Imperial Tobacco versus British American Tobacco

Of the two major British tobacco players, Imperial Tobacco seems the sounder investment and the former now the more dangerous investment. A bid by BAT for Imperial would almost certainly be rejected by the competition authorities, in my view. The concentration of market share in Europe would be too great. I would therefore hold Imperial and avoid BAT.

Having just completed some observations of British American Tobacco (BATS), I now turn to Imperial Tobacco (IMT).

The first and most obvious thing to say about its share price performance over the last twelve months is to remark firstly on how both companies’ shares have outperformed the FTSE 100 index, but to add how much better Imperial Tobacco has performed versus British American Tobacco. Over the last fifty two weeks the FTSE 100 index has slid about 6%; BATS share price by comparison has risen 3% (beating the FTSE 100 by over 9% in relative terms) and most notably the Imperial Tobacco price has increased by more than 22%. The obvious question to ask is: why?

Tobacco shares have obviously done better than the rest of the market because their high dividend payout policies as well as the growth in those payouts make them defensive in a falling market. More interestingly, Imperial Tobacco outdid its competitor British American Tobacco because the former was seen much more of a bid target than the latter, which some believed could be a potential bidder for Imperial. This has been my determining position in the choice of share, particularly since BAT came under the increasing threat of plain packaging. The latest stories from the market are that BAT has raised the finance to make a bid approach to Imperial.

At this stage in the proceedings, I point out that although Imperial Tobacco has much greater sales revenue – £25.3 billion versus £14 billion – it gets far less profit out of sales than BAT. Last year, BAT’s gross margin was a reported 77% in contrast with Imperial’s 20%. I add that BAT’s operating margin was 32% against Imperial’s operating margin of just under 8%, and that its net margin was 31% versus 8%. Clearly, one is more the higher margin branded business and the other is the lower margin commodity business. But what had been British American Tobacco’s advantage (its brand strength) is now turning into its Achilles’ heel (if and when plain packaging regulations spread to more markets worldwide). In those circumstances, it would make sense for BATS to buy or merge with Imperial in order to buttress its margins by reducing unit costs as a result of a greater scale of operations.

In any event, that has always been my view and my reason for preferring Imperial Tobacco as an investment this time last year. But now that the Imperial share price has so decidedly beaten the BAT share price, where do we go from here?

Technically, that is to say trying to judge trends from the share price charts, both shares look as though they are heading south for a while, having had a good run against the market. As explained in my observation about BAT yesterday, its share price looks as though it is within a clearly definable trading range, the upper level of which looks as though it also represents a lot of overhead share price resistance. That said, as I pointed out above, the BAT share price did briefly breach resistance by getting into new share price territory when it fleetingly touched 3,931p on the last day of last month, before heading down again. It demonstrated a moment of confidence that exceeded previous levels. Irritatingly, it posed a question rather than merely proving a point by failing to get there at all.

The Imperial share price has had an obvious upward trend and it looks to be towards the top of the upper out swings from the central trend. This suggests that the share price remains on trend and could come down whilst remaining on that upward trend. In other words, these are the sorts of correctional movements frequently seen in growth stocks – as I always tend to say on these occasions of chart interpretation, have a look to judge for yourself. To my eye, it suggests a share price that could ‘technically’ come back to around 3,200p – an implied 10% correction within trend.

Turning to ‘fundamentals’, what are the market expectations of Imperial Tobacco share performance? The market consensus estimates are a 10% increase in earnings next year, to near 233p share, giving them a forward price to earnings valuation of 15 times. The annual dividend next year is also estimated to rise by 10% to 155p, putting these shares on a forward annual dividend yield of around 4.4% (4% historic).

As a bid target, the company has an enterprise total asset value of £30 billion commanded by an equity valued at £5.3 billion. In the last balance sheet there was a reported £2 billion of cash, which was a big improvement on the year before.

My personal opinion is that if Imperial was bid for it seems to be in a good position to ask for a price that is at least level to the current market price. The historic price earnings ratio based on earnings per share of about 16.5 times looks a reasonable exit PER. The big question is whether such a bid, were it to happen, would get approval. The UK government would probably be happy to have one UK taxpaying entity take over another. However, they will have a different perspective on the matter in the meeting rooms of the EEC competition policy authority. They could easily say no for obvious reasons. My judgment is to stay with Imperial, which seems to be making the best of life in terms of operating cash flow and prospective earnings. On a forward estimated PER of 15 times and a prospective estimated annual dividend yield of 4.4%, Imperial offers enough to justify a holding on conventional investment yardsticks. BAT, on the other hand, has that killer plain packaging problem to contend with.