QUALIPORT
Good Old Gallaher

By Maynard Paton (TMFMayn)
March 6, 2003

Good old Gallaher (LSE: GLH). The tobacco firm is one of just two FTSE 100 shares to have made notable headway over the past twelve months. (The other? Imperial Tobacco (LSE: IMT)). At a time when many businesses are struggling, yesterday's annual results from Gallaher underlined the company's resilience. Steady demand, loyal customers, few rivals and strong cash generation are what you want in a tricky economy. All in all, Gallaher remains a firm Qualiport watch list favourite (as does Imperial, for that matter).

(Why does the Qualiport like tobacco? Find out here. A refresher on Gallaher can be found here, too.)

Results 2002

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

To December 31st                1998    1999    2000    2001    2002

Turnover (£m)                  4,255   4,343   4,454   5,455   7,640
Duty (£m)                     (3,317) (3,382) (3,415) (4,082) (5,101)
Turnover Excluding Duty (£m)     938     961   1,039   1,373   2,539

Operating Profit (£m)            394     422     445     480     573
Exceptional Items (£m)             -       -       -     (31)      -
Net Interest (£m)                (72)    (76)    (94)    (94)   (134)
Pre-tax Profit (£m)              322     347     351     356     448

Earnings per share (p)          32.2    36.7    40.8    45.9    51.2
Dividend per share (p)          20.5    22.3    23.8    25.5    27.6

A full contribution from Austria Tabak (purchased during 2001 for £1.1b) largely accounted for the 2002 profit leap.

In a steady home market, UK operating profits fell 5% to £283m after increased marketing spend. Domestic market share of cigarettes slipped from 38.5% to 37.7%, but had recovered to 38.6% by January 2003. Gallaher also kept its prominent positions in cigar, hand-rolled tobacco and pipe tobacco sales. Excluding excise duty, UK operating margins remained an eye-popping 48%.

Gallaher's running of Austria Tabak appears to be progressing well. Cigarette volumes on the Continent totalled 45.7b sticks, up 11% on a pro-forma basis. Rolling out established central European brands into the Czech Republic, Hungary and the Balkan countries aided the performance. Gallaher maintained its strong positions in Austria (49% market share), Sweden (41%), Estonia (24%) and Republic of Ireland (51%).

Gallaher also did well in the Commonwealth of Independent States. Volumes were up 26% to 74b sticks, with market share in Russia improving marginally to 13%. Sales in Kazakhstan and Ukraine also performed strongly.

Cash flow

The 2002 results emphasised Gallaher's appealing cash flow characteristics:

To December 31st                1998    1999    2000    2001    2002

Operating Profit (£m)            394     422     445     480     573

Working capital change (£m)     (236)    782    (183)     59    (198) 

Depreciation (£m)                 23      27      33      50      74
Net capital expenditure (£m)     (36)    (32)    (59)   (108)   (101)

Although volatile, aggregate working capital movements have created a net inflow of cash over the past five years. Gallaher confirmed the working capital increase witnessed in 2002 had already been largely reversed.

Capital expenditure has averaged 160% of the reported depreciation charge since 1998, with increased spending no doubt due to overhauling Austria Tabak. On balance though, capex remains low when compared to profits. It's worth noting too that Gallaher generated a £573m operating profit on tangible fixed assets of £564m during 2002. From the findings of this study, it's clear the company is heavily reliant on attractive, difficult-to-replicate intangible qualities.

On the debt front, net borrowings stood at £2.5b at the end of December. Net interest cover for the year was 4.3, which for a steady firm like Gallaher, is quite comfortable.

Low working capital, low fixed assets and high borrowings naturally combine to generate a great return on shareholders' equity. Since the end of 1997, Gallaher has generated additional earnings of £102m while shareholders' funds have increased by £307m. The resultant incremental return on equity comes to a very respectable 33%.

Commendably, Gallaher has fully adopted FRS17, the somewhat controversial pension accounting standard. Unlike most of blue chip companies, Gallaher registered a pension surplus (of £213m).

Valuation

In terms of valuation, the threat of litigation, ethical issues, 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. (On the litigation point, Gallaher has never paid out a penny in smoking-related damages, nor is the company exposed to any US legal action.)

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 9.7% and a prospective dividend yield of 5.6%. Assuming 6% growth this year, 510p would see Gallaher shares offer 'average value'. All things remaining equal, should the shares fall notably below that level, the Qualiport could well be a buyer.

More: The Benefits Of Tobacco | Gallaher 2001 Results