Western European markets will follow.
Albeit in our view probably the weakest corporate GDB, Lucky Strike has done well in

Germany despite higher prices. Encouraged by its performance, BAT is hoping that the brand can glean a 5% share across Europe, equivalent to its share in Germany. Admittedly this is stretching but at least demonstrates the ambition within the management team.
Accelerating volume growth, especially of focus brands
BAT volume (bn units) Underlying group volume International brands Of which: Global drive brands Of which: Other International brands Other/tail brands
Source: BAT, DrKW Equity research estimates

H1-04 321 111 54 57 210

H1-05 327 119 57 62 208

% chg 2 7 6 8 -1

Q1-04 155 53 25 28 102

Q1-05 156 57 26 31 99

% chg 1 7 2 12 -3

Q2-04 166 58 29 29 108

Q2-05 171 62 31 31 109

% chg 3 7 9 5 1

Volume up-tick already visible in Q2

In Q2 2005 underlying subsidiary volume growth picked up from +1% in Q1 to +3% with Global Drive Brands accelerating from +2% in Q1 to 9% in Q2. For example, Kent grew +13% in Q2 (+25% outside Japan), Lucky Strike grew share in Germany and grew volumes +9% outside Germany, Pall Mall jumped +28% in Q2 (Germany +50%, Italy +20%, Russia +14% and Turkey +77%) with Dunhill the loser, falling by 8-9%. For the full year BAT is dampening down expectations by guiding towards 1.5-2% group volume growth because of tougher comparisons. We agree that Germany is likely to see renewed volume weakness in Q4 without a compensating manufacturer price increase. BAT is also indicating that the Italian shipment volume bounce in Q2 to -1% from -9% in Q1 is likely to be short-lived as it sees full year Italian consumption down 4-5%. Our BAT model builds in 2.4% revenue growth longer-term and (stripping out costsavings, see other section) no top-line driven margin improvement. Given how mix is such an important part of the top-line story, hopefully this is another area (on top of cost savings) where BAT could surprise on the upside. The countries where each GDB has enjoyed the most success could become Brand Captains for wider regions. For example, BATs Russian marketeers could spearhead Kent into Europe. Germany could be Captain for Lucky Strike and Italy for Pall Mall. Kent has perhaps 12 innovations in its pipeline older innovations could be passed down to say Pall Mall (car hi-fi analogy: radio cassettes were once premium).

More confidence internally than ever perceived before

The marketing challenge is to migrate minor brands that add cost and complexity to the GDBs without excessive volume leakage to competitors. This will not be easy but there appears renewed faith in the organisation to relaunch not just value brands but subpremium and premium as well. Its GDB volumes are starting to build a nice momentum, boding well for the future, both for volumes and for mix.

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14 September 2005

Top 24 markets
BAT focuses its resources on 24 cigarette markets of the world that together represent some 77% of global volume and some 20bn of industry profit, which in turn is perhaps 85% of the global profit pool. For BAT, we estimate that the T24 markets represent some 86% of its subsidiary volume and around 80% of its EBITA. An analysis of the volume and profit market shares indicates the profit opportunity that the T24 markets could hold for BAT. For like-for-like comparisons, we strip out the US and China from the data, in effect reducing the analysis to the T22 (we do this because BATs US exposure is via its 42%-owned associate RAI while China is a closed market, thus leaving it in distorts the picture). On this basis we estimate that BAT has a 33% volume share of the T22 but only a 16% profit share. BATs volume share is fairly similar between high and low value markets (32-33%). However, contrary to our expectations BATs profit share looks better in the high rather than the low value markets (on our estimates 23% and 9% respectively).
T24 Cigarette volume forecast
CAGR Cigarette volumes (bn) High value* Low value* Total T24 2004 1,289 2,788 4,077 2014E 1,025 2,724 3,749 2004-14E (%) (2.3) (0.2) (0.8) Industry profit (bn) High value* Low value* Total T24 2004 12.3 7.9 20.2 2014E 15.0 10.8 25.8

Industry profitability (T24)

CAGR 2004-14E (%) 2.0 3.2 2.5

High value markets include:Australia, US, Canada, Switzerland, UK, Malaysia, South Africa, Germany, GCC (Gulf Co-operation Countries), France, Japan, Italy and Spain.

Low value markets include: South Korea, Nigeria, Mexico, Venezuela, China, Turkey, Brazil, Russia, Argentina, Pakistan, Bangladesh

Source: BAT

Source: BAT

If BATs T22 profit share reaches its volume share, this implies a 2bn profit upside

Taking its T22 profit share from the estimated 16% to say 24% (still way below BATs volume share) would imply a 1bn profit opportunity. For context, we have BATs EBITA rising 1.2bn over the next ten years. Clearly if BAT can push its profit share closer to its volume share the opportunity is much larger, at over 2bn. If BAT attains its objective of growing EBITA 6% CAGR over the next 9-10 years, the implied profit upside is indeed 2bn. BAT believes that despite a projected volume decline of about -1% CAGR, the top 24 markets can expand their profit pools by 2.5% CAGR, with the 13 higher-value markets growing by 2% and the 11 lower-value markets growing at a slightly faster rate of 3.2% driven by the latters faster population growth and faster GDP per capita. While we generally agree with the notion of faster profit growth from low value or developing markets, we suspect BATs assumptions for the low value markets are substantially too conservative. Stripping out China from BATs estimates would imply similar profit growth and weaker unit profit growth from the remaining low value markets; this intuitively sounds a little harsh to us.

BATs industry profit growth assumptions look conservative

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BAT

14 September 2005

Top-24 markets: total volumes and BATs volume share of key markets
(Total market volume) 400 350 300 250 200 150 100 50 Russia USA 114 60 26 Brazil Japan 97 23 Germany 11 Turkey 13 South Korea 30 Italy 6 Spain 40 Pakistan 17 GCC 135 114 113 111 100 90 65 55 3 UK 54 9 France 47 18 Mexico 37 11 Argentina 35 18 Bangladesh 34 18 Canada 24 22 South Africa 23 10 Australia 18 12 Malaysia 15 7 14 11 Nigeria 11 10 Venezuela 300 295 379

92

BAT share

Market

Note Only 23 markets shown, China is excluded.

Source: DrKW Equity research estimates, BAT

A 1.5% corporate volume growth target looks stretching. We assume 0.6%

Nonetheless, taking BATs T24 assumptions as proxies for global future trends gives an indication of what volume and profit share BAT needs to take in order to achieve its goals. BATs objective is to grow subsidiary volumes by around 1.5% per annum. If global volumes trend down at -0.8%, in line with the T24 assumptions, this suggests that BAT needs to widen its volume share from 21% (world ex-US and China) to 27% between 2004 and 2014. To capture this incremental share organically, while not impossible, certainly sounds a challenge given BATs global share over the last decade has only moved significantly on the back of acquisitions. We currently assume BATs long-term volume growth to be 0.6% CAGR. This implies BATs share rising from 21% to 24% over ten years.
Top-24 markets: estimated BAT EBITA split
Germany GCC France Japan Italy Spain South Korea Nigeria Mexico Venezuela Turkey
Others Pakistan Argentina Russia Brazil Venezuela Mexico Nigeria Spain Italy Japan France Australia Canada Switzerland

Top-24 markets: estimated BAT volume split

Switzerland Canada Australia Others Malaysia South Africa UK

Switzerland

Malaysia South Africa Germany

Bangladesh

Pakistan Russia Argentina High value Low value

Brazil

South Korea

Others

High value
Source: DrKW Equity research estimates

Low value

Others

Source: DrKW Equity research estimates

Our estimate of BATs EBITA growth requires only minor gains in share of industry profit

In our projections we have BATs EBITA growing 4% CAGR on average to 2014E. This would be equivalent to BAT increasing its world (ex-US and China) profit share from nearly 16% to just over 18%, which does not seem unreasonable to us. If BAT has been too conservative in its T24 profit growth assumptions then the profit share requirement to meet our estimates becomes even more achievable.

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BAT

14 September 2005

Financials
BAT: Profit & loss projections
Year-End 31 Dec (m) Europe Asia-Pacific Latin America AME America-Pacific Total volumes (bn sticks) Growth (%) Europe Asia-Pacific Latin America AME America-Pacific Group revenue Growth (%) Europe Asia-Pacific Latin America AME America-Pacific Unallocated costs EBITA Growth (%) Margin (%) Goodwill Amortisation Exceptionals Profit from operations Share of associates, post-tax Net interest PBTA, pre-exceps PBT, Reported Tax Charge Tax Rate (%) PAT Minorities Net Attributable Profit Share buyback (%) Average Shares - Diluted (m) Adjusted Diluted EPS Growth (%) DPS Growth (%) Dividend cover (x)
Source: DrKW Equity research estimates

2000 208.1 86.5 164.5 238.0 109.4 806.5 7.2 2904 1405 1615 1599 4092

2001 230.2 204.1 162.9 104.0 105.9 807.1 0.1 3189 1911 1619 1192 4128 3.7

2002 232.6 192.5 153.0 92.2 107.0 777.3 (3.7) 3064 1792 1410 1087 4026 (5.5) 547 463 393 260 1018 0 2681 (3.2) 23.6 (378) 0 2303 0 (190) 2491 2113 (818) 38.7 1295 (143) 1152 2299 66.55 7.7 35.2 10.0 1.9

2003 249.8 192.2 149.5 98.2 103.2 792.9 2.0 3502 1765 1309 1289 3562 0.4 536 473 440 337 995 0 2781 3.7 24.3 (405) (596) 1780 0 (213) 2568 1567 (779) 49.7 788 (157) 631 4.9 2241 69.21 4.0 38.7 10.0 1.8

2004 04-IFRS 268.1 200.5 147.6 105.3 131.1 852.6 7.5 4990 1714 1276 1347 3083 8.6 726 515 428 366 795 0 2830 1.8 22.8 (511) (196) 2123 0 (237) 2593 1886 (662) 35.1 1224 (126) 1098 2.8 2156 75.83 9.6 41.9 8.2 1.8 41.9 76.53 3632 (673) 28.8 2959 (130) 2829 24.0 0 1171 3760 126 (254) 750 495 448 360 639 (103) 2589 4452 1629 1273 1339 2075 240.2 131.7 147.6 97.6 68.4 685.5

2005E 243.9 130.6 149.6 113.4 43.7 681.2 (0.6) 3479 1620 1702 1441 1027 9268 (13.9) 776 519 553 405 401 (129) 2525 (2.5) 27.2 0 0 2525 361 (248) 2277 2638 (717) 31.5 1921 (122) 1799 3.0 2124 84.7 10.7 45.3 8.0 1.87

2006E 245.3 131.9 148.9 116.8 42.3 685.1 0.6 3626 1669 1744 1499 991 9529 2.8 886 544 550 429 390 (131) 2669 5.7 28.0 0 0 2669 428 (244) 2425 2853 (764) 31.5 2089 (127) 1963 3.0 2061 95.3 12.4 48.9 8.0 1.87

2007E 247.2 133.9 148.9 119.1 40.9 689.9 0.7 3752 1720 1779 1544 965 9760 2.4 1002 573 565 450 382 (133) 2838 6.3 29.1 0 0 2838 438 (214) 2624 3062 (827) 31.5 2236 (132) 2104 0.0 2030 103.7 8.8 55.4 13.3 1.87

2008E 249.4 135.9 148.9 120.3 39.5 694.0 0.6 3890 1772 1815 1575 940 2.4 1127 595 580 466 375 (135) 3009 6.0 30.1 0 0 3009 447 (160) 2848 3296 (897) 31.5 2398 (137) 2261 0.0 2030 111.4 7.5 59.5 7.5 1.87

2009E 251.9 137.9 148.9 121.5 38.6 698.7 0.7 4027 1825 1851 1607 931 2.5 1177 618 595 483 372 (137) 3107 3.3 30.3 0 0 3107 456 (107) 2999 3455 (945) 31.5 2510 (142) 2368 0.0 2030 116.7 4.7 62.3 4.7 1.87

2010E 254.4 140.0 148.9 122.7 37.8 703.7 0.7 4169 1880 1888 1639 928 2.6 1226 641 610 500 370 (139) 3208 3.3 30.5 0 0 3208 458 (54) 3154 3612 31.5 2619 (148) 2471 0.0 2030 121.7 4.3 65.0 4.3 1.87

2011E 256.9 142.8 148.1 124.0 37.0 708.8 0.7 4316 1947 1916 1672 926 2.6 1277 668 621 517 368 (141) 3311 3.2 30.7 0 0 3311 460 2 3313 3773 31.5 2729 (154) 2576 0.0 2030 126.9 4.2 67.8 4.2 1.87

2012E 259.5 144.2 147.4 125.2 36.3 712.6 0.5 4446 1996 1945 1706 924 2.2 1329 689 633 535 366 (143) 3409 3.0 30.9 0 0 3409 463 59 3469 3932 31.5 2839 (160) 2679 0.0 2030 132.0 4.0 70.5 4.0 1.87

2013E 262.1 145.7 146.6 126.4 35.6 716.4 0.5 4580 2046 1974 1740 922 2.2 1382 710 644 553 362 (145) 3507 2.9 31.1 0 0 3507 465 120 3627 4093 31.5 2950 (167) 2784 0.0 2030 137.2 3.9 73.3 3.9 1.87

2014E 264.7 147.1 145.9 127.7 34.9 720.3 0.5 4719 2097 2003 1775 920 2.2 1435 732 656 571 359 (146) 3607 2.8 31.3 0 0 3607 468 183 3790 4259 31.5 3065 (173) 2891 0.0 2030 142.5 3.9 76.1 3.9 1.87

11615 12039 11379 11427 12410 10768

9991 10240 10504 10777 11016 11261 11513

541 361 425 370 878 0 2575 22.2 (376) (399) 1800 0 (278) 2297 1522 (660) 43.4 862 (170) 692 2340 56.92 8.9 29.0 10.7 2.0

505 509 428 310 1019 0 2771 7.6 23.0 (392) (49) 2330 0 (265) 2506 2065 (886) 42.9 1179 (169) 1010 2297 61.82 8.6 32.0 10.3 1.9

(994) (1043) (1093) (1143) (1194)

19

BAT BAT: Cash flow projections

Year-End 31 Dec (m) Operating Profit - post excepts Depreciation & Amortisation EBITDA - subsidiaries Working Cap Requirement Provisions/Others Operating Cash Flow Dividends from Associates Net interest paid/rec'd Tax Paid Net Cash Flow From Operations Capex Capex/sales (%) Asset Disposals Free Cash Flow Acquisition of Subsidiaries Acquisition of Intangibles Acquisition of Participations Business Disposals Total Net Expansion Net cash in (out) before financing - Cash Dividends Paid - Issue of Shares etc. - FX, others (Inc)/Dec in Net Debt
Source: DrKW Equity research estimates

14 September 2005

2000 1739 777 2516 355 (113) 2758 30 (530) (598) 1660 (362) 3.1 120 1418 88 (104) (258) 1402 (580) (692) (1404) (1274)

2001 2176 788 2964 291 24 3279 38 (586) (858) 1873 (515) 4.3 68 1426 (342) 0 (8) 0 (797) 1076 (638) 3 (86) 355

2002 2180 716 2896 132 (82) 2946 40 (405) (907) 1674 (490) 4.3 55 1239 0 (68) 0

2003 1777 882 2659 252 156 3067 46 (424) (709) 1980 (428) 3.7 25 1577 0 (84) 0

2004 1794 846 2640 17 (61) 2596 81 (417) (703) 1557 (333) 2.7 27 1251 (3) 0 (71) 206 (174) 1383 (823) (528) 68 100

2005E 2525 277 2802 174 (60) 2916 261 (348) (717) 2112 (280) 3.0 0 1833 0 0 0 0 (280) 1833 (905) (742) 0 186

2006E 2669 285 2954 44 (60) 2937 311 (344) (764) 2140 (258) 2.7 0 1882 0 0 0 0 (258) 1882 (810) 0 125

2007E 2838 292 3130 46 0 3176 318 (314) (827) 2353 (229) 2.3 0 2125 0 0 0 0 (229) 2125 0 0 1101

2008E 3009 299 3307 19 0 3326 324 (260) (897) 2492 (234) 2.3 0 2259 0 0 0 0 (234) 2259 0 0 1119

2009E 3107 293 3399 (21) 0 3378 330 (207) (945) 2556 (265) 2.6 0 2291 0 0 0 0 (265) 2291 0 0 1076

2010E 3208 297 3504 (23) 0 3482 333 (154) 2667 (272) 2.6 0 2396 0 0 0 0 (272) 2396 0 0 1124

2011E 3311 302 3613 (24) 0 3589 336 (98) 2783 (297) 2.8 0 2486 0 0 0 0 (297) 2486 0 0 1160

2012E 3409 307 3717 (24) 0 3692 339 (41) 2898 (296) 2.7 0 2601 0 0 0 0 (296) 2601 0 0 1220

2013E 3507 314 3822 (3) 0 3819 342 20 3038 (324) 2.9 1 2715 0 0 0 0 (323) 2715 0 0 1278

2014E 3607 321 3928 (3) 0 3925 345 83 3160 (332) 2.9 2 2830 0 0 0 0 (330) 2830 0 1 1338

(994) (1043) (1093) (1143) (1194)

65 (1798)

(438) (2285) 1236 (707) 6 (63) (305) (773) (693) (69)

(948) (1024) (1140) (1215) (1271) (1326) (1381) (1436) (1492)

472 (1840)

BAT: Balance sheet projections

Year-End 31 Dec (m) Gross Tangible Fixed Assets Accumulated depreciation Net Tangible Fixed Assets Net Intangible Assets Participations/Investments/ESOP Total Net Fixed Assets Net Working Capital NWC/ sales (%) Net Capital Employed Net debt LT Assets/Liabilities/Provisions Shareholders' Equity Minority Interest Group Equity Cumulative Goodwill written off
Source: DrKW Equity research estimates

2000 5228 2600 7158 728

2001 5334 2678 6546 786

2002 5231 2602 6248 820

2003 5357 2578 8012 845

2004 4636 2232 7135 2201

2005E 4018 1585 7135 2201

2006E 4132 1628 7135 2201

2007E 4232 1634 7135 2201

2008E 4332 1639 7135 2201

2009E 4389 1612 7135 2201

2010E 4449 1586 7135 2201

2011E 4532 1581 7135 2201

2012E 4611 1570 7135 2201

2013E 4714 1580 7135 2201

2014E 4819 1591 7135 2201

(2628) (2656) (2629) (2779) (2404) (2434) (2504) (2597) (2693) (2777) (2863) (2951) (3041) (3134) (3228)

10486 10010 692 6.0 391 3.2

9670 11435 11568 10921 10964 10970 10975 10948 10922 10917 10906 10916 10927 511 4.5 33 0.3 321 2.6 147 1.6 104 1.1 57 0.6 39 0.4 60 0.6 83 0.8 106 1.0 131 1.2 134 1.2 137 1.2

11178 10401 10181 11468 11889 11068 11067 11028 11014 11008 11005 11023 11037 11050 11063 4206 1456 5097 419 5516 1652 3851 1467 4754 329 5083 1707 3379 1350 5185 267 5452 1565 5219 1541 4483 225 4708 1432 5119 1354 5220 196 5416 1145 5090 1354 4306 318 4624 1145 4965 1354 4304 444 4748 1145 3864 1354 5234 576 5810 1145 2745 1354 6202 713 6915 1145 1670 1354 7129 855 7984 1145 545 1354 8103 1003 (615) (1835) (3113) (4452) 1354 1354 1354 1354

9128 10201 11325 12504 1157 1317 1484 1657

9106 10285 11518 12809 14161 1145 1145 1145 1145 1145

Share prices of companies mentioned

Altria BAT Malaysia Gallaher Imperial Tobacco ITC Japan Tobacco Richemont Reynolds American Souza Cruz
Source: Reuters

US$71.02 MYR36.50 861p 1,535p INR1,856 1,590,000 CHF49.95 US$81.97 BRL27.30

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14 September 2005

Disclosure appendix
Disclosures under US regulations
The relevant research analyst(s), as named on the front cover of this report, certify that (a) all of the views expressed in this research report accurately reflect their personal views about the securities and companies mentioned in this report; and (b) no part of their compensation was, is, or will be directly or indirectly related to the specific recommendation(s) or views expressed by them contained in this report. Any forecasts or price targets shown for companies and/or securities discussed in this report may not be achieved due to multiple risk factors including without limitation market volatility, sector volatility, corporate actions, the unavailability of complete and accurate information and/or the subsequent transpiration that underlying assumptions made by DrKW or by other sources relied upon in the report were inapposite.

Recommendation history charts

Past performance is not an indicator of future performance.

Dresdner Kleinwort Wasserstein Research Recommendation definition (Except as otherwise noted, expected performance over next 12 months)
Buy: Add: Hold: 10% or greater increase in share price 5-10% increase in share price +5%/-5% variation in share price Sell: Reduce: 10% or more decrease in share price 5-10% decrease in share price

Distribution of DrKW equity recommendations as of 30 Jun 2005

All covered companies
Buy/Add Hold Sell/Reduce Total
Source: DrKW

Companies where a DrKW company has provided investment banking services (in the last 12 months)
43 27 9 79 54% 34% 11%

270 212 92 574

47% 37% 16%

Additional disclosures under other non-US regulations

The disclosures under US regulations above should be read together with these additional disclosures. DrKW or an affiliate regularly holds trading positions in the securities of BAT. Recipients should note that DrKW may have submitted a draft of this report (with recommendation/rating, price target/spread and summary of conclusions removed) to the relevant issuer(s) for factual review and that amendments may have been made following that review. In respect of any compendium report covering six or more listed companies, please refer to the following website for all relevant disclosures: www.drkwresearch.com/disclosures/

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Unless otherwise noted, the securities mentioned in this report are priced as of 14 September 2005 at 10.00am. Time given is local to the address shown at the bottom of the first page of this report.

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whatsoever for any such material, nor for any consequences of its use. This report is for the use of the addressees only, is supplied to you solely in your capacity as an investment professional or knowledgeable and experienced investor for your information and may not be reproduced, redistributed or passed on to any other person or published, in whole or in part, for any purpose, without the prior, written consent of DrKW. DrKW may distribute reports such as this in hard copy, electronically or by Voiceblast. DrKW and/or any of its clients may undertake or have undertaken transactions for their own account in the securities mentioned in this report or any related investments prior to your receipt of it. DrKW specifically draws recipients attention to the disclosures contained in the Disclosure Appendix but notes that, excluding (i) DrKWS LLC and (ii) the research analyst(s) responsible for this report unless specifically addressed in the "Disclosures under US regulations": (a) DrKW and its directors, officers, representatives and employees may have positions in or options on the securities mentioned in this report or any related investments or may buy, sell or offer to buy or sell such securities or any related investments as principal or agent on the open market or otherwise; and (b) DrKW may conduct, solicit and/or engage in other investment and/or commercial banking business (including without limitation loans, debt securities and/or derivative, currency and commodity transactions) with the issuers or relating to the securities mentioned in this report. Accordingly, information may be available to DrKW, which is not reflected in this report or the disclosures. In this notice DrKW means Dresdner Bank AG and/or Dresdner Kleinwort Wasserstein Securities Limited and any of their affiliated or associated companies and their directors, officers, representatives or employees and/or any persons connected with them. Additional information on the contents of this report is available at www.drkwresearch.com and on request. Dresdner Kleinwort Wasserstein Securities Limited 2005

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Summary financials and key valuations

Profit and loss statement
2004 Sales Sales growth EBITDA EBITDA margin EBITA EBITA margin Pre-tax profit Tax Tax rate Attrib profit excl except, gw Attrib prof growth ex exc, gw Attrib profit margin Avg diluted no sh m % m % m % m m % m % % m 10,768 -5.8 3,516 32.7 2,589 24.0 2,461 (673) 27.3 2,331 50.3 21.6 2,156 2005E 9,268 -13.9 3,064 33.1 2,525 27.2 2,638 (717) 27.2 1,799 -22.8 19.4 2,124 2006E 9,529 2.8 3,264 34.3 2,669 28.0 2,853 (764) 26.8 1,962 9.1 20.6 2,061 2007E 9,760 2.4 3,448 35.3 2,838 29.1 3,061 (826) 27.0 2,103 7.2 21.6 2,030
Source: DrKW Equity research estimates

Sales by region, 2005E

Africa & Middle East 16% AmericaPacific 11%

Asia-Pacific 17%

Europe 38%

Latin America 18%

Balance sheet
2004 Tangible fixed assets Intangible fixed assets Working capital Cap employed Net (debt)/cash Shareholders equity Minorities Total liabilities and equity m m m m m m m m 2,232 7,135 321 13,034 (5,119) 5,220 196 8,186 2005E 1,585 7,135 147 12,213 (5,102) 4,294 318 6,773 2006E 1,628 7,135 104 12,212 (4,990) 4,279 444 6,994 2007E 1,634 7,135 57 12,173 (3,889) 5,209 576 8,158

EBITA by region, 2005E

Africa & Middle East 15% AmericaPacific 15%

Cash flow
2004 Operating cashflow Gross cash flow (Capex) Free cash flow Change in net debt m m m m m 2,596 1,557 (333) 1,251 100 2005E 2,916 2,112 (280) 1,832 174 2006E 2,937 2,140 (258) 1,882 112 2007E 3,176 2,353 (229) 2,124 1,100
Source: DrKW Equity research estimates

Europe 29% Latin America 21%

Asia-Pacific 20%

Ratios
2004 P/E P/FCF Yield EV/ EBITDA DAFCF/EV FCF Yield FCF/ sales EBITA/ Net interest Dividend cover Post tax ROCE ROE Net debt/ equity Capex/total depreciation Capex/ sales Working capital/ sales P/B EPS growth x x % x x % % x x % % % x % % x % 10.8 20.0 3.6 6.5 0.0 5.0 11.6 10.7 1.8 15.1 36.6 78.0 NA 2.8 3.0 3.9 10.6 2005E 13.8 13.2 3.9 9.5 0.1 7.5 19.8 11.6 1.9 17.2 33.1 88.6 NA 3.0 1.6 4.5 10.7 2006E 12.3 12.5 4.2 8.7 0.1 8.0 19.7 12.7 1.9 18.6 36.2 85.0 NA 2.7 1.1 4.3 12.4 2007E 11.3 11.1 4.7 8.0 0.1 9.0 21.8 15.2 1.9 19.7 33.1 56.1 NA 2.3 0.6 3.7 8.8

Shareholder structure
Total no. of shares Free float Major shareholders R&R Holdings SA Barclays Global Investors Fidelity Legal & General IM M&G IM % % % % % 28.60 3.41 3.03 2.71 2.34 m % 2,107 71.4

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