Flag pole alert - part 5

Below is Bank of America Merrill Lynch's latest piece of research on Imperial Tobacco, which appears to suggest China National Tobacco Corporation is the most credible suitor for the FTSE 100-listed company.

Top 4 global tobacco companies hold >70% volume share

Tobacco is a consolidated sector with the top 4 owning 3/4 of market volume (ex-China) from 1/2 10Yago. PMI/BAT/JT/IMT hold 30%/18%/17%/8% volume share, respectively. We attribute share gain to consolidation, higher exposure to EM & brand portfolio/mix. PMI gained the most share (+400bps) while IMT lost some (-100bps) over the last 5Y.

From 4 to 3 or is China the next surprise consolidator?

North America, LatAm & Australasia each have 3 players holding on avg a 95% volume share. One more big tobacco deal could consolidate the global market from 4 to 3 main players. The #4 - IMT -has been speculated as a takeover target in the press and could potentially be carved-out among the 3 leaders, most likely the #3 (JT) & #2 (BAT) to limit anti-trust issue (Table 7). But in the short term we believe CNTC, also a potential bidder for IMT according to press reports, is in our view the most likely suitor given its willingness to expand internationally..

Past M&A: 15x EBITDA, 40% prem, 10%/30% rev/EBIT syn

On avg, tobacco acquisitions have priced at 3x sales, 10x EBITDA & 12x EBIT; more recent deals at 6-7x sales & 14-16x EBITDA which compares to European tobacco stocks trading now at 6-7x sales & 12x EBITDA. The most recent big deal - RAI/LO - put a 40% premium to the share price; historically big deals closed at 30% average premium. A deal delivers synergies of 10% of sales (range 8%-13%) and30% of EBIT on average. We also list state-owned and independent tobacco companies that could be viewed as targets on page 14.

Scenario analysis: JT / IMT the most accretive

On our estimates and based on 3x net debt/EBITDA JT/PMI/BAT/IMT have $22/10/3/0bn M&A firepower; IMT acquisition by JT/BAT/PMI scenario would be c20%/10%/10% accretive (3Y avg) & implying c1/3 of equity financing & 3Y avg ROIC at 5-6%. Looking at antitrust & earnings enhancement we believe JT is the most likely listed bidder. Our BAT/ RAI scenario is earnings dilutive given the current BAT leverage & RAI valuation.

CNTC more compelling suitor for IMT than the Big Three 

Speculation of an IMT takeover started close to a decade ago but intensified recently withJT/BAT/PMI/CNTC mentioned in the press as possible suitors. The likelihood of a deal happening in the near future is, in our view, increased by IMT's valuation (15x '16 PE, 32% discount to Staples) & debt financing rates, both attractive, but perhaps offset by the imminence of UK (18% of group EBIT)plain packaging implementation in May '16. For the potential listed bidders, the fundamental rationale is less compelling than for CNTC given IMT's fragmented portfolio, geographical mix skewed to developed markets & antitrust issues (especially the US ITG business, 20% of IMT's EBIT).

Tobacco our preferred sector in Staples, Buy BAT & IMT

We reiterate our Buy ratings on BAT and IMT on fundamentals. We see CNTC as the most likely suitor near-term as brand migration and anti-trust likely would not be such an issue. We view BAT as a less likely potential suitor as leverage is stretched; we believe PMI would likely face too many anti-trust issues resulting in limited earnings enhancement; and JT may be occupied with integrating NAS.