QUALIPORT
Forget Tradition, Think Tobacco

By Maynard Paton (TMFMayn)
April 19, 2001

Carburton Street, London -- Warren Buffett has made a fortune from investing in "consumer franchises". His investments in the likes of Coca-Cola (NYSE: KO.) and Gillette (NYSE: G.) are now inscribed in stock market folklore. However, the Qualiport's foray into this type of stock picking hasn't been entirely in the same league. Our investment in Unilever (LSE: ULVR) was ultimately disappointing. Paying too high a price for pedestrian growth was the cause.

But the underlying theory of buying into consumer goods companies is simple. They typically produce stable and predictable operating performances, while their high margin branded products usually equate to all-round superior financial characteristics. All good qualities for a long-term buy and hold investor.

Alongside its involvement with Unilever, the Qualiport has reviewed Cadbury Schweppes (LSE: CBRY), Reckitt Benckiser (LSE: RB.) and Diageo (LSE: DGE) in the past. My general dislike towards these four companies is that, in order to improve their dull top line sales growth, each is constantly re-jigging its corporate direction, which leads to significant acquisition activity, substantial exceptional items and complex accounts.

So, how about an alternative industry for consumer franchise investing, away from the "traditional" areas of food, drinks and household goods? How about tobacco?

Tobacco

The UK stock market has three tobacco firms: British American Tobacco (LSE: BATS), Imperial Tobacco (LSE: IMT) and Gallaher (LSE: GLH). While they all suffer from the familiar "consumer franchise" problem -- a slow rate of organic sales growth -- all three do have qualities that are missing from the Unilevers and Reckitts of this world:

* Focus. The tobacco players concentrate purely on tobacco-based products. The "traditional" consumer companies tend to spread themselves over a whole range of different products, leading I'm sure, to lower economies of scale.

* Fewer exceptional charges: Perhaps as a follow on from the focus issue, hardly a year goes by without a traditional consumer company throwing in a significant acquisition-related exceptional charge. One-off restructuring costs in the tobacco industry are minor in comparison.

* Lower valuations: While growth rates of traditional consumer companies are generally equal to their tobacco counterparts, the valuations are not. These days, the likes of Unilever sell on P/Es of around 20. The low valuations accorded to the tobacco companies can be seen below.

Company         Share price    Market Value    Prospective
                    (p)            (£m)       P/E   Div. Yield

BAT                 526           11.446       8.5     6.0
Imperial            711            3,701      10.4     4.8
Gallaher            453            2,779      10.7     5.5

Pricing power

Coupled with the above, one other great feature of the tobacco industry is the obscenely high operating margins to be had. Strip out the duty paid to the Government, revealing the actual profit made by the company, and the pricing power available to anybody manufacturing branded tobacco products is clear to see. The latest results from Gallaher highlight this great investment characteristic:

To 31st December 2000              (£m)        

Turnover                           4,454
Duty                              (3,415)

Turnover excluding duty            1,039
Operating Costs                     (605)
Operating Profit                     434

Operating margin on
turnover excluding duty             41.7%

Pick one of three

So, are tobacco firms worth investigating further for a long-term investment? I think so. Having had cursory glances at all three, Gallaher looks to be the pick of the bunch.

Helped by its Benson & Hedges and Silk Cut brands, Gallaher is the UK leader with a market share of 40%. What's more, through last year's purchase of Liggett-Ducat, Gallaher is also the market leader in the former Soviet Union, the world's fourth largest cigarette market. Overseas profits now contribute 20% of Gallaher group profits, and increased by an underlying rate of 20% last year.

Imperial's stable of UK brands puts the company in the number two spot in this country. However, while overseas operations contribute a third of Imperial's group profits, the company's latest preliminary results failed to highlight any country where the company had a market lead. That said, like Gallaher, Imperial's underlying international profits grew by 20% last year.

The far larger BAT is a very different proposition. The group has significant operations in the ultra-competitive US market, exposure to which has resulted in:

* a recent restructuring programme, to stem a declining market share and to "remain competitive", and;
* the threat of punitive litigation claims.

Reading BAT's latest results, it's difficult to gauge the progress in its international "growth" markets. The numbers are clouded by the company's 1999 merger with Rothmans and the underlying non-US, non-European picture is hard to determine. 

Overall, with strong domestic bases, no US litigation threats, and a smaller size that could tempt a predator in this consolidating industry, Gallaher and Imperial are my two favourites. And I'd give Gallaher the nod due to its market leadership in the UK and Russia. In due course, I'll investigate Gallaher's business and finances in more detail. But in the meantime, you can have your say on the tobacco industry...

Your turn

Using the poll below, complete the following phrase:

"Tobacco companies are..."

• Great long-term buy and hold consumer franchises
• Suitable only for Value or Income investors
• Investment timebombs due to impending litigation
• Ethically unsound for investment purposes
• ...er, I don't know

Click here to vote.