QUALIPORT
The Benefits Of Tobacco

By Maynard Paton (TMFMayn)
September 9, 2002

"The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors."

Legendary US investor Warren Buffett said that in a 1999 Fortune interview.

"What is the sustainable competitive advantage of this business?" is a key question for long-term investors. If you can't answer the question, your investment will struggle. Over the coming months, the 'sustainable competitive advantage' attractions of the major industries followed by the Qualiport (namely banks, newspapers, radio, television, ports, stock exchanges, restaurants and home furnishing retailers) will be highlighted. Today, we'll kick off with tobacco.

UK tobacco

Imperial Tobacco (LSE: IMT) and Gallaher (LSE: GLH) are both on the Qualiport's watch list. What's so special about shares in cigarette firms?

As in most other countries, the tobacco industry in the UK is dominated by a handful of companies. In terms of cigarettes (which make up by far the largest part of the sector), Imperial has 42% of the market, Gallaher has 38%, Philip Morris (NYSE: MO.) has 7% and British American Tobacco (LSE: BATS) has around 6%. It's a similar story with cigars, handrolling tobacco, pipe tobacco and cigarette papers; each area is the preserve of Imperial and Gallaher.

Imperial and Gallaher have a long history of dictating the UK tobacco market. Both companies are the result of a century of domestic consolidation and, over the past decade or two, Imperial and Gallaher's market shares have fluctuated around 30-45% with industry leadership alternating between the two.

The reasons behind the continuation of this duopoly are:

* Brand loyalty: By their very nature, smokers are creatures of habit. Most of the brands in the Imperial and Gallaher stables have been around for years and are well entrenched in the sector;

* Legislation: Increasing advertising restrictions prevent new market entrants quickly establishing their rival products. When Imperial bought German firm Reemtsma, it stated: "The acquisition of established brands in targeted markets... is increasingly attractive as the cost and timescale required to establish equivalent brand value through organic growth can be considerable".

In addition, strict regulations concerning the manufacture and presentation of cigarettes and their packaging restrict the opportunities for a groundbreaking rival. For instance, the recent EU directive concerning reductions in cigarette tar, nicotine and carbon monoxide will further limit the scope for an innovative newcomer;

* High excise duty:  With a fixed amount per pack levy, the UK has the highest rate of excise duty on tobacco in Europe. For every £1 spent on cigarettes, almost 83p goes directly into the Government's coffers. As such, there's limited potential for anybody wishing to gain a greater foothold in the domestic market through steep price discounting, and;

* Established distribution networks: Involving an army of salesmen and the ownership of vending machines, Imperial and Gallaher both have strong distribution networks. A good sign of this strength comes from the mighty Philip Morris. Even with all its resources and familiar brands, the US firm sells its products through Imperial's distribution facilities rather than go it alone.

Financial evidence

The financial evidence of Imperial and Gallaher's dominance is shown below:

Company             Year To    Operating profit   UK operating margin
                              / tangible assets      (exc. Duty)

Imperial Tobacco    31/03/02         2.8                  47%
Gallaher            30/06/02         1.2                  46%

As this study shows, Imperial and Gallaher are in the top six FTSE 100 companies when it comes to relying on inherently attractive intangible assets. Furthermore, UK operating margins of nearly 50% also suggest domestic business franchises.

However, both companies produce about half of their profits overseas, where margins tend to be lower. Activities in Europe, Africa and Asia help Imperial generate robust, 32% operating margins (the recently purchased Reemtsma had operating margins of about 15% prior to purchase). However, last year's purchase of Austria Tabak has distorted the overseas performance of Gallaher. Low margin distribution activities have left international margins at just 10%. Excluding Europe, Gallaher's other foreign businesses generate decent, 21% margins.

While margins may be lower, the acquired businesses brought with them many dominant market positions. Imperial now leads the way in Germany (22% market share), Slovakia (44%) and Slovenia (76%), with Gallaher the frontrunner in Ireland (51%), Austria (49%) and Sweden (42%). Those market shares, plus economies of scale and greater cost management skills, should improve international margins over time. And as evidenced by Imperial and Gallaher acquiring the overseas businesses, foreign markets have very similar barriers to entry to those outlined earlier for the UK.

Gallaher results

The purchase of Austria Tabak bolstered the recent interim performance of Gallaher:

Six months to                30 June 2002           30 June 2001

Turnover (£m)                    4,217                 2,292
Duty (£m)                        2,517                 1,753   
Tunover less duty (£m)           1,700                   539  
Operating profit (£m)              296                   220
Pre-tax profit (£m)                228                   181

Earnings per share (p)            25.1                  21.6
Dividend per share (p)             8.8                   8.2

The highlights from the results were:

* The benefits of foreign acquisitions have been better than expected, leading to medium- and long-term earnings per share growth to exceed previous expectations, and;

* A joint venture with the China National Tobacco Corporation (CNTC), who will manufacturer and distribute one of Gallaher's cigarette brands in China. With the Chinese smoking nearly one in three of the world's cigarettes, breaking into this market is the long-term goal of every tobacco firm. At present, the state-run CNTC controls 98% of the market.

At 681.5p, Gallaher shares stand on a forward price to earnings (P/E) ratio of 13.7 and offer a prospective dividend yield of 3.8%. Such ratings are far above Gallaher's average since flotation (a P/E of 10.3 and dividend yield of 5.7%). Those average ratings (the use of which is explained here) indicate an entry price of 497p or less.

More: Forget Tradition, Think Tobacco | Tobacco: Is It Worth The Litigation Risk?