Imperial Brands could be a great recovery play

7 mins. to read
Imperial Brands could be a great recovery play

Robert Stephens, CFA, discusses why a changing business model could lead to improving growth prospects for Imperial Brands.

Nothing stands still in the investment world. However, the changes that are currently ongoing in the tobacco industry are perhaps the greatest and most significant in a generation.

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The release of innovative next-generation products such as e-cigarettes has caused a shift in demand among consumers towards less-harmful alternatives to cigarettes. This has contributed to a continued decline in cigarette volumes globally, with increasing demand for reduced-risk products being a contributing factor as consumers become increasingly health conscious.

Amidst this change, shares such as Imperial Brands now appear to lack the defensive appeal that has been a cornerstone of their investment case for many years. In response, investor sentiment has declined, and the stock now trades on a low earnings multiple and a high yield.

What has been lost in defensive appeal, though, could be made up for in growth potential. Imperial Brands is driving through efficiencies in order to become leaner and more flexible as it seeks to expand its next-generation product capacity. Although there are regulatory risks ahead for products such as e-cigarettes, reduced-risk products could lead the company’s sales and profitability higher over the long run.

Therefore, after a period of disappointing share price performance, the stock could offer investment appeal. With pricing power still high across its cigarette brands, the company may have the time and resources required to successfully transition into a next-generation products business. Although its evolution may not be smooth, it could be highly profitable for long-term investors in my opinion.

Product innovation potential

While there have been attempts in past decades to offer less-harmful nicotine-based products to consumers, e-cigarettes have proven to be a breakthrough product in recent years. According to Public Health England, they are at least 95% less harmful than cigarettes. For this reason, they are viewed as a positive product by regulators in a number of countries, where they are generally considered to be a means of quitting smoking.

Imperial Brands has a strong position within the e-cigarette industry through its blu brand. It has been expanded into a variety of key markets, including the US and UK, and is expected to be available in 20 different countries by the end of the year. Next-generation products such as blu e-cigarettes are set to become a more important part of the company’s financial future, with them expected to contribute positively to net profit this year.

Innovation is expected to become an increasingly important part of the reduced-risk products industry. Consumers are becoming increasingly health conscious, as well as increasingly demanding of the nicotine-delivery products they use. This could mean that an ‘arms race’ within the next-generation products segment takes hold over the long run, with the major tobacco companies all likely to invest heavily to find even less harmful products that provide incremental consumer satisfaction.

With Imperial Brands having acquired next-generation product innovation business Nerudia, it has plans to release a number of innovative new products. They include tobacco-free snus in Sweden, as well as a heated tobacco product called Pulze in a variety of countries. Heated tobacco products work by heating, rather than burning, tobacco in order to provide a similar consumer experience to cigarettes, but with reduced health risks. As such, they could appeal to a wider range of smokers than e-cigarettes.

Clearly, it is difficult to accurately predict which products will prove to be popular among consumers in the long run. But as one of the largest tobacco and nicotine-delivery companies in the world, Imperial Brands seems to be well-placed to develop its next-generation products in order to keep up with evolving consumer tastes.

Cashflow and dividends

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Of course, Imperial Brands will continue to generate the vast majority of its revenue and profit from conventional cigarettes for the foreseeable future. Although cigarette volumes are falling across the industry, they are a highly price-inelastic product. This means that price rises have thus far more than offset volume declines, and this situation could remain in place over the medium term. This should provide the company with the cash flow and financial stability required to invest heavily in next-generation products that will eventually contribute the lion’s share of its sales and profitability.

The company is continuing to improve its efficiency through cost optimisation programmes. The first programme was completed in the previous financial year, with it generating £300 million in annual cost savings. The second programme is set to deliver a further £300 million per year in cost savings from 2020.

Improved cash flow is not only expected to lead to reinvestment in next-generation products, but also in increasing dividends. Having lifted dividends per share by 10% in the previous financial year, Imperial Brands is expected to increase shareholder payments by a further 8% this year. Following its share price fall of a third in the last two years, it now has a forward dividend yield of 8%. As such, it could offer income investing potential – even as it continues to experience a period of rapid change from a business perspective. With dividends due to be covered 1.4x by profit this year, there could be further scope for rising dividends in future years.

Since the company’s share price has fallen heavily in the last couple of years, it now trades on a P/E ratio of 9. This suggests that it could offer a wide margin of safety, and may have significant scope for an upward rerating should its investment in innovative new products lead to improving financial performance over the long run.

An increasingly onerous regulatory backdrop

As well as consumer tastes evolving as many people become increasingly health conscious, cigarette volumes may also be declining due to continued regulatory changes. In the UK, for example, plain packaging has been introduced in recent years, as well as a ban on smoking tobacco products in public places. In the US, the FDA is considering tougher rules on cigarettes, with it being mooted that a reduction in nicotine levels could be ahead over the long run.

E-cigarettes are also expected to become increasingly regulated over the medium term. Although they are viewed as a useful means for smokers to move away from more harmful tobacco products, there are concerns, particularly in the US, that they are becoming highly popular among teenagers and younger people. As a result, it is expected that there will be increasingly onerous rules on the flavours that can be used in e-cigarettes in order for them to become less appealing to younger people. There may also be more stringent regulations on where and to whom e-cigarettes are sold.

Clearly, regulations have been changing for a sustained period of time within the tobacco industry. It would be unsurprising for this trend to continue, which could affect the prospects for the e-cigarette and wider next-generation product industry. It could mean that there is continued uncertainty surrounding the wider nicotine-products industry, and that some products ultimately prove to be more successful than others in what may become a highly fluid industry.

Outlook: looking beyond cigarettes

With there being around 1 billion smokers in the world, there is likely to remain a high demand for cigarettes and reduced-risk products over the long run.Investors appear to have factored in the potential risks facing the industry as it seeks to successfully evolve to take into account changing consumer tastes and increasingly onerous regulations. Although companies such as Imperial Brands may experience an uncertain outlook over the next few years, and their defensive appeal may ebb away, their growth potential could increase.

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The company has a strong foothold in the e-cigarettes industry through its blu line of products. It is also investing heavily in product innovation, with it aiming to release further new products that are less harmful and increasingly authentic in terms of the consumer experience when compared to cigarettes. While it will take time for next-generation products to fully catch-on among consumers, they are likely to become an increasingly important part of the company’s financial performance over future years.

With Imperial Brands having a relatively high dividend yield and a low valuation, it seems to offer a mix of income and value investing potential. The changes it is making to its business from a cost optimisation perspective could lead to improved efficiency. They may also provide greater resources to reinvest in future growth prospects, as well as pay a higher dividend.

For investors who have benefited from the stability and defensive characteristics of tobacco companies in the past, those attributes may fade away to a large extent over the medium term. While this may reduce the industry’s appeal for some investors, others are likely to focus on the growth potential which next-generation products offer.

Therefore, there could be further volatility ahead for the Imperial Brands share price in the short run. In the long term, though, it may be able to generate significant growth. As a result, it appears to have investment appeal.

Comments (1)

  • David Lawson says:

    A well balanced article in view of the recent weakness in the share price. Appears there has been amajor forced sellar covering redemtions in his open ended fund which has lead to the current depressed share price. Excellent baanced article. Well done Robert Stevens.

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