Imperial's emerging strength

True, some readers don't like it when, as it were, we puff shares in tobacco companies. And why should they? After all, their products are legalised killers. Others take the pragmatic approach - shares in cigarettes makers offer the attractions of steady cashflows and reliable dividends.

Combined with continual operational improvements and the ability to push through price increases, the FTSE 100 tobacco giants Imperial Tobacco and British American Tobacco have also been able to deliver consistent profit improvement over the years. That's despite selling a product whose use is in terminal decline, particularly in the developed world, where people continue to quit smoking. Smokers in emerging market are picking up some of the slack, but not enough to stop a decline in what tobacco companies call 'white stick equivalent' volumes.

The lack of operations in emerging markets was a big reason why Imperial Tobacco lacked the investor appeal of BAT, which for many years has had a focus on developing economies. As a result, where BAT's share price has climbed 18 per cent in the past year, Imperial's has marked time - down 3 per cent in the same period.

But the distinction between Imperial and BAT is becoming fuzzier. The £11bn takeover of the Spanish tobacco giant, Altadis, took Imperial into markets in Asia and Africa. These now account for 40 per cent of the group's volumes and were the key driver of a strong performance in the first quarter of 2010-11. Volumes in Africa, the Middle East and Asia Pacific climbed 4 per cent, helping the group turn a 2.9 per cent drop in volumes in 2009-10 into an overall 1.2 per cent increase in the first quarter. In mature Western markets, where overall sales are declining, Imperial held market share steady, even though competitors absorbed increases in tobacco duties into their prices. In contrast, Imperial pushed through a near 4 per cent increase in prices during the period, to increase net tobacco revenues by 5 per cent.

That's partly because, like BAT, Imperial has focused its marketing on key brands - in its case, Davidoff, Gauloises and West. Volumes for these products climbed 7 per cent in the first quarter, although the company says that was flattered by a change to distribution arrangements in the Middle East.

However, Imperial has not forgotten its so-called 'value' brands - in particular JPS - whose success is helping it keep market share in mature markets. Fine cut tobacco - known as rolling tobacco in the UK - also continues to climb in popularity, with volumes up another 6.3 per cent on top of the 8.7 per cent growth seen in 2009-10. After losses of market share in 2009-10, it was encouraging to see Imperial's fine-cut brands regaining market share in the UK and Spain.

Spain nevertheless remains a tough market for Imperial, and its increased presence there is the down-side of the Altadis acquisition. On top of Spain's deep economic troubles, tobacco duty was increased late last year and a ban on smoking in public was widened, all of which meant market volumes fell 10 per cent. Further unfavourable legislation could hit the group this year - in the UK, which accounts for a fifth of Imperial’s operating profit, the government plans to ban advertising at the point of sale and enforce plain packaging.

Exposure to Spain and the UK may be why Imperial's shares are rated well below BAT's - 10 times underlying profits forecast for 2010-11 against 12 times for BAT's. It's also the reason why Imperial's shares offer more dividend yield; and the payout is likely to be boosted as management intends to nudge up the pay-out ratio from 47 per cent of underlying earnings in 2009-10 to 50 per cent.