Imperial Tobacco: A low-priced addictive purchase

Last month Imperial Tobacco made two very positive announcements, both of which reinforce our view that shares in cigarette manufacturers are a sound investment for recessionary times.

Both announcements relate to the company's £11bn bet on Spanish-based Altadis. They are that Altadis is being successfully integrated, and that a large slice of debt has been refinanced.

Altadis was purchased in 2007 and prompted Imperial into making a £4.9bn rights issue early in 2008. And, so far, Imperial's share price has fallen around 30 per cent since the deal, so these positive announcements are pretty important.

In particular, the Altadis deal raised two concerns. First, even after the rights issue, Imperial's debt remained heavy - it was £11.6bn at the end of September 2008, up from £4.7bn a year earlier. Second, would Imperial be able to secure the synergies relating to the acquisition.

On the first issue, although Imperial is paying generously to re-finance its borrowings, the doors of the banks are clearly open. This means that lenders see Imperial's cash flow as secure, which, in turn, should give investors confidence. Imperial sold a €1.5bn bond due in 2016 and a £1bn bond due in 2022. Both come with a coupon around 7 per cent, but the re-financing means that lenders are confident the tobacco manufacturer will continue to churn out free cash flow, the cash that, in theory, is available for distribution to shareholders. For example, in 2007-08 Imperial generated just over £1bn of free cash, enough to pay the dividend twice over. Also, these bond issues lend credibility to management's stated aim that Imperial will, on average, not pay more than 5.5 per cent interest on its debt obligations in 2009, and will not be in danger of breaching its borrowing covenants.

Besides, debt should not be a big issue for Imperial if it achieves the cost-cutting and revenue synergies it has outlined for the forthcoming years from the Altadis acquisition. It has guided the market to expect synergies of £160m in 2009, rising to £270m in 2010 and £360m by 2012. And last month Imperial's bosses said the group is "on track" towards delivering these savings, which is no mean feat. City analysts are confident that it will, despite the inherent difficulties it will face in dealing with French and Spanish trade unions when it closes down factories.

In the recent past Imperial's bosses have shown that they can handle big integration projects. In particular, it successfully integrated Germany's Reemtsma Cigarettenfabriken, which it acquired in 2002, exceeding analysts' expectations. Still, integrating companies should be in management's blood. After all, Imperial spent over 10 years until 1996 as part of Hanson Industries, the definitive acquisition-driven conglomerate.

More share tips and updates...

So we are inclined to believe Imperial's statement that Altadis is being integrated effectively, and provides a platform for future growth of the group's brands.

Not just this, but Imperial's trading statements have prompted City analysts to upgrade their profits forecasts. Admittedly, part of this is due to the fact that Imperial generates over 60 per cent of its profits outside the UK yet reports its accounts in sterling. So Imperial will benefit, in particular, from its revenues in euros, which account for almost all of the remaining 40 per cent.

In addition, Imperial's market share is steady or growing in many of its key markets, and pricing generally remains favourable. True, this does not alter the fact that cigarette volumes are declining on average 2 per cent a year in developed markets, though this is being compensated for by growth in emerging markets.

So City analysts continue to forecast growth in Imperial's earnings and dividends of between 5 and 10 per cent a year for the next few years. Such growth looks all the more impressive given the rate at which many companies are cutting their payouts. Indeed, BP sent shock waves through dividend watchers this month when it said that it did not plan to increase its payout this year for the first time since the mid 1990s.

True, the nature of Imperial's politically-incorrect and harmful business means it will always be under some pressure, particularly as governments ratchet up excise taxes. For example, there is a significant tax increase on the way in the US, which accounts for 10 per cent of Imperial’s revenues.

The threat of excise tax increases lies in the developing markets, too. And tobacco companies are starting to rebel against their role as de-facto tax collectors for the state. As British American Tobacco’s chief executive Paul Adams said, in a thinly veiled threat to governments, if taxes make cigarettes too expensive, consumers switch to contraband.