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Imperial Brands - blu buffeted by US regulator

Nicholas Hyett | 12 November 2018 | A A A
Imperial Brands - blu buffeted by US regulator

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Imperial Brands Group Ordinary 10p

Sell: 1,479.50 | Buy: 1,480.50 | Change -32.00 (-2.11%)
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Media reports that the US Food & Drugs Administration (FDA) may be looking to ban menthol cigarettes have rocked the tobacco sector this morning. Following the acquisition of Kool from Reynolds, US menthol is an important, but comparatively small part of Imperial's business.

The FDA is also said to be considering a ban on certain types of flavoured e-cigarettes. That's perhaps more significant for Imperial because of the recent launch of its myblu e-cigarette, which features multiple flavours in a 'pod system' said to be being targeted by the FDA.

The wider US market, which includes conventional, unflavoured cigarettes, accounted for 27.6% of operating profit.

There has been no formal confirmation from the FDA.

Imperial shares fell 2.6% in early trading.

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Our view

Any conversation about Imperial has to address two contradictory facts.

On the one hand the whole industry is seeing a steady decline in tobacco volumes. On the other, Imps continues to promise annual dividend increases of at least 10% "over the medium term".

Over the last decade Imperial's been able to pay out more, despite selling less, by steadily increasing prices and incessantly trimming operating costs.

There are plenty of cost cutting opportunities left. Imperial has various regional brands with limited wider appeal. Migrating consumers off those to a select number of stronger Growth Brands significantly reduces cost and complexity. But that can't continue forever.

Although we're generally supportive of the focus on margins over volumes, the decision to invest in protecting and developing its brands makes sense. Scale is the key to success in the tobacco industry, and as the smallest of the big-four tobacco giants, Imperial can ill-afford to lose ground to rivals.

Investment will be particularly important for the recently acquired US brands. They played second fiddle under Reynolds' ownership, so turning them into powerful national players requires investment. Early signs have been promising, although a potential ban on menthol brands is bad news for the smaller Kool and Salem brands.

Imperial's gaining market share again, but investment will slow rather than reverse volume declines. That makes Imperial's vaping and heated tobacco products crucial to success. Historically Imps has trailed the field. A recent marketing splurge means things are heating up, but a potential ban on flavoured cartridges is a blow.

Borrowing's falling, but isn't yet in rude health and more debt needs to be paid off. The ever-present regulatory threat also has the potential to throw a spanner in the works. Those worries have seen the shares fall 12% in the last year, despite its impressive dividend record, and the company now trades on a PE ratio of just 9.8 times, 15.5% below its longer term average.

Nonetheless, Imperial generates bucket loads of cash, and can comfortably cover its dividend payments at present. With debt falling, interest payments are less burdensome than they once were, and the likely sale of European logistics business Logista will deliver a steady flow of cash.

In our view, Imperial's prospective yield of 7.5% means the shares look like an attractive option for income-seeking investors. But what is one of the most generous dividend policies in the market cannot continue forever.

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Full Year Results

Full year net revenue was up 2.1% in the year reaching £7.7bn, with tobacco contributing 1% and next generation products (NGP) a further 1%. That was despite a 3.6% decline in tobacco volumes.

Total adjusted operating profit rose 2.9% to £3.8bn, with Tobacco and NGP contributing £3.6bn and the remainder from Imperials' stake in distribution group Logista.

The full year dividend rose 10% to 187.8p.

The shares were broadly unmoved in early trading.

Despite the decline in tobacco volumes, Imperial actually outperformed the wider tobacco market across its footprint where volumes fell 5%. Growth Brands saw volumes rise 2.1%, gaining 0.7 percentage points of market share.

The group's Asset Brands now account for 66.9% of total revenue, having seen revenues rise 8% over the year. The group's Specialist Brands, including Backwoods, Kool, Rizla, Skruf and Premium Cigars, delivered particularly strong performances.

NGP posted £200m of sales in the year, and sales were running at £300m a year by the year end. The flagship myblu product is now available in the US, UK, France, Germany, Japan, Italy and Russia. The group plans to launch its first heated tobacco product, Pulze, in early 2019.

Imperial delivered £110m in incremental cost savings in 2018, and raised £281m from sales of non-core assets (including part of its stake in Logista and 'other tobacco products' in the US).

Cash conversion remained strong, at 97%, helping to reduce adjusted net debt by £0.8bn. As a result adjusted net debt/EBITDA now stands at 2.9 times.

Imperial expects to deliver revenue growth towards the upper end of its 1-4% target range in the coming year. Investment in blu will increase by around £100m in the first half of next year, resulting in slightly lower operating profit in the half. Guidance for medium term earnings per share growth remains unchanged at 4-8% a year.

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Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Thomson Reuters. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Investments rise and fall in value so investors could make a loss.

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 disclosure for more information.