BRITISH AMERICAN TOBACCO (OP, TP GBp3800): We reinstate our rating on BAT that has arguably the most consistent track record in consumer staples (constant FX EPS growth). Where the model may differ in the coming years is the use of cash flow. With net debt/EBITDA over 2.5x following recent M&A the short-term emphasis will be on debt reduction instead of buybacks. Imperial Tobacco may well receive plaudits for its new-found US exposure, but BAT also now also earns c20% of its net profit in the US (2016 estimate) - and arguably through a better business in its 42% stake in Reynolds. Associates now play a key role in BAT's valuation with Reynolds being 22% of the group's market cap, with the 30% stake in ITC representing a further 12%. Both these businesses trade at a higher 2016E P/E multiple than BAT (21x and 17x respectively) - strip these out and BAT's multiple would drop from 14.8x to 13.5x, in line with Imperial Tobacco.
IMPERIAL TOBACCO (OP, TP GBp3600): We reinstate coverage with an Outperform rating and a price target of £36. We raise our 2015/16 EPS by 15%. The $7.1bn acquisition of some US brands from Reynolds has the potential to be a game changer for Imperial since it transforms the US business. We believe the deal ticks both the strategic and financial logic boxes, with a starting return on investment target of 10%+. Elsewhere the group's core European market (65% of profits pre the U.S. deal) looks to be stabilising after 3-4 pretty torrid years.The 13.6x 2015/16E earnings is a significant 35% discount to staples versus long term average 30%.