QUALIPORT
Profiting From The Power of Tobacco

By Maynard Paton (TMFMayn)
November 9, 2004

The tobacco sector has been a safe haven for investors during the bear market. Since November 1999, Imperial Tobacco (LSE: IMT) shares have rallied 109%, while British American Tobacco (LSE: BATS) and Gallaher (LSE: GLH) have gained 53% and 51% respectively.

The inherent features of the tobacco industry make its constituents ideal long-term buy and hold material. Particular draws to the Qualiport include customer brand loyalty, advertising restrictions, high excise duty and established sales networks, which all help to keep newcomers out and give the existing players a sustainable competitive advantage. Other plus points are the sector's economic insensitivity and the repeat purchase nature of the products. Read more.

The Qualiport's watch list includes Imperial Tobacco and Gallaher. Supported by some chunky acquisitions and continual cost cutting, the two firms have reported impressive financial progress over the last few years:

Imperial Tobacco

Year to September 30	2000	2001	2002	2003	2004
Turnover (£m)	5,220	5,918	8,269	11,412	11,005
Duty (£m)	(3,920)	(4,444)	(6,077)	(8,212)	(7,973)
Turnover less Duty (£m)	1,300	1,474	2,219	3,200	3,032
Operating profit (£m)	568	619	789	1,135	1,218
Exceptional items (£m)	-	-	(103)	(39)	(122)
Net interest (£m)	(110)	(110)	(147)	(237)	(204)
Pre-tax profit (£m)	458	509	539	859	892
Earnings per share* (p)	53.6	59.0	68.4	90.0	101.6
Dividend per share (p)	26.4	28.8	33.0	42.0	50.0

                                          
(*Underlying. All figures adjusted for goodwill)

Gallaher

To December 31	1999	2000	2001	2002	2003
Turnover (£m)	4,343	4,454	5,455	7,640	7,993
Duty (£m)	(3,382)	(3,415)	(4,082)	(5,101)	(5,407)
Turnover less Duty (£m)	961	1,039	1,373	2,539	2,586
Operating profit (£m)	422	445	480	573	622
Exceptional items (£m)	-	-	(31)	-	(39)
Net interest (£m)	(76)	(94)	(94)	(134)	(131)
Pre-tax profit (£m)	347	351	356	448	457
Earnings per share* (p)	36.7	40.8	45.9	51.2	55.5
Dividend per share (p)	22.3	23.8	25.5	27.6	29.6

(*Underlying. All figures adjusted for goodwill)

The franchise power of the tobacco companies are emphasised by high operating margins. In the UK, where the two groups combine to control over 80% of the cigarette market, Gallaher's latest reported margin was a superb 50% while Imperial's was an eye-popping 57%. Outside the UK, Gallaher's distribution business brings its overseas margins down to 11%, while Imperial in contrast generates international margins of 35%.

Another strong point is cash flow:

	Imperial 2004	Imperial 2000-2004	Gallaher 2003	Gallaher 1999-2003
Operating profit (£m)	1,218	4,329	622	2,542
Net change to working capital (£m)	79	(386)	24	558
Depreciation (£m)	106	310	93	277
Net capital expenditure (£m)	(48)	(238)	(107)	(408)

Over the past five years, Gallaher has on aggregate reported a net inflow of working capital, while Imperial has seen just 9% of annual operating profits absorbed into stocks, debtors and creditors.

Both have low fixed asset requirements as well. Gallaher diverts 16% of its annual profits into tangible assets on average, while Imperial spends just 6%. Indeed, what other company can produce over £1b of annual operating profits, yet need only purchase tangible assets of about £50m a year?

The steady nature of the tobacco industry plus the prodigious cash flow allows Imperial and Gallaher to operate with large amounts of debt. Imperial's latest results showed net borrowings of £3.6b, although underlying operating profits covered net interest payments a reasonable 6.0 times. Gallaher's most recent annual figures revealed £2.5b net debt and net invest cover of 4.8 times.

Despite all the shareholder positives, tobacco shares have traditionally traded on relatively low ratings (presumably due to a mixture of ethical, legislation, litigation and ex-growth concerns). The following table summarises the current valuation of the two groups and compares them to the average ratings seen since their flotations in the 1990s (in these instances, earnings are generally equivalent to free cash flow):

	Imperial	Gallaher
Current share price (p)	1,278	699
Rolling 12-month EPS (p)	101.6	56.7
Earnings yield (%)	7.95	8.11
Rolling 12-month DPS (p)	50.0	30.15
Dividend yield (%)	3.91	4.31
Since flotation:
Average earnings yield (%)	8.95	9.45
Average dividend yield (%)	4.45	5.53

Imperial would have to be priced between 1,129p and 1,134p and Gallaher between 548p and 602p to be valued in line with their past average ratings. Although the Qualiport would want to buy in somewhere below the average rating, exactly how much discount to demand is a debatable point. Lopping off 10% for instance would equate to an Imperial buy price of about 1,016p and a Gallaher buy price of around 518p.

With Imperial and Gallaher doing well and sporting market their ratings above their historical averages, the only safe conclusion to be made at present is that now seems not the best time to invest.

BAT

But what about the third member of the tobacco sector, BAT? What's put the Qualiport off the firm in the past has been its US activities and exposure to possible bankrupting Stateside litigation. However, this year BAT completed a deal with RJ Reynolds and swapped its American businesses for a 42% stake in the newly formed Reynolds American International (NYSE: RAI). In theory at least, BAT should no longer be liable to any US legal damages.

At 848p a share, BAT trades on a P/E of 11.7 (earnings yield 8.58%) and offers a dividend yield of 4.69%. (For the record, the Reynolds American stake is worth £2.37b or 110p a share). Using the past ratings for Imperial and Gallaher (neither of which have had any US litigation worries), BAT shares would also appear to offer 'average' value at present.

But unlike Imperial and Gallaher, BAT currently has a share buyback programme in operation. During the first nine months of 2004, BAT spent £368m (equivalent to 17p per share) on its own shares, with another £698m (32p per share) spent in 2003. On the face of it, BAT appears to be led by shareholder-orientated management and is swilling in cash. Debts are more manageable than at Imperial and Gallaher as well. Net interest payments were covered ten times by underlying operating profits during the nine months to September 2004.

Another possible advantage over Imperial and Gallaher is BAT's greater reliance on faster growing tobacco markets overseas. So far this year, 46% of group profits have occurred in Asia, Latin America, Africa and the Middle East.

There are many other issues to consider, but with the sector's general attractions and the US legal worries all but gone, a Qualiport review of BAT now looks in order.

More: A 10% Tobacco Yield | Great Growth In A No-Growth Sector

Portfolio value

Holding	Number of shares	Closing price 08/11/04 (p)	Value (£)
Associated British Ports	681	469.5	3,197.30
Emap	372	805	2,994.60
Halma	1,920	156.75	3,009.60
Johnston Press	1,608	552.5	8,884.20
London Stock Exchange	2,018	375	7,567.50
Cash			87.41
Total			25,740.81