Imperial Tobacco Group PLC - Earns Outperform Rating With A Target Price Of 4,411p

Source from:  Seeking Alpha 11/10/2015

Summary

Significant benefits are still expected from Imperial Tobacco's cost optimizing program, contributing positively towards bottom line performance.

The stock remains attractive to investors, given company's ability to continue delivering 10% dividend growth.

More avenues can be explored such as increasing market share in premium cigarette segment and improving global diversity.

These inputs lead to upgrade in Imperial Tobacco's stock from Market Perform to Outperform.

We upgrade Imperial Tobacco Group PLC (OTCQX:ITYBY) from Market Perform to Outperform with target price of 4,411p. The rating upgrade is backed by expectations that the company would continue to deliver significant cost savings from its cost optimization program and generate sufficient cash flows to support 10% dividend growth target in future.

Significant Cost Savings Delivered

The FY 15 results provided strong evidence that cost optimization program undertaken by the Bristol based tobacco giant is streaming in significant improvements towards bottom line. Ignoring the impact of recent US acquisition and currency devaluation, our estimates suggest that the company's adjusted operating profits have increased by almost 6% since FY 13. During the same period, sales volumes declined 11%, representing 20% improvement in profit per stick.

On constant currency basis, the FY 15 revenue was 1% lower than that of FY13.The bottom line improvements streamed in from lower overheads and unit cost. Partial improvement in profitability is attributed to the higher pricing and lower proportionate sales in Iraq and Syria (low price and margin regions).

We believe that Imperial Tobacco has the scope to further reduce unit cost over the next three years, attributed to significant cost savings of almost £100 million (constant currency) expected to be delivered from the cost optimization program and the potential to improve fixed cost recovery in US.

Free Cash Flows Enough To Deliver 10% Dividend Growth

The company's management has committed to deliver 10% dividend growth per annum, which translates into dividend yield of 5.3% in FY 18 as compared to staples sector's average dividend yield of 3.1%. The figure below outlays dividend yield comparison of Imperial Tobacco with its peers.

The company's dividend growth target seems to be anomalously high as compared to industry averages. However, our calculations suggest that the company has the potential to generate enough cash flows to deliver targeted 10% dividend growth.

For FY 15, the company reported 19% YoY higher free cash flows (FCF) to £2.1 billion, despite of cash restructuring cost of £120 million to £256 million related to US acquisition and cost optimization program. Imperial's 10% YoY higher dividend was covered by 1.7x of FCF. After deducting dividend, surplus of £800 million was still left to partially offset the £4.6 billion acquisition.

For FY 16, we estimate that FCF will reported negative growth, as higher EBITDA margin would be more than offset by higher tax and interest payments. However, this will still leave dividend 1.4x covered and another £700 million for debt repayments. Moving forwards, we forecast modest increase in FCF, but substantial enough to support 10% dividend growth.

Possible Avenues to be explored

At present, Imperial Tobacco's share is under represented in (higher gross margin) premium cigarette segment. Our estimates suggest that every 1% (absolute) increase in market of premium cigarette industry will positively contribute 20 to 30 bps (basis points) towards bottom line. The figure below illustrates the market share of major tobacco players in global premium cigarette industry.

At the same time, we believe that Imperial Tobacco's global footprint is less diverse than most of its competitors including British American Tobacco plc (NYSEMKT:BTI) and Philip Morris International Inc. (NYSE:PM). We estimate that Imperial tobacco derives almost 65% operating profit from six markets including US, UK, France, Germany, Australia and Spain. We believe that the company needs to spread its foot print around the globe so that the impact of specific issues, such as the recent plain packaging issue in UK, could be curtailed. The figure below illustrates the geographical split of expected FY16 profits.

Financial Valuation

The following is an excerpt of the financial performance of the Imperial Tobacco. All the figures below are given in £ million except for percentages

In order to derive financial valuation, we have taken into account the above-mentioned factors and extrapolated recent past averages to forecast future trends. The table below summarizes the key assumptions for projections till 2020.

With regard to capital structure, the company has only 29.7% debt based on Market Value. By applying discounted cash flow (DCF) valuation method, assuming terminal free cash flow to firm (FCFF) growth of 0.5%, the enterprise values turns out to be £56.43 billion. Taking into account long term debt of £14.2 billion, the equity value turns out to be £42.2 billion. Assuming 957.1 million outstanding share, the intrinsic value of stock is estimated to be 4,411p, representing upside potential of 25% from Friday's closing price of 3,539p. Enditem