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Why I Wouldn’t Buy Imperial Tobacco Group Plc Or British American Tobacco plc

After steep losses during August, Imperial Tobacco (LSE : IMT) shares have embarked upon a notable recovery in recent months, before going on to reach new highs in November as a result of renewed speculation that British American Tobacco (LSE: BATS) could soon make a bid for its rival.

Wringing the rag dry

Today isn’t the first time that I have written about this subject. In my view, investors in companies like Imperial Tobacco should probably be slightly concerned about leverage, particularly in light of the cost implications that rising interest rates will have.

Both businesses are highly leveraged while operating within a challenging regulatory and consumer environment. In my view, the long-term investment case for these companies is diminishing, and in light of the recent gains, investors should reassess their positions in the shares.

With organic revenue growth topping out long before now, management at both companies have only two options available to meet their commitments to shareholders. These are: a) boosting earnings and returns by cutting fat from the bone (cost cuts); or b) inorganic growth through acquisition.

Now both companies have made progress in their efforts to reduce product costs and to reduce operational costs in recent periods, but this strategy can only ever yield limited gains without further acquisitions.

This is while I cannot help but feel that M&A driven growth is merely a move to delay the inevitable. This is because any acquisitions will probably involve the issuance of at least some debt in addition to taking on the debts of the acquired company, which merely reinforces my concerns over leverage.

If the tobacco industry were a leather rag then I would be inclined to describe it as one that has almost been wrung dry, at least as far as investment potential is concerned…

Leverage, either which way…

In the year to September, total debt at Imperial increased by a considerable 43%, bringing debt/equity to 2.7x, which means that the group now has nearly three times the amount of debt as its shareholders do equity.

For those who thought that it would be difficult to top that, BAT is actually worse off than its rival Imperial, with total borrowings up by 26% year to date and debt/equity now over 3.1x.

Furthermore, if BAT were to acquire Imperial, the combined entity’s balance sheet would be little improved without a considerable rights issue.

Valuation, dividends & disappointment

From a valuation perspective, the shares now trade at 15x the consensus estimate for earnings in the current year, which compares well with the 18.5x multiple for BAT. However, it is an open question as to whether these multiples could be judged as appealing or not.

In addition, despite Imperial honouring its pledge to grow dividends by 10% per annum in the year to September 2015, broker estimates suggest that shareholders could now be in for a disappointment in the current year.

The average estimate is for dividend growth in the low single digits — with implied cover at 1.5x, for the current period.

Summing up

To me, the leverage issues mean that any anticipated cost synergies would have to be significant for the rumoured deal to offer any tangible benefit to shareholders.

Just about the only thing that is clear at present is that Imperial shares have benefited considerably from various forms of speculation of late, while high leverage and the prospect of meagre dividend growth ahead continues to do the underlying investment case little justice.

Therefore, either which way, it would seem most likely that any further gains are going to be limited from here.

As a result, I’d probably take the quarter’s performance as a cue to book profits and walk away before anybody else does — and certainly before interest rates begin to move.  

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James Skinner has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.