This is the third installment of a series on international tobacco that started with industry leader Philip Morris (NYSE:PM) and continued with its foremost competitor British American Tobacco (NYSEMKT:BTI). In this article, we will take a look at number 3 and number 4 positioned Japan Tobacco (OTCPK:JAPAY) and Imperial Tobacco (OTCQX:ITYBY). We believe one of these companies is trading at an attractive discount to fair value, with a number of catalysts on the horizon to realize underlying worth, with investors getting an attractive dividend while waiting.
(Table: The largest tobacco companies in the international market (ex China and the USA: Japan Tobacco AR14)
Japan Tobacco
Japan Tobacco is the successor to the former state tobacco monopoly of Japan, where it still is the largest player in a tobacco market that has opened up to foreign competition. Despite being a public company, the Japanese government still has an important stake in JT, which is currently at 33.3% (reduced from 50% earlier). The Japan Tobacco Act states that the Japanese state must maintain ownership of no less than 1/3rd of JT's share capital. Another law (the Tobacco Act) states that tobacco prices must be approved by the Japanese Ministry of Finance before going into effect. While price increases are generally approved, we feel these arrangements make no sense, since they make the Japanese government both a beneficiary of JT's economic performance as well as its regulator. To most Westerners, it must seem weird that a government would have an interest in a business whose product is a health hazard, while at the same time incurring significant healthcare costs as a result of that product. In our opinion, this arrangement puts the Japanese government in a situation where it has opposing interests, and which potentially makes it a party in tobacco litigation. Japan Tobacco first branched out into international markets when it acquired the international business of R.J. Reynolds in 1999. Japan Tobacco operates its international tobacco business separately from its domestic business in a subsidiary called JTI. In 2007, it fortified its international tobacco operations by acquiring U.K.-based Gallaher. In the years since, several smaller acquisitions have followed, including shisha (water pipe) tobacco business al-Nakhla, as well as an equity stake in tobacco distributor Megapolis of Russia (together with Philip Morris). Water pipe tobacco smoking is especially popular in the Middle-East and North Africa, and consumption in this niche category has been on the rise. Japan Tobacco is the third-largest international tobacco manufacturer, with a large presence in the Japanese, Russian and U.K. tobacco markets, as well as many other countries. It has global aspirations for its tobacco business and a couple of internationally well-known brands, but is also more regionally focused than Philip Morris and British American Tobacco. On top of its Japanese and international tobacco businesses, Japan Tobacco also operates a pharmaceutical business, a foods and a beverage business that are mainly focused on Asia. We will not specifically discuss those business segments in this article, focusing purely on the tobacco business as compared to its international peers. The reason the food and pharmaceuticals businesses are excluded is because they only constitute a relatively small smart of JT's sales (about 17.5%) and a negligible part of its operating profit. On top of that, we consider them to be outside our area of expertise. Given the subpar returns on these businesses when compared to the tobacco business, we feel JT would probably be better off focusing solely on tobacco.
The largest cigarette brands in the international market (excl. China and the USA: Japan Tobacco AR 2013)
Brand Portfolio and Market Presence
JT's international brand portfolio consists of the rights (excluding the USA) to famous brands such as Camel and Winston. Its Japanese brands are very strong in its domestic market, but relatively unknown internationally. Notable exception to this rule is Mevius, which is the largest cigarette brand in Japan and Taiwan. Japan Tobacco has been introducing this brand into more international markets over the past years. Mevius is a brand that has been morphed out of Japanese brand Mild Seven; it has been rebranded in its domestic market as well. Its new name is apparently an abbreviation of Mild Seven Evolution I & U (which doesn't make much sense to me). Rebranding or morphing is a practice that is becoming more in vogue amongst tobacco manufacturers as a strategy to cope with declining volume in smaller brands. To readjust their brand portfolios towards larger, international brands, companies sometimes choose to gradually merge a brand into a similar one, hoping to shift its customer base to the surviving brand. In the case of Mevius, the metamorphosis is intended to reposition the brand into a more internationally appealing offering for the premium segment. The Gallaher acquisition also gave JTI the mid-priced brand LD (short for Liggett Ducat), which it claims now holds a number 2 position in the mid-price segment of the global cigarette category. As can be seen in the table above, Winston, Mevius and Camel are amongst the largest international cigarette brands in the world (excl. China and the USA). Especially Winston has grown into a very valuable brand, with a worldwide number 2 position and a number of attractive share positions in large markets. Winston is also the largest cigarette brand in emerging markets Russia and Turkey.
Brand volume (bn sticks) for Japan Tobacco. Unfortunately, JT stopped reporting volume on most of its GFB brands. However, volume for Flagship brand Winston is available and shows strongly rising volume over the past decade. Declining volume for Mevius is mostly due to a declining cigarette market in Japan (Japan Tobacco Annual Reports 2006-2013).
JT has a similar brand strategy as British American Tobacco: in order to concentrate its brand portfolio more around cigarette brands that have international expansion opportunities, it has focused on developing sales and brand equity for its most promising brands, called Global Flagship Brands (GFB). The GFB portfolio consists of Winston, Camel, Mevius, LD, Sobranie, Benson & Hedges, Silk Cut and Glamour. The first two brands (excl. USA) were acquired in the R.J. Reynolds International acquisition of 1999; Mevius and Glamour are JT brands; LD, Sobranie, B&H and Silk Cut all came with the 2007 Gallaher acquisition. Please note that some of these brands have other rights-holders in certain markets. Winston, Camel, JD and Mevius seem to be the most valuable brands from an international perspective, with a strong emphasis on Winston. Even though JTI consists of at least two large separate tobacco businesses that were integrated into one, JTI has grown strongly on an organic basis as well. Japan Tobacco really seems to have managed the Reynolds International and Gallaher brands very well since acquiring both companies. In Japan, its domestic tobacco business still holds a very strong market leading position, despite increasing international competition from Philip Morris and British American Tobacco. Geographically speaking, Japan Tobacco's business is strongest in certain parts of the areas of West Europe, East Europe, the Middle East and Africa and certain parts of Asia. It's almost absent from the Americas region, holding only minor market shares in certain countries (Mexico, for instance). Apart from Japan, Korea, Malaysia and Taiwan, it is also largely absent from many Asian markets.
The table shows market share data on some of Japan Tobacco's most important markets. JT has a presence in many more countries, but only the most important are shown (JT AR 2013 and investor presentations).
Japan Tobacco separates its tobacco business into a couple of separate regions. The domestic business forms its own operating segment. The international business is separated into North & Central Europe, South & West Europe, CIS+ and Rest of the World. For comparative purposes, we have combined both European segments into Europe as a whole. Japan Tobacco has (very) strong leadership positions in the large but declining markets of Japan and Russia. It also leads the market in Ireland, Sweden, Austria, Sudan, Tanzania, Taiwan, Gambia, Jordan, Guinea, the Maldives, Iceland, Georgia, Kyrgyzstan and Mongolia. Of course, its positions in Russia and Japan are extremely important to Japan Tobacco because of the vast size of these markets. It's got second-place market share positions in the U.K., Italy, Turkey, South Africa, Nigeria, Malaysia, DRC, Lebanon, Mozambique, Austria, Lithuania, Latvia, Greece, Ukraine, Belarus, Romania, Kazakhstan and Azerbaijan. A lot of these markets are quite small, but the market shares in the U.K., Italy, Malaysia and Ukraine are very valuable as well, because of the respective market sizes. Unfortunately, Japan Tobacco cannot rely on as many market share leadership positions as Philip Morris or British American Tobacco have. On the other hand, its market share performance in many markets has been quite strong, especially when taking into account that JT has only held ownership of the Reynolds International brands for 15 years and just 7 years for the Gallaher brands. In Japan, its full control of the tobacco market has eroded to the 60% range, but seems to have stabilized at this level. Its Russian business is its largest business outside of Japan, and consists of the Reynolds International brands, as well as the strong position Gallaher had in Russia prior to the acquisition. Gallaher brand LD, for instance, had a strong Russian presence pre-acquisition, which might have been an important part of Gallaher's attraction to Japan Tobacco. In Russia, its market share is currently around 35%, but has seen some pressure over the past years. This has been most notable in volume performance, but the market-leading Winston has managed to grow its share of the market. Therefore, JT's share of value in this market has gone up. The Russian market is still quite fragmented regarding brand market shares, but we expect the larger brands to consolidate their position in future years, which may benefit JT through its ownership of Winston. Especially since Winston has a similar market positioning as Marlboro, which is weak in the Russian market at just over 1% market share.
The table below shows overall volume performance in Japan and in all separate international regions. Also shown is the volume of GFB brands per region and GFB as a % of international sales. Japan Tobacco has been very successful in growing volume in its international division. At the bottom of the table, total Japan Tobacco cigarette volume is shown. The Japanese cigarette market is in decline, which can clearly be seen in lower JT sales volumes (All volumes in bn. sticks: Japan Tobacco Annual Reports 2006-2013)
When taking a longer-term perspective of its volume performance, both in Japan and in international markets, it becomes clear that Japan Tobacco has really done an outstanding job growing its volume internationally, and has been able to quite successfully defend its domestic position against PM and BAT. Its share of the Japanese market has come down over the years, but remains at a very high 61.5%. JT's international volumes have been helped to an important degree by the acquisition of Gallaher in 2007, which can be seen in sharply rising international volume reported over 2007 and 2008. Its international volume has declined since peaking in 2008, probably due to declining cigarette markets in Europe and EMEA, but generally speaking, it has done a very good job with both the Reynolds International and the Gallaher brand assets. Especially Winston has been turned into an international powerhouse, while Camel and LD have been very successful as well. Japan Tobacco certainly has big ambitions for its international tobacco business; it has formulated the goal of making Winston the largest-selling cigarette brand in the world, and has formulated a similar goal for Mevius regarding the premium category. We consider these goals to be extremely ambitious, though; Winston has certainly narrowed the gap with Marlboro over the past decade, but it still trails the PM flagship by a very wide margin, and is mostly dominant in declining markets. This is also true for Marlboro, but PM has a much wider international market presence, making its sales platform for growing Marlboro in emerging markets a formidable competitive quality. Regarding Mevius, JT's ambition seems even more stretched, because it currently only leads the market in Japan and Taiwan, making the ambition to grow it into the world's best-selling premium brand something of a wild dream, in our opinion.
Financial Performance
Japan Tobacco's sales grew by 13.18%, while operating profit climbed by 21.8% in FY 2014 (year-ended March 31st). This strong performance was to a large degree driven by its international tobacco operations, which grew sales by 25.7% and operating profit by 30% (in yen). The domestic tobacco business grew revenue by 3.37% and operating profit by 7%. However, its international operations' performance is distorted because of the conversion to yen. Measured in USD, the international tobacco business grew revenues by 3.9% and adjusted EBITDA by 7.5%, which is still good but far more modest and a better indication of underlying performance, in our opinion. Volume performance was negative for the international business, whose performance was driven by higher pricing. For its domestic business, both volume and pricing were higher. Diluted EPS came in at ¥235.35, while the dividend paid was at ¥96. Tokyo-listed shares last changed hands for ¥3438.5, which gives the stock a trailing P/E of 14.6x and a dividend yield of 2.79%. The P/E seems quite modest, but we think it is indicative of the reliance on international earnings that have to a large degree been driven by a declining yen. We think that Japan Tobacco would be especially vulnerable in case of a dollar/yen currency trend reversal, which has worked in its favor so far. Also, the dividend yield is quite low for a tobacco stock, although this is due in part to its payout ratio of about 40% (which is lower than its tobacco peers, but also leaves room for raises).
The share price performance for Japan Tobacco over the past two years has been driven in large part by the rising dollar/yen rate, which has given its international earnings as reported in yen an enormous boost (graph pulled from MarketWatch: The blue line is JT's share price, while the brown line is USD/JPY currency rate).
The financial performance of Japan Tobacco is to a large extent reliant on the tobacco operations, which accounted for 82.5% of its sales and almost all of its operating income during the past fiscal year. The domestic business had rising volumes because it is still recuperating from the tsunami of 2011 when its supply chain was disrupted, which caused its market share to drop. Its domestic market share has since then rebounded, driving volume gains in a declining market. Since the start of Abenomics, the yen has been declining against almost all large international currencies, especially the dollar and the euro. This has given the profits of JT's international tobacco business an enormous boost when converted back to yen, which has driven a strong increase in the share price of the company. For a foreign investor in JT, this situation has a downside which is absent for Japanese investors; their yen-denominated shares have decreased in value when converted back into their domestic currencies, largely or entirely undoing the gains that have been realized in the shares. For the sole reason that JT is a yen-denominated asset, we would refrain from purchasing the stock ourselves, even though its international tobacco business seems to have outperformed the tobacco industry as a whole. The reason we have for this position is that the Japanese government's economic policies seem to be based largely on debasing their own currency, in an attempt to stimulate exports and spur domestic inflation. This makes holding yen-denominated assets a potentially risky undertaking. Our opinion regarding JT is strengthened by the enormous reliance on both the Japanese and Russian cigarette markets, both of which are in decline. Even though we believe there's a good chance JT will outperform the Russian market as a whole on the back of Winston's strength, we feel there are more attractive alternatives in the international tobacco industry that are less regionally dependent.
Imperial Tobacco
Imperial Tobacco was formed as a reaction to the entrance of the American Tobacco trust into the U.K. market in 1901. It was intended to offer a counterweight to its American competitor, led by Buck Duke, of whom British tobacco manufacturers suspected that he had plans to dominate the U.K. market. The Imperial Tobacco Company of Great Britain and Ireland, as its full name was, came to dominate the U.K. market just as American Tobacco dominated the U.S. market at that time. To this very day, Imperial Tobacco still holds an important share of the U.K. market for tobacco products, and has build up a presence in other countries as well, mainly through acquisitions in mainland Europe. In 2008, it acquired Altadis (which was a combination of the former tobacco monopolies Seita of France and Tabacalera of Spain, merged in 1999) for more than €15 bilion, which was the largest tobacco acquisition of all time (until the bid for Lorillard surfaced this year). Due to the economic crisis that started in that same year and struck especially hard in Southern Europe, Imperial Tobacco has had to write off a significant part of the goodwill associated with the Altadis buyout. Imperial Tobacco is currently the fourth-largest international tobacco manufacturer, but is definitely not as global as Philip Morris, British American Tobacco or even Japan Tobacco. Its fourth position may be perceived more positively than reality warrants. The company is smaller than the other three companies, doesn't have a global brand portfolio like the other three and is much more regionally focused, particularly on Europe. Opposite to the other three, it does have a direct presence in the U.S. tobacco market, primarily through its cigar operations and by way of its acquisition of Commonwealth Brands in 2007. Its U.S. cigarette presence is currently focused on value brands, but the company is set to enlarge its presence through the brand acquisition associated with the Reynolds American (NYSE:RAI) and Lorillard (NYSE:LO) merger. This potential acquisition would add American brands Kool, Winston, Salem and Maverick (and e-cigarette blu) to Imperial's brand portfolio in the U.S., making it the third-largest player in the U.S. market (although at a considerable distance to the other two), with close to a 10% share. Since the brand acquisition was proposed at a low multiple to combined EBITDA performance (8.75x), we believe this transaction may add substantial value to Imperial Tobacco. The company itself also thinks that the transaction is attractive. Its CEO has cited the fact that cigarettes are generally very affordable in the USA (some areas excluded), which may offer upward pricing potential post-merger. Imperial Tobacco also believes there's more brand equity remaining in the Winston brand than is currently being realized. Of course, the closure of the Lorillard-Reynolds deal is still subject to regulatory approval in the U.S. Besides the brand acquisition being attractive on a standalone basis, we also think it may increase the chances of Imperial Tobacco becoming a target in tobacco industry consolidation itself (which will be addressed in the final part of this article).
Brand Portfolio and Market Presence
Imperial Tobacco's business consists largely of three distinctly different tobacco product areas. Its largest business is its cigarette and fine cut tobacco segment, which in the international market (excl. USA) consists of both local market brands, as well as some with international exposure, such as Gauloises, West and John Player Special. The company claims to be the fine cut leader due to its ownership of roll-your-own tobacco brands such as Golden Virginia and Drum. Secondly, Imperial Tobacco has a global cigars business which leads the category internationally. Its cigars business owns famous premium cigar brands, such as Montecristo and Cohiba and mass market cigar brand Backwoods. Finally, Imperial Tobacco also has a tobacco paper business which owns leading rolling paper brand Rizla among others, and which is complementary to its fine cut tobacco business. In the USA, it currently has USA Gold, Fortuna, Rave, Malibu Lights and Sonoma. Imperial Tobacco doesn't really have brands that are truly global. The company was for a long time focused on its domestic business in the U.K., which owns leading domestic brands such as Lambert & Butler (L&B) and Richmond. During the last two decades or so, Imperial Tobacco has embarked on an acquisition spree, acquiring many brands in the process. Its tobacco portfolio therefore consists of a lot of local and regional brands, of which only some have international exposure. It's also largely focused on the mid-priced and low-priced segments of the tobacco market. Notable exceptions are its ownership of premium cigarette brand Davidoff (which it acquired from privately held Tchibo in 2006), as well as premium brand Gauloises. Its cigar business, on the other hand, is mostly positioned towards the premium segment. The company does not report volume performance on a brand or market level, which severely limits visibility of its relative position vs. its peers. Our estimate (based on reported market shares, as well as data from competitors) is that it is currently underperforming the tobacco industry on an organic basis.
Imperial Tobacco divides its tobacco brand portfolio into "Non-assets" and "Assets", the latter of which is divided into the "Growth" and "Specialist" categories. The Non-asset portfolio is not shown, but consists of declining local brands (Imperial Tobacco investor presentation).
Imperial Tobacco's growth portfolio consists of its larger cigarette brands that have potential for market share gains. These brands are (super) premium Davidoff and Gauloises, brand houses John Player Special and West plus USA Gold. Brand houses are combinations of several brands that are visually distinctive, but are managed as if one brand. The Specialist brands are mostly brands in niche segments of the tobacco market, such as dark cigarettes (Gitanes), slim cigarettes (Style), fine cut (Drum etc.), premium and mass market cigars (Cohiba etc.), snus (Skruf) and tobacco rolling paper (Rizla). In our opinion, Davidoff, Gauloises, JPS and West are by far the most valuable brands in the Imperial Tobacco portfolio, although its cigar brands have very significant brand equity in their own category.
Imperial Tobacco divides its geographic markets into "Returns" and "Growth" markets (Imperial Tobacco investor presentation).
Its geographic segments are classified and managed as Returns Markets (North and South) and Growth Markets. In Returns Markets, Imperial Tobacco generally has relatively high market share (>15%) and manages mostly for financial returns, while in Growth Markets, Imperial Tobacco has low market share and sees potential for gains (these may be declining cigarette markets overall). As can be seen in the table above, its Returns Markets mostly consist of European countries, as well as Australasia. Its Growth Markets are mostly in Asia and EMEA, as well as in the USA, where Imperial Tobacco currently has about 4.5% share of market (which might increase towards 10% if the RAI/LO brand acquisition proceeds.)
Imperial Tobacco's most important market currently is the U.K., where it is the market share leader with a 44% share in cigarettes (2013) and about 47.5% share in fine cut tobacco (2012). Its primary competitor in this market is Japan Tobacco, but BAT and PM are also present (although with modest market shares). Its second-largest market where it leads the category is in Spain, where it held about 28.3% of the market in cigarettes and 41.6% of the fine cut segment (2012). In Germany, it is the number 2 in market share, with about 25.8% of the cigarette market and 22.3% of the fine cut segment (2012). In Scandinavia, it has been active in the snus category through the Skruf brand, and held about 27% of the category in Norway and 7.2% of the category in Sweden, mostly acquired through sharp pricing tactics with low-priced Skruf. In Australia, Imperial Tobacco has sharply increased its market share in recent years, up from 19.3% in 2012 to 28.3% currently. It has employed aggressive pricing tactics to achieve these results (possibly aided by diminished brand relevance because of the plain-packaging regulation). In other markets, it held the following market shares: in Taiwan 13%, in Turkey 5.5%, in Italy 3.3%, in Kazakhstan 8% and in Cambodia 36% (as of Feb 2014). Altogether, it seems fair to conclude that apart from the U.K., Spain and Germany, the company doesn't have dominant market positions in important cigarette markets. Imperial Tobacco is also active in large markets such as France and Russia, but unfortunately, we don't have market share numbers for those countries (we think it is number 2 or 3 in France; from competitor share numbers, we can conclude it only has a modest number 4 position in Russia).
This table shows volume performance for the different reporting regions and the volume total for Imperial Tobacco. Italicised numbers are volume tons, while bold numbers are billions of sticks or equivalents. (Data from Imperial Tobacco Annual Reports 2002-2013)
Please note that large acquisitions happened in 2002 (Reemtsma) and 2008 (Altadis), which drove cigarette and fine cut volume gains, as well as several smaller acquisitions such as Commonwealth (2007). Fine cut volume reporting was changed in 2011 from volume tons (tonnes) to billions of stick equivalents. Also note that in 2012, the company changed the metric for converting volume tons of fine cut to billions of stick equivalents. We believe this change has benefited reported volume somewhat (which may or may not have been used to sugarcoat the volume numbers). Imperial Tobacco has been hit very hard by the economic crisis in Europe, especially since it sells large volumes in southern countries Spain and France. This exposure has contributed to declining volume numbers overall, which seemed to accelerate in 2013. The crisis has also shown itself in rising sales of fine cut tobacco across the continent, because smokers have turned to this category as a cheaper alternative to cigarettes. Imperial has benefited from this trend to some extent, but its three peers have jumped into this category by introducing brand extensions, which have been quite successful. Last fiscal year was really quite difficult for Imperial Tobacco, which saw volume drop by -7% to 317 billion stick equivalents. In the Annual Report, the CEO stated volume was down from 341 bn. in 2012, while my own data says volume was 336.6 bn in 2012. We believe that the 2013 numbers now include converted cigar volumes, which it didn't include in total stick equivalents before. What struck us is that it stopped reporting volume numbers on individual markets in 2013, which was a very difficult year for the company. It also stopped reporting market share numbers this year, which it did include in its Annual Report 2012. The last time Imperial didn't report volume numbers was in 2004, when it also experienced a severe drop in volume. The 2004 numbers turned up in the Annual Report for 2005, though, when a notable improvement could be reported. It may be that we've interpreted this the wrong way, but to us it looks like Imperial Tobacco stopped reporting its volume because the numbers looked quite bad. On the other hand; it pulled the same trick in 2004, and has done quite well since then.
Financial Performance
Even though 2013 was a very difficult year regarding volume (-7%), Imperial Tobacco still managed to keep its revenue decline limited (-1%) and even slightly grow gross profit (+0.64%) on the back of strong upward pricing. Both in 2012 and 2013, the company impaired meaningful amounts of its intangible assets associated with the Altadis acquisition. This was due in part to very poor performance of its Spanish tobacco business, which we believe to be an industry-wide issue caused by the economic recession. Adjusted for these non-cash charges, EPS is much higher than the reported number shown in the income statement below. Adjusted EPS for 2013 was actually 210.7p, while the current dividend rate is 120p. With the stock last trading at £25.35, the shares have a trailing P/E of only 12x earnings, with a dividend yield of 4.73% (the company is committed to raising the dividend by 10% annually, giving the stock a 5.05% anticipated dividend yield). Adjusted earnings per share have been guided by the company to come in slightly higher this year as well.
Income statement from the Annual Report 2013 of Imperial Tobacco
The mediocre performance by Imperial Tobacco has caused its stock to languish versus its tobacco peer group. We believe that the stock is priced too cheaply at the moment, and will make our case by calculating the value of Imperial Tobacco to a private buyer. This theoretical buyout valuation makes it possible to determine the intrinsic value of its stock. Despite downward volume trends in most of its markets, we feel a multiple of 12x adjusted earnings to be too low for this company, given the strong potential for upward pricing on its product. We will also discuss two catalysts that may drive short-to-medium term value realization in its stock. As we have discussed in an earlier article, most tobacco buyouts have happened in the 12x-13x EV/EBITDA range. Given the tough circumstances for Imperial's business in Europe, we will calculate its theoretical buyout value using the lower end of this historical range. Because we don't have full visibility on current-year EBITDA performance, we will use fiscal year 2013 EBITDA, combined with balance sheet debt and cash levels as of March 31st 2014 to calculate EV/EBITDA. We estimate EBITDA in 2014 to come in at a similar adjusted level as 2013, making this calculation relevant to current value. Based on a 12x EV/EBITDA multiple, we estimate the fair value of Imperial Tobacco to be £28 per share. However, this excludes any potential value that may accrue from the pending RAI/LO brands acquisition in the USA.
This is Imperial's own estimate of the financials behind the RAI/LO brand acquisition.
If the brand acquisition in the U.S. takes place, this would add about $0.8 bn to the EBITDA of Imperial Tobacco. Its estimate of combined EBITDA would result in £3.9 bn of EBITDA for Imperial Tobacco post-acquisition. At the same time, it will add a meaningful amount of debt to Imperial's balance sheet, even though the $7.1 bn acquisition price is not intended to be entirely debt-financed, but in part through cash holdings. Part of that cash comes from the IPO of Imperial's logistics subsidiary Logista that took place in July of this year, generating proceeds around €475 mln for slightly more than 27% of the shares. Besides the realized proceeds, which will be used to finance part of the RAI/LO brand acquisition, at the current market price, Imperial's remaining 73% stake in Logista is worth almost €1.3 bn. We estimate that total debt of £3-£4 bn related to the acquisition will be added to Imperial's balance sheet in case the deal goes through. Post-acquisition, our valuation of Imperial Tobacco would go up meaningfully using the same 12x EV/EBITDA multiple, and would result in a per share value of about £33.
The potential RAI/LO brand acquisition is our first catalyst that will create value for Imperial Tobacco. The second catalyst is a potential acquisition of Imperial Tobacco itself. The most likely candidate to pursue Imperial Tobacco would be Japan Tobacco, since an acquisition by either Philip Morris or British American Tobacco would encounter regulatory concerns in too many markets (the USA in case of BAT). Even though Japan Tobacco and Imperial Tobacco both have a large presence in Europe, the only market where we believe a combination would be troublesome on anti-competitive grounds is the U.K., where the vast range of local brands that can be sold to either British American or Philip Morris makes a combination of the former two complex but workable. The acquisition would also give Japan Tobacco meaningful exposure to the U.S. market, which it didn't have until now, as well as global ownership of the Winston brand. This last part is something we believe to be very attractive to Japan Tobacco, which strongly believes in the brand's potential. Its outperformance with Winston since acquiring the international rights from Reynolds in 1999 gives us reason to believe the Winston brand may be revived in the U.S. market. Its brand recognition in this market is still high, since it was the best-selling cigarette in the U.S. market between 1966 and 1972, as well as the best-selling filter cigarette between 1954 and 1972. When it was dethroned by Marlboro, it remained the number 2 brand into the mid-1990sm until it was unsuccessfully reimaged and dropped to 5th place in 2000. Apart from potentially acquiring U.S. rights to Winston, we believe several other brands in Imperial's portfolio have meaningful appeal to Japan Tobacco. Combining both companies' brand portfolios will make it possible to accelerate value creation from super premium Davidoff especially. This brand would be complementary to JTI's brand portfolio, where it would be positioned above the premium Winston. Also, Gauloises and West would make powerful additions to the Japan Tobacco brand portfolio. West shows a lot of similarities to JT's LD brand, with similar positioning and brand look, creating possibilities for brand phasing. We believe Gauloises to be a brand with strong potential in Africa (especially in the former French colonies), which is a region that Japan Tobacco has increasingly targeted in recent years (evidenced by its recent al-Nakhla acquisition in Egypt and the Haggar acquisition in Sudan). Imperial already would add a meaningful African presence to Japan Tobacco, especially in North Africa, where it has a market leading position in Morocco, for example. Imperial would also complement the sparse Asian presence of Japan Tobacco. And finally, the Imperial premium cigar portfolio offers value to Japan Tobacco, given the potential for expanding premium cigar distribution in its EMEA and Asian markets, such as Russia, Japan, Korea and Taiwan. We consider Imperial Tobacco a buy with a 10% discount to fair value (calculated at £28 per share), as well as a possible 30% upside if the RAI/LO deal proceeds (post-merger value £33), with an expected 5% dividend yield. The discussed takeover scenario serves as a free bonus.
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The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
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