[Intl-tobacco] Canada: Rothmans' run may be near end as company faces triple threat

[Robert Weissman]

Toronto Globe and Mail


    Rothmans' run may be near end as company faces triple threat


      Contraband, indoor smoking bans and litigation could slow its momentu=
m

By KATIE ROOK

Tuesday, August 2, 2005 Page B13
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Tobacco company *Rothmans Inc.* is sleeping with one eye open.

Canada's second-largest tobacco company is facing a triple threat from
contraband cigarettes, indoor smoking bans and pending litigation.

However, it still managed a first-quarter profit and impressive market
share gain. But the momentum may cease.

"This [stock] is expensive," said David Hartley, an analyst with First
Associates Investments. "Going forward, it's all about valuation of the
stock and I think we've hit the end of the rope in terms of this stock
going up. I think the valuations have finally become unreasonably
stretched."

An increase in payout ratio (dividends as a percentage of share profit)
to 86 per cent from 55 to 60 per cent two or three years ago has caused
Rothmans to trade at 20 times earnings, 10.5 times EBITDA (earnings
before interest, taxes, depreciation and amortization) and 20 times free
cash flow, Mr. Hartley said. Historically, Rothmans' peers have traded
at 12 times earnings, 14 times EBITDA and 12 to 14 times free cash flow.

A week ago, Toronto-based Rothmans reported an increase in first-quarter
profit to $29.7-million or 44 cents a share from $23.8-million or 35
cents a year earlier.

Despite an industry-wide decline in volume, the 60-per-cent-owned
Rothmans Benson & Hedges Inc. was able to harness growth by being the
first of Canada's three tobacco companies to offer discount cigarettes.

Revenue after excise duty and taxes increased to $176-million from
$161.8-million.

Rothmans' share of the domestic market increased to 31.3 per cent from
27.9 per cent a year earlier.

"You have to remember market share was only 21 per cent two years ago
and now they're at 31.3 per cent. That's a phenomenal management job
right there," Mr. Hartley said.

The cigarette price category, or discount cigarettes, barely existed
three years ago and now represents more than half of Rothman's business,
chairman John Lute said in a conference call.Rothman's price category
cigarettes, which include Number 7, Canadian Classics and Mark 10,
represented about 38 per cent of total reported industry domestic
cigarette sales volume in fiscal 2005, an increase from 7.2 per cent in
fiscal 2003 and 18.3 per cent in fiscal 2004.

"As this change took place, we were quick to accept the days of
predictability were over and that for the foreseeable future, this
industry would be at best variable and at times volatile," Mr. Lute said.

The 4.72-per-cent dividend yield of the sin stock was in line with its
peers, Mr. Hartley said. But it was almost identical to the dividend
yield of low-risk BCE Inc., Canada's largest communications company, and
power producer TransAlta Corp. Mr. Hartley's recommendation and 12-month
price target are "under review." The stock closed Friday at $25.40 on
the Toronto Stock Exchange.

A Merrill Lynch & Co. Inc. analysis voiced concerns that Rothmans may be
vulnerable regarding market share as competitor JTI-Macdonald Corp. has
launched another brand into the lower-tier category at a price lower
than both Rothmans' and Imperial Tobacco Canada's.

"[Rothmans Benson & Hedges] has over the past 12 months taken two
separate price increases in the discount category; this may make the
ability to take further increases more difficult," the report
said.Rothmans blamed higher taxes for the proliferation of contraband
cigarettes.

"Governments are simultaneously raising taxes to unprecedented levels
and placing increasingly rigid restrictions on the industry. This set
the stage for the growth of counterfeit and contraband product, which is
a growing problem for everyone," Mr. Lute said.In 2004, the RCMP seized
120,582 cartons of contraband cigarettes across Canada, valued at
between $40 and $70 each, spokeswoman Nathalie Desch=EAnes said. In 2003,
three shipments from China were intercepted and 357,298 cartons were seized=
.

Indoor smoking bans have led to lower cigarette consumption in the
winter, and Rothmans is continuing to research what impact this trend
will have on the stock price.

"It seems to make sense that that would be the case, but we're
continuing to do analysis," Mr. Lute said.

There have been no developments in litigation brought against tobacco
companies, but a positive result for the plaintiffs in British Columbia
and Quebec could burden the tobacco industry.

In British Columbia, the Supreme Court is reviewing the province's right
to sue tobacco companies for health care recovery costs while
class-action litigation is proceeding in Quebec.

"The risk comes in waves the way the market looks at it. When court
cases are upon us, the stock tends to contain a greater risk premium
than at times when the news is low," Mr. Hartley said.

"I think [litigation] is going to be a factor in the near term if the
result is positive for the province."

*Smokin'*

Rothmans has racked up first-quarter profit and impressive market share
gain, but industry challenges could ease its momentum.