QUALIPORT
Do Cigarettes And Alcohol Offer Value?

By Maynard Paton (TMFMayn)
May 9, 2002

"It's a crazy situation. But all I need are cigarettes and alcohol!" Oasis frontman Liam Gallagher may not be a well-known stock picker, but his lyrics have a certain resonance with the Qualiport. That's becuase portfolio watch list members Allied Domecq (LSE: ALLD) and Imperial Tobacco (LSE: IMT) recently published their interim results. Although both companies remain simple and stable, is either in a crazy "undervalued" situation?

Allied Domecq

Here are Allied's latest results:

Six months to Feb 28th                2002      2001       Change (%)

Turnover (£m)                        1,704     1,457          17
Operating Profit (£m)                  313       277          13
Pre-tax profit (£m)                    251       236           6

Earnings per share (p)                17.2      16.1           7
Dividend per share (p)                 4.9       4.5           9

Key points about Allied are:

* Capitalised at £4.8b, Allied is one of the world's leading drinks companies. Famous names in Allied's cabinet include Ballatine's scotch whisky, Beefeater gin, Tequila Sauza, coffee liqueur Tia Maria and Harvey's Bristol Cream. Those and other tipples generate over 90% of group revenues and profits. The balance is generated by Allied's franchising of Dunkin' Donuts, Baskin-Robbins and Togo food outlets.

* New distribution agreements and acquisitions have fuelled recent growth. Securing the marketing and development rights of Stolichnaya vodka in the US, plus the purchase of New Zealand wine firm Montana, helped the comparative interim performance. On an underlying basis, the latest figures showed a flat drinks performance. Like-for-like, volumes slipped 3% while turnover increased 4%. 'Organic' operating profits improved by 2% to £260m.

* The disposal of various retail business a few years ago alongside fresh acquisitions has made an accurate judgement of Allied's profit re-investment potential very difficult. For example, the recent purchase of German spirits group Kummerling (£126m) and Spanish wine firm Bodegas y Bedibas (£198m) made no "material impact" on the latest results. However, the return on average equity employed during the past year comes to 12.4%. The complex accounts won't improve when Allied purchases the Malibu spirit brand from Diageo (LSE: DGE) for £560m.

* On the surface though, Allied looks an appealing business. Strip out government excise duty, and the drinks business generates operating margins of 24% (the fast food division has 24% margins too). In terms of fixed assets, the past twelve months has seen net capital expenditure of £99m. Compared to operating profits of £573m, Allied's business looks largely based on attractive intangibles.

* After replacing the £61m depreciation charge with £99m of capital expenditure, Allied produced free cash flow of 27.3p per share on a trailing twelve month basis. Assuming 6% growth in the forthcoming year, a share price of 386p would offer a prospective free cash flow yield of 7.5%. But as before, the latest results don't give any new clues to determine whether Allied's acquisition spree will generate decent returns for shareholders.

Imperial Tobacco

Here are Imperial's latest results:

Six months to March 30th              2002      2001       Change (%)

Turnover (£m)                        3,145     2,767          14
Operating Profit (£m)                  310       274          13
Pre-tax profit (£m)                    261       223          17

Earnings per share (p)                37.1      32.3          15
Dividend per share (p)                12.0      10.8          11

Key points about Imperial are:

* Worth £7.4b, Imperial is the world's fifth largest tobacco firm. It is one of just two major players in the UK market, while the recent £3.5b purchase of Reemtsma has given the group a substantial presence in Germany and a handful of minor European nations. Popular brands in the Imperial stable include Lambert & Butler, Embassy, Superkings, West, Davidoff and Peter Stuyvesant.

* Increasing its market share from 39.0% to 42.4%, plus a new deal to distribute cigarettes for Philip Morris (NYSE: MO), helped operating profits improve 11% to £170m in a 'resilient' UK market. International profits rose 17% to £149m, a performance almost entirely due to the first contribution from African acquisition Tobaccor.

* Although growth is low, Imperial excels in just about every financial department. Strip out government excise, and domestic operating margins come to 47%. International margins excluding duty are 32%. With operating profits of £640m, net capital expenditure of just £42m over the past twelve months means cash flow is fantastic. Not surprisingly, over the four years ending September 2001, Imperial has recorded a juicy 22.1% incremental return on equity.

* Tobacco shares traditionally sell on low valuations. Since its flotation, Imperial shares have traded on an average prospective earnings yield (effectively a free cash flow yield) of 9.1%. As outlined here, Reemstma should contribute post-tax profits of around £156m following full integration. Assuming 6% growth, the core Imperial business could produce earnings of £413m over the next twelve months. With projected earnings per share of 77.3p, a share price of 849p would see Imperial shares stand on their historic average rating.

More: Allied Domecq: Drinks Mix Creates Financial Haze | Imperial Buys Reemtsma | Cough Up For Imperial?