The Financial Impact of Macroeconomic Changes within the UK and Europe on Imperial Tobacco - Case Study Example

? Macro-Economic Issues Macro-Economic Issues Imperial tobacco plc (IMT: L) has a prominent global presence when it comes to the manufacturing and distribution of tobacco and tobacco related products. It is the fourth largest cigarette manufacturer in the world, leads the market of United Kingdom and has found newer markets in North America, Eastern Europe and Africa (Hargreaves Lansdown, 2012). This research aims to analyze the financial impact on Imperial Tobacco as a result of major macroeconomic changes occurring within UK and across Europe. The impact would stem around profitability, efficiency, risks and leverage. At first a brief overview of the UK economy for FY 10, 11, 12 would be given and would then be followed by the effects on Imperial tobacco. Then a speculation would be made as to how Imperial tobacco would respond to these macroeconomic changes based on strategy and corporate objectives of Imperial tobacco. The growth of the UK economy seems sluggish in the aftermath of the financial crisis. The crisis had hit the UK from both eastern and western borders. This includes the housing market crash of US and the Euro Zone Debt crisis. Between 2008 and 2010, the GDP growth rate has been negative (Trading Economics, 2012) and the rate after 2010, although positive, has not been satisfactory. There is also a fear of double dip recession since the second quarter of FY 12 has experienced a GDP growth rate of -0.2 % (BBC News, 2012), the production sector has also experienced a decline of 1.4% , followed by a fall in construction output of 0.5 % and compensation of employees by 0.3%. Now coming to the fiscal statistics, the National debt to GDP ratio stands at 80 %, the budget deficit has been reduced and increased VAT yield show signs of fiscal tightening. Interest rates are an all time low and despite of this bank lending to small businesses is falling. Low interest rates and increasing current account deficits are also putting pressure on the British Pound. A falling pound would hurt distributors country wide since import costs would rise as they would have to pay more in terms of the domestic currency. Unemployment hovers around 8.4 % and no signs of improvement are expected. Consumer confidence shows no signs of improvement despite yearly increases in current expenditure (The Economist, 2012). In addition to, UK has seen some major structural changes over the years, of which the most notable is the ageing population. Ageing population refers to a rise in the average age of the population of a country over time. So it is unlikely that the market for UK would continue to grow. In addition to, this has the impact of increasing wage levels across the economy as Labor supply reduces in the long run. Apart from these macroeconomic issues, the tobacco industry has been subjected to severe regulatory policies around the world which include: Increased duties year on year Ban on cigarette advertising Ban on smoking in public places Allegations of illicit trade Plans to introduce plain packaging All these regulations tend to have a negative impact on tobacco industry, with the exception of the levying of excise duties which would be discussed later on. Imperial tobacco seems to be quite resistant to macroeconomic changes. The risks that currently pose threat to Imperial tobacco plc are interest rate risks and exchange rate risks. Interest rate risks accommodate the financing and profitability of the company since Imperial Group plc has a high Debt to Equity ratio and raises a large amount of capital from debt capital and Bank loan markets. Now if the bank fail to meet their obligations of refinancing the debt then it would definitely limit the ability to capitalize on global opportunities and mitigate threats. Movement in interest rates can also affect the credit rating of Imperial tobacco and reduce its profitability because of increased finance costs.To reduce these risks Imperial employs various hedging strategies and has invested some of its mound of cash into interest and income earning investments. Imperial tobacco’s debt to equity ratio has reached its peak in 2008. From then onward it has worked to reduce its debt to equity ratio to increase profitability and the ability to go as a going concern. The company’s debt to equity ratio is of 1.33 (Debt/Equity) while gearing ratio (total liabilities/total assets) is of 74.8 %. This has continuously reduced interest expense (both in absolute terms and as a percentage of Revenue) to such an extent that the net interest expense (interest expense less investment income) is positive. However, the gearing ratio is still high and this poses a significant amount of risk as Imperial tobacco has a low beta, is slightly affected by cyclical changes and faces a mature global market. So if the market is not growing rapidly, then interest burden would make Imperial unprofitable as an investment. CEO Cooper commented that the reduction in net debt provides us with increasing acquisition opportunities worldwide to reduce costs, improve margins and seek inorganic growth. Imperial has had a history of takeovers and plans to continue to penetrate in the emerging markets as mature markets have been faced with a declining trend over a number of years due to increasing health concerns . Its Spain based subsidiary Altadis , which was acquired in 2008, has resulted in overall cost reductions of 300 million Euros since its acquisition. This represents the cost optimization strategy of Imperial Tobacco which has made it a must have in investors portfolio. However, imperial faces black market sales allegations in Spain and ban in public smoking. Despite of this, Spain is the third biggest contributor of sales after UK and Germany (Imperial Tobacco, 2011). Imperial tobacco is a low risk business as it produces goods with moderate income elasticity of demand and low price elasticity of demand. Therefore it is less susceptible to Macroeconomic changes. It has also developed its markets outside UK to diversify risks and seek growth globally. In amidst the crisis, Imperial tobacco has managed to grow revenues and reduce income tax expense as a percentage of revenue. The previous annual report shows revenue of 29.2 billion pounds as compared to 20 billion pounds in 2008. Although sales in terms of volume has decreased, but the net change in revenue was still positive. This increase in revenue can also be attributed to psychological and social factors as cigarette smoking increases in times of skepticism and depression. Tobacco stocks also act as a safe haven for investors in times of recession as consumer fail to economize on cigarette consumption. Imperial tobacco one year return is around 34.2 % which clearly indicates that it has outperformed the FTSE 100 index (Financial Times, 2012). The unemployment rate can also provide an indication as to whether labor costs are likely to rise or fall in the future. If the unemployment rate is high, then this may enable firms to hire workers at lower compensation and thus optimize their resources. The unemployment rate of UK seems quite high and this may have been used effectively by Imperial Plc since its General, selling and administration expenses have reduced from 3 billion pounds in 2010 to 2.9 billion in 2011 (Bloomberg BusinessWeek, 2012). This has given Imperial a considerable amount of operating leverage to work with. Exchange rate can be a major determinant of Imperial’s profits since it exports tobacco to various parts of the world. Exchange rate is defined as the price of one currency in terms of another. Recently, Imperial experienced a rise in profits as the British Pound appreciated against the Australian Dollar. In addition to, some of the debt is also denominated in foreign currencies and this makes the cost of debt vulnerable to exchange rate fluctuations. In 2011, Sales outside UK accounted for 83 % of revenue and 81 % of profit from operations (Imperial Tobacco, 2011). In addition to, Imperial tobacco purchases tobacco leaf in US dollars and packaging material from various countries in their own currencies. So if the British Pound depreciates against these currencies, which is forecasted due to the rising burden of the current account deficit and a failure to grow, then Imperial would experience a drastic fall in profitability as raw material costs and selling expenses would rise. A sensitivity analysis has been carried out in the latest annual report of the company indicating that a paper loss would occur if British Pound appreciates against the Euro or the US dollar (Imperial Tobacco, 2011). The Direct tax rates also affect the ability to retain profits or to distribute them as dividends. UK is one of the highest tax regions in the world. The current rate of corporate tax is 27 %. In 2010, the Tax was 28 % as UK remained prudent with its aims to balance the budget and reduce the debt to GDP ratio. This has had an impact on the after tax profits of Imperial tobacco. The UK economy wishes to reduce its debt to GDP ratio, so higher tax rates may be expected. Higher tax rates may limit the ability to obtain equity finance to fund growth since dividends are paid out of after tax profits and dividend yield is one of the key investor ratios when it comes to investing for current income. Another major macroeconomic issue that Imperial faces is the smuggling of tobacco and tobacco related products. This is closely related with the level of Excise duties associated with the consumption of tobacco. Tobacco, being a demerit good, is heavily taxed worldwide and has been banned in public places in many countries such as Spain. Excessive levels of excise duty dampen the demand for cigarettes and especially the Premium Brands as consumers shift to cheaper cigarettes. This has been a major constraint in revenue growth, which is one of the primary focuses of Imperial tobacco. Excessive levels of Excise duty also encourage smuggling as consumers would try to evade taxes. Smuggling can take the form of both importing from regions with lower taxes as well as manufacturing fake products. This has been a growing concern for Imperial as it is destroying its brand image, decreasing revenue and eroding profits. It also has legal ramifications on Imperial and its business partners as they may be subjected to allegations. Imperial is working jointly with other governments to improve checks regarding these products which include volume verification and customer authenticity. The future of smuggling entirely depends upon the tax structure of UK: a raise in the levels of duties may encourage more illegal trade. The UK budget for FY12 had increased the duty on Premium brands by 33pc and on Economy Brands by 50pc (Hall, 2011). This has been the main legislative weapon for the UK government to deter smoking rates as smoking remains the biggest avoidable cause of death in the UK. The government expects to raise 355 million pounds by 2015 as revenue from taxation on smoking. Although these measures has had the effect of promoting illicit trade, it has also contributed to increased profitability of Imperial tobacco plc as this provides them with an opportunity to raise prices due to consumer expectations of higher prices every year. Increased prices for cigarettes with stable average costs lead to proportional increase of profit margins. As a result, the company’s full year earnings jumped 8%. Despite all of these macroeconomic disasters that UK is going through, Imperial stands victorious with a surplus amount of cash to meet obligations, growing revenues, Dividend yield and Adjusted Earnings per share and reduced leverage. Since it has started to increase its global presence through logistics, joint ventures and green field ventures, it would be able to hedge risks by providing the product portfolio to emerging markets such as India. Outsourcing and exporting options remain open to Imperial because of its reputation as a socially responsible entity. Bibliography BBC News, (2012). UK economy shrank 0.2% revised data confirms. [online] Available from: http://www.bbc.co.uk/news/business-17152253[Accessed 25 March2012]. Bloomberg BusinessWeek, (2012). Imperial Tobacco Group plc (IMT:London). [online] Available from: http://investing.businessweek.com/research/stocks/financials/financials.asp?ticker=IMT:LN&dataset=balanceSheet&period=A¤cy=native[Accessed 25 March2012]. Financial Times, (2012). Imperial Tobacco Group PLC. [online] Available from: http://markets.ft.com/research/Markets/Tearsheets/Summary?s=IMT:LSE[Accessed 25 March2012]. Hall, J. (2012). Budget 2011: Tobacco industry furious at tax rises. 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