Under CEO Alison Cooper, Imperial Tobacco (IMT) is slowly transforming from an also-ran – albeit a highly profitable one – to a significant player and potential consolidator in the global tobacco industry. But despite recent value-creating acquisitions in the United States, 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 and British American Tobacco due to their superior scale. We attribute a portion of Imperial's lower returns on invested capital, averaging almost 17% over the past five years, lower than peers, to the firm's capital-intensive logistics business, which is a drag on ROIC and masks the highly profitable tobacco business, with margins in line with those of its larger competitors. Therefore we approved when last year the firm announced that it was to partially sell Logista through an initial public offering. We expect further reductions in Imperial's economic interest in Logista because we see little benefit from owning distribution assets in the tobacco industry. Imperial's margins are driven by its footprint in super-premium categories, and it remains at a cost disadvantage to its larger rivals. Imperial's operating costs per pack were 37p in fiscal 2014, above the 27p of Philip Morris and 28p of British American. About 40% of total operating costs in cigarette manufacturing are fixed, so scale delivers operating leverage and lowers average cost and creates a cost advantage through procurement pricing power. Although a clear number four – excluding China – in terms of cost advantages, its overlap with its larger competitors is essentially restricted to the European Union, Ukraine, and Australia. In developing markets which make up about 60% of volume, the firm competes with local players and holds a clear cost advantage through its superior scale. Given that Imperial is at a structural disadvantage to its bigger rivals, we think a valuation discount to Philip Morris (PM) and British American (BATS) is appropriate. However, the firm has strong competitive advantages.
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