Flag pole alert - the series returns - part 5

Tuesday, 24 January 2017, 10:08 am

The scribblers over at French broker Exane BNP Paribas were pushing the Japan Tobacco for Imperial Brands line hard this morning although I have still not unearthed any new facts (it's called journalism) that might substantiate their theory.

Obviously, I will let loyal readers know when I do but for the time being I have pasted Exane's note below.

IMPERIAL BRANDS: BUY ! ZERO M&A PREMIUM DESPITE VERY STRONG M&A CASE...

THE CASE FOR A JAPAN TOBACCO (JT) BID FOR IMPERIAL BRANDS (IMB)

Will the Big 4 (PMI, BAT, JT, IMB) finally become the Big 3 anytime soon ? I see a strong case for it…
1. JT wants to be the Biggest Tobacco company in the World. With the combination BAT/Reynolds, and a case for a future combination PMI/Altria, JT won’t be a spectator…

2. JT not interested in the US market ? Think again. Things are changing…

3. New Structure at JT from 1 January + Management changes at JT International with Mr M&A becoming CEO on 1 April 2017…

4. Japanese companies have big appetite for international assets…Weak GBP vs Strong Yen makes IMB attractive. Also look at interesting converging of EV/EBITDA multiples…
5. JT seeing massive pressures in its 2 biggest markets…Japan and Russia…Time to dilute these risks ? IMB has very little exposure to these 2 countries.

6. BAT, likely JT partner for IMB bid, kept enough flexibility to acquire IMB’s UK assets despite Reynolds deal…BAT keen to have a bigger UK profit pool. JT may want to wait completion of BAT/RAI expected this summer to make a move in H2 2017…Unless they work with Private Equities.

7. IMB warned in November for FY2017 due to big investments of GBP300mln to support its brands. Similar scenario with UK Tobacco company Gallaher before bid by JT in 2006/07. Good time for a predator to strike…

MY CONCLUSION: ZERO M&A PREMIUM TODAY OFFERS A BUYING OPPORTUNITY…
* Bid could happen anytime, even if it is fair to assume that JT may wait for completion of BAT/RAI this summer. Hence deal more likely in H2 2017 or in 2018.
* Time to start building a position…be ahead of the herd. …
* Very good risk/reward below 3600p
* I see max downside risk at 3200p (or about 10%).
* A bid would likely come above 4500p (at least 25% upside)…A multiple in line with the BATS/RAI deal would imply a bid price of 5,150p (43% upside)
* Our Outperform rating comes with a Target price of 4000p (11-12% upside) assuming no M&A angle.


Detailed email below


1. JT WANTS TO BE THE BIGGEST TOBACCO COMPANY IN THE WORLD.
WITH the combination BAT/REYNOLDS, and a strong case for a future combination PMI/ALTRIA, JT WON’T BE A SPECTATOR.

Japan Tobacco (JT) expressed at several occasions its ambition to become the biggest tobacco company in the world (ex-China).

JT is currently number 3 of the big 4 international players. The gap with number 2 will get a lot bigger as BAT with Reynolds leapfrogs PMI (which in time may well combine with ALTRIA).

Currently second, JT will become third with the combination of BAT and Reynolds American.
The industry is consolidating fast. Looking the past decade, Gallaher, Altadis, UST, Lorillard, Souza Cruz are all gone and now Reynolds…

The emergence of the NGP (Next Generation Products) notably iQoS by PMI and also the risk of litigation in the US virtually gone, make a stronger case for global consolidation.

This is why BAT wants to acquire RAI and why the big debate is if PMI will try to acquire ALTRIA. Don’t expect JT to be a spectator.

2. JAPAN TOBACCO NOT INTERESTED IN THE US MARKET ?….THINK AGAIN. THINGS ARE CHANGING…
The main pushback for a bid by JT for IMB, is the fact that JT said several times in the past that they do not want US exposure by fear of the US litigation risk.
Considering the evolution of the industry, the US market is becoming increasingly attractive…great pricing power and great potential for the NGP, while the litigation risks are virtually gone…

Imperial brands acquired about 7% of the US market through disposal from the combination Reynolds/Lorillard, on the top of the 3% it already controlled. IMB apparently negotiated as part of the deal that it will not carry any litigation risk associated to the acquired businesses in the US and that the risk will stay with Reynolds. According to the SEC, while IMB and Reynolds/Lorillard were finalising their talks, another party tried to enter the bidding process…maybe JT once they understood that there was NO litigation risk ?
The US business of IMB is consequently mostly litigation free. It would allow JT to access the most exciting market in the world. It would also allow JT to control its Winston brands globally (currently Winston is controlled by Imperial in the US and by JT everywhere else). Finally it would gain control of Imperial’s Blue in the vapour segment.

Japan Tobacco has a modest presence in the US with ecig business Logic. Also note its launch last year of the LD brand in North/South Carolina. So Japan Tobacco does not seen so allergic to the US market anymore…

3. NEW STRUCTURE at JT and MANAGEMENT CHANGES AT JAPAN TOBACCO INTERNATIONAL…Mr M&A will be soon CEO of JTI…

On 29 November, JT announced a new structure for its Tobacco Business. Japan Tobacco will establish an advisory committee for the president of the Tobacco Business to facilitate “further growth of the business”, according to company statement. The committee will discuss mid- to long-term growth strategies, including resource allocations related to business investments. The new structure took place on 1 January 2017.
Also on 29 November, JTI (Japan Tobacco International) announced a management change. CEO McCoy will be retiring on 31 March 2017. His successor on 1 April 2017 will be Eddy Pirard, currently Executive VP, Business Development, Corporate Affairs and Corporate Communications. The statement highlights “…Eddy has more recently led all our M&A activities across the world, including the acquisition of Natural American Spirit outside the US and an equity stake in NTE in Ethiopia.” Basically Mister M&A at JTI becomes CEO….who bought the large UK based tobacco company Gallaher in 2006 for Japan Tobacco ? It was Japan Tobacco International…


4. JAPANESE COMPANIES HAVE BIG APPETITE FOR INTERNATIONAL ASSETS…WEAK GBP vs STRONG YEN MAKES IMPERIAL EVEN MORE ATTRACTIVE. RELATIVE VALUATION INTERESTING…

See the recent FT article “Japan Inc on the hunt for post-Brexit deals” highlighting that Japanese firms have snapped up 37 UK companies so far this year. http://on.ft.com/2haffHW

Japanese businesses have spent $33.5bn to purchase 37 British companies in 2016. That compares with 29 Japan to UK deals worth $9.5bn in 2015. Much of that spending is attributed to SoftBank’s $32bn purchase of UK chip designer Arm Holdings in July. The article says “While several of the Japan to UK deals were suspended following the June 23 referendum, bankers say talks have resumed and the pace of buying will pick up next year. Deals are in the pipeline in a range of sectors…”. Looking at the very high price/multiple paid recently by Asahi for the Central&Eastern European assets of SABMiller, it is clear that Japanese companies are keen to acquire international exposure away from difficult domestic market. The Yen is approaching an all-time high vs. the GBP…See Chart A.

Interesting to highlight the convergence of EV/EBITDA multiples (key M&A metric) for JT and IMB…Looking atChart B, you will see that historically the EV/EBITDA multiple of Imperial Brands was much higher than JT. Not the case anymore…

5. JT SEEING MASSIVE PRESSURE IN ITS 2 BIGGEST MARKETS…JAPAN and RUSSIA…TIME TO REDUCE THOSE RISKS ? IMB has very little exposure to these countries
We estimate that Japan is about 29% of group sales and 40% of group profit for Japan Tobacco. His second biggest market is Russia with 11% of sales and 15% of profits.
Both markets are at risk for JT in coming years and interestingly….IMB has very limited exposure to these 2 markets: Japan is about 0.5% of sales and profits and Russia is 3% of sales and 1.5% of profits.

In Japan…Japan Tobacco is under pressure with PMI making a big push with its new revolutionary “heat no burn” technology iQoS, taking share. BAT recently launched Glo. JT did not apply for a raise prices at the start of 2017 as expected… a sign that they feel under pressure. The success of their NGP “Ploom Tech” will be compared to the strong success of IQoS.

In Russia…the press reported earlier in January that the authorities are considering new tobacco regulations…According to Kommersant, the Health Ministry has drafted plan to almost triple taxes on cigarettes and expand list of public places where smoking is prohibited. Measures are aimed at reducing smoking rate from current 33% of adult population to 25% in 2022. Tax may be raised from at least 2,123 rubles per 1,000 packs currently -- depending on price of individual unit -- to at least 6,000 rubles per 1,000 packs from 2020. Health Ministry calls for introducing uniform cigarette packs without mentioning brands, banning tobacco sales to anyone born after 2015. It also wants to expand smoking ban to multi-family apartments, transport stops and pedestrian under-passages, impose taxes and restrictions for electronic cigarettes and vapes.


6. BAT, LIKELY PARTNER, KEEPS ENOUGH LEEWAY TO AQUIRE IMPERIAL’S UK BUSINESS DESPITE ACQUISITION of REYNOLDS…BATS KEEN TO HAVE A BIGGER UK PROFIT POOL. JT MAY WANT TO WAIT COMPLETION OF BAT/RAI TO MAKE A MOVE…UNLESS THEY DECIDE TO WORK WITH PRIVATE EQUITY…

The other pushback for a bid by JT for IMB is the fact that JT probably needs BAT and that BAT is currently busy acquiring Reynolds.
Indeed the UK market would be an issue for JT. The UK is a second biggest market of Imperial (after the US). It is about 16% of group profits with a 39% market share. Japan Tobacco has a 41% market share. The combination would be rejected by the UK regulator. That’s why BAT with a 10% share in the UK with virtually no profit (value end offering) would be the obvious buyer of these assets. BAT said at several occasions that a bigger profit pool in their domestic market would create tax optimisation opportunities…With the expected introduction of a minimum excise tax in March/April in the UK, the BAT positioning at the value end will be hit hard at the benefit of main stream brands (JT and IMB)…hence the market share and profit pool of BATS in the UK are likely to be under pressure from April.
I find interesting to notice how BAT has structured its offer for Reynolds with much more paper than required…the current offer agreed last week implies that BAT will have a Net debt/EBITDA multiple of ~3.8x. If BAT just took the UK at 11x EBIT for GBP6.5bn, it would add 0.4x to the leverage ratio…so it is do-able IF Reynolds goes through at current price. The other markets with potential antitrust issues (Spain, Ireland, Austria) would likely add another 0.2x to leverage.

The New CEO of JT will start on 1 April…he may want to wait for the completion of the BATS/RAI deal expected this summer, hoping that BATS won’t have to pay more (due to improved US tax outlook).
He may want then to talk to BAT about acquiring the UK business and potentially other smaller European assets of IMB…Now if he is in a rush, he may also decide to work with the private equity (PE) community…PE firms know that BAT will be a keen buyer in the next 2-3 years. PMI may want to acquire some other markets where the regulator may oppose the combination.

JT can buy 75% of IMB and stay under 4.5x EBITDA using full treasury shares.

7. IMPERIAL BRANDS WARNED in NOVEMBER for 2017…BIG INVESTMENT PROGRAMME of GBP300 TO SUPPORT ITS BRANDS…SIMILAR SCENARIO WITH GALLAHER BEFORE ACQUISTION BY JT in 2007. GOOD TIME FOR A PREDATOR TO STRIKE…

To further drive delivery of our strategic priorities and underpin revenue growth over the medium term, we will invest an additional £300 million, which, net of investment returns, will have a £200 million impact in 2017. This will be partly offset by £90 million of cost optimisation savings….The phasing of the increased investment will be biased to the early part of 2017, resulting in lower revenue and profit in H1, offset by a stronger H2 performance. We expect a return to constant currency earnings growth in line with our medium-term guidance of 4-8 per cent from the 2018 financial year. We continue to prioritise capital discipline and strong cash conversion to underpin our commitment to deliver dividend growth of at least 10% next year and over the medium term.

This guidance implies a low single digit EPS growth at constant currency in FY17. We understand the expectation is EBIT down high single digit in H1 (October to March) and up high single digit in H2.
For the GBP300m if FY17 investments, GBP200m is ongoing as GBP100m will be payback and then there are additional savings on top (but not realised until 2020)..

The ‘new investment’ of GBP300m in FY17 will be behind ‘selected quality growth opportunities’. These ‘opportunities’ are on more customer engagement, brands, pricing.
It reminds me the fighting mood of Gallaher in 2006 before being acquired by Japan Tobacco International with a bid in December 2016.

Imperial wants to send the message that it is still very much in a fighting mode and remains ambition about the future as shown by the recent JV agreed with the Chinese National Tobacco Company (CNTC)
With a depressed performance in 2017 notably in H1, it may be a good time to strike for a potential predator ?

MY CONCLUSION: ZERO M&A PREMIUM OFFERS OPPORTUNITY TO BUY NOW…DEAL COULD HAPPEN ANYTIME…EVEN IF IT IS FAIT TO ASSUME THAT JT MAY WANT TO WAIT COMPLETION of BAT/RAI this SUMMER. TIME TO START BUILDING A POSITION…BE AHEAD OF THE HERD… VERY GOOD RISK/REWARD…

  • I find incredible that despite all of the above, there is ZERO M&A premium on the name today.
  • The market is aware that the H1 performance will be lacklustre, hence lack of appetite at the moment. H1 results on 3 May.
  • But the stock offers a very good risk/reward here…Trading on a 33% discount to staples (Historic range 40% discount to parity). See Chart C. Trading on 12.4x CalPE18, the risk of multiple contraction if US gvt bond yield keep rising is limited in context of European staples at a 18.5x average PE
  • The stock offers a safe DY of 5.3% in Cal18. The stock (like BAT) finds a floor when it reaches 6% dividend yield. Hence max downside risk is around ~3200p or circa 10% downside (considering imminent ex-div date: 54.1p on 16 Feb).
  • BATS is offering circa 16x for Reynolds, higher than the standard historic range of 12.5 to 14.5x range for trailing PEs for large deals in Tobacco. Japan Tobacco has the reputation to pay high multiples (JT paid 250x EV/EBITDA for the acquisition of Natural American Spirits).

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[Disclaimer - the information on Betaville does not consitute any form of investment recommendation and is not intended to be relied upon by readers in making, or refraining from, any investment decisions].

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