BAT still has the puff to fly higher

Alliance UniChem offers the right prescription; Colt Telecom facing far too many hurdles
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Shares in British American Tobacco, the maker of Pall Mall and Dunhill cigarettes, have shown no signs of running out of puff in the past year. Thanks to a couple of, er, Lucky Strikes, they are up a third since we wrote positively on them last year. A month later, the US tobacco industry won a famous court victory, overturning 2000's record $145bn damages award to Florida smokers.

And in October, BAT said it plans to merge its US subsidiary, Brown & Williamson, with its rival RJ Reynolds, a deal it said removes the litigation risk that has always hung over BAT shares. Not everyone agrees it will quite do that, since BAT will still own 47 per cent of the combined group. But the deal is certainly a neat way of making the value of its US business - where profits fell by a third in 2003 - more transparent, and there are a whopping $500m in cost savings to be squeezed out.

The declining attractions of smoking in the West were exacerbated last year by tax rises in continental Europe that drove customers to cheap brands which are less profitable for BAT. Competition is also intense. Other factors, including restructuring costs and losses on disposals, pushed the pre-tax profit for 2003 down to £1.6bn from £2.1bn the year before.

BAT is leading the quest for new smokers in the developing world, though, and it is here where the company is seeing the "momentum" that it promised yesterday would sustain the group in 2004. The company generates so much cash that it can be lining up bids for assets in Bulgaria, Turkey and other countries at the same time as buying back huge parcels of its own shares to boost the "earnings per share" figure on which its share price is valued.

Was 2003 a year of happy coincidences not to be repeated? It seems unlikely BAT will have such share price spikes again, but it is not noticably overvalued at 11 times earnings, with a 5.4 per cent dividend yield. For investors who don't balk at the ethics of Big Tobacco, and who are as concerned for dividend income as capital gains, BAT is still a worthy purchase.

Alliance UniChem offers the right prescription

Alliance Unichem - which, like British American Tobacco, boasts Kenneth Clarke, the former chancellor and health secretary, as deputy chairman - runs Moss, the UK's largest chain of chemist's shops. It is also one of Europe's biggest wholesalers of drugs, the middleman between the pharmaceuticals manufacturers and the pharmacies.

The company requires all the political lobbying skills it can get its hands on, since spiralling health costs in Europe are forcing governments to cast around for savings, and that can mean a lot more regulation of drug prices and wholesalers. Two years ago, the Italian government's reforms held back Alliance UniChem's figures; yesterday it was a new regulatory regime in France. Not that the 2003 results were poor. The company's pre-tax profit was up 17 per cent to £196.3m, thanks to cost savings and the growing use of cheap copies of branded drugs, where margins are slightly fatter. Regulatory pressures remain, it said, but they are quite manageable.

It lobbied so well in the UK, in fact, that the Office of Fair Trading's plan to throw open the pharmacy market to supermarkets has been substantially watered down. Instead, there are significant growth opportunities from using pharmacists to offer simple advice and some health monitoring, as the National Health Service tries to unclog doctors' surgeries.

Alliance UniChem still has big holes in what could, one day, become a truly pan-European wholesaler and retailer. In Germany, the continent's largest drug market, it hopes the competition authorities will enable it to take control of Anzag, a wholesaler of which it currently owns 29 per cent. There are also moves afoot to push into Eastern Europe. On the retail side, France and Germany are yet to deregulate to allow chain ownership of pharmacies. These long-term opportunities more than counterbalance the regulatory threats. Buy.

Colt Telecom facing far too many hurdles

Colt Telecom - whose services and 32 city telecoms networks provide businesses in the UK and continental Europe with an alternative to BT and the other former monopolies - is ten years old and has come a long way in a short space of time.

Over the period since flotation in 1996, its shares came a long way up and a long way down again. Now, though, at much lower levels, things are moving in the right direction again. Even factoring in yesterday's 6 per cent drop to 116p, the stock has more or less trebled in the past year.

It has put behind it the nastiness of a High Court battle with a rebel bondholder trying to force the company into administration. Turnover was up a respectable 14 per cent in 2003. And the prospect of the company reporting a profit inches ever closer, albeit not until 2006 at the earliest.

The company has £800m in the bank. That sounds like a huge amount but Colt has more than £1bn of bonds falling due between 2005 and 2009 which it must repay while continuing to invest in its network.

It is also worth remembering this is a business that is still a loss-maker at the bottom line, and 2004 will be another year of cut-throat competition in an over-expanded market

Analysts generously suggest valuing Colt on a multiple of underlying, rather than pre-tax, profits. But even at 11 times the expected 2004 figures, it is already at a mighty premium to its peers, which trade on multiples between six and nine.

Sell.

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