Imperial Tobacco reported solid fiscal 2009 results that confirm our thesis that the firm's positioning in value categories will give it a short-term performance boost. We are maintaining our fair value estimate.
Fiscal 2009 net tobacco revenue grew 5% after adjusting for foreign exchange movements and the acquisition of Altadis. We think this is very respectable, given the economic challenges in the firm's key markets, but we doubt that this level of growth will be sustainable in 2010. Imperial's product portfolio is concentrated in value categories, and volumes have benefited from smokers tightening their belts in recent quarters. However, if global consumer sentiment recovers next year and smokers resume their migration to more expensive brands, we expect the premium products of rivals such as British American Tobacco and Philip Morris International to more effectively exploit that trend.
Imperial's drive to cut costs yielded some results in fiscal 2009, with the operating margin increasing 130 basis points to 15.8%. Although we are impressed by this performance in a challenging environment, we expect the firm's newly acquired logistics business to face rising costs in the near term from higher energy prices.
We are pleased that the firm has announced a succession plan to CEO Gareth Davis. Current chief operating officer Alison Cooper will replace Davis when he retires in May 2010. Cooper has a decade-long tenure at Imperial and has been instrumental in the firm's expansion in international markets. We think the appointment of an insider will ensure the continuity of the firm's strategy to increase sales globally.
Fair value estimate 1,751p ¦ Fair value uncertainty: High ¦ Economic Moat: Wide
Thesis
(Last updated 20-08-2009)
We think that Imperial Tobacco's scale, its strong portfolio of brands across a range of price points, and the addictive nature of its products give the firm a wide economic moat. However, Imperial's reliance on mature European markets for a significant amount of its revenue and its limited exposure to adjacent categories such as smokeless tobacco could restrain the firm's long-term growth trajectory, while the global economic downturn is likely to provide some near-term head winds.
Despite its lack of an international megabrand, such as Philip Morris' Marlboro, Imperial owns a range of niche brands that have local appeal, including John Player Special, Davidoff, and Fortuna cigarettes, along with Rizla roll-your-own paper and Golden Virginia loose tobacco. The firm is particularly strong in the UK, where its leading discount brands Lambert & Butler and Richmond contribute to the firm's 46% market share, and it holds a 37% share in Spain and a 27% share in Germany. Through its recent acquisition of Commonwealth Brands, Imperial has expanded its footprint to the US.
Although Imperial has an impressive foothold in several developed markets, it is not as strong as some of its competitors in emerging markets, many of which are still growing and are currently more lightly regulated. In 2008, around 71% of revenues came from developed markets. The acquisition of Altadis in 2007 is a step in the right direction, in our view, because it gives Imperial dominant market shares in Morocco and the Ivory Coast, adding to its existing presence in Russia and Ukraine. The deal also catapults the firm to the leading position in the global cigar manufacturing category. However, Imperial generated more than one third of its revenues in declining Western European markets in 2008, and until it mounts a stiffer challenge to its competitors in a broader number of emerging countries, we think that despite the potential for synergy benefits from the Altadis acquisition, Imperial will underperform the industry leaders.
In addition to the long-term challenges the company faces in its key European markets, the economic downturn is likely to provide some short-term challenges. As increasingly cautious consumers look to reduce spending, 2009 could be a litmus test year for brand loyalty in the cigarette industry. Although Imperial does offer some popular discount products in most markets, any trading down from its premium offerings, such as Regal and Embassy, will have a negative impact on the firm's profitability. Furthermore, governments around the globe are struggling to balance their books and could see raising taxes on tobacco products as a way to generate revenue. This is likely to have an adverse effect on volumes.
Valuation
Our fair value estimate for Imperial is 1,751p per share. We assume that
organic revenues increase by just over 2% in 2009, as we expect the
economic downturn to expedite the decline in volumes in mature markets.
We forecast that revenues pick up modestly after that, rising to a
long-term growth rate of almost 4% in 2013, as the firm is able to
mitigate slumping volumes with price increases. The acquisition of
Altadis' less profitable logistics business has driven profitability
lower, but we think that Imperial will gain some margin benefit as it
cuts duplicate costs. The margin expansion, however, will likely be
partially mitigated by rising fuel costs. We forecast that operating
margins will be around 27% in 2009, and that elevated fuel costs lower
the firm's long-term margin to around 26%. Our adjusted revenue and
margin differ from those reported by the company because we adjust
revenue to exclude excise taxes.
Risk
Imperial, like all tobacco firms, faces the risk that retail prices will
be forced higher by governments around the world increasing tax
revenues, as they struggle to balance their books. With an extensive
global footprint, Imperial is exposed to currency movements and
geopolitical risk in a number of countries, including emerging markets.
As the firm continues to integrate Altadis, the European tobacco and
logistics firm it acquired last year, Imperial faces integration risk
and the possibility that it may not achieve the synergies it had
intended.
Strategy
Imperial Tobacco is focused on strengthening its position as a major
international tobacco player by growing organically and through
acquisition, particularly in developing markets. Management has also
stated its intention to improve margins by cutting costs and to manage
the firm's cash effectively through the efficient employment of capital.
Management & Stewardship
Gareth Davis has been at the helm of Imperial Tobacco since it was spun
off during the 1996 breakup of Hanson. We think that Davis has vast
experience in the tobacco industry and has been instrumental in the
company's successful acquisition strategy in recent years. Chairman Iain
Napier joined the board in 2000 and has served as chairman since 2007.
We are also impressed with his executive experience in the consumer
packaged-goods industry. Although we applaud the company for keeping the
roles of CEO and chairman separate, five executives sit on the firm's
14-member board, and we think that the functionality and independence of
the board would be improved if some of these executive-director
positions were eliminated. Furthermore, we would prefer to see all
directors face re-election every year, because we think that the
staggered elections currently in place are not in the best interests of
shareholders. Compensation appears to be reasonable relative to the
firm's peers, with incentive-based elements forming a majority of most
executives' total compensation packages. However, we think that Imperial
slightly overpaid for Altadis, its European logistics business acquired
in 2008, and we think there could have been more efficient uses of
shareholders' capital than this lower-margin, capital-intensive business.
Profile
Imperial Tobacco is the world's fourth-largest international tobacco
company with total annual volumes of more than 300 billion cigarettes
sold in more than 160 countries. The firm holds the leading global
position in the fine-cut tobacco and hand-rolling paper categories, and
it is the leading seller of cigars in the US, France, and Spain. Through
its acquisition of Altadis, the firm has a significant logistics
platform in many parts of Western Europe.
Growth
We expect Imperial to be able to increase its revenues by between 3% and
4% annually in the long term, as the firm's ability to raise prices and
opportunities to expand into developing markets should offset declining
volumes in Western European markets.
Profitability
Despite the challenges the company faces in some developed markets,
manufacturing cigarettes is still very profitable, and we expect the
firm to generate operating margins, on an adjusted basis, of around 26%
in the long term.
Financial Health
Imperial has around £10 billion of long-term debt on its balance sheet,
of which around £2.5 billion matures in 2010. However, we expect that
the solid free cash flow that the firm generates will continue to allow
the firm to meet its debt-repayment schedule.
Bulls Say
1. Imperial is the fifth-largest tobacco manufacturer in the world, with
an estimated 6% market share and a portfolio that includes several
strong brands.
2. The firm has built a strong track record of execution in recent years by successfully integrating the firms it has acquired and delivering top-line growth and synergies.
3. Imperial has the UK distribution rights to Marlboro, the iconic brand owned by Philip Morris International.
4. Through its Golden Virginia and Drum brands, Imperial is the global leader in fine-cut tobacco, and through Altadis, it is the leading manufacturer of cigars.
Bears Say
1. With 37% of tobacco revenue generated in Western Europe in 2008,
Imperial has significant exposure to mature tobacco markets, many of
which are experiencing volume declines.
2. The acquisition of Altadis increases the firm's exposure to Western Europe, particularly France and Spain.
3. The global economic downturn could lead to trading down to cheaper brands or even greater numbers of smokers quitting.
4. Governments around the world are struggling to balance their books and could see cigarette tax hikes as an opportunity to raise revenues.
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