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European Tobacco: M&A Ahead?
Posted by: Fede Zaldua (IP Logged)
Date: October 26, 2013 11:32AM

In the US, the M&A cycle already started in 2012 thanks to an ameliorating economy, the still (very) permissive financing conditions and high levels of free cash flow being generated by companies. As a matter of fact, in 2013, M&A dealing activity is up by 16% year-over-year. In Europe, the cycle is starting just now. The reason is simple: The economic recovery has been much more anemic in the old continent than in the US. That said, dealing activity is gathering pace and its up by 20% year-over-year.

My bet is that, in Europe, 2014 shall be a busy year in terms of M&A activity. The first companies to be targeted should be those trading at a cheap level within resilient sectors such as consumer staples. The first company that came up in my radar was UK's Imperial Tobacco (ITYBY) which is a strong business selling at a reasonable price. The stock has already been acquired by great investors such as Tom Russo's Gardner Russo & Gardner.

Recent Operational Performance

Imperial's performance for the last nine months was hardly great. Volumes were down by 7% (worse than expected) mostly explained by weak performance in Eastern Europe and the Middle East. Naturally, European markets, where Imperial makes three-quarters of its sales and two-thirds of earnings, were also disappointing. Germany, Spain, France and Russia were all softer than expected.

On the other hand, thanks to a better price-mix (prices came up by 3% in the first quarter and by 5% in the second), higher margins were able to sustain Earnings Per Share (EPS). The company has indeed maintained its EPS guidance even when volumes should come down once again in the next quarter.

Overall, the company is trying to resist European volume trends while successfully putting in practice its pricing power. Even when market-trends flow against Imperial's top-line, the company should be able to grow its Free Cash Flow (FCF) per share once again in 2013 -its 2013 FCF yield should be as high as 9%. Some businesses are simple great. They deliver growing cash yields to its owners even when conditions are tough.

Value at a Great Price

Imperial trades cheaply and pays a great, sustainable and for-ever-growing 4.5% cash dividend yield. The company's 2014 10.4 times P/E multiple represents a 40% discount to what most European consumer staples sell for. Besides, the owner of brands such as Davidoff and Gauloises, trades at a much more conservative level than its direct tobacco peers. Philip Morris International (PM) and British American Tobacco (BTI) sell for 2014 15 and 14.2 times earnings, respectively.

Hence, through buying Imperial's stock, you can get a reliable-simple business which is expanding margins through cutting costs and increasing prices (margins are as high as 43%) for just 10.4 times earnings.

An M&A target

Imperial Tobacco, whose portfolio even includes Cuban cigars such as Cohiba and Montecristo, is a great buy for bigger companies. The UK-based company, which is gaining market share in Europe and has huge growth opportunities in Africa, has a total market capitalization of $38 billion. This is a completely doable deal for a much bigger and conservatively indebted player such as British American Tobacco or Philip Morris International.

Stocks Discussed: ITYBY, PM, BTI,
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