QUALIPORT
Imperial Tobacco: Seriously Tempting

By Maynard Paton (TMFMayn)
April 30, 2001

Carburton Street, London -- Having had a cursory look at the three listed UK tobacco companies the other week, today I'm narrowing down the companies to just one. While I'd already dismissed British American Tobacco (LSE: BATS) because of its large exposure to the ultra-competitive and litigious US market, of the remaining two, I did give Gallaher (LSE: GLH) the nod over Imperial Tobacco (LSE: IMT). Subsequent research, however, leads me to believe Imperial is the better long-term bet.

Why Imperial?

Together, Gallaher and Imperial both dominate the UK cigarette market. Gallaher has a total domestic market share of 41%, while Imperial has a 38% share. Overall, there's nothing much to choose between the two on the home cigarette front. However, Imperial scores on its international and other tobacco-related operations, the main areas of future growth for both companies.

Imperial is the UK and world leader in the smaller, but faster growing areas of roll-your-own tobacco and cigarette papers. Gallaher, on the other hand, has little presence in these product markets. What's more, I'm not entirely comfortable with Gallaher's attempts to gain market-leading positions overseas.

Gallaher's £270m purchase of Liggett-Ducat, the market-leader in Russia for cigarettes, valued the acquired business at over 30 times historic earnings. Compare that to Imperial's £650m purchase of Dutch concern Van Nelle Tabak, the world leader in roll-your-own tobacco, acquired on a price to earnings (P/E) ratio of about 16. And with international profits currently contributing a greater proportion of group profits at Imperial than at Gallaher, 41% versus 20%, and those profits having grown at a faster rate in recent years too, Imperial do look the superior long-term proposition.

The business

Imperial Tobacco, valued at £3.3b and a member of the FTSE 100, manufacturers a wide range of branded tobacco related products.

In the UK, its range of cigarettes (including Embassy, Regal and Superkings brands) provides the company with a 38% market share. Imperial also owns the UK market leaders in pipe tobacco (39% market share), cigarette papers (75% market share) and roll-your-own tobacco (64% market share).

The majority of Imperial's UK profits come from cigarettes, a market that "officially" declined 10% during 2000. Because of the ever-rising Government duty imposed on cigarettes, smokers are increasingly turning towards less expensive alternatives, such as cheap (and usually illegal) imports, or roll-your-own tobacco. Despite the official decline, Imperial, has not suffered financially. It still benefits from the overseas sales of it UK brands, and the company is gaining from the gradual switch by smokers to "rolling their own". Imperial's domestic operating profits have edged up 1.5% annually since 1997, a performance aided by productivity improvements and an overall "stable" marketplace.

Imperial's international expansion has been driven by both organic growth and acquisitions. Its 1998 purchase of Van Nelle Tabak made the company the world-leader in the roll-your-own market. Imperial now have around 30% of this particular global market, and should benefit from synergies relating to its existing roll-your-own products and through its leading cigarette paper operation.

Elsewhere, acquisitions have provided prominent cigarette market shares in Australia, New Zealand and Western Africa. Overall, "underlying" (ie. excluding acquisitions and currency movements) international profits have increased by 33%, 26% and 19% over the past three years.

The financials

Here's Imperial's record since its demerger from Hanson (LSE: HSN) in 1996:

To September 30th           1997    1998    1999    2000

Turnover (£m)              3,878   4,029   4,494   5,220
Duty (£m)                 (3,044) (3,081) (3,292) (3,920)

Turnover Exc Duty (£m)       834     948   1,202   1,300

Operating Profit (£m)
  -- UK (£m)                 312     319     330     329             
  -- International (£m)       79     117     188     231
  -- Total (£m)              391     436     518     560

Earnings Per Share (p)      40.7    44.4    55.4    62.5

Dividend Per Share (p)      21.4    23.4    27.5    31.7

As previously highlighted, tobacco firms have obscene operating margins. Strip out the duty paid to Governments, to reveal the actual costs associated with production, and Imperial's operating margin is a stunning 43%. Lower margin foreign products have impacted group margins of late, although UK margins have held reasonably steady at the 49%(!) level.

Cash and capital expenditure

Even better, Imperial is a high margin business whose profits are essentially reflected in cash.

To September 30th           1997    1998    1999    2000

Operating Profit (£m)        391     436     518     560

Working capital change (£m) (236)    216      77    (123)

Capital Expenditure (£m)     (36)    (31)    (62)    (49)

Although volatile, movements in working capital have broadly evened out over the past four years. And expenditure on fixed assets is hardly a drag on cash resources either, it running at around 10% of operating profit.

With minimal working capital and fixed asset commitments, Imperial's free cash flow goes mainly towards funding acquisitions. However, the corporate activity has been aided by borrowings too.

To September 30th            1997    1998    1999    2000

Operating Profit (£m)        391     436     518     560

Acquisitions (£m)           (168)   (669)   (134)     (3)

Increase in borrowing (£m)   246     324      81      60

Debt funding

Using debt to partly fund Imperial's growth has resulted in an impressive incremental return on equity performance. However, accounting niceties relating to the Hanson demerger have heavily distorted Imperial's balance sheet. But using Imperial's cash flow statement, a rough return on equity figure can be calculated.

Since 1997, total expenditure on fixed assets and acquisitions has totalled £1,166m. Net borrowings, however, have increased by £711m over that time. Therefore, equity shareholders have invested £455m of their cash during the past four years to improve profits. Post-tax earnings in that time have risen from £212m to £323m, an increase of £111m. The effective incremental return on equity is thus 24.4% (£111m/£455m).

Of course, the attractive reinvestment performance does come with a price. With a debt mountain of £1,383m, Imperial's interest cover is just 4.5 times. Retained profits, including acquisition synergies, should flow through and help pay down the debt in due course. All the same, the greater the debt, the greater the investment risk.

Valuation and Summary

Imperial has many attributes worthy of a Qualiport company. The company has a dominant presence in many of its markets and its repeat purchase, simple to understand products have a predictable and stable demand. High margins combined with low capital expenditure leads to a prodigious cash flow and impressive returns for equity shareholders. While the company is heavily indebted, the plus points more than make up for the borrowing downside.

At 720p per share, with earnings growth of around 9% expected for the next two years, Imperial shares stand on a prospective P/E of 10.5 and offer a prospective dividend yield of 4.7%. Hardly a demanding rating, although it's a rating that Imperial has averaged since 1997. Overall, I'm seriously tempted to buy Imperial shares right now. However, call it prudent patience or sheer cowardice, I'm going to defer any decision until at least next week, when Imperial publishes its interim results. But given the right results and the right share price, Imperial could very well be the next Qualiport member.

More:  Forget Tradition, Think Tobacco | Imperial Tobacco's discussion board | website