QUALIPORT
Don't Quit Tobacco

By Maynard Paton (TMFMayn)
December 2, 2002

Qualiport watch list company Imperial Tobacco (LSE: IMT) published its full-year results last week. The £3b purchase of German firm Reemtsma dominated preceedings, it helping the cigarette company register a 26% increase in pre-tax profits. In general, the statement provided no reason why shareholders should quit their tobacco investing habit. Indeed, Imperial remains an attractive business for long-term investors. As identified in this feature, Imperial and other leading tobacco players possess significant competitive advantages. What's more, tobacco companies are simple, steady and visible businesses that have little appetite for shareholders' capital. (For those wanting a refresher, previous Imperial write-ups can be found here, here, here and here.)

Results

The table below shows Imperial's five-year performance:

To September 30th           1998    1999    2000    2001    2002

Turnover (£m)              4,029   4,494   5,220   5,918   8,269
Duty (£m)                 (3,081) (3,292) (3,920) (4,444) (6,077)

Turnover Less Duty (£m)      948   1,202   1,300   1,474   2,219

Operating Profit (£m)        436     518     568     619     789

Earnings Per Share* (p)     37.2    46.4    53.6    59.0    68.4
Dividend Per Share (p)      19.6    23.0    26.5    28.9    33.0

The year to September 2002 witnessed group turnover jump 40% to £8,296m, operating profits increase 27% to £789m, adjusted earnings per share improve 16% to 68.4p and the dividend grow 15% to 33p per share. The following table segregates the four-and-a-half month contribution of Reemtsma from Imperial's 'continuing' operations:

Year to September 2002    Turnover    Operating     Operating     Operating
                          Exc. Duty    Profit        Profit         Margin
                            (£m)        (£m)        Increase        (%)
                                                      (%)

UK                          764          390                        51.0
- Organic                   739          373           6            50.5
- Philip Morris              18           17
- Reemtsma                    7            -

Germany                     274           67                        24.5
- Organic                    69           13          30            18.8
- Reemtsma                  205           54                        26.3

Rest of Western Europe      495          217                        43.8
- Organic                   447          211           9            47.2
- Reemtsma                   48            6                        12.5

Rest Of World               686          115                        16.8
- Organic                   198           26         (41)           13.1
- Tobaccor                  174           42                        24.1
- Reemtsma                  314           47                        15.0

Following a "modest" increase in excise duty and "vigorous activity" by HM Customs & Excise, the UK duty paid tobacco market increased in size "for the first time in many years". Imperial's market share of the home market continued to improve, from 39.7% in 2001 to 42.9% in 2002. A new distribution contract with Philip Morris (NYSE: MO.) aided the domestic performance, too. Emphasising Imperial's near duopoly with Gallaher (LSE: GLH), UK operating margins are an unbelievable 51%.

Germany is second only to the UK as Europe's most profitable tobacco region. Imperial now controls 20% of the market and the Reemtsma purchase undoubtedly helped the company's existing German brands perform well during the year. Although the German market suffers significantly from low margin, private label competition, there's still obvious scope for Imperial to drive improvements in margins. Elsewhere in Europe, solid performances in France and Ireland helped produce operating margins of 47%. Meanwhile, additional costs and investments combined with a rationalisation of operations left 'Rest of the World' profits down 44%.

Cash flow

The latest results reaffirmed Imperial's attractive cash flow profile:

To September 30th           1998    1999    2000    2001    2002

Operating Profit (£m)        436     518     568     619     789

Change in Working
     Capital (£m)            216      77    (123)    (11)    (35)

Depreciation (£m)             16      20      33      34      54
Net Capital Expenditure (£m) (30)    (61)    (47)    (38)    (54)

Although somewhat volatile on an annual basis, the past five years have seen a net inflow of working capital cash. Furthermore, cash spent on tangible assets has averaged a relatively tiny 8% of operating profits over the same period. Indeed, as this study confirms, Imperial is overloaded with those all-important intangible assets. The company is undoubtedly a cash fountain.

Return on equity

Calculating Imperial's incremental return on shareholders' equity is not a straightforward task. Accounting nuances following the 1996 Hanson (LSE: HSN) demerger left Imperial with a rather complex balance sheet. However, by focusing on Imperial's retained profits, a rough figure can be deduced.

Over the five years ending September 2002, Imperial retained £835m of earnings while improving annual earnings by £223m. The incremental return thus comes to a very attractive 27% (It's worth noting this calculation has conservatively made no 'annualisation' adjustment to the part-year Reemtsma contribution for 2002). Debt, though, has played a major part in producing such alluring returns. Since 1997, the funding of various acquisitions has seen net debt increase from £1.2b to £3.7b. Imperial's net interest bill for 2002 was £147m, which was covered a comfortable 5.4 times by operating profits.

Valuation

Based on the latest results, at 932p, Imperial's shares stand on a historic price to earnings ratio of 13.6 and offer a dividend yield of 3.5%. Normally, that would be seen as an undemanding valuation. However, tobacco shares often appear cheap as investors traditionally build 'litigation/legislation/ethical discounts' into their valuations. (On the litigation point, 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 market 'discount' in the past to determine a suitable valuation for the company today. 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 9.03% and an average prospective dividend yield of 4.53%.

Annualising Reemtsma's 2002 contribution, assuming no profit growth at Imperial's other businesses, adding in the £170m of expected cost savings and taxing the lot at 30% gives earnings per share of 85p for 2003. Assume also a 40p per share dividend and, with those past valuations in mind, an entry price of 915p would see Imperial shares on an 'average' rating. All things remaining equal, should the shares fall notably below that level, the Qualiport will be tempted.

More: The Benefits Of Tobacco | Imperial's Interim Results | Imperial Buys Reemtsma | Imperial's 2001 Annual Results