Imperial Tobacco (LSE: IMT) shareholders must be rubbing their hands with glee. Takeover speculation has pushed the stock higher this week.
Imperial’s enterprise value is $61bn. Competitiveness must be preserved, so we rule out a merger or a blown-out offer from a larger rival, in spite of clear signs that M&A activity in the sector is back on the agenda.
How about a leveraged buyout, however?
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If private equity strikes a benchmark deal, shareholders will be the obvious winners but Imperial bondholders, whose holdings are already a tad overvalued, will register a significant paper loss.
Leveraged Buyout (LBO)
It’s hard not to suggest private equity involvement when takeover talk emerges in the tobacco industry. It’s also impossible not to recall the dreadful outcome of the $30bn-plus buyout of RJR Nabisco in 1989.
In LBOs, the buyer loads a huge amount of debt onto the balance sheet of the acquired company, whose resulting capital structure is usually so stretched that equity capital can be as low as 15% of the total capital needed to run the business as a going concern. The reminder is debt or equity-like capital, which may or may not include repayments of the principal until maturity.
Under private equity ownership, the cash flow of the target is essentially used to reduce leverage, usually in less than five years, while the equity is expected to appreciate on the back of improved efficiency and growth.
Imperial believes it will be able to cut costs to the tune of £300m yearly over the medium term. As for growth, management is adamant the future is bright.
Imperial is not RJR Nabisco, but any possible buyer would have to bet that Imperial has turned the corner after three years during which its stock has underperformed the sector by 11 percentage points.
Credit, Leverage, Bondholders
LBOs are attractive when they are struck at low trading multiples. The stock of Imperial hit a record high this week. Its relative valuation is well above median, while its net leverage is above 3 times.
Another caveat is that Imperial can be bought out only if at least three private equity firms – say KKR, Blackstone and TPG — agree to work together, which heightens the deal’s execution risk.
Bad news for a buyout? No, really.
Estimates for revenues are not impressive, but Imperial is a defensive business, and its top-line will likely outpace inflation for years to come. Its unlevered free cash flow profile stands out: it has averaged £2 billion annually since 2009.
Moreover:
- The syndicated loan market and the high-yield bond market would be supportive of net leverage as high as 10 times for the right target.
- Credit market conditions are just as loose as they were seven years ago.
- Borrowers are in charge: those with strong relationships can borrow as much as they want and on their very own terms.
Assuming a low-ball bid at a 15% premium, Imperial’s market cap would be about $51bn, for an implied enterprise value of $70bn.
If the equity financing backing the LBO is just 20% of the purchase price, Imperial’s net leverage will surge to 10x. The promise of improved efficiency and better growth would allow bankers to suggest that net leverage would be lower at 8x, on a pro-forma basis.
The deal is do-able. Bondholders won’t be pleased.
Imperial has a large amount of long-term debt outstanding offering a gross yield in the region of 2% to 3%. Prices of Imperial debt have felt the strain in recent weeks and they are looking for direction. Bondholders tempted to sell out now may consider to re-invest proceeds in the stock, whose current valuation is still acceptable – whether or not a deal actually takes place.
