Stefan Bomhard has a new mantra for Imperial Brands: focus. The new CEO unveiled a five-year strategic plan that will concentrate investments both geographically and on emerging categories that are likely to become the largest profit pools in the future. We think the plan makes sense because it essentially recognizes Imperial's place in the marketplace--it is a fast follower, rather than a leader, in most markets, but a highly profitable one with strong cash flow generation potential that should drive returns to shareholders higher in the coming years.
The overarching shift in strategy seems to be that investment will focus on categories and geographies where Imperial has existing strengths, and where consumer demand is likely to be strong. In the core cigarette business, for example, Imperial prioritizes five tobacco markets in which it holds significant share and which represent a combined 72% of Imperial's tobacco operating profit (U.S., U.K., Germany, Spain, and Australia). The company has lost share in these markets (except the U.S.) for several years, and increased investments behind its key brands should help stabilize volume declines. Other markets, as well as the firm's smaller brands, will be managed to maximize cash flow. In next generation products, Bomhard will attempt to diversify the big bet placed on vaping by exiting vaping markets in which it has not gained traction so far, in order to target its investments on more profitable opportunities. In heated tobacco, it will shift its geographic focus from Japan, where it has very limited share and distribution structure, to Europe, where it has some large shares.
We think Bomhard's plan will unlock value at Imperial. By making more consumer and capability-centric investments, we expect the financial performance of the company to improve. We are a little more skeptical, however, as to whether he can achieve this without a margin reset. Imperial has already ceded first mover advantage to Philip Morris International, and the strategy to improve performance seems to depend on regaining share, rather than driving category growth. This is unlikely to come cheap and may require higher spending going forward.
Economic Moat | by Philip Gorham Updated May 04, 2021
Imperial Brands’ wide economic moat is built around intangible assets in the tobacco business. Tight government regulations have made barriers to entry almost insurmountable and have kept market shares stable in the core combustible business. Consumers are fairly brand-loyal, particularly in premium price segments, creating another intangible asset that is no longer as prevalent in other consumer categories. Finally, economies of scale give the large-cap manufacturers an advantage in tobacco leaf procurement and distribution. Nevertheless, we regard the firm as being slightly lower-quality than its larger competitors Philip Morris International and British American Tobacco, owing to its portfolio skew to developed markets, where volume declines are more pronounced, and to discount categories. We estimate that following Imperial’s U.S. acquisitions, 20% of volume is in premium segments, roughly in line with Japan Tobacco, but more than half is in discount segments.
Intangible Assets
Tobacco contains nicotine, an addictive substance that suppresses the cessation rate. According to data from the Tobacco Atlas, more than 60% of all smokers intend to quit, and 42% have attempted to quit over the last 12 months. Yet in most markets, the smoking rate is in only a very modest decline, implying that a majority of smokers attempting to quit fail to do so. Academic research (Lewis et al, 2015) has shown that while cessation rates are not correlated with consumer brand loyalty, premium price segments are associated at a statistically significant level with lower cessation rates. Imperial manages a barbell portfolio, with exposure both to discount and superpremium segments (the latter through brands such as Davidoff and Gauloises).
The addictive nature of the product forms a powerful competitive advantage when combined with very tight government regulation that over the years has served to dampen market share volatility and competition on price. Tobacco advertising is severely restricted in most markets, with bans on most forms of mass marketing. This not only makes it very difficult for hypothetical new entrants to gain the attention of smokers, but it also dampens competition between incumbent manufacturers. Volume shares at the manufacturer level have been very stable for decades, primarily, we believe, because the lack of marketing communication has discouraged brand switching. Marketing spend intensity varies across consumer product categories, but manufacturers in more competitive categories roughly spend on average a high-single-digit percentage of sales on marketing. Big tobacco manufacturers have historically spent around 1.5% of sales on advertising (although we expect next-generation products to require greater spending), with the difference accruing to the EBIT margin. Some other regulations may also have had the unintended consequence of limiting competition on price and creating a barrier to entry. Point-of-sale display bans limit manufacturers’ ability to communicate pricing, thus creating a disincentive to engage in price promotional strategies, which have historically contracted the industry profit pool. Perhaps the most clear-cut example of regulation creating insurmountable barriers to entry has been the impact of the FDA in the U.S., where Imperial is the third-largest manufacturer in factory-made cigarettes with a near-9% share. The marketing of new tobacco products is subject to FDA approval, which is only granted following consideration of a request to market a new product or for requests made before March 2011, under the substantial equivalence test, which limits marketing approval only to products that are proven to possess similar characteristics and risk profiles to predicate products.
Despite consumer segmentation in other consumer product categories amid eroding brand loyalty, brand equity remains relevant in tobacco. This is in no small part due to the absence of challenger brands because of high regulatory barriers to entry, and because of the tight restrictions on marketing. Brand loyalty tends to be higher in premium price segments, and more than half of Imperial’s portfolio is in the commoditized discount segments, where brand loyalty is lowest and consumers are price-sensitive.
Cost Advantage
Unlike its larger competitors Philip Morris International, Japan Tobacco, and British American Tobacco, we do not believe Imperial Brands has a cost advantage. Cigarette manufacturing is a scalable business model because of the homogeneity of the product, and there is an inverse correlation between volume and average operating cost per unit. As Imperial is smaller, its average cost is higher than that of PMI. In fiscal 2020, we estimate that PMI’s operating costs per pack of cigarettes (excluding the RRP business) was $0.40 on volumes of 629 billion sticks. At a cable rate of 1.40, we estimate comparable costs per pack were $0.49 for Imperial Brands (in the 12 months to Sept. 30, 2020), on just over one third the volume of PMI. Imperial's average cost is similar to that of Japan Tobacco (at $0.41 per pack) despite JT's portfolio being concentrated in the midpriced segment.
Wide Versus Narrow
Though it may seem counterintuitive in a declining industry, we have conviction that our wide moat rating is appropriate because we believe Imperial is very likely to continue generating excess returns on invested capital for the next 20 years. The sustainability of current levels of profitability and returns on capital depend on the positive impact of price/mix being at least in line with the annual volume decline. At some point in the future, we expect there to be a tipping point at which the consumer is no longer willing to continue accepting price increases above the broader rate of inflation, leading to an increase in price elasticity. The example of Australia gives some insight into how such a kink in the demand curve might occur globally. Since 2011, a series of Draconian anti-cigarette measures in Australia have led to the introduction of plain packs and tax increases that caused the doubling of the retail price of cigarettes in just six years, which in turn led to the smoking rate falling from 16% to 13% over the same period, and to significant trading down between price segments. A pack of 20 cigarettes (equivalent; a standard pack contains 25 sticks in Australia) now costs almost $28.00 at current exchange rates, well above the roughly $17 average retail price in the U.K., $7 in the U.S., and roughly $5 on average globally, according to the World Health Organization. Assuming the Australia experience is applicable to price elasticity in other markets, it appears likely that there remains a great deal of headroom for price increases globally. At 4% real pricing (based on 6% nominal price/mix and 2% global inflation), this crude calculation suggests that it will be 2046 before global pricing reaches levels at which price elasticity increased in Australia. This is comfortably longer than 20 years, the benchmark period that we expect wide-moat companies to continue generating economic rent.
The spread of Imperial’s return on invested capital, or ROIC, over its weighted average cost of capital, or WACC, is narrower than that of PMI because of the less efficient logistics assets. Imperial does not break down its balance sheet between its tobacco and logistics operations, but based on the run rates of depreciation and amortization, and assuming similar useful lives across segments, we estimate that the ROICs of the tobacco business are 10 percentage points higher than the consolidated ROIC, which implies the tobacco business generates ROIC including goodwill of close to 30%.
Fair Value and Profit Drivers | by Philip Gorham Updated May 04, 2021
Our fair value estimate for Imperial's ADRs is $41. Our valuation implies fiscal 2021 multiples of 19 times our earnings forecast, which, unlike consensus, is not adjusted for amortization, and 11 times EV/adjusted EBITDA, and a dividend yield of 5%. These implied multiples represent a slightly lower valuation than competitors Philip Morris and British American, which we think is justified, given that Imperial's positioning as a fast-follower is likely to lead to a slower growth profile.
We think the medium-term guidance provided in Imperial's recent strategy update is realistic, and it is in line with how we have modeled the business historically. Our base case, therefore, reflects very similar assumptions to those provided by management. We forecast low-single-digit revenue growth (a CAGR of 1%) over the next five years. This implies that volume declines are controlled but still faster than those of the broader industry, while mid-single-digit pricing drives revenue slightly higher.
Our steady state EBIT margin assumption of 28.6% is in line with the margin achieved in the years since the U.S. acquisitions. It implies some opposing factors--an improvement in profitability from a more focused approach to investment, offset by ongoing spending requirements in both cigarettes and especially in NGP categories. If Imperial is to compete in heated tobacco, it is likely to have to follow its competitors into a broader range of products than are available today.
Risk and Uncertainty | by Philip Gorham Updated May 04, 2021
Our uncertainty rating for Imperial Brands is medium. The performance of the industry during the disruption of the COVID-19 pandemic suggests that tobacco remains a highly defensive industry. Fat tail risk remains, however, and we think Imperial has more inherent risk than some of its competitors due to its turnaround plan.
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. Imperial's presence in the U.S. gives it exposure to FDA risk, including the recent announcement of a plan to ban menthol in cigarettes in the U.S. Imperial generated 19% of its revenue and 28% of its EBIT in the U.S. in 2020, and owns the second largest menthol brand, Kool.
In general, we believe regulation does little to affect the economic moat or the cash flows of tobacco manufacturers, and in some cases, regulation actually limits competition, lowers cost, 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 a share of about 20%, 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.
The emergence of cigarette alternatives does present the tobacco manufacturers with heightened risk. We believe the greatest risk is that the industry evolves into a fragmented series of sub-categories, limiting the previous benefits of scale and making it difficult to replicate margins of the lucrative cigarette business.
Capital Allocation | by Philip Gorham Updated May 04, 2021
We award Imperial Brands a capital allocation rating of Poor. The Poor rating reflects the significant mistakes made in the allocation of capital to developing vaping products, as well as overly aggressive dividend growth in recent years, though we note that these missteps were made under previous management.
As alternatives to cigarettes gained traction over the last few years, the multinational manufacturers have mitigated risk by diversifying their product portfolios. Imperial Brands adopted a very limited strategy, making a large bet on vaping by acquiring Blu during the break-up of Lorrilard in 2014, while staying on the sidelines of heated tobacco. We always regarded that as a mistake because we expected heated tobacco to be the most likely new generation category to win consumer adoption. Nevertheless, Imperial's error was not the acquisition of Blu; its error was its attempt to scale this commoditized category globally, while ignoring the merits of heated tobacco. The $7.1 billion, or 7 times EBITDA, paid for the Lorillard assets afforded some optionality on Blu. Subsequent investments behind Blu have been significant, however, while Imperial remained a spectator as heated tobacco grew to 20% of the tobacco market in Japan, with Philip Morris International the primary beneficiary. Meanwhile, the vaping category contracted materially in 2020, particularly in the U.S. following a regulatory clampdown on nicotine liquid flavors, and Imperial's net revenue from next generation products (primarily vaping) halved in fiscal 2020.
Other transactions have brought mixed results. The 2007 acquisition of Altadis appeared rich, at 14 times EBITDA, a valuation at the high end of historical tobacco transactions. Although the logistics business Logista, that came to Imperial with Altadis, was retained following the recent strategic review, we would not be surprised if it is jettisoned eventually, as it is a drag on ROIC. Reemtsma, bought in 2002 for 12.7 times EBITDA, was also acquired at an above-historical valuation for the industry, but Tobaccor at 1.5 times sales was a value-enhancing deal.
Imperial recently underwent a major leadership transition. Chairman Mark Williamson stood down from his post in February 2020 and was replaced by senior independent director Therese Esperdy. Also in February 2020, longtime CEO Alison Cooper retired, making way for Stefan Bomhard, the former CEO of Inchcape, the auto dealer and distributor. The additional departure of Matthew Phillips, Imperial's chief development officer, will further add to the power vacuum in the short term, but the management turnover has cleared the way for a holistic strategic overhaul.
We expect capital allocation to be more prudent under Bomhard. Imperial was forced to abandon its aggressive policy of growing the dividend by 10% annually in 2018, and indeed cut the dividend slightly during fiscal 2020. Having lost ground to first movers in heated tobacco and other new categories, Imperial must first spend behind the business, and that appears to be the top capital allocation priority at present, as well as maintaining investment-grade credit. If Bomhard's turnaround succeeds, he has indicated that share buybacks may return in the coming years.
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