Imperial Is Royally Undervalued

The company has made great strides in portfolio optimization, reducing its total brand count 32% by the end of fiscal 2017; it targets a total reduction of 50% by 2020. Execution on the brand-migration program has been impressive, with a consumer-retention rate of around 95%. The streamlined portfolio should allow for more-focused brand investments and sustainable cost reductions.

We think the success or failure of Imperial’s strategy--and the reason for its recent valuation discount--lies in its choice of targeted profit pools. Geographically, we like the 2015 acquisitions of assets in the United States, because we believe the core combustible market offers multiyear opportunities for price/mix-driven growth. However, in Imperial’s next-generation product portfolio, the focus remains firmly on vaping, a category that we believe is commodified with fairly low barriers to entry. Competitors have invested more heavily in heated tobacco, a category that we suspect may have more success in attracting quitting smokers and could be more profitable. Nevertheless, given its distribution capabilities, particularly in Europe, we think Imperial could regain lost ground if it entered the heated tobacco category, and it has announced plans to test-market heated tobacco products in the near future.

Imperial achieves best-in-class tobacco margins in the mid-40s as well as 90%-plus free cash flow conversion and has a medium-term target of 10% annual dividend growth. While the company has lost ground to competitors in heated tobacco, we believe its wide economic moat, derived from brand equity and distribution capabilities, should allow it to catch up in this important profit pool and continue to deliver these metrics in the medium term.

Premium Brands Widen the Moat Strong intangible assets at the premium end of its portfolio are at the core of Imperial Brands' wide economic moat. In addition, a broad platform of nicotine and tobacco products, which is being extended to include next-generation products, particularly in vaping, gives the company economies of scope and scale that make it difficult for new entrants to overcome. Finally, the addictive nature of tobacco products makes demand fairly price-inelastic, and with few substitute products outside the portfolios of the Big Tobacco companies, a favorable industry structure exists for the largest players in which pricing, for the most part, is rational.

Tobacco brands’ intellectual property has created loyalty among tobacco users toward the brands they enjoy. Despite the advertising ban on tobacco products in many developed markets, brand identity through product differentiation and trademarks allows manufacturers to charge premium prices for their products. In fact, it is the bans on advertising that help to keep market shares stable and new entrants out. As the fourth-largest cigarette manufacturer behind Philip Morris International PM, British American Tobacco BTI, and Japan Tobacco, Imperial holds 9% of the global market (excluding China), a share that has remained organically fairly flat since 2008. It is in loose tobacco that Imperial Tobacco holds the most brand loyalty, particularly through Golden Virginia, the global leader in roll-your-own tobacco, and Rizla, the number-one paper brand, but its cigarette labels also contribute to its intangible assets.

Historical returns on invested capital lend support to our wide moat rating. Imperial has generated returns on invested capital of 15% on average over the past five years, and we forecast returns to remain in the mid- to high teens over the next five years, comfortably ahead of our 7.8% estimate of the company’s weighted average cost of capital.

Plain Packaging Could Erode Pricing Power Our fair value uncertainty rating for Imperial Brands is low. Evidence from the recent economic volatility suggests that industry fundamentals--and therefore manufacturers' cash flows--remain stable. With pricing power intact, the greatest operational risks, in our view, are plain-packaging legislation and the growth of adjacent categories in which Imperial does not have a strong presence.

Any investor owning tobacco stocks should have the stomach for fat-tail risk. Although the businesses are generally stable, government intervention is an omnipresent threat. Litigation risk is substantially lower for the European players because most countries do not have a class-action legal process. Nevertheless, we regard government and legal risks as low-probability events with high potential impact that investors should be aware of.

In general, we believe regulation does little to affect the economic moats or cash flows of tobacco manufacturers, and in some cases, regulation actually limits competition, lowers costs, and strengthens pricing power. Plain packaging is different, though, because we believe that it could facilitate trading down, which would erode pricing power. Australia, where Imperial holds about 20% share, has taken the lead on plain packaging, with countries such as Britain, Ireland, and France all following suit with similar legislation. Although we think Imperial’s strong presence in value categories could lead to increased market share in the event of trading down, we would be concerned about the global industry profit pool if plain packaging is introduced in other major markets.

Imperial is slightly more leveraged than its peers, primarily because of the 2015 acquisitions of U.S. assets from Reynolds American and Lorillard. However, its presence in developed markets makes it a cash-generating machine, even more so since the U.S. acquisitions. The company has been operating in recent years on a strongly negative cash-conversion cycle, and cash conversion has been up there with the best-in-class performers across the global consumer staples space. We expect cash conversion (defined as operating cash flow divided by operating income) to run close to 100% over our five-year explicit forecast period, even though it faded slightly to 91% in 2017. This cash flow generation should allow the company to pay down the acquisition debt fairly quickly, and we expect Imperial to return to a more normalized leverage position by 2020.

Management has guided to dividend growth of 10% in the medium term. We think this is achievable, and we forecast three years of 10% dividend growth. At a payout ratio close to 90%, however, we expect dividend growth to mimic earnings growth, which we expect to hover around the midsingle digits from 2022.