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Imperial Brands - FDA vapour ban to hit profits

Sophie Lund-Yates, Equity Analyst | 5 February 2020 | A A A
Imperial Brands - FDA vapour ban to hit profits

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Imperial Brands Group Ordinary 10p

Sell: 1,842.50 | Buy: 1,843.50 | Change 21.50 (1.18%)
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In a trading statement ahead of its AGM Imperial Brands reported problems in the US and European vapour markets.

Revenue is now expected to be in line with last year's, and first half adjusted earnings per share are expected to be down around 10%.

The shares were down 10.1% following the news.

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Our view

Tobacco shares aren't for everyone, and global tobacco volumes have been falling for decades.

However, smokers' willingness to pay ever higher prices mean tobacco giants have managed to protect their margins and grow dividends even as the smoking population dwindles. Crucially, the companies have almost always traded on relatively high dividend yields, allowing investors to reinvest at attractive rates.

The question is whether the trick can be repeated going forwards. That depends on price increases offsetting the decline in cigarette volumes, and the inability of governments to capture these increases through higher tobacco duties.

Next Generation Products (NGPs) offer a potential path to growth, and Imperial has primarily invested in vapour via blu. A lot's riding on the reduced harm claims though. A recent spate of health scares have prompted aggressive action from the US Food and Drug Administration, and vapour could end up end up getting its wings clipped before it really gets off the ground. Not only would this render Imperial's existing investments far less valuable, it would also leave the whole industry reliant on falling tobacco volumes.

The replacement of Imperial's longstanding CEO, Alison Cooper, with Stefan Bomhard from Inchcape means a shake-up is probably on the cards. But here's where things stand at the moment.

Firstly let's deal with Imperials big attraction, the 11.1% dividend yield. It will no longer be growing 10% a year, but the group has recently committed to a progressive (read growing) dividend, with surplus cash returned through share buybacks. Cash is something Imperial does well, with 95% of operating profits converting to operating cash and ultimately being available for management to distribute or invest as they see fit. It's worth remembering though, this won't be sustainable if tobacco volumes dwindle to almost nothing, so there are no guarantees.

Imperial's brand portfolio gives it commanding positions in several European markets and an attractive opportunity as an insurgent player in the US. Its positions in developed markets mean it doesn't have the same exposure to rising populations and economic growth in emerging markets as some peers.

However, cigarettes are still relatively affordable in several of Imperial's key markets, such as the US, so prices could still have some way to go. Meanwhile, management has been improving efficiency in priority markets by moving smokers onto a smaller number of global brands.

Imperial's carrying about 3x net debt to underlying cash profits, which is higher than we might like, but not prohibitive for a company with such dependable earnings.

Finally, as Imperial is the smallest of the four tobacco giants there's a possibility they'll get bought out by one of the bigger players. This isn't proposed at the moment though - and if it is, competition regulators may prove a major hurdle given current market concentration.

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AGM Trading update

Imperial's Tobacco division has had a good start to the year, and the group gained market share in most of its priority markets. Improvements in price and product mix have offset weaker volumes in Europe, while the US remains strong despite anticipated wholesaler destocking following price increases.

Next Generation products have struggled as the US Food and Drug Administration (FDA) has banned some flavours of vapour cartridges. As a result Imperial has written down the value of its inventory, which is expected to have around a £45m impact on first half adjusted operating profit, which is in line with previous estimates. Imperial has also implemented a new cost saving program, which will result in a full year net impact on adjusted operating profit of around £40m.

Current exchange rates are expected to reduce half year revenue and adjusted earnings per share by around 1%, and by about 3% at full year results. As previously guided, full year free cash flow will be impacted by around £220m of one of costs relating to Russian taxes and the Von Erl acquisition.

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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 for more information.