Imperial tobacco is a giant of the tobacco industry. With a presence in 160 countries and over 50 factories responsible for production, Imperial tobacco is truly a global brand. Imperial tobacco manufactures, markets, distributes and sells a range of cigarettes, tobaccos, cigars, rolling papers and tubes. The company is divided into two segments; tobacco and logistics. The tobacco division is responsible for the manufacturing, marketing and sales of tobacco and tobacco related products. The logistic division looks after the distribution of tobacco products to tobacco manufacturers. The company has its headquarters in Bristol, UK. Imperial tobacco is listed on the London stock exchange and as of 19th July 2010 has a market capitalization of approx. 18,955 million sterling pounds and is a constituent of the FTSE 100 index. Imperial tobacco has a labor force of 38,000 strong.
History
At the very beginning of the 20th century American tobacco company (ATC) which virtually had a monopoly in USA set its sight on Britain. Individually the British companies could not counter the cross Atlantic threat. In December 1901 the 13 family run businesses led by Wills, Players and Lambert & Butler joined hands and formed the Imperial tobacco company. As a result of fierce competition, in September 1902 Imperial tobacco and American tobacco collaborated and formed British American tobacco. In the 1911 the regulators in USA split British American tobacco following an anti-trust ruling. This resulted in a complicated situation in which British American tobacco owned some of Imperial's brands outside the UK and Imperial owned some of British Americans tobacco's brand in the UK. Half a century later in 1973 both companies regain control of most of their respective brands. In 1980 Imperial sold off its last financial holdings in British American tobacco and parted ways. In 1985 then Hansen trust presently Hansen plc made a successful bid to buy imperial and the takeover was completed the following April. In October 1996, after ten years with Hanson PLC, Imperial regained its corporate independence and the Imperial Tobacco Group PLC was listed on the London Stock Exchange as a FTSE 100 company.
Trend, Strategy, Growth (geographical / market analysis)
To keep up pace with rapidly changing world and hence capitalize on opportunities Imperial tobacco has fashioned synthetic growth as opposed to organic. Since its incorporation at the London stock exchange there has been a flurry of acquisitions. In early 1997 Imperial acquired Rizla, the world's number one manufacturer of rolling papers. The following year in 1998 Imperial purchased the Netherlands-based tobacco business of Douwe Egberts Van Nelle and its famous Drum, Van Nelle, Amphora and Winner brands of roll-your-own and pipe tobacco. This acquisition had a strategic significance; strengthened Imperial's presence in Europe. This was only the start; the following year in 1999 Imperial targeted the Pacific Rim. A portfolio of quality cigarettes, rolling paper and roll your own tobacco brands were acquired in Australia and New Zealand. In 2000 Imperial turned its focus back on Europe and in September of that year Imperial acquired The Baelen Group, a Belgian manufacturer of roll your own tobacco. The European expansion continued the following month of November when Imperial acquired EFKA group, a German based manufacturer of rolling paper and tubes. The parent company was not alone in this wave of acquisitions, in December 2000 one of imperial's subsidiary Sinclair Collins acquired Mayfair vending. In early 2001 Imperial ventured into a completely new region; sub Saharan Africa through the 75 % acquisition of Tobaccor, the second largest manufacturer/ distributer in the region. This move had great strategic significance as Tobaccor had growing presence in Vietnam hence provided imperial with a gateway to Asia. It is no surprise that Imperial increased its stake in Tobaccor to 87.5% and even has agreed to buy the remaining 12.5%. In August of 2001 Imperial entered into an agreement with Philip Morris International for the right to sell and distribute Marlboro, Raffles and Chesterfield cigarettes in the UK. Marlboro is the world's best selling premium American blend cigarette and access to it gives Imperial a significant edge over its competitors. 2002 was another eventful year for Imperial tobacco, in May of that year Imperial acquired 90% shares of Reemtsma Cigarettenfabriken, a Germany based international tobacco company with strong presence in Germany, central and Eastern Europe and Asia. This acquisition had strong strategic implication as it complemented Imperial's currents strong holds in the UK, Western Europe and African markets. Two years later in 2004 Imperial acquired the remaining shares of Reemtsma Cigarettenfabriken. In May 2004 Imperial established itself in a new region, North America by acquiring CTC Tube Company of Canada. In 2005 Skruf, a Swedish manufacturer of snus was added to the portfolio of Imperial's subsidiaries. 2006 was a important year for imperial tobacco mainly because the world renowned brand of cigarettes Davidoff was acquired and Gunnar Stenberg AS, a Norwegian distributer of tobacco products was also taken over. In April 2007 the fourth largest US cigarettes manufacturer, Commonwealth Brands was acquired. 2008 added Altadis to the list of acquired companies. Altadis is the fifth largest cigarette manufacturer in the world and is also a market leader in cigars. This sums up the eventful M&A expedition of Imperial Tobacco.
Product (Brands) Portfolio
Imperial tobacco categorizes its products into two distinct types; international strategic brands and other (local) brands. The international strategic brands are popular and well known globally while other (local) brands are regional but also well established. Contrary to common belief that this would lead to cannibalization of sales of one segment by the other, the two groups complement each other.
The international strategic brand includes Davidoff, West, Gauloises, John Player Special (JSP), Rizla, Drum and Golden Virginia. Davidoff a premium cigarette brand is a star product for Imperial tobacco and is sold in over 100 countries. Davidoff has a strong presence in Taiwan, Greece and the Middle East and is poised to establish itself in South Korea and India where it was launched in 2010. West's strongholds include Germany, Central and Eastern Europe. West is the largest international brand of Imperial tobacco in terms of volume. Gauloises is a mid priced international brand and can be found worldwide. John Player Special (JSP) is available in Western Europe and Australia. Rizla is another star of the Imperial product portfolio and is the world's best selling rolling paper. Rizla products can be found in over 120 countries. Rizla is top player in its industry in UK, Belgium, Greece, France, Italy, Scandinavia and Africa with UK as its biggest market. The Drum brand has great strategic importance as it is the world's second largest producer of fine cut tobacco and masterfully complements the Rizla brand. Drum is sold in over 45 markets and is primarily concentrated in Netherlands, Germany, France, UK and Belgium. Golden Virginia is another fine cut tobacco brand which is sold in over 35 markets and is a market leader in the UK.
The other (local brands) includes Classic, Excellence, Fortuna, Gitanes, Lambert & Butler, Maxim, Richmond, Sonoma, USA Gold and Windsor Blue. Classic is a value brand and is well established in Ukraine and Turkey. Excellence has strong presence in the sub Saharan Africa. Fortuna is a major player in Spain, Southern Europe and Morocco. Fortuna has recently been introduced in Russia and Brazil. Gitanes' markets consist of France and Middle East. Lambert & Butler (L&B) is the best selling cigarette in the UK and is sold across Western Europe. Maxim is sold in throughout Russia and Eastern Europe. Richmond a relatively recent brand (launched in 1999) enjoyed rapid growth and is now second biggest brand in the UK. Sonoma is an American brand and is very unique because it is the preferred brand for the US military. USA gold is also an American brand and caters to the price sensitive sector of the market. Like USA gold the Windsor Blue targets the economy sector but in the UK.
Competition
Being a global giant, Imperial tobacco has many competitors such as Philip Morris, Japan tobacco and British American Tobacco (BAT). Because of the shared history and region of headquarter BAT is the primary competitor of Imperial tobacco. The tobacco industry is unique in terms of its market structure. Almost half the market, 41% to be exact is concentrated in one geographical area (China) and is not open to competition as the state directly owns the manufacturing. The competition is in the rest of the world (around 46% of total market share). Philip Morris leads the pack with 16% share followed by BAT with 13% share, Japan tobacco is third with 11% share and Imperial tobacco is two places behind BAT at forth with 6% share.
BAT has 250 brands in its portfolio and 50 factories in 41 countries. BAT employees 60,000 people across the globe. In 2009 BAT generated revenues of 14,208 million sterling pounds. BAT products can be found in more than 180 markets and its products are market leaders in more than 50 market. BAT is well diversified geographically and product wise. BAT like Imperial offers a range of products including cigarettes, cigars and snus. Within each product category different price range brands are offered. The primary brands offered by BAT include Dunhill, Kent, Lucky Strike and Pall Mall. Major shareholders of BAT are Blackrock which owns 6.66%, Reinet Investments with 4.22% stake, Legal and General Group plc with 4% ownership and the directors own around 0.03% shares.
Chapter 2 (Financial Analysis)
This chapter deals with the quantitative analysis of Imperial tobacco with regards to its own past performance and primary competitor. The primary tool deployed to execute this task is ratio analysis. The ratios calculated are used for time series and cross sectional analysis. The category of ratios calculated includes liquidity, efficiency, profitability and leverage. Each ratio that is calculated is detailed with regards to the interest of three different stakeholders (investors, lenders and creditors).
Financial ratios are widely used by practitioners to determine the health of the business primarily because of their simplicity and ease of use. Ratios allow for establishment of proportionality i.e. profits as a percentage of sales. The greatest utility of ratio analysis comes from the fact that it allows for comparison of different types and scales of businesses. By utilizing proportionality which is inherent in ratios, this approach makes it possible to compare apples to orange. Where absolute values would be meaningless ratios come to the rescue. It should be noted that although ratios are easy to calculate but are difficult to interpret. Ratios are useful in determining the strengths and weaknesses of a business but are incapable of determining the source of those strengths and weaknesses hence are only a good starting point of an analysis. Ratios are very useful in terms of identifying the focal points which require further analysis. This is a very convenient luxury as there is of information available on most organizations. Ratios can be expressed in various forms such as multiples, fractions and percentages. It is possible to calculate large number of ratios and can be tailored if need be. There is no standard list of ratios that can be applied to the financial statements. Variations in choice and calculation of ratios can be found in practice but it is essential that the choice and calculation should be consistent hence allow for comparison.
Ratio analysis is a very scientific process in its nature but there is an element of judgment involved which is sometimes neglected and results in a flawed appraisal process. Ratio analysis has its share of limitations. The first limitation is that ratios are not immune to the garbage in garbage out (GIGO) phenomenon hence are dependent on the quality of financial statements as they use inputs from those statements. There exists a remedy for this shortcoming, provide adequate resources the analyst could prepare his/her own adjusted statements if he/she is not comfortable with financial statements provided by the business. The second problem of ratio analysis results from the combination of inflation and accounting conventions. Inflation results in distorted figures and hence ratios because according to accounting convention Balance sheet values must be reported at historical cost and are not adjusted for inflation. This means ROCE would be biased upwards for a business that acquired its assets earlier vis-à-vis a business that acquired its assets more recently assuming there is inflation. This problem can be remedied by using real (inflation adjusted) figures. The third limitation of ratio analysis pertains to the information omitted by this process. Although proportionality is very useful as it allows for comparison of different scale of businesses but at times can be misleading. For example a ROCE of 30% is seems more appealing than 25%, but a ROCE of 30% with only 1,000 pound operating profit compared to a ROCE of 25% with 1,000,000 pounds of operating profits tells a different story. It is important to look at absolute values especially when it comes to profits, capital, debt and assets. The fourth shortcoming of ratio analysis results from the difference in basis for comparison. Accounting convention allows for choice which creates distortion. For example the choice available for inventory costing (LIFO and FIFO) affects efficiency ratios in an inflationary environment. Differences in choice of financing used by different businesses also add to the problem of evaluation of ratios. The fifth limitation concerns Balance sheet ratios. A Balance sheet is for a year but represents only a specific point in time within that year hence for seasonal business can give a completely different picture than the most likely scenario and renders the ratios useless. The sixth and the final limitation is similar to the fourth one. The fourth limitation explained the legal plausible distortions. Ratios are also subject to illegal manipulations through window-dressing of accounts and are more common than investors and regulator would like.
Even with its share of limitations, ratio analysis is a very purposeful tool and has proved its worth time and again when used in conjunction with other methods and attention is paid to its shortcomings. Research illustrates that ratios are very useful in determining financial failures (Beaver 1966; Altman 2000).
Profitability
Return on capital employed (ROCE)
ROCE measures the effectiveness by which funds have been utilized. ROCE expresses the relationship between operating profit and the long term capital invested to generate those profits. This ratio is very useful as it determines the returns to all providers of long term finance. In 2006 and 2007 the ROCE was higher than BAT then the ratio declined significantly in 2008 before increasing again in 2009. The reason for the decline was both a reduction in operating profit as percentage of sales which was reduced to 7.17% from 11.49% the previous year and the increase in capital employed which resulted from the acquisition of Altadis. The later factor's affect on ROCE was much more significant than the relatively small reduction in operational profitability. The acquisition of Altadis was 16.2 billion Euros (approx. 14.6 billion GBP) of which 9.2 billion pound were financed through debt and the remainder 5.4 billion pounds from a rights issue (Reuters, web, 18/7/07). This significantly increased the capital base and reduced ROCE sharply.
On average in terms of ROCE imperial follows BAT closely and the trend is remarkably similar as well. Both companies ROCE is reduced from 2006 to 2008 and then starts to increase in 2009. This ratio is primarily of concern to investors and lender while is relatively unimportant to creditors. In this particular case investors and lender need not worry as both the value and trend are positive.
Operating Profit Margin (OPM)
Operating profit which is also known as the earnings before interest and tax reflects trading operational profitability. Since interest in not taken into account when operating profit is calculated hence difference in financing preference of businesses does not affect this ratio. OPM relates the results of operating activities to the sales and can be used to gauge efficiency of operations.
Imperial tobacco has relatively stable (with the exemption of 2008; acquisition of Altadis) OPM which makes it similar to BAT in terms of trend. There is a general downward trend till 2008 and then the ratio rises for both Imperial and BAT. Since this ratio uses operating profit as an input hence is concerning to both investors and lender and not so much to creditors as costs of inputs has been taken into account prior to the calculation of operating profits. The investors and lenders should take a note of this ratio.
Gross Profit Margin (GPM)
The GPM relates the gross profit to sales. Gross profit is calculated by subtracting cost of sales from sales revenue. This ratio measures profitability of selling and sourcing prior to taking account of any other expenses. In the case of both Imperial and BAT the cost of sales primarily has two components the cost of raw materials (mainly leaves) and duty. The distinctive feature of the tobacco industry is that in its total cost of sales the proportion of cost of raw materials is must less than that of duty. For imperial tobacco the duties account for 55.5% of total cost of sales.
In 2006 there was an approximately 10% gap between Imperial's and BAT's gross profit margins. Since then the difference has converged year on year basis. The increasing trend in Imperial's gross margins is due to the fact that the duties relative to sales have decreased even though the cost of raw materials relative to sales has increased. The decrease in duty overweighs the increase in price of inputs hence puts downward pressure on net cost of sales which results in an increase in gross profits and hence GPM. This ratio is relevant to all three types of stakeholder. Investors and lenders would be interested in this ratio for obvious reasons but creditor would also keep a close eye GPM. Although the absolute value of gross profit might appeal more to trade creditors rather than a GPM.
Return on Ordinary Shares (ROS)
ROS measures the amount of profits available to the owners of the business. The owners (ordinary shareholders) have a residual claim on profits and hence have claims on the funds left over once all obligations of the business are met.
Imperial has a very unique trend which can easily be a source of nightmare for the uninformed investor. The decline in ROS from 2006 to 2007 is due to the fact of increase in shareholder equity which resulted from translation gains and increase in retained earnings. Profit margins and share capital remained stable from 2006 to 2007. The sharp decline in 2008 owes to the massive increase in capital. In 2008 Imperial issued approx. 4.9 billion GBP to fund the Altadis deal (annual report; note22). There was a decrease in net profit margin due to increase in financing cost which resulted from increase in debt. The debt proceeds were used to fund the remainder of the Altadis deal. The decrease in net profit margin coupled with a massive in share capital caused the nose dive in ROS. This ratio is of primary concern to the investor and not so much to lenders and trade creditors. Investors should keep a close on this measure as it is expected to rise following the integration of Altadis, any delay in appreciation or further reduction in this ratio is cause for serious concern to the investor.
Efficiency
Average Inventory Turnover (AIT)
Inventory turnover measures in days the average time taken to sell the stock. This is a very useful efficiency ratio. There is no absolute value that can serve as a benchmark but in general the lower this ratio the better. Longer inventory turnover days add to costs in terms of holding cost, obsolesce cost and opportunity cost. Too low AIT is also not desirable as it puts upward pressure on transaction costs.
The AIT for imperial tobacco rises sharply in 2008. In streamline operating conditions this can be a source of concern but this is not the case as in 2008 Altadis was acquired and inventories were more than doubled to 2.8 billion GBP from .998 billion GBP. The cost of sales relative to sales remained stable in this period hence the increase in inventory from the acquisition was the sole reason for the jump in AIT. BAT has a relatively much more stable AIT compared to Imperial tobacco. Investors should be concerned with this ratio because the longer AIT the less free funds available to invest and earn excess return. Assuming interest payments are annual or semiannual, lenders should not be too worried as long as this measure is close to the industry average. Trade creditors should pay special attention to this measure as an increase in AIT would likely result in delayed payments and might possibly cause liquidity problems for them.
Asset Turnover (AT)
Asset turnover ratio measure the sales revenue generated as a multiple of total assets deployed to achieve those sales. Generally the higher the ratio the better assets are being managed. The guide line is that this ratio should closely follow the industry average, any large deviations are a cause of concern and demands further analysis to determine the source.
This measure is a source of concern for two reasons. First, it is below the absolute value of 1 and second it is much lower than its competitor; BAT. The sharp decline in 2008 is due to the acquisition of Altadis which significantly increased the asset base hence lowering the ratio. This ratio concerns investors and lenders. Investors' and lenders' funds which are utilized to finance the operations through acquisition of assets are inefficient on relative basis.
Sales per Employee (SPE)
This ratio measures human resource productivity. Workforce is one of the most important resources of a business and its effectiveness is a source of competitive edge for most businesses. Generally businesses would prefer this ratio to be higher.
In this measure Imperial has a clear advantage over its competitor but BAT is catching up quickly. Imperial tobacco manages its human resource much more effectively compared to its physical assets. Even though the sales increased in 2008 there was a sharp decline in SPE because the labor force was increased to 40,285 from just 14,221 the year before. Investors could determine the quality of their appointed agents through his measure. Lenders and trade creditors would not be much interested in this ratio.
Average Settlement Period for Trade Receivables (ASP-TR)
The average settlement period for trade receivables measures on average how long do credit customers take to settle their respective dues in terms of days. This amount represents funds tied up and hence incurs opportunity cost. Generally the lower the measure the better, high values can cause liquidity problems for the business. On the other hand very low ASP-TR might signal harsh sales policy which might alienate customers.
Imperial and Bat follow the same trend over time. On average the difference between Imperial and BAT has been increasing in favor of BAT. Trade receivables as a percentage of total assets and current assets has been decreasing hence the increase in ASP-TR is not very concerning. Investors, lenders and trade creditors would be interested in this measure as it represents cash generation ability and can significantly affect liquidity situation of the business.
Liquidity
Current Ratio (CR)
Liquidity is of paramount importance to any business. Many profitable businesses have failed because of lack of proper liquidity management. Current ratio is a measure of liquidity and is calculated by dividing current assets with current liabilities. Generally the higher the current ratio the more liquid the business but a too high current ratio may indicate improper utilization of resources.
The current ratio for Imperial is troubling for two reasons. First the absolute value is less than 1 and second problem pertains to the trend. The current ratio is decreasing and diverging from BAT both of these characteristics are a source of serious concern. The reason for the low ratio is relatively high current liability. Current liabilities have significant trade and other payable. Of the total 7,451 million GBP trade and other payables only 1,247 million GBP are trade payables. Other taxes, duties and social security contribution account for 5,779 million GBP (annual report; notes 15). Investors, lenders and trade creditors should all be very concerned regarding the liquidity position of imperial.
Acid Test Ratio (ATR)
Acid test ratio is very similar to current ratio and also gives insight into the liquidity position of a business. The difference between acid test and current ratio is that acid test ratio excludes inventories from current assets. Reason being that for many businesses it is relatively hard to convert inventory into cash quickly. Generally the higher the ratio the better and the value of 1 is considered as a lower threshold.
In the case of imperial tobacco inventories are the second largest head in current assets after trade and other receivables. Hence this measure gives an even more discomforting picture. The trend and the absolutes values are both very disturbing. Investors, lender and creditors should take this into account as an illiquid business is a failed business.
Cash Generated From Operations to Maturing Obligations (CFO-MO)
Cash generated from operations to maturing obligations is a unique liquidity measure at it takes inputs from two different financial statements, the balance sheet and cash flow statement. The inclusion of a cash flow metric has a significant advantage as cash flow statement represents a period of time unlike balance sheet which is snapshot in time and may not be representative of the whole year. Generally the higher the ratio the better it is for the business.
This liquidity measure tells the same story as its predecessors with one positive difference which the trend is positively changing. But the absolute value of the ratio and the difference with BAT are not very comforting. There has been a steady increase in cash from operations which is a good sign but current liabilities remain the focal point the liquidity concern.
Leverage
Gearing Ratio (GR)
Gearing also known as leverage refers to the level of debt financing in the capital structure. Debt financing is long tern source with fixed cost unlike equity. This results in possibility of amplified return to share holders but there is a cost involved which is greater variation in return and hence risk. Generally low gearing is preferred over high.
Initially Imperial tobacco was highly geared but this ratio has decreased and converged with BAT's. In absolute terms the metric is still very high but since its similar to its competitor hence is not as much as a concern. Gearing affects the risk profile of the business and hence is important for all stake holders. This measure is especially important for inventors and lender as it affects them directly. Investor returns would vary with gearing and the level of debt would determine the margin available for further financing.
Interest Cover (IC)
Interest cover ratio measures the amount of operating profits available to service the interest cost. The lower this ratio is the greater the risk to lenders that the interest payments will not be met. This relates to greater risk to shareholders as it increases the chance that lender would take action against the business.
At initial glance the figures look very worrying. The sharp decline is attributed to increase in debt which was used in the acquisition of Altadis. Irrespective of any reason a value close to one is alarming which the case is in 2008 and 2009. Because of significant investment Imperial tobacco manages to avoid a plausible bankruptcy scenario. But the difference with BAT is a source of serious concern and requires further in dept analysis. This ratio is particularly important to the lenders of the business.
Chapter 3 (Shareholder Returns)
