Imperial Tobacco (IMT) has announced that it is to sell part of Logista, its logistics business acquired with the Altadis purchase in 2007, through an IPO on the Spanish stock exchanges. Given that the firm had already announced that it was reviewing strategic options for the business, we are not surprised at today's announcement because we do not think the capital-intensive logistics business adds a great deal of value to Imperial's core tobacco business.
Imperial will retain its direct distribution capabilities, so we do not think this affects our wide economic moat rating. We are also retaining our £26 fair value estimates for the shares and ADRs, respectively, until the pricing of the IPO is revealed, but we doubt it will have a material impact on our valuation.
Distribution is a capital-intensive business that is detrimental to both margins and returns on capital. Imperial's tobacco business, although smaller, generates operating margins north of 40%, in line or above those of larger rivals Philip Morris International and British American Tobacco. Its logistics business, on the other hand, generates a low single digit operating margin, dragging the overall margin to the low-30% range (on a normalised basis) and returns on capital to the mid-teens, well below the 30% ROIC of its larger competitors.
In addition, direct store distribution (DSD) adds little, strategically, to the tobacco business. Unlike the soft drinks industry, for example, in which we believe DSD generates a competitive advantage because it provides the ability to influence shelf space and product placement, in-store displays of tobacco products are more heavily regulated in developed markets, so the competitive advantages of DSD are limited.
DSD is still worthwhile in some markets, however. Philip Morris International (PM) acquired a stake in a distributor in Russia in December 2013 in order to refine its route to market and protect the industry profit pool. However, in general, we believe that tobacco companies will increasingly shy away from vertical integration into the distribution channel.
The only surprise about the carve-out of Logista is that Imperial is retaining a majority stake. This means that the business will continue to be reported as a subsidiary under the consolidation method, and that the asset-heavy business will continue to weigh on returns on capital and profitability. Retaining a minority stake would have allowed Imperial to report Logista not as a consolidated subsidiary, but as an investment, and remove the distribution assets from the parent company's balance sheet, while still retaining influence over the business. We expect Imperial to reduce its stake over time.
Historical transactions of tobacco distribution businesses are few, but we estimate the valuation of the logistics business could be around £1.1 billion, based on 6x 2013 EBITDA and 1.2x 2013 sales. This is well below the 14x EBITDA that Imperial originally paid for Altadis, but that deal included the tobacco assets of Altadis that are not included in the Logista IPO. We expect Imperial to use the cash to pay its dividend, make small acquisitions, and invest in the organic growth of its next generation products.
