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Will Imperial Tobacco Group PLC Be The Next Takeover Candidate?

The merger of Reynolds America and Lorillard, the number two and three in the US tobacco market, is another stage of consolidation in the tobacco industry. There’s a decent chance that Imperial Tobacco (LSE: IMT) could be next to fall.

Imperial is on a roll, with the shares at an all-time high. It’s poised to pick up some of the assets and brands currently owned by Reynolds and Lorillard that they will have to shed to pass muster with competition authorities.

It is about to float its Spanish logistics operation, valued at £1.4bn. Imperial is selling a third, so the £0.5bn or so will come in handy for buying brands from the two American companies.

But there’s something else buoying Imperial’s shares. It’s one of those companies subject to perennial takeover speculation, with Japan Tobacco most often cited as the leading acquirer.

This time is different

This time it could happen. The economic logic of consolidation in the tobacco industry is undeniable. It serves a shrinking market, with pockets of growth increasingly difficult to find as governments worldwide become more antagonistic. Profit growth must come disproportionately from cost-cutting, hence the economic importance of scale.

A big deal provokes others. Executives analyse the changed competitive landscape, corporate financiers run slide-rules over valuations, and investors ask questions. True, the Reynolds/Lorillard merger has been on the table for months, but a real deal crystallises thinking. It’s a sure-fire bet that analysts in Japan Tobacco will be dusting down the Imperial Acquisition file and re-running the numbers.

Curve ball

E-cigarettes are the curve ball of the tobacco industry. With global sales running at $3bn a year, it’s clear e-cigarettes have turned the corner of the S-curve beloved of marketing executives, and are firmly in the grip of ‘early adopters’. That should see sales accelerate: Wells Fargo has predicted that US sales of e-cigarettes could exceed those of tobacco in under a decade.

But there are huge questions over e-cigarettes: how they are regulated; safety; social acceptability; whether they are a health-cure or a health-risk. The economics are also uncertain. E-cigarettes have been developed by small start-ups, and with Big Tobacco’s grip on customer loyalty undermined by plain packaging regulation and a groundswell of public distrust, it’s not clear whether the e-cigarette industry needs Big Tobacco.

The big firms have the cash to buy e-cigarette makers, but they could still be outflanked as the new technology takes off. So consolidation is still the safest way of maintaining profits and extending executive careers. Those slide-rules will surely be out.

Dividends

Investors face the same long-term uncertainty of whether tobacco is a declining industry or one undergoing technological transformation. But fat dividends funded by prodigious cash flow, spiced with occasional M&A, is decent reward. Even at their elevated levels, Imperial’s shares yield 4.8%.

Reinvesting dividends like that can make you seriously wealthy. Even with no increase in the payout and no share price movement, your portfolio would be half as big again after five years, and nearly double after ten. But it's vital to pick shares that will reliably pay dividends over such timescales.

'How to Create Dividends for Life' is an exclusive report from the Motley Fool packed with advice and tips on how to gain from the compounding effect of dividend reinvestment. You can download it by clicking here. It's free and completely without obligation.

Tony Reading has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned.