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Should You Give Up On Imperial Tobacco Group PLC?

It is no secret that Imperial Tobacco (LSE: IMT) (NASDAQOTH: ITYBY.US) has been struggling during the past few years. Indeed, a combination of razor-thin profit margins from Imperial’s European logistics operation and falling cigarette sales have pressured the company’s bottom line.

What’s more, after several decades of debt funded acquisitions, Imperial is struggling with interest costs that consumed one third of the company’s operating profit during 2012.

Having said all of that, Imperial should not be left for dead just yet.

Imperial is a highly cash generative company, producing around £2 billion of free cash flow during 2012, which was considered a bad year for the company. Moreover, this free cash flow has allowed the company to reduce net debt by 30% over the past five years. 

Additionally, within Imperial’s recent third-quarter trading update, management revealed that sales of the company’s key strategic brands, West, JPS, Davidoff and Gauloises Blondes had outperformed the wider market. 

Furthermore, Imperial is currently undertaking a ‘cost optimization’ program. This program is targeting annual cost savings of £300 million from September 2018. I project that this program should boost the company’s operating profit margin by 20% by 2018, based on 2012’s numbers. 

Valuation

Unfortunately, many market participants do not have much faith in Imperial’s future and as a result the company trades at a significant discount to its only London listed peer, British American Tobacco. Specifically, Imperial currently trades at a forward P/E ratio of 10.5, while British American trades at a ratio of 14.6.

What’s more, City analysts predict that Imperial’s dividend yield will hit 5.8% during 2014. However, City analysts predict that British American will only yield 4.8% for the same period. 

Attractive target

Considering the wave of consolidation in the tobacco sector during the past few decades and Imperial’s current low valuation, I believe that the company is an attractive takeover target for its larger peers.

In particular, many City analysts have long considered Japan Tobacco to be Imperial’s best suitor. Indeed, it would appear that Japan Tobacco is currently well placed to make an offer as the company’s profits exploded 16% during the first quarter of this year alone.

In addition, interest rates in Japan are currently at record low levels so it is likely that Japan Tobacco would have no trouble raising funds for the deal.

Foolish summary

All in all, Imperial’s low valuation, high dividend yield and prospect of a takeover indicate to me that Imperial is not a company that you should give up on just yet. 

Big tobacco companies such as Imperial are well known for their impressive cash generation, reliable dividends and resilient growth.

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> Rupert owns shares in Imperial Tobacco.