Annual Report and Accounts 2006

Included within the above performance metrics are a number of management performance measurements, namely Underlying profit from operations, Underlying operating margins and Free Cash Flow.

Underlying earnings measures

The table below reconciles Underlying profit from operations, as we define it, to what we believe is the corresponding IFRS measure, which is profit from operations.

	2006 £m	2005 £m	2004 £m
Profit from operations	909	995	819
Add back:
Restructuring	133	71	139
Amortisation and impairment of intangibles	38	6	7
Non-trading items	(40)	(25)	(18)
UK product recall	30	–	–
IAS 39 adjustment	3	(22)	n/a
Underlying profit from operations	1,073	1,025	947

A segmental analysis of Underlying profit from operations is presented alongside profit from operations in Segmental reporting of the audited financial statements.

In addition, we present Underlying earnings per share, along with a reconciliation to reported earnings per share in Note 13 to the audited financial statements. We calculate Underlying earnings per share, which is a non-GAAP measure, by adjusting Basic earnings per share to exclude the effects of the following:

• Restructuring costs;
• Amortisation and impairment of intangibles;
• Non-trading items;
• Exceptional items;
• IAS 39 adjustment; and
• The tax impact of the above.

The reconciling items between reported and Underlying performance measures are discussed in further detail below.

The costs we incurred in implementing the Fuel for Growth project and integrating acquired businesses are classified as restructuring costs. Our four year Fuel for Growth initiative aims to reduce direct and indirect annual costs by £360 million by 2007. Achieving these benefits is expected to require total restructuring spend of £500 million over the life of the project, with £300 million of capital expenditure.

We view these costs as costs associated with investments in the future performance of the business and not part of the Underlying performance trends of the business. Hence these restructuring costs are separately disclosed in arriving at profit from operations on the face of the income statement.

Our trade is the marketing, production and distribution of branded confectionery and beverage products. As part of our operations we may dispose of subsidiaries, associates, brands, investments and significant fixed assets that do not meet the requirements to be separately disclosed outside of continuing operations. These discrete activities form part of our operating activities and are reported in arriving at profit from operations. However, we do not consider these items to be part of our trading activities. The gains and losses on these discrete items can be significant and can give rise to gains or losses in different reporting periods. Consequently, these items can have a significant impact on the absolute amount of, and trend in, profit from operations and operating margins and are not included in the Underlying performance trends of the business.

Our performance is driven by the performance of our brands, other acquisition intangibles and goodwill, some of which are predominantly internally generated (e.g. the Cadbury brand) and some of which have been acquired (e.g. the Adams brands). Certain of the acquired brands and other acquisition intangibles are assigned a finite life and result in an amortisation charge being recorded in arriving at profit from operations. There are no similar charges associated with our internally generated brands and other intangible assets. In addition, from time to time, the Group may be required to recognise impairments of intangibles and goodwill. No similar charges can occur from our organically grown businesses. We believe that excluding acquisition intangible amortisation and goodwill impairment from our measure of operating performance allows the operating performance of the businesses that were organically grown and those that have resulted from acquisitions to be analysed on a more comparable basis.

We seek to apply IAS 39 hedge accounting to hedge relationships (principally under commodity contracts, foreign exchange forward contracts and interest rate swaps) where it is permissible, practical to do so and reduces overall volatility. Due to the nature of our hedging arrangements, in a number of circumstances, we are unable to obtain hedge accounting. We continue, however, to enter into these arrangements as they provide certainty of price and delivery for the commodities we purchase, the exchange rates applying to the foreign currency transactions we enter into and the interest rates that apply to our debt. These arrangements result in fixed and determined cash flows. We believe that these arrangements remain effective economic and commercial hedges.

The effect of not applying hedge accounting under IAS 39 means that the reported results reflect the actual rate of exchange and commodity price ruling on the date of a transaction regardless of the cash flow paid at the predetermined interest rate, rate of exchange and commodity price. In addition, the movement in the fair value of open contracts in the period is recognised in the financing charge for the period. Whilst the impacts described above could be highly volatile depending on movements in exchange rates, interest rates or commodity prices, this volatility will not be reflected in our cash flows, which will be based on the fixed or hedged rate. The volatility introduced as a result of hedge accounting under IAS 39 has been excluded from our Underlying performance measures to reflect the cash flows that occur under the Group's hedging arrangements.

From time to time events occur which due to their size or nature we consider to be exceptional. The gains and losses on these discrete items can have a material impact on the absolute amount of, and trend in, the profit from operations and result for the year. Therefore any gains and losses on such items are analysed outside Underlying to enable the trends in the Underlying performance of the business to be understood. Where exceptional items are excluded from the Underlying result we provide additional information on these items to enable a full understanding of the events and their financial impact.

The items treated as exceptional in the period covered by this report are:

• UK product recall - in 2006, the incremental direct costs (net of directly attributable insurance recoveries) incurred in recalling seven Cadbury branded product lines in the UK and two in Ireland have been excluded from the Underlying results of the Group. The impact on trading following the recall is included in Underlying results. Further details regarding the UK product recall are set out on page 74.
• Nigeria - in 2006, the Group's share of Cadbury Nigeria's adjustments to reverse the historical over-statement of financial results has been excluded from the Underlying equity accounted share of result in associates on the grounds that these adjustments had accumulated over a period of years and were a consequence of deliberate financial irregularities. The charge is not considered to represent the Underlying trading performance of the business. Further details regarding the overstatement of results of the Group's Nigerian business are set out on page 74.
• Release of disposal tax provisions - in 2006, we reached agreement with the UK tax authorities as to the tax due in connection with the disposal in 1997 of Coca-Cola & Schweppes Beverages, a UK bottling business and the disposal in 1999 of the Group's beverage brands in 160 countries. This has resulted in the release of unutilised provisions totalling £51 million within discontinued operations. The original disposal gains, net of tax, were treated as discontinued operations and excluded from the Underlying results in the relevant years. Consistent with the original treatment, the release of the unutilised provisions has been excluded from the Underlying earnings of the Group.
• Recognition of UK deferred tax asset - in 2005, we recognised a deferred tax asset in the UK for the first time, which resulted in a £104 million credit to the current year taxation charge. As a consequence of its size and one-off nature, this amount has been excluded from the Underlying earnings of the Group.

In order to provide comparable earnings information the tax impact (where applicable) of the above items is also excluded in arriving at Underlying earnings. In addition, from time to time the Group may make intra-group transfers of the legal ownership of brands and other intangible assets. These transfers may give rise to deferred tax gains or losses which are excluded from the Underlying results.

For the reasons stated above, "Underlying profit from operations", "Underlying earnings" and "Underlying earnings per share" are used by the Group for internal performance analysis. They are the primary information seen and used in any decision making process by the CEC. The Group also uses Underlying profit as a key component of its primary incentive compensation plans including the Annual Incentive Plan, the bonus scheme for all employees of the Group.

"Underlying profit from operations", "Underlying earnings" and "Underlying earnings per share" exclude certain costs, some of which affect the cash generation of the Group. Assessing and managing our performance on these measures alone might result in the concentration of greater effort on the control of those costs that are included in the Underlying performance measures. In order to mitigate this risk, we also manage the business, and set external targets for, cash flow. The costs of restructuring projects are deducted in arriving at the cash flow measures we use and hence the careful monitoring of these costs is ensured.

The CEC does not primarily review or analyse financial information on a GAAP basis for profit from operations, earnings or earnings per share. The CEC bases its performance analysis, decision making and employee incentive programmes based on "Underlying profit from operations", "Underlying earnings" and "Underlying earnings per share". For these reasons, and the other reasons noted above, we believe that these measures provide additional information on our Underlying performance trends to investors, prospective investors and investments analysts that should be provided alongside the equivalent GAAP measures.

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Free Cash Flow

References to "Free Cash Flow" refer to the amount of cash we generate after meeting all our obligations for interest, tax and dividends and after all capital investment.

	2006 £m	2005 £m	2004 £m
Net cash from operating activities	620	891	745
Add back:
Additional funding of past service pensions deficit	67	31	–
Income taxes paid on disposals	83	–	–
Less:
Net capital expenditure	(300)	(261)	(259)
Net dividends paid	(270)	(257)	(257)
Free Cash Flow	200	404	229

Net capital expenditure includes purchases of property, plant and equipment (£384 million) less proceeds on disposal of property, plant and equipment (£84 million). Net dividends paid includes dividends paid (£272 million), dividends paid to minority interests (£4 million) less dividends received from associates (£6 million).

"Free Cash Flow" is not a defined term under IFRS and may not therefore be comparable with other similarly titled non- GAAP cash flow measures reported by other companies. Free Cash Flow is the measure we use for internal cash flow performance analysis and is the primary cash flow measure seen and used by the CEC. We believe that Free Cash Flow is a useful measure because it shows the amount of cash flow remaining after the cash generated by the Group through operations has been used to meet purposes over which the Group has little or no discretion such as taxation and interest costs or those which are characteristic of a continuing business, for example capital expenditure and dividends. Free Cash Flow therefore represents the amount of cash generated in the year by the Underlying business and, provides investors with an indication of the net cash flows generated that may be used for, or are required to be funded by, other discretionary purposes such as investment in acquisitions, business disposals and the drawing and repayment of financing.

In 2006, payments of £67 million made into our principal Group defined benefit pension arrangements in respect of past service deficits have been excluded from Free Cash Flow. These payments are part of a wider pension funding strategy for the period from 2005 to 2008. We believe that the funding of these pension deficits is a discretionary use of Free Cash Flow comparable to the repayment of external borrowings and has therefore been added back in calculating the Free Cash Flow. We will continue this reporting practice in future years. We continue to report the cash cost of funding pension obligations arising in respect of current year service within Free Cash Flow.

In 2006, tax payments arising on disposals of £83 million, principally a £74 million payment to the UK tax authorities in settlement of a tax dispute arising on the 1997 disposal of Coca-Cola & Schweppes Beverages, have been excluded from Free Cash Flow. This aligns the treatment of the tax with the treatment of the disposal proceeds which are excluded from Free Cash Flow.

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Net debt

References to "Net debt" refer to the total borrowings of our business, including both short-term and long-term bank loans, bonds and finance leases, after offsetting the cash and cash equivalents held by the business and our short-term investments.

The table below reconciles Net debt, as we define it, to the corresponding IFRS balance sheet captions.

	2006 £m	2005 £m	2004 £m
Short-term investments	126	47	21
Cash and cash equivalents	269	332	325
Short-term borrowings and overdrafts	(1,439)	(1,194)	(610)
Obligations under finance leases	(22)	(20)	(20)
Borrowings – non current	(1,810)	(3,022)	(3,520)
Obligations under finance lease – non current	(33)	(43)	(66)
Net debt	(2,909)	(3,900)	(3,870)

"Net debt" is not a defined term under IFRS and may not therefore be comparable with other similarly titled non-GAAP debt measures reported by other companies. Net debt is the measure we use for internal debt analysis. We believe that Net debt is a useful measure as it indicates the level of indebtedness after taking account of the financial assets within our business that could be utilised to pay down debt. In addition the net debt balance provides an indication of the net borrowings on which we are required to pay interest.

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Explanation of performance analysis

Following the disposal of our beverage businesses in Europe, South Africa and Syria this component of our business has been classified as a discontinued operation in accordance with IFRS 5. IFRS requires that the results of these businesses be excluded from revenue, profit from operations, financing and taxation and the after-tax result be shown as a single line item on the face of the income statement below taxation, with a corresponding re-presentation of the prior periods. Hence in the analysis that follows all reference to revenue growth, Underlying profit from operations growth and profit from operations growth excludes the pre-disposal result of these beverage businesses. A separate discussion of the Discontinued operations is presented on page 77.

IFRS requires that the Cash flow statement reflects the cash flows of the Group, including discontinued operations, and hence all cash flow analysis, including references to Free Cash Flow, include the pre-disposal cash flows occurring within these businesses.

The review below starts with an overview that analyses revenue and Underlying profit from operations, including the impact of exchange rates, and acquisitions and disposals in 2006 and 2005. As part of the review there is an analysis of marketing, restructuring costs, amortisation and impairment of intangibles, non-trading items, UK product recall, IAS 39 adjustments, share of result in associates, financing, taxation, discontinued operations, minority interests, dividends and earnings per share.

Following the executive summary, there is a review of the comparative results of each of the continuing business segments. Each segment reviews revenue, Underlying profit from operations and restructuring costs. Underlying profit from operations refers to each segment's profit from operations before restructuring costs, non-trading items, amortisation and impairment of intangibles, exceptional items and IAS 39 adjustment. This is the measure of profit or loss for each reportable segment used by the CEC and segment management.

The meanings of certain terms used in this operating and financial review are as follows:

References to "re-presented" information refer to the re-presentation of 2005 information to classify the South Africa beverages business as discontinued. In 2005, our beverage businesses in Europe and Syria were classified as discontinued operations. In 2006 we announced and completed the disposal of our South African beverages business. As this disposal was part of our strategic decision to exit beverages outside the Americas and Australia it was also classified as discontinued operations. As required by IFRS we have re-presented the 2005 and 2004 financial statements on a comparable basis.

References to "constant exchange rates" refer to the method we use to analyse the effect on our results attributable to changes in exchange rates by recomputing the current year result using the prior year exchange rates and presenting the difference as exchange movements.

References to "excluding acquisitions and disposals" are to "base business" growth excluding the first 12 months' impact of acquisitions and the last 12 months' impact of disposals. This impact is referred to as growth from acquisitions and disposals. Once an acquisition has lapped its acquisition date it is included within the base business results as there is a comparative period in the prior year results to compare the performance to. Acquisitions and disposals are excluded from the base business results as this provides comparisons of base business performance for users of the accounts.

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