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Tobacco consolidation could smoke out Imperial offer

TAKEOVER TIP OF THE YEAR: A compelling valuation, eye-catching yield and important capital expenditure make the company a promising acquisition candidate
January 5, 2017

Conditions look ripe for further consolidation in the tobacco sector in 2017 and we think Imperial Brands (IMB) may well end up on the block. The company is making good progress with its strategy of focusing on core brands following its purchase of the offtakes from the merger of Reynolds American (US:RAI) and Lorillard (US:LO). These brands have given Imperial increased exposure to the US market, which is expected to be a key draw for acquirers now high-profile litigation has subsided and despite a general decline in sales volumes in developed market.

IC TIP: Buy at 3,474p
Tip style
Income
Risk rating
Low
Timescale
Long Term
Bull points
  • Industry consolidation
  • Attractive yield
  • Cost savings
  • Growth strategy to start bearing fruit
Bear points
  • Dollar debt
  • Developed market volume declines

Meanwhile, the other UK player in this market, British American Tobacco (BATS), has recently added a spark to the market's expectation of further sector consolidation with a $47bn approach for the 58 per cent of Reynolds it did not already own, and there's industry speculation that Philip Morris International (US:PM) is on the hunt.

Imperial looks a bargain buy for any would-be acquirer. Based on its enterprise-value (market cap plus net debt) to cash profit (EV/ebitda) ratio, which is a valuation metric popular with acquirers, the company is the most attractively rated of the big global tobacco players (see table below).

 

NameTIDMPriceMkt CapEV/fwdEBITDAfwd DYFwd PE
British American TobaccoBAT4,558p£85.0bn16.33.64%16.3
AltriaUS:MO$67.34$131bn14.53.50%20.2
Reynolds AmericaUS:RAI$55.98$79.8bn14.23.17%22.1
Philip Morris IntUS:PM$90.70$141bn13.64.54%19.0
Swedish MatchS:SWMASEK289SEK54.5bn13.34.75%17.4
Japan Tobacco JP:JTY2,914Y7.8tn11.53.40%16.7
Imperial BrandsIMB3,536p£33.9bn10.84.83%12.9

Source: Bloomberg

 

Importantly, we think actions being taken by Imperial to address the causes of this valuation gap should improve sentiment as 2017 progresses, regardless of whether any bid comes in. Chief executive Alison Cooper believes the group can achieve sustainable growth by focusing on 125 brands, half the amount Imperial had when she joined in 2007. Imperial is now not too far from this target, with brand numbers standing at 184. And migrations - where it encourages consumers to switch away from brands it wants to mothball - are proving successful. In its recent results, management said more than 95 per cent of consumers had completed the transition from one brand to another.

This has made the group's 'growth' and 'specialist' brands a more significant driver of performance, accounting for just over 60 per cent of reported tobacco net revenue. There are encouraging signs, with growth brand volumes rising 4.3 per cent in the year to 30 September 2016 with a 50 basis point increase in market share. Growth brands include Davidoff and Lambert & Butler, while specialist brands include Gitanes, Kool and Golden Virginia.

The latest push by the group to boost sales involves the investment of £300m next year - or £110m net of expected returns from the investment during the year and cost savings. While sceptics have questioned why this additional investment in sales is necessary, we think it looks a canny move, as the cost should be offset by currency gains for the year. With the benefits from this spending expected towards the latter half of 2017, there's the potential for sentiment to improve as the year progresses, especially if investors become more convinced the group can achieve its goal of 4 to 8 per cent medium-term EPS growth from 2018. Earnings growth will also be supported by the announcement late last year of a programme to cut costs by an additional £300m a year by 2020 for an expected one-off charge of £750m. An earlier £300m cost-cutting programme is already well advanced.

There is also the potential for a rebound following the shares' recent derating in the wake of Donald Trump's election. As bond yields have risen in the expectation of more aggressive interest rate rises - substantiated by the recent Fed rate rise decision - so-called bond-proxy stocks (reliable dividend payers) such as Imperial have been hit. Imperial's next-12-month forecast yield has leapt from 3.8 per cent earlier this year to a very attractive 4.8 per cent (see chart below).

 

Source: Bloomberg

 

There's a good chance 2017 could bring a more sober assessment of the interest rate outlook, which would benefit Imperial - especially given the Fed's recent history of 'dovishness'. What's more, Imperial's commitment to annual dividend rises of 10 per cent, which has been the standard for eight years, means yield growth should stay well ahead of inflation - something that the market is arguably undervaluing at the moment. The dividend also looks pretty secure based on last year's free-cash-flow cover of 1.7 times and the company's record of paying down £2.1bn of net debt, on a constant currency basis, over the past two years. That said, currency movements have had a negative effect on reported debt.

 

IMPERIAL BRANDS (IMB)
ORD PRICE:3,474pMARKET VALUE:£33.3bn
TOUCH:3,474-3,475p12M HIGH / LOW:4,154p3,324p
FORWARD DIVIDEND YIELD:5.4%FORWARD PE RATIO:11
NET ASSET VALUE:554p*NET DEBT:£12.9bn

Year to 30 SepTurnover (£bn)Pre-tax profit (£bn)**Earnings per share (p)**Dividend per share (p)
20147.422.50203128
20157.002.62213141
20167.983.04250155
2017**9.013.42281171
2018**9.163.68303188
% change+2+8+8+10

Normal market size: 750

Matched bargain trading

Beta: 0.84

*Includes intangible assets of £20.7bn, or 2,160p a share

**Barclays forecasts, adjusted PTP and EPS figures