Operating and Financial Review

Future Trends

Future Revenue and Profit from Operations may be affected by both external factors and trends that alter the environment in which we carry out our business as well as internal management driven initiatives aimed at improving our business performance. These two drivers of trends are discussed below.

External Factors

As a manufacturer and distributor of branded confectionery and beverage products we are impacted by changing consumer trends affecting the principal product markets in which we operate.

Both the confectionery and beverage markets in which we operate are growing. However changing consumer preferences may affect growth rates in certain confectionery products and carbonated soft drinks, particularly in developed markets where the risks of obesity have a higher profile. A discussion of these industry trends and how we are positioned to respond to these factors is set out in the Description of Business section (see pages 19 and 20).We have sought to address these changing consumer preferences through continuing product innovation and diversification.

In confectionery, we have sought to expand our product range in sugar and functional confectionery products and chewing gum. The majority of our gum products are sugar-free. We also continue to review our confectionery portion sizes, our marketing efforts and our labelling to ensure they address consumer concerns. We continue to expand our business operations in developing markets, which are viewed as having the potential for significant volume growth.

In beverages this includes expansion into still and fruit-based beverages. We have a strong and successful portfolio of diet beverage drinks, which is a significant driver of growth in our America Beverages business. There is no significant difference between the margins earned on diet and regular carbonated beverages.

A significant part of our business is conducted through licensing arrangements, notably with bottlers of our beverages products in the USA. There is also a greater concentration of our customer base around the world, generally due to the consolidation of retail trade. Changes in bottling arrangements, such as the termination of certain 7 UP licences in 2002 in the USA, or pricing pressures from customers in countries with concentrated retail trade, could adversely impact our Revenue or Profit from Operations in particular market segments for a period of time.

Raw materials, energy and transportation costs represent a significant proportion of our cost base excluding labour. We buy a variety of raw materials, including agricultural commodities and packaging materials, and also purchase energy in the form of oil, gas and electricity. The prices of raw materials and energy fluctuate from time to time. Sustained or rapid increases in these prices can adversely impact our profitability, although we have hedging programmes in place to smooth the effect of these changes, and also aim to raise the prices of our products to compensate for any cost increases.

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Internal factors

Financial Goals

We are committed to generating superior shareowner returns and in pursuit of this goal have set three external financial performance goals for the 2004 - 2007 period. These are:

• Revenue growth in the base business of between 3% and 5% per annum at constant currency;
• Underlying operating margin growth of between 50 and 75 basis points per annum at constant currency; and
• Free Cash Flow totalling £1.5 billion at constant currency over the four year period.

Integral to our achievement of these goals are the Fuel for Growth and Smart Variety initiatives. The Goals and Priorities, Fuel for Growth and Smart Variety programmes are discussed in the Description of Business section of this Annual Report on pages 6 to 8.

In 2005, we met our revenue goal and continued our good progress on our Free Cash Flow goal. In 2006 the Group expects to deliver underlying sales growth and margin growth within the financial goal ranges and to continue to generate cash flow in line with its stated four year target.

Strategic Developments

In the two years following the Adams acquisition, we focused on integrating the business, growing organically and reducing debt. By early 2005, with all the major Adams integration programmes successfully completed, we started a new programme of reallocating resources against our highest growth and return opportunities.

A key development in 2005 was the announcement of the sale of our Europe Beverages business for €1.85 billion (£1.26 billion). The sale was completed on 2 February 2006. The implications of the disposal on the on-going results of our business are discussed in further detail below.

We have also initiated a programme to identify and dispose of other non-core brands and businesses. In aggregate, the sale of these non-core assets is expected to raise proceeds of between £250 million and £300 million by the end of 2007, with a corresponding reduction in revenues of approximately the same amount. We have also commenced a programme to identify and dispose of surplus properties with the aim of raising proceeds of approximately £100 million.

The proceeds of these disposals are being used to further strengthen our positions in priority and emerging markets through acquisitions and capital investment and to increase the funding of our defined benefit pension schemes.

Major capital investment projects recently announced include:

• £40 million investment to expand moulded chocolate capacity in the UK.
• £30 million investment to expand gum capacity in Mexico.
• £70 million investment to build a green-field gum plant in Poland by 2008.
• £20 million investment to expand chocolate capacity in Asia Pacific.

In the future, we expect to spend over half of our capital expenditure on growth initiatives, such as new or enhanced production facilities.

Investments in acquisitions, completed or announced, include:

• The purchase of Green & Black's, a premium organic chocolate business.
• An increase in our stake in Kent, the leading Turkish sugar confectionery business, from 66% to 95%.
• The purchase of Dan Products, the leading gum business in South Africa.
• Taking majority control of Cadbury Nigeria, following the increase in our stake from 46% to over 50%.

Following recent valuations of our major pension funds, we have decided to make additional payments into certain of our defined benefit schemes. The purpose of these payments is to significantly reduce the deficits and ensure that the schemes are appropriately funded going forward. We are making one-off payments of approximately £125 million before the end of 2006, inclusive of £31 million paid in 2005 and will be increasing our annual cash contributions over the following few years into these defined benefit schemes. The total cost of this commitment will be around £190 million. Following these payments we expect the IAS 19 pension deficit, which was £369 million at 1 January 2006, to be significantly reduced.

Disposal of Europe Beverages

In February 2006 we completed the disposal of Europe Beverages for gross proceeds of ¤1.85 billion (£1.26 billion). Net proceeds after tax and expenses are expected to be £1.15 billion and will be used to reduce the Group's debt and increase the funding of the Group's pension obligations.

The disposal of Europe Beverages will have a number of implications on the results of the business in 2006 and beyond, including:

• an expected profit on disposal of approximately £480 million, to be recorded in discontinued operations outside underlying earnings in 2006;
• a reduction in the contribution of Europe Beverages to Total Group Earnings. In 2005 this contribution amounted to £81 million;
• a reduction in the Group's level of debt and a reduction in the total financing charge. As the average interest rates on the Group's debt are expected to remain around 5% it is expected that the disposal will be earnings dilutive; and
• a reduction in the Group's free cash flow. In 2005, Europe Beverages contributed £77 million to the Group's Free Cash Flow of £404 million.

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2006 Outlook

In 2006, we will continue the good progress we have made over the last two years, as we create a business which can deliver sustainable profitable growth. The flexibility provided by the sale of Europe Beverages and disposals of other non-core assets will enable us to further strengthen our confectionery and beverage platforms through strategic capital investments and bolt-on acquisitions.

We expect another good year of Revenue growth driven by an active innovation programme, although comparisons will be to our strong 2005 results. Commodity costs remain challenging with oil prices staying high and sweetener and aluminium prices increasing sharply in the last months of 2005. We expect to more than offset these increases through a combination of price increases and cost reduction initiatives but margin progress will be weighted towards the second half of the year. For the year as a whole, we expect to deliver results within our goal ranges.

In 2006, we expect Restructuring costs to be around £100 million as we continue to implement the Fuel for Growth programme. In December 2005, we announced our intention to build a new green-field gum factory in Poland. Following commissioning of the factory in 2008, we will significantly reduce our gum supply requirements from Gumlink A/S and hence incur minimum penalties under the terms of the agreement. Hence within the £100 million of estimated 2006 Restructuring costs, we expect to recognise an estimated £10 million in respect of these penalties in 2006 and a further £20 million in 2007.

In 2006, the average interest rate on debt is expected to remain at approximately 5%. The use of the Europe Beverages disposal proceeds to reduce average debt is expected to result in a significant reduction in the financing charge.

The 2006 tax rate will be dependent on a number of factors including the possible resolution of tax cases with various tax authorities and the tax consequences of any acquisitions or disposals in the year. However we expect the tax on underlying profits to increase in 2006 to around 31%.

Capital expenditure in 2006 is expected to be around £300 million.