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QUALIPORT
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A key tenet of successful long-term investing is drawing a circle of competence. Focusing on a few familiar industries is more likely to produce rewards than spreading your knowledge over a myriad of different sectors. The UK tobacco sector is probably the easiest to investigate, it having just two notable players. With Imperial Tobacco (LSE: IMT) already on the Qualiport watch list, it's time to look at its major rival: Gallaher (LSE: GLH) The business Gallaher was established in 1857 to manufacture Irish roll pipe tobacco. A string of acquisitions subsequently diversified the group into cigarettes and cigars, the most notable purchase being Benson & Hedges in 1955. In 1975, Gallaher was bought by the American Tobacco Company. After disposing of various non-tobacco businesses, Gallaher was spun off from its parent in 1997 and floated on the London stock market. In 2000, Gallaher made its first notable move outside the UK and Republic of Ireland with the £260m purchase of Liggett-Ducat, a leading cigarette firm in Russia. Last year, Gallaher bought Austria Tabak for £1.1b, the major tobacco firm in Austria and Sweden. In the UK, Gallaher and Imperial dominate the tobacco market. During 2001, Gallaher had a 39% domestic market share of cigarette sales, while Imperial reported a 41% share. After decades of being the overall market leader, Gallaher has been losing ground in recent years. Increases in Government excise duty has led to many smokers 'trading down' to lower priced cigarettes. This trend has largely favoured Imperial's stable of products, with premium Gallaher brands such as Benson & Hedges and Silk Cut losing out. However, Gallaher has not sat back, having introduced low-price cigarette brands Mayfair in 1992 and Sovereign in 1996. Other famous names in the Gallaher range include Hamlet, Amber Leaf and Condor. The financials Here's the five-year record of Gallaher:To December 31st 1997 1998 1999 2000 2001
Turnover (£m) 4,415 4,255 4,343 4,454 5,455
Duty (£m) (3,446) (3,317) (3,382) (3,415) (4,082)
Turnover Excluding Duty (£m) 969 938 961 1,039 1,373
Operating Profit (£m) 385 394 422 445 480
Exceptional Items (£m) - - - - (31)
Net Interest (£m) (45) (72) (76) (94) (94)
Pre-tax Profit (£m) 341 322 347 351 356
Earnings per share (p) 35.7 32.2 36.7 40.8 45.9
Dividend per share (p) 19.3 20.5 22.3 23.8 25.5
Gallaher has shown steady progress in recent years. However, it's worth noting the group's contrasting geographical performances.
To December 31st 1997 1998 1999 2000 2001 UK Turnover Excluding Duty (£m) 745 701 724 708 634 Operating Profit (£m) 322 324 347 346 307 International Turnover Excluding Duty (£m) 225 237 237 331 1,082 Operating Profit (£m) 60 66 73 97 174In the UK, Gallaher's dominant position has allowed operating margins (on turnover excluding duty) to increase from 43% to 48% over the past five years. The slump in UK profits during 2001 should be a one-off, the fall being due to new Government restrictions on the prepayment of duty ahead of the Budget. Acquisitions have helped fuel international growth, although various low margin businesses at Austria Tabak caused overseas margins to fall from 29% to 16% in 2001.
Cash flow and return on equity
To December 31st 1997 1998 1999 2000 2001 Operating Profit (£m) 385 394 422 445 480 Working capital change (£m) (67) (236) 782 (183) 59 Depreciation (£m) 22 23 27 33 50 Net capital expenditure (£m) (30) (36) (32) (59) (108)Just like Imperial, Gallaher is a wonderful cash cow. Although volatile, the past five years have seen a cumulative outflow of cash from working capital. Furthermore, up until the recent acquisitions, expenditure on tangible fixed assets had remained at less than 10% of operating profit. The recent surge in capital expenditure is no doubt due to acquisition integration requirements.
The relative lack of assets does cloud Gallaher's return on equity calculation though. As the table below shows, large amounts of debt allow Gallaher to essentially operate without shareholder funding.
To December 31st 1997 1998 1999 2000 2001 Earnings (£m) 244 221 247 259 289 Tangible fixed assets (£m) 151 183 188 295 552 Intangible fixed assets (£m) 119 126 160 366 1,368 Net debt (£M) (1,097) (1,692) (874) (1,404) (2,426) Shareholders' funds (£m) (482) (438) (424) (471) (211)On an incremental return on equity basis, the 1997 figures are complicated by Gallaher's demerger. At that time, Gallaher took on borrowings of £945m part way through the year. In comparison to subsequent years, earnings in 1997 were effectively flattered by the lower interest charge.
Going on the performance between 1998 and 2001, the company generated additional earnings of £78m while shareholders' funds increased by £227m. The resultant incremental return on equity comes to 34.4%. While additional borrowings have undoubtedly underpinned Gallaher's reinvestment accomplishments, 20%-plus return on equity figures would still be generated if debt and interest payments were removed from the calculation.
Valuation and summary
Imperial Tobacco is ahead of Gallaher on many points. For starters, Gallaher is playing catch-up in the low-price UK cigarette sector. In addition, Imperial's record of purchases (notably including the world's fifth largest tobacco firm, Reemstma) looks far more attractive than Gallaher's acquisition of two relatively minor European players. On a financial basis, Imperial's performance is generally the more appealing, too.
That said, tobacco is a great industry for investors. It's simple, visible and steady, and has high margin products and great cash flow characteristics. All in all, the average cigarette company is much more attractive than most other businesses. Even though it's second best to Imperial, Gallaher is still alluring.
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 Gallaher's 1997 flotation, its shares have, on average, traded on a forward earnings yield (in this case, a genuine proxy for a free cash flow yield) of 10.3% and a prospective dividend yield of 6.1%. Assuming 6% growth this year, 461p would see Gallaher shares offer 'average value'.