Trading Down in EU Markets to Benefit Imperial

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 more lightly regulated. Developing markets accounted for 60% of Imperial's volume in 2010, but they contributed only 33% of net tobacco revenue. This lags international competitors such as Philip Morris International and British American Tobacco, which generate at least one third of revenue from emerging markets. The acquisition of Altadis in 2008 was a step in the right direction, however, 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 31% of its net tobacco revenue in declining European Union markets in 2010, and until it mounts a stiffer challenge to its competitors in a broader number of emerging countries, we think 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. Consumers are likely to continue to spend cautiously in 2011, and 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 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 volume.

Valuation
Our fair value estimate is 2,200p per share, which implies forward fiscal 2011 price/earnings of 12 times, enterprise value/EBITDA of 9.4 times, and a free cash flow yield of 10.1%. Volume and pricing are the main drivers of our valuation. We assume internal revenue increases just 1% in fiscal 2011, as continued trading down has a negative mix effect, but we forecast revenue to pick up after that, rising to a long-term growth rate of between 3% and 4%. The acquisition of Altadis' less profitable logistics business has driven profitability lower, but we think Imperial will gain some margin benefit as it cuts duplicate costs. Any potential for margin expansion, however, will probably be partially mitigated by rising fuel costs. We forecast Imperial's operating margin to average 18% over the next decade, lower than most major competitors because of the firm's discount brand portfolio and less profitable distribution business. 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 revenue 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. Although the litigation environment is more benign in international markets than it is in the US, the risk of product liability lawsuits against the firm still exists.

Management & Stewardship
Gareth Davis had been at the helm of Imperial Tobacco since it was spun off during the 1996 breakup of Hanson, but he retired in May 2010 and was replaced by COO Alison Cooper. Cooper has solid experience in the industry and was an integral figure in the acquisition of Altadis. Chairman Iain Napier joined the board in 2000 and has impressive executive experience in the consumer packaged goods industry. Although we applaud the company for keeping the roles of CEO and chairman separate, 4 executives sit on the firm's 13-member board, and we think 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.

Overview
Financial Health: Imperial had around £10 billion in debt on its balance sheet at the end of fiscal 2010 and a debt/EBITDA ratio of more than 3 times, materially above its peers as a result of the Altadis acquisition in 2008. However, EBITDA should cover interest expense almost 7 times over the next decade, and we expect the firm to meet its debt-repayment schedule and use excess free cash flow to reduce debt. We forecast the company's credit metrics to improve over our 10-year explicit forecast period.

Profile: Imperial Tobacco is the world's fourth-largest international tobacco company (excluding China National Tobacco) with total annual volume 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 United States, France, and Spain. Through its acquisition of Altadis, the firm has a logistics platform in Western Europe.

Bulls Say
-- Imperial is the fourth-largest tobacco manufacturer in the world (excluding China), with an estimated 6% market share and a portfolio that includes several strong brands.
-- Imperial has built a strong record of execution in recent years by successfully integrating the firms it has acquired and delivering top-line growth and synergies.
-- The firm has the UK distribution rights to Marlboro, the iconic brand owned by Philip Morris International.
--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
--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.
--The acquisition of Altadis increases the firm's exposure to Western Europe, particularly France and Spain, where the cigarette market is in decline.
--The global economic downturn could lead to trading down to cheaper brands or even greater numbers of smokers quitting.
--Governments around the world are struggling to balance their books and could see cigarette tax hikes as an opportunity to raise revenue

Philip Gorham, CFA is an equity analyst with Morningstar.

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