QUALIPORT
Tobacco In Trouble

By Maynard Paton (TMFMayn)
May 12, 2003

British tobacco shares have been great 'buy and holds' over the past five years. Though the FTSE 100 has slumped 34% since May 1998, watch list firms Imperial Tobacco (LSE: IMT) (up 173%) and Gallaher (LSE: GLH) (up 83%) have put in majestic performances.

However, as investors cling to the industry's reliable brands and stable cash flows during the bear market, the sector is beginning to unravel in the States. Profits there have been hit by cut-price competition and unfavourable litigation rulings. Will the same problems eventually dog the two UK players?

Q1 USA

First-quarter figures from three major US players made for grim reading:

* Altria (NYSE: MO) reported Philip Morris USA sales down 24% to $3.8b and operating income down 41% to $742m.
* British American Tobacco (LSE: BATS) reported Brown & Williamson's 'contribution' being halved to £39m.
* RJ Reynolds (NYSE: RJR) reported sales down 20% to $1.2b and operating income down 55% to $297m.

All three 'full price' tobacco companies suffered at the hands of a growing breed of discounters. No wonder, since a pack of Philip Morris Marlboro or RJ Reynolds Camel sells for an average of $3.41 -- 56% more than the average 'deep discount' price of $2.18. Such a differential has allowed the cut-price operators to increase their market share from 3% in 1998 to 10% now. Indeed, RJ Reynolds has pointed to new data suggesting 13% of the 415b sticks sold last year in the US were of the discount variety.

Litigation is also proving a problem. American tobacco firms are already bound by the 1998 Master Settlement Agreement, whereby they'll pay $246b over 25 years to the 50 US states. In April though, an Illinois judge took the legal problems one step further. After losing a $10b damages claim concerning 'light' cigarettes, the judge then ordered Philip Morris USA to post a $12b bond (subsequently reduced to $7b) before it could appeal. Talk of bankruptcy soon emerged. Read more.

UK

Could similar discount and litigation issues threaten Imperial and Gallaher, the two dominant UK players? Probably not.

* Levied on a fixed-amount-per-pack basis, UK excise duty prevents the levels of discounting seen in the US. For every £1 spent on cigarettes at the moment, roughly 80p goes into government coffers, 10p covers operating costs and 10p is left as operating profit. As such, a discounter is limited to a 20% price advantage in the UK, or 10% if it wants to make money.

* Imperial and Gallaher have been involved in numerous domestic legal cases over the years, yet neither has paid out a penny in damages. There will always be scope for new UK claims, but it's fair to say the more obvious routes for damages have already failed.

* English law prohibits the awarding of the stratospheric 'punitive' damages that make all the headlines in the US. The less chance of a big payday, the less chance a law firm will take on cases that appear to be perennial losers.

While US tobacco firms suffer from that country's legal and regulatory systems, rampant discounting and bankrupting legal bills would appear to be a long way off for UK players Imperial and Gallaher.

Imperial interims

On May 6th, Imperial published a steady set of interim figures:

Six months to                31 March 2003        31 March 2002

Turnover (£m)                   5,355                3,145
Duty (£m)                      (3,852)              (2,348)
Turnover exc. Duty (£m)         1,503                  797
Operating profit (£m)             401                  310
Pre-tax profit (£m)               290                  261

Earnings per share (p)           37.4                 31.0
Dividend per share (p)           12.0                 10.0

Key points about Imperial's figures are:

* The benefits from last year's £3.5b purchase of Reemtsma have started to appear. Cost savings of £45m were produced in the first half and the company remains on track for synergies of at least £170m for 2004. Margins in Germany, Reemtsma's main market, are now 34% compared to 25% prior to purchase.

* Though Imperial's domestic market share increased from 42.4% to 43.8%, interim UK operating profits fell from £188m to £177m. More imports, higher duty and greater promotional expenditure prior to the industry advertising ban were to blame. International profits rose 144% to £320m, a performance almost entirely due to a full contribution from Reemtsma.

* Although organic growth is low, Imperial excels in just about every financial department. Strip out government duty, and domestic operating margins come to 50%. International margins excluding duty are 27%. With annualised operating profits of £967m, net capital expenditure of just £79m over the past twelve months means cash flow is fantastic. Not surprisingly, over the five years ending September 2002, Imperial has recorded a wonderful 27% incremental return on equity.

* Tobacco shares traditionally sell on low valuations. Since its 1996 flotation, Imperial shares have traded on an average prospective earnings yield (effectively a free cash flow yield) of 8.9% and dividend yield of 4.5%. With projected earnings per share of 86.5p and dividend per share of 39p for the current year, a share price of 920p would see Imperial shares stand roughly in line with their historic rating.

More: Tobacco: Is It Worth The Litigation Risk? | The Long-Term Benefits Of Tobacco