QUALIPORT
Great Growth In A No-Growth Sector

By Maynard Paton (TMFMayn)
November 20, 2003

It's becoming difficult to kick the tobacco habit. Monday's full-year results from Imperial Tobacco (LSE: IMT) showed significant progress, with the £3b purchase of Reemtsma yielding better-than-expected savings and lifting profits by 40%. A favourite on the Qualiport watch list, Imperial continues to enjoy substantial competitive advantages and remains a steady, predictable and cash generative business.

(Refreshers on Imperial can be found here, here, here, here and here.)

Five-year summary

A summary of Imperial's performance since 1999 is shown below. It's an exceptional record, especially so when considering tobacco consumption has been in decline in most countries for many years:

Year to September 30th      1999    2000    2001    2002    2003

Turnover (£m)              4,494   5,220   5,918   8,269  11,412
Duty (£m)                 (3,292) (3,920) (4,444) (6,077) (8,212)
Turnover Less Duty (£m)    1,202   1,300   1,474   2,219   3,200
Operating Profit (£m)        518     568     619     789   1,135
Exceptional Items (£m)         -       -       -    (103)    (39)
Pre-tax Profit (£m)          400     458     509     539     859

Earnings Per Share (p)      46.4    53.6    59.0    68.4    90.0
Dividend Per Share (p)      23.0    26.4    28.8    33.0    42.0

(All figures adjusted for goodwill)

The year to September 2003 saw the first full-year contribution from Reemtsma, the German cigarette firm acquired in May 2002. The purchase supported 44% increases to turnover excluding duty (to £3.2b) and operating profits (to £1,135m). Some £150m of cost savings were produced in 2003, while synergies of £210m are expected in 2004, £40m above Imperial's original target.

The next table highlights Imperial's attractive operating margins:

Area                          Turnover    Operating    Operating
                              exc duty     profit        margin
                                (£m)        (£m)           (%)

UK                               760         406           53 
Germany                          645         228           35
Rest of Western Europe           652         307           47
Rest of the World              1,143         194           17

Total                          3,200       1,135           35

The high margins in part stem from significant market positions. Market share in the UK crept up to 44% (versus 38.5% for Gallaher (LSE: GLH)), while Ireland edged higher to 32%, Germany kept steady at 20%, Poland increased to 19% and Australia held at 18%. However, it would appear Imperial's 4% market share in Spain, 7% in Greece, 5% in Russia, 11% in Taiwan and 9% in Vietnam provide very generous mark-ups, too.

Cash flow

Within the results, Imperial declared its average conversion rate of operating profit into cash since 1997 was 87%. Imperial's cash fountain appeal is reflected in the next table:

Year to September 30th        1999    2000    2001    2002    2003

Operating Profit (£m)          518     568     619     789   1,135
Change in Working
     Capital (£m)               77    (123)    (11)    (35)   (296)
Depreciation (£m)               20      33      34      54      83
Net Capital Expenditure (£m)   (61)    (47)    (38)    (54)    (59)

Working capital suffered a large outflow in 2003, which was largely due to VAT settlements and the timing of price increases. Over the past five years however, just 8% of operating profits have funded working capital requirements. In addition, Imperial's expenditure on tangible fixed assets remains incredibly low. The prodigious cash flow allowed the dividend to be lifted 27%.

Imperial's large, reliable cash stream also permits chunky levels of debt. Year-end net borrowings stood at £4.1b and interest payments were covered 4.8 times. Furthermore, the group's asset-light and debt-funded nature has provided the foundation for superior incremental returns on shareholders' equity. In the five years to September 2003, earnings have increased by £421m while retained profits and exceptional items have totalled £1,073m. The incremental return thus comes to a robust 39%.

Summary

It's not hard to see why long-term shareholders remain hooked on Imperial. In the past four years, a time when many companies have floundered, Imperial has almost doubled earnings and dividends. Though acquisitions and cost savings have driven the performance, high barriers to entry, loyal customers and leading brands should keep the momentum going for some time to come.

The real quandary for prospective Imperial investors is valuation. Despite significant earnings growth, the shares traditionally carry a low rating. Declining Western markets, ethical considerations, threats of litigation and tougher legislation continually weigh on Imperial's market rating. Since the 1996 demerger from Hanson (LSE: HNS), Imperial has sported an average a price to earnings (P/E) ratio of 11.2 and offered a dividend yield of 4.5%. A sustainable re-rating looks unlikely; rarely has the market given Imperial a P/E above 15 or yield of below 4%.

Even the prospect of growth overseas won't ignite Imperial shares any time soon, that despite Imperial signing a ten-year Chinese production deal and announcing plans to move into Turkey (the world's seventh largest cigarette market). Making it big in China is of course the Holy Grail for tobacco industry, the country consuming one in three of the world's cigarettes (some 1,700b sticks every year). Imperial is presently gunning for Chinese volumes of 500m and achieving, say, a 10% share of Turkey would give it another 100m. However, with Imperial's stick sales currently amounting to 222b, these ventures are drops in the ocean.

Assuming extra cost savings of £60m and no further profit growth, earnings per share of 94p and perhaps a dividend of 46p can be expected in the current year. Going on Imperial's post-demerger ratings, a 1,038p share price would roughly represent 'average' value. That compares with today's 1,054p.

More: Don't Quit Tobacco | Tobacco In Trouble | The Benefits Of Tobacco