On Thursday, shares of Imperial Tobacco (IMT) closed 0.6% down on the back of a fairly soft first-half trading update and an unfavourable duty restructuring in the UK budget. However, we think the firm is quite well positioned to benefit from ongoing regulatory pressure in Britain, and our fair value estimates of £22 and $69 remain in place.
Imperial announced that revenue is likely to grow 2% in the first half of fiscal 2011, with volume growth of 1%. This is a slowdown from the 3% revenue growth in fiscal 2010, but we think some trade inventory shifts could mean that some purchases were shifted from the first half to the second this year. The company's first-half period ends March 31, and results should be released in May. Despite these soft figures, we think the market is underestimating Imperial's short-term potential. At less than 11 times fiscal 2011 earnings and 9 times 2011 EV/EBITDA, the shares have around 15% upside, in our opinion. Imperial is our pick in an industry that appears fairly valued at present, because we think the market is misunderstanding the ultimate implications of several regulatory pressures in its core market of the United Kingdom.
The British government announced Wednesday that it will raise the tobacco duty on cigarettes 2% above the rate of inflation (the consumer price index is currently 4.4%) and that a wider restructuring of tobacco duty would add 33p ($0.51) to a premium pack of cigarettes and 50p ($0.78) to a discount pack. This closing of the price gap could diminish the value proposition of economy brands, which could hurt Imperial, given its leading share of the U.K. market and positioning in economy brands such as Windsor Blue. However, in light of the relative inelasticity of cigarettes, we expect manufacturers of premium brands, including British American (BATS) and Philip Morris (PM) International, to raise prices to maintain the price gap, which would stabilise volume and market shares. Furthermore, Imperial is the dominant player in loose tobacco in the U.K. with its Golden Virginia brand, and this tax hike could encourage trading down to roll-your-own cigarettes.
There are other reasons we think the market may be missing the value in Imperial Tobacco's shares. We think the firm could be the winner from recent legislation in the U.K. to ban in-store displays of cigarettes in England, as competitors' inability to promote price discounts could set in stone Imperial's industry-leading market share. Plans to promote plain packaging may also play into the hands of Imperial Tobacco at the expense of British American and Philip Morris International, if trading down accelerates. However, we think legislation to introduce plain packaging could run aground on intellectual property grounds, and we think such a ruling is a low-probability outcome.
