Imperial Tobacco's (IMT) interim management statement for the nine months ending June 30 2014 suggested that business is on track to meet our full-year expectations.
Under CEO Alison Cooper, Imperial is slowly transforming from an also-ran – albeit a highly profitable one – to a significant player and potential consolidator in the global tobacco industry.
Though details in the release were scarce, we believe the outperformance of the Growth Brands lends support to our wide economic moat rating, which is based on the strength of some of Imperial's brands, the addictiveness of its products, and its cost advantage through economies of scale. We regard these as a solid set of results. We think Imperial is positioned for the economic recovery in Europe, and we think there is modest upside to the current share price.
Growth Brands which make up around 40% of revenue performed well in the first nine months of the fiscal year, with underlying volume growth of 3% and revenue growth of 7%. We are particularly encouraged by the strong performance of Davidoff and the weakness in fine cut tobacco, indications that European markets may be improving.
The severe recession in Southern Europe interrupted a long-term trading up trend, and we expect any macroeconomic improvement in the region could soften consumers' price sensitivity. Unemployment in the region remains high, so any recovery is likely to be gradual, but such a development would be a net positive for Imperial, given its presence in super premium categories.
Despite recent value-creating acquisitions in the United States, however, we think there is more work to do, and of the three wide-moat European cigarette manufacturers we cover, we prefer the competitive positioning of Philip Morris International (PM) and British American Tobacco (BATS) due to their superior scale.
Management highlighted Russia and the Middle East as weak spots in the first nine months of the year. Russia is the second-largest market in the world, behind China, and we estimate that it represents around 8% of Imperial's volumes.
Although the current geopolitical instability is likely to weigh on near-term results, we do not think this is a structural issue that impairs Imperial's long-term opportunities for positive price/mix growth.
In July we raising our fair value estimate to £26.50 from £26 following the announcement that Imperial will acquire assets from Reynolds American and Lorillard. Our valuation implies fiscal 2016 multiples of 15.7 times earnings, 10.4 times enterprise value/adjusted EBITDA, and a 2016 dividend yield of 5.0%.
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