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Imperial - Stronger margins but lower volumes

Equity research team | 8 November 2016 | A A A
Imperial - Stronger margins but lower volumes

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Imperial Brands Group Ordinary 10p

Sell: 1,579.50 | Buy: 1,580.50 | Change 28.00 (1.80%)
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Stronger margins but lower volumes

The beneficial impact of the recently acquired US brands helped Imperial's full year results show a 12% increase in adjusted earnings per share at constant exchange rates (CER), despite a broad based 3% decline in total tobacco volume.

The shares fell 2% following the announcement.

Our View

Imperial has historically focussed on margins and cash flow, instead of chasing volume growth. That's delivered a steady return for investors. Full year results marked a bit of a departure.

Brand migrations and cost savings remain a key focus. Imperial has a large number of local and regional brands with limited consumer appeal (Portfolio Brands). The group is migrating consumers across to a select number of stronger, higher quality Growth Brands. This significantly reduces cost and complexity.

However, the extra £300m a year investment announced at full year results - aimed at brand building, customer engagement and sales execution - suggests that the group believes it now needs to do more to defend and build market share.

Although we're supportive of Imperial's focus on margins, the increased spend makes sense. The acquired US brands played second fiddle under Reynolds and turning them into powerful national brands requires money. Steadily declining share in other key markets, despite positive performances from Growth Brands, should also be addressed.

Longer term, the tobacco industry is subject to numerous risks, with governments increasingly keen to crack down on smoking. Plain packaging in the UK and Ireland from mid-2016 (and its possible adoption in other EU markets) is a potential threat; and taxes will only go up. In theory, that makes it harder to keep pushing up prices.

Nonetheless, if Imperial can keep a firm grip on costs and successfully integrate and build the US brands, it ought to be able to grow profits, pay off debt, and return further cash to shareholders. Despite a generous dividend policy, net debt is expected to fall by c. 20% over the next four years. Imperial's long terms prospects remain bright.

Analysts are forecasting a yield of 5% for 2017, with Imperial targeting dividend growth of at least 10% a year over the medium term.

Full Year Results:

Tobacco net revenues increased 9.7% (CER), with operating margins up 0.6 percentage points to 46.9% as Imperial continue to cut costs, which fall £65m this year. That has led to a 10.4% increase in adjusted operating profit for the full year.

Although overall tobacco volume declined, growth brands saw volume increase 4.3% with market share up 0.5%. Growth and Specialist brands (which includes the group's cigar brands) now account for 60.1% of reported tobacco revenue. Recently acquired US brands Winston and Kool increased their market share.

The dividend rises 10%, as expected, with the group committing to the same level of increase in the medium term. Imperial's reported net debt rose by £1.4bn to £12.9bn, however this is mostly due to the group's debt being dollar denominated. Stripping out the adverse currency move shows a net debt reduction of £1bn.

Outlook:

Imperial hopes to achieve an additional £300m in annual savings by 2020, of which £90m is expected to be delivered next year. The group will invest a further £300m a year in growth brands from 2017.

Unless otherwise stated, all estimated figures, including prospective dividend yields, are taken from a consensus of analyst forecasts compiled by Thomson Reuters. These estimates should not be taken as a reliable indicator of future performance.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research for more information.