QUALIPORT
A 10% Tobacco Dividend

By Maynard Paton (TMFMayn)
September 4, 2003

Brand loyalty, legislation, excise duty and distribution networks: they're the four factors that make UK tobacco companies great businesses to buy and hold. They're by no means the greatest of growth businesses -- the domestic cigarette market appears to be in terminable decline -- but for earnings reliability, high returns on capital and super cash flows, they're difficult to beat.

Qualiport watch list member Gallaher (LSE: GLH)(NYSE: GLH), the number two UK tobacco group, yesterday published its half-year figures. The performance was steady, but the shares are not obviously undervalued. However, for those with a taste for tobacco and prepared to look further afield, there's a stock currently offering a 10% dividend yield...

Gallaher interims

The table summarises Gallaher's half-time progress:

Six months to                30 June 2003       30 June 2002

Turnover (£m)                    3,823              3,661
Duty (£m)                       (2,537)            (2,517)
Turnover less duty (£m)          1,286              1,144
Operating profit (£m)              305                289
Exceptional items (£m)             (38)                 -
Pre-tax profit (£m)                203                225

Earnings per share (p)            26.6               25.2
Dividend per share (p)            9.45               8.80

(All figures adjusted for goodwill)

Geographically, Gallaher's performance was mixed. In the UK, sales (excluding duty) fell 6% to £285m as cigarette volumes declined by 8% (to 10b sticks) and smokers continued to 'downtrade' to the cheaper end of the market. But arresting a decline seen over the last few years, Gallaher's domestic market share edged up from 37.7% to 38.3%. Underlying UK operating profits slid £2m to £143m, though operating margins remain a very healthy 50%.

Gallaher did much better overseas. Net turnover in continental Europe increased 13% to £1,275m while profits improved 16% to £123m. Leading market shares in Austria (46%) and Sweden (40%) were maintained, albeit eroded by a couple of percentage points. Elsewhere, adverse currency movements hit profits from the Commonwealth of Independent States, while a sharp rise in volumes helped boost income from Africa, Asia and the Middle East.

The six-month achievements helped 'normalised' earnings per share move from 25.2p to 26.2p and enabled the dividend to be raised 7% to 9.45p per share.

In terms of valuation, UK tobacco shares traditionally stand on low ratings. Since its 1997 flotation, Gallaher has, on average, traded on a forward earnings yield (in this case, a genuine proxy for a free cash flow yield) of 9.5% and a prospective dividend yield of 5.6%. Assuming no growth over the next twelve months, 527p would see Gallaher shares offer 'average value'. Gallaher's shares today trade around 562p.

BAT

The cheapest of the three London-listed tobacco shares is almost always British American Tobacco (LSE: BATS). If you believe the current forecasts, BAT's 637p shares offer a 10.6% forward earnings yield and a 6.1% prospective dividend yield.

BAT's 'value' stems from its operations in the US. The world's second-largest listed cigarette group owns Brown & Williamson, which alongside rivals Altria (NYSE: MO) and RJ Reynolds (NYSE: RJR), has been struggling of late with cheap 'generic' alternatives. Then there are the courts: Altria is still embroiled in a legal fight over the posting of a potentially bankrupting $12b bond. All in all, there are plenty of worries Stateside.

With mature Western markets proving difficult to gain profit momentum, international acquisitions have been the driver for the sector's growth. In terms of the London trio, Gallaher bought Austria Tabak for £1.4b in 2001, Imperial Tobacco (LSE: IMT) purchased Reemtsma for £3.2b in 2002 and BAT picked up Ente Tabacchi Italiani for £1.6b in July.

Unlike many other industries, acquisition mishaps are somewhat of a rarity in the tobacco sector. No doubt that cigarette firms keeping to what they know best and the relative simplicity of cigarette manufacturing ensures the corporate activity runs smoothly. Indeed, Gallaher and Imperial have so far both delivered on all their integration promises.

The main acquisition problem for tobacco shareholders is usually a boardroom getting carried away with their cost-cutting projections. When BAT bought ETI, it told shareholders: "The price we are paying is higher than the market has been expecting, but it reflects... our view of the long-term prospects for the business and synergies that can be achieved." In fact, the price BAT paid was 50% greater than the second highest bid.

RJR

Buy BAT? Well, the litigation dangers have always put the Qualiport off. But for investors that like the characteristics of the tobacco industry and possess a greater appetite for risk, RJ Reynolds is worth a look. The owner of the Winston and Camel brands has had a disastrous time recently, with second-quarter profits slumping 67%. If competition, litigation claims and a costly restructure weren't enough, recent 'buy-out' legislation could drown RJR with losses.

Anyway, RJR's latest 2003 prediction was of earnings per share between $2.78 and $2.96 and a maintained dividend of $3.80 per share. So at $36, RJR stock offers a price to earnings ratio of 12-13 and a dividend yield of 10.6% -- albeit the payout won't be covered by profits.

So the upshot is simple: Americans keep on puffing, all the troubles blow over, profits revive and RJR stock becomes a multi-bagger. Or RJR goes bust. Or maybe, RJR's £2b market value tempts a bigger rival like BAT to make another purchase.

More: The Benefits Of Tobacco | Gallaher Annual Results 2002