Why I Wouldn’t Buy Imperial Tobacco Group Plc Or British American Tobacco plc

Here is my view on Imperial Tobacco Group Plc (LON: IMT) shares

| More on:

The content of this article was relevant at the time of publishing. Circumstances change continuously and caution should therefore be exercised when relying upon any content contained within this article.

When investing, your capital is at risk. The value of your investments can go down as well as up and you may get back less than you put in.

Read More

The content of this article is provided for information purposes only and is not intended to be, nor does it constitute, any form of personal advice. Investments in a currency other than sterling are exposed to currency exchange risk. Currency exchange rates are constantly changing, which may affect the value of the investment in sterling terms. You could lose money in sterling even if the stock price rises in the currency of origin. Stocks listed on overseas exchanges may be subject to additional dealing and exchange rate charges, and may have other tax implications, and may not provide the same, or any, regulatory protection as in the UK.

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More.

After steep losses during August, Imperial Tobacco (LSE : IMT) shares have embarked upon a notable recovery in recent months, before going on to reach new highs in November as a result of renewed speculation that British American Tobacco (LSE: BATS) could soon make a bid for its rival.

Wringing the rag dry

Today isn’t the first time that I have written about this subject. In my view, investors in companies like Imperial Tobacco should probably be slightly concerned about leverage, particularly in light of the cost implications that rising interest rates will have.

Both businesses are highly leveraged while operating within a challenging regulatory and consumer environment. In my view, the long-term investment case for these companies is diminishing, and in light of the recent gains, investors should reassess their positions in the shares.

With organic revenue growth topping out long before now, management at both companies have only two options available to meet their commitments to shareholders. These are: a) boosting earnings and returns by cutting fat from the bone (cost cuts); or b) inorganic growth through acquisition.

Now both companies have made progress in their efforts to reduce product costs and to reduce operational costs in recent periods, but this strategy can only ever yield limited gains without further acquisitions.

This is while I cannot help but feel that M&A driven growth is merely a move to delay the inevitable. This is because any acquisitions will probably involve the issuance of at least some debt in addition to taking on the debts of the acquired company, which merely reinforces my concerns over leverage.

If the tobacco industry were a leather rag then I would be inclined to describe it as one that has almost been wrung dry, at least as far as investment potential is concerned…

Leverage, either which way…

In the year to September, total debt at Imperial increased by a considerable 43%, bringing debt/equity to 2.7x, which means that the group now has nearly three times the amount of debt as its shareholders do equity.

For those who thought that it would be difficult to top that, BAT is actually worse off than its rival Imperial, with total borrowings up by 26% year to date and debt/equity now over 3.1x.

Furthermore, if BAT were to acquire Imperial, the combined entity’s balance sheet would be little improved without a considerable rights issue.

Valuation, dividends & disappointment

From a valuation perspective, the shares now trade at 15x the consensus estimate for earnings in the current year, which compares well with the 18.5x multiple for BAT. However, it is an open question as to whether these multiples could be judged as appealing or not.

In addition, despite Imperial honouring its pledge to grow dividends by 10% per annum in the year to September 2015, broker estimates suggest that shareholders could now be in for a disappointment in the current year.

The average estimate is for dividend growth in the low single digits — with implied cover at 1.5x, for the current period.

Summing up

To me, the leverage issues mean that any anticipated cost synergies would have to be significant for the rumoured deal to offer any tangible benefit to shareholders.

Just about the only thing that is clear at present is that Imperial shares have benefited considerably from various forms of speculation of late, while high leverage and the prospect of meagre dividend growth ahead continues to do the underlying investment case little justice.

Therefore, either which way, it would seem most likely that any further gains are going to be limited from here.

As a result, I’d probably take the quarter’s performance as a cue to book profits and walk away before anybody else does — and certainly before interest rates begin to move.  

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

James Skinner has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

More on Investing Articles

Smiling family of four enjoying breakfast at sunrise while camping
Investing Articles

How I’d turn my £12,000 of savings into passive income of £1,275 a month

This Fool is considering a strategy that he believes can help him achieve a stable passive income stream with a…

Read more »

Person holding magnifying glass over important document, reading the small print
Investing Articles

2 top FTSE 250 investment trusts trading at attractive discounts!

This pair of discounted FTSE 250 trusts appear to be on sale right now. Here's why I'd scoop up their…

Read more »

Smiling young man sitting in cafe and checking messages, with his laptop in front of him.
Investing Articles

3 things that could push the Lloyds share price to 60p and beyond

The Lloyds share price has broken through 50p. Next step 60p? And then what? Here are some thoughts on what…

Read more »

Young female business analyst looking at a graph chart while working from home
Investing Articles

£1,000 in Rolls-Royce shares a year ago would be worth this much now

Rolls-Royce shares have posted one of the best stock market gains of the past 12 months. But what might the…

Read more »

Investing Articles

Are HSBC shares a FTSE bargain? Here’s what the charts say!

There are plenty of dirt-cheap FTSE 100 banking stocks for investors to choose from today. Our writer Royston Wild believes…

Read more »

Three signposts pointing in different directions, with 'Buy' 'Sell' and 'Hold' on
Investing Articles

Just released: Share Advisor’s latest ‘Hold’ recommendation [PREMIUM PICKS]

In our Share Advisor newsletter service, we provide buy, sell, and hold guidance for our universe of recommendations.

Read more »

Investing Articles

Investing £5 a day could help me build a second income of £329 a month!

This Fool explains how £5 a day, or one less takeaway coffee, could help her build a monthly second income…

Read more »

Smart young brown businesswoman working from home on a laptop
Investing Articles

2 FTSE income stocks investors should consider buying in April

Income stocks are a great way to build wealth. Our writer details two picks she believes investors should consider snapping…

Read more »