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QUALIPORT
By
Carburton Street, London -- Qualiport watch list company Imperial Tobacco (LSE: IMT) published its full-year results this morning. There were no surprises within the statement, with acquisitions helping the company notch up a 10% increase in profits. Overall, Imperial remains an attractive business. It's a simple, steady, market-leading operation that has little appetite for shareholders' capital. Industry The key features of the UK tobacco industry are: * It's a market dominated by Imperial and Gallaher (LSE: GLH). In terms of cigarettes, which make up the bulk of the UK tobacco market, Imperial presently has a 41.4% market share. Meanwhile, Gallaher has approximately 38-40% of the UK cigarette market, with the balance largely divided between British American Tobacco (LSE: BATS) and Philip Morris (NYSE: MO.) * It's a market that will probably remain dominated by Imperial and Gallaher. Both companies have been the major UK tobacco players for decades, while new entrants have historically been very limited. Barriers to entry include strong existing brands and government duty, the latter restricting any new entrant gaining market share via discount pricing. * It's a market that, officially at least, is in decline. UK cigarette volumes have fallen from 83b to 55b since 1995. However, legal and illegal imports have risen over that time in response to substantial increases in UK excise duty. Three out of ten cigarettes in the UK are reportedly bought overseas. Financial Here's Imperial's record since its demerger from Hanson (LSE: HSN) in 1996. Given the maturity of the UK market, profit growth is driven by international expansion and cost cutting. Recent corporate purchases have included Rizla, the world's leading cigarette paper business; Van Nelle Tabak, owner of the world's best selling roll-your-own tobacco brand, and; Tobaccor, a firm that has the sole cigarette manufacturing rights in eight African countries. Excluding duty paid to various governments, Imperial's group operating margin remains a healthy 40%. UK margins were 47% for 2001. Although margins have been eroded following the group's gradual move to lower priced segments of the cigarette market, it's clear that Imperial continues to have plenty of brand-based pricing power. Cash flow The main financial attraction to Imperial is the company's cash flow profile. Although somewhat volatile on an annual basis, cash absorbed into working capital over the past five years has amounted to just 3% of operating profits. Furthermore, whilst almost double the total depreciation charged since 1997, cash spent on tangible assets has averaged a relatively tiny 8% of operating profits. Indeed, as this study shows, Imperial is brimming with those all-important intangible assets. No doubt about it -- Imperial is a veritable cash fountain. Return on equity
But debt has played its part in producing such enticing returns. Since 1997, the funding of acquisitions has seen net debt increase from £1.2b to £1.5b. Imperial's net interest bill for 2001 was £110m, which was covered 5.6 times by operating profits. However, after stripping out debt from Imperial's balance sheet, adding back (tax adjusted) interest payments to earnings, and adjusting shareholders' funds for some £1.5b of purchased goodwill, Imperial's return on average equity comes to a handsome 20.3% on a conservatively adjusted, and unleveraged, asset base. Valuation Based on today's results, at 846.5p per share, Imperial shares offer a historic free cash flow yield of 8.3%. Normally, that would be a very attractive valuation. However, tobacco shares always appear cheap as investors build 'litigation discounts' into their valuations. On this point, remember that Imperial has never paid out a penny in smoking-related damages, nor is the company exposed to any US legal action. As mentioned before, it's worth reflecting on how the stock market has judged Imperial's 'litigation discount' in the past to determine a suitable valuation for the company today. Thus, since the 1996 demerger, Imperial shares have traded on an average prospective earnings yield (which, in this case, is essentially the free cash flow yield) of 9.44% and an average prospective dividend yield of 4.82%. At the moment, brokers are expecting earnings per share of 78.0p and a dividend per share of 36.6p in the current year. With those forecasts and past valuations in mind, an entry price of 793p would encompass an average 'litigation discount'. All things remaining equal, should they fall below that level, the Qualiport will be tempted to cough up for Imperial shares. More: Imperial Tobacco: Seriously Tempting | Tobacco: Is It Worth The Litigation Risk? | Imperial Tobacco discussion boardTo September 30th 1997 1998 1999 2000 2001
Turnover (£m) 3,878 4,029 4,494 5,220 5,918
Duty (£m) (3,044) (3,081) (3,292) (3,920) (4,444)
Turnover Less Duty (£m) 834 948 1,202 1,300 1,474
Operating Profit* (£m)
-- UK (£m) 312 319 330 329 325
-- International (£m) 79 117 188 239 294
-- Total (£m) 391 436 518 568 619
Earnings Per Share* (p) 40.7 44.4 55.4 64.1 70.6
Dividend Per Share (p) 21.4 23.4 27.5 31.7 34.5
(*adjusted for goodwill)
To September 30th 1997 1998 1999 2000 2001
Operating Profit (£m) 391 436 518 568 619
Change in
working capital (£m) (236) 216 77 (123) (11)
Depreciation (£m) 13 16 20 33 34
Net capital
expenditure (£m) (36) (30) (61) (47) (38)