QUALIPORT
Imperial Returns

By Maynard Paton (TMFMayn)
March 28, 2002

Three weeks ago, Qualiport watch list member Imperial Tobacco (LSE: IMT) announced the purchase of German rival Reemtsma. On the strategic front, the £3.5b deal looks a sound move. After outmanoeuvring one or two other interested parties, Imperial has made a quantum leap into the sector's global top tier. Although Imperial's shares have risen 27% to 1,164p since the announcement, is there an investment opportunity at hand?

(For those unfamiliar with Imperial Tobacco, this review outlines the business and investment attractions of the company.)

Consolidation

The Reemtsma purchase continues the general trend of consolidation in the global tobacco industry. In recent years, the sector has witnessed:

* Mexico 1997: The purchase of Tabacalera Mexicana by Philip Morris (NYSE: MO.) for $400m and the purchase of Cigarella La Moderna by British American Tobacco (LSE: BATS) for $1.7b.

* 1999: The merger of BAT and Rothmans;

* 1999: The merger of SETIA, the market leader in France, and Tabacalera, the market leader in Spain, to form Altadis;

* 1999: The purchase of the international operations of RJ Reynolds (NYSE: RJR) by Japan Tobacco for $8b, and;

* 2001: The purchase of Austria Tabak by Gallaher (LSE: GLH) for £1.4b.

By purchasing the world's fifth largest industry player (by volume), Imperial has stepped up from its previous 12th place ranking to close the gap on the sector's major players. With annual cigarette volumes of around 180b expected after the tie-up, those ahead of Imperial/Reemtsma will just be the Chinese state-owned China National Tobacco Company (cigarette volume of c1,700b), Philip Morris (c900b), BAT (c800b) and Japan Tobacco (c500b).

Apart from the usual reasons of economies of scale and cost cutting, all the corporate activity is spurred by increasing restrictions being placed upon the tobacco industry. As Imperial stated in their offer documentation: "The acquisition of establish brands in targeted markets, at a time when the regulatory environment is becoming more stringent and controls on advertising are growing, is increasingly attractive as the cost and timescale required to establish equivalent brand value through organic growth can be considerable. As such, the Acquisition presents Imperial Tobacco with an excellent opportunity to acquire strong brand value in many of its targeted markets, within an accelerated timeframe."

While increasing industry regulation makes a great barrier to entry for established tobacco companies in their domestic market, the flipside is the difficulty it creates when expanding into new markets. Certainly in European markets, the race is now on to snap up the best tobacco brands before legislation leads to total advertising blackouts.

Reemtsma

Owning brands such as West, Peter Stuyvesant, Davidoff and R1, Reemstma is Germany's leading cigarette company with a 22% market share. The group also has a presence in a handful of other European markets, notably Slovakia (44% market share), Slovenia (76%) and Kyrgystan (61%). In addition, Reemstma also has the largest presence of all foreign multinationals in Taiwan (15% market share). Taiwan, of course, is an important stepping-stone in the ultimate quest for all global tobacco firms: an entry into the lucrative, but currently state-run, Chinese market.

On the financial front, the privately owned Reemtsma offers plenty of scope for cost reduction:

To December 31st                 1998     1999     2000
                                 (€m)     (€m)     (€m)

Turnover                       6,577    7,003    7,235
Duty                          (4,294)  (4,528)  (4,676)
Turnover (excl. duty)          2,283    2,475    2,559

Operating Profit                 279      379      400
Pre-tax Profit                   354      436      456
Earnings                         244      249      302

Although Reemtsma's operating margins (on turnover excluding duty) are 15%, they pale into insignificance when compared to Imperial's 41%. Annual cost savings of at least £170m (€280m) are expected in 2004. It's worth noting that Reemtsma's 'estimated' EBITDA for 2001 was €458m, a decline from the previous year's €557m figure. The shortfall was caused by increased competition in Germany and the group's exit from various distribution arrangements.

To help fund the Reemtsma purchase, Imperial will soon launch a 2 for 5 rights issue. This should raise around £980m. The balance, some £2.2b, will come from additional borrowings. Unfortunately, details of Reemtsma's 2001 financial performance are a little sketchy. But after making various assumptions, the group looks to have made an operating profit of £224m last year.

Assuming also:

* Underlying profits remain flat;
* Savings of £170m are produced;
* Interest on the £2.2b of debt is charged at 7%, in line with Imperial's current borrowings, and;
* Tax is charged at 35%, Reemtsma's average rate over the past 3 years...

...then Reemstma should (eventually) contribute annual post-tax profits of £156m. With Imperial shareholders forking out £980m, the implied return on equity comes to a decent 15.9%.

With Imperial earning £350m after tax last year, earnings per share (EPS) for the enlarged group should be approximately 69.3p post-rights issue. As Imperial's historic EPS is 70p, it appears the deal is broadly neutral in the short-term. However, looking further down the line, Imperial is in a far stronger strategic position than before.

In terms of valuation, the threat of litigation, ever-greater industry restrictions, continuing increases in excise duties and generally mature Western markets all combine to leave tobacco shares traditionally standing on low ratings. Since Imperial's 1996 flotation, its shares have, on average, traded on a prospective earnings yield (in this case, a genuine proxy for a free cash flow yield) of 9.1%. Assuming 10% cash flow growth this year for Imperial and the above performance for Reemtsma, 845p would see the shares of the Imperial/Reemstma combine offer 'average value'.

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