A few days ago I wrote an article recommending British American Tobacco (BTI) because of its outstanding dividend, its presence in emerging markets such as Brazil and its determination to boost its below industry average margins. Now, I will take a look at a company which (1) Its more concentrated in the ailing European Market but (2) Is the most obvious M&A candidate within the big tobacco companies. Let's take a look at Imperial Tobacco (ITYBY) and try to make a compelling investment case for this big tobacco company.
On Valuation, performance and cash dividends
Imperial (IFT)'s 2013 results were in line with consensus, but management expects 2014 to be another year of transition. The market now is forecasting 2% EPS growth thanks to continued share buybacks. Moreover, Imperial's management does not expect any improvement in the operating environment, which remains tough. As a matter of fact, analysts expect volumes to decrease by 4%, with flat organic top line growth driven by an ameliorating price mix.
On valuation, the company trades cheaply relatively to overall tobacco companies. Imperial sells for 10 times 2014 EV/EBITDA and 10.8 times earnings. In addition, the company is expected to pay a 5.5% cash dividend yield. British American Tobacco sells for 10.2 times 2014 EV/EBITDA and 14 times earnings, paying a 4.6% cash dividend yield. Meanwhile, Philip Morris International (PM) — which is held by Joel Greenblatt and Mario Gabelli — sells for 11.6 times 2014 EV/EBITDA and 15 times earnings, paying a 4.4% cash dividend yield.
A Great M&A Candidate
Among the large and international tobacco companies, the media has cited Imperial Tobacco as a potential M&A candidate. While M&A has historically been a source of earnings growth for the tobacco industry, few options remain available after the consolidation process that took place in the mid-2000s. With China closed and international companies unlikely to push into the U.S. market, Imperial stands out as the most obvious takeover candidate within the space. The reasons are straightforward: (1) Imperial's market capitalization is “just” $37 billion and (2) Synergies from consolidating Imperial’s European operations could provide a significant source of earnings growth.
Even when Imperial has a large presence in declining markets such as France and Germany, the company also owns extremely valuable brands such as Davidoff, Gauloises (which is still growing nicely in France) or Cohiba, which is the worldwide symbol for high-quality Cuban cigars. Furthermore, the company trades at a significant discount to peers and pays a wonderful cash dividend yield in a world which is still offering extremely low interest rates. On top of its excellent cash dividend, the company remains committed to keep on buying back shares and increasing its cash payout ratio. Indeed, Imperial's management intends to increase cash dividends at a year-over-year rate as fast as 10%.
For all the reasons detailed above I think it makes sense to make a bet on Imperial Tobacco in particular and in tobacco companies in general. Despite being involved into a generally declining market, tobacco is one of the few consumer staples related sectors that still trade at a reasonable level.