Imperial puffs ahead

It may not impress those of a politically correct disposition, but cigarettes - despite being the cause of a multitude of potentially lethal diseases - are a great business. Their addictive power drives repeat sales and that leaves the tobacco companies capable of churning out consistently decent performances, pretty much regardless of the economic conditions. After all, people don't tend to kick their smoking habit simply because there's a recession - they are instead far more likely to trade down to cheaper brands. That leaves value-focused cigarette maker, Imperial Tobacco, which sells such well known budget brands as Lambert & Butler, JPS and Golden Virginia, well placed.

Those defensive characteristics were on display when the group issued a trading update this month, which reiterated the positive trends highlighted in July's third quarter trading statement. In particular, the group's less mature markets such as Africa and the Middle East are delivering solid volume growth. Imperial's Gitanes brand, for example, saw volumes rise 33 per cent overall in the nine months to June in such regions. Eastern Europe looks robust, too. "We are seeing our value brands increase share with Maxim in Russia benefiting from continued downtrading and Classic in Ukraine performing particularly well," said management in July.

Things are also looking up in the group's more mature markets. Although volumes declined 1 per cent in the UK during the year to June, that's better than the mid-single digit declines that had previously been the norm. And Imperial's focus on value is proving especially successful. The group's Golden Virginia Yellow brand, for instance, had already grabbed a 1 per cent slice of the market by June after its March launch. Its economy-focused JPS Silver brand, launched last November, has done even better, boasting a 3 per cent market share by mid-2009.

Ironically, that party reflects the fact that recession-hit UK smokers are less able to go abroad now to buy cheaper offerings. Yet even in Spain - one of weakest of the more mature European markets - Imperial was able to point to success. While volumes there fell 4 per cent overall in the year to June, the group's fine-cut tobacco volumes grew 44 per cent in the first nine months, as its Fortuna brand picked up market share.

So, the €16.2bn (£14.6bn) acquisition of Spanish tobacco company, Altadis, completed in January 2008 is looking like an increasingly smart move, adding a market-leading position in France and Spain to complement its huge presence in the UK and Germany. And all the indications are that Altadis is bedding in well - management said this month that the integration process is proceeding well and remains on track to deliver the previously-stated synergy targets of €180m in the current financial year, and €400m by end-September 2012.

That said, the Altadis deal bulked up the group's debt pile to eye-watering levels. Even after May 2008's £4.9bn rights issue, net debt stood at £15.2bn at the half-year stage, up from £11.7bn at the year end. But while investors will need to keep a close watch on the debt burden, there is reason to expect improvement. Analysts reckon that management is increasingly focused on tackling the debt pile and broker Evolution Securities expects net debt to fall to £11.9bn by the end of September, and to £10.8bn by end-September 2010. That prospect was enough for the broker to upgrade its 2010 earnings estimate by roughly 5 per cent at the end of September.

Regulation is also set to remain a factor in a sector where the product can have such severe health implications - stiffening government rules around cigarette marketing, growing limitations on where people can smoke, and increased taxation remain an ever-present threat. Yet people will continue to smoke, so those concerns shouldn't detract from the Imperial's defensive characteristics. That's especially true if investors aren't totally convinced that the buoyant performance of the stock market's cyclical sectors in recent month might not prove sustainable should doubts arise about the strength of economic recovery. A prospective dividend yield of over 4 per cent looks good for income investors, too.