Stock to Watch: Imperial Tobacco

Source from:  Interactive Investor 02/08/2012

What to make of a volatile start to 2012 for tobacco shares, and first-quarter results from Imperial Tobacco (IMT) which show aspects of a decline in sales? Why have the shares jumped in response? Tobacco is an awkward yet pertinent investment theme. It can feel profoundly unethical and deny you the excitement of owning part of a genuine growth company that can multiply in value. But in a low-growth to recessionary environment it is a touchstone for dependable returns, especially dividend income. This explains the firm to strong performance of tobacco shares last year as investors scrambled to protect wealth amid worrying inflation and zilch interest on cash. Despite signs of weakening performance in countries where health concerns and taxes undermine tobacco sales, developing countries enjoy strong sales momentum. The addictive power of nicotine may be the most ruthlessly effective way to limit an equity portfolio's downside risk. It was along such a rationale that I drew attention to IMT last May at about 2,200p - not the best timing, as the price then eased to 2,000p, but last autumn's rally over £24 - together with a 5% yield covered twice by earnings - showed IMT's appeal while many other shares were capitulating. The New Year drop to 2,200p marked a change in investors' appetite towards higher-risk assets. But despite the rally in financial and mining shares, and some improving economic data, major risks remain and it's important to be aware of the dynamics affecting defensive shares like this. This 1 February, IMT declared that cigarette volumes had declined by 7% in the final quarter of 2011 - with tobacco net revenues down 1% - as a result of issues in Syria, Spain, the US and Ukraine. The company preferred to present an "underlying" view excluding these challenges, to assert sales momentum with good progress in emerging markets and with EU gains. While this feels spin-doctored, most likely the market was reassured that overall progress affirms expectations for IMT's year to end-September 2012. Company REFS shows the brokers' consensus for 13% earnings growth this financial year and about 8% in 2012/13, more positively dividend growth is estimated 21% and 11% respectively. Despite mixed aspects of group performance, this is going to appeal to income hunters. A key influence is whether a "defensive" or "growth" agenda prevails within market sentiment. With markets nervous again over Greece and stresses within the eurozone, IMT has started the week edging up above 2,400p. If fears grip again over the next few weeks, defensive shares like this should at least hold their ground relatively better - which is why it makes sense to monitor them for a balanced equity portfolio. A worry has surfaced however that IMT has enjoyed a major period of efficiency gains, boosting profits, and must now reinvigorate sales. This is unfair in that revenue grew strongly from £3.3 billion to over £28 billion in the three years from 2006/07 to 2008/09, even if assisted by acquisitions. Redburn Partners, an independent broker, estimates that 60% of the profit growth came from efficiencies with a much lower level of reinvestment than British American Tobacco (BATS). "We see limited evidence of increased investment in research and development, marketing and distribution, while remedial spend in Spain and the UK to stem losses in market share, may absorb resources." IMT's financial releases could certainly do more to clarify investment in the brands and regions. The cash-flow statement for 2010/11 shows an increase in purchasing of property, plant and equipment from £269 million to £341 million and £22 million spent on software, although this is not what Redburn means by investment. Ironically there is surplus cash: the company is committed to regular share buybacks amid a £500 million a year programme, and has increased its payout ratio. The latest update says: "Supporting our sales growth agenda, we have been optimising our revenue investments, reallocating the investment focus across our footprint to maximise our returns." This is too general a remark however, it needs substantiating in future prelims/interims now investment is a key factor in the market's eye. European sales are so far holding up well, showing how tobacco is resilient - at least during the early stages of recession. "In the UK and Germany, innovative new products and gains in our value portfolio continue to support our strong positions in cigarette and fine-cut tobacco." Spain has been a difficult market although IMT's main European exposure is the UK, France and Germany - so it is less likely to be dragged down by the southern states mired in debt. Recent appointments look promising. A previous global marketing director of Vodafone (VOD), currently chief executive of Grohe AG, the luxury bathrooms and kitchens fittings group, has become a non-executive director and two new senior management appointments made in the Americas and Asia-Pacific - so IMT should not lack fresh perspectives on marketing issues, which can quickly influence investment decisions. Admittedly this company is now of a size that reduces scope for efficiency gains by acquisitions - needing to find targets large enough to be earnings enhancing - and may also be less of a bid candidate itself. So it does indeed put more emphasis on demonstrating the path to organic growth. Some analysts continue to see a more attractive cash flow valuation versus British American Tobacco although you can jump between preferred valuation models. I think a main reason to keep a watch on IMT and other tobacco shares is the market's "glass half-full" attitude this year which may yet be broken by any of the macro risks, from Greece defaulting to fiscal drag weighing on America. It is perhaps the first kind of share to consider when mark-downs strike. Enditem