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Imperial Brands - Next Generation Products drag profits down

Nicholas Hyett, Equity Analyst | 17 November 2020 | A A A
Imperial Brands - Next Generation Products drag profits down

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Imperial Brands Group Ordinary 10p

Sell: 1,558.00 | Buy: 1,559.00 | Change -0.50 (-0.03%)
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Imperial Brands' full year net revenue rose 0.8% at constant currency to £8.0bn. Operating profit fell 4.8% to £3.5bn due to losses in Next Generation Products (NGPs) and COVID and regulatory costs.

The group's 2020 dividend will amount to 137.7p per share, in line with the rebased level announced in May.

Management expects low-to-mid single digit operating profit growth in 2021.

The shares rose 3.9% following the news.

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Our view

Tobacco is a defensive sector because demand isn't very sensitive to economic conditions. This has broadly held true during the COVID-19 pandemic, although Imperial still suffered from higher costs because of the virus.

Fundamentally though, not much has changed. Tobacco shares remain contentious, and global tobacco volumes have been falling for decades.

Smokers' willingness to pay ever higher prices meant tobacco giants were able to protect margins and grow dividends even as the smoking population dwindled. However, Imperial recently took the bold, but necessary in our view, decision to cut its dividend to focus on debt reduction.

That will be welcome news for new CEO, Stefan Bomhard, who started his tenure on 1 July 2020, giving him greater flexibility over the years ahead.

At the last count Imperial was carrying about 2.7 times net debt to underlying cash profits, which management wants to bring down to 2-2.5 times by the end of 2022. The sale of the Premium Cigar business will help here - although we still think Imperial's losing an attractive asset.

The question now is whether growth can be achieved going forwards, which will be essential if the dividend is to grow again. That depends on price increases offsetting the expected declines 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 its blu brand. Health scares and legislation in the US have severely knocked progress and sent growth into reverse. While we think NGPs have a future it doesn't look like growth will be anywhere near as fast as some were hoping. This has reduced the value of Imperial's existing investments, and caused it to scale back future funding. It remains to be seen what line the new CEO will take.

As the smallest of the four tobacco giants, rumours often swirl that Imperial will get bought out by one of the bigger players. This certainly isn't imminent though - and we think competition regulators would prove a major hurdle given the already high degree of market concentration.

The other important thing to consider with tobacco stocks is that many institutional investors can't, or won't, invest in the sector. This may mean that the shares are rated lower than the outlook for the industry really warrants, but it's hard to see attitudes changing and valuations recovering. Any investment case therefore has to be built around the dividend yield, which is substantial even after the cut.

However, it may be the case that the tobacconists can't keep squeezing more money out of an ever-smaller population of smokers. If so, the dividend stream is bound to dry up eventually.

Imperial Brands key facts

  • Forward Price/Earnings Ratio: 5.4
  • 10 year average Forward Price/Earnings ratio: 11.0
  • Prospective yield: 9.9%

All ratios are sourced from Refinitiv. Please remember yields are variable and not a reliable indicator of future income. Keep in mind key figures shouldn't be looked at on their own - it's important to understand the big picture.

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Full year results (figures are underlying)

Tobacco volumes fell 2.1%, although this represented an improvement on some existing trends and Imperial gained market share. Share gains were primarily driven by lower value markets. NGP revenue fell 27%, but declines were heaviest in the first half and the second saw substantial improvement.

In Europe revenue fell 0.8% to £3.6bn, primarily reflecting a 21.9% fall in NGP revenue to £98m. Tobacco revenue was flat. The group gained market share in France and Spain but, despite a strong financial performance, lost share in the UK and Germany. Sales were also held back in holiday destinations and in Duty Free. Operating profit for the division fell 5.9% to £1.6bn.

In the Americas revenue rose 0.4% to £2.5bn, although volumes fell 3.3%. Tobacco revenue rose 1.9% to £2.4bn and NGP revenue fell 34.3% to £71m. Imperial gained cigarette market share, although this mostly came at the discount end of the market. COVID-19 also increased manufacturing costs in the region. Operating profit fell 3.4% to £1.0bn.

In Asia, Africa and Australasia revenue rose 4.3% to £1.9bn, reflecting 5.0% growth in tobacco and a 23.8% fall in NGPs. The group gained share across all priority markets. Operating profit fell 8.7% to £674m, as NGP losses mounted and coronavirus affected manufacturing costs.

Adjusted net debt fell from £11.4bn to £10.3bn, primarily reflecting temporary working capital movements. Net debt to cash profits was 2.7x, ahead of the group's 2-2.5x target. Underlying cash conversion was 107%.

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This article is original Hargreaves Lansdown content, published by Hargreaves Lansdown. Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Refinitiv. 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.