Davidoff-to-Gauloises Blondes maker’s shares are weak, but cash flow remains strong

Share in Tobacco manufacturer Imperial Brands (IMB) moved higher on a decision to make its dividend policy less generous.

While this seems counter-intuitive the move went some way to alleviating concerns the company was paying out too much to shareholders and that its dividend growth was unsustainable, at least if the company wanted to keep its net debt-to-earnings ratio at comfortable levels.

Currently trading on a dividend yield approaching 10%, the shares have been in a declining trend with investors fretting over the structural decline in combustible cigarette volumes, the threat of rising regulation and concerns over Imperial’s future beyond tobacco; thus-far, expansion of less harmful next-generation products (NGPs) has lagged rivals.

Management’s tendency to over-promise and under-deliver, not to mention an increased investor focus on ethical investments, have also weighed on demand for the equity.

HOW DOES IMPERIAL BRANDS MAKE MONEY?

For the uninitiated, Imperial Brands makes and sells cigarettes, fine cut tobacco, smokeless tobacco, papers, cigars and next generation nicotine products (NGPs) primarily focused on the e-vapour opportunity.

Growth brands include Davidoff, John Player Special, Winston, Gauloises Blondes and blu, while specialist brands span Golden Virginia, Kool and Rizla.

Steered by chief executive Alison Cooper, Imperial Brands is highly diversified geographically, selling to 160 markets globally, although its combustible cigarette business is highly concentrated in developed markets including the US, UK, Germany, France, Spain and Australia.

Despite its status as a perennial takeout target, Imperial Brands trades on trough multiples.

This is potentially interesting as it is nearing the end of a multi-year transformation from traditional cigarette seller into a focused brand builder attempting to boost share of an e-cigarette market dominated by Altria-backed Juul.

WHY HAVE INVESTORS BEEN STUBBING THE SHARES OUT?

Cigarette companies were long-prized for their strong brands, pricing power, fat  margins and strong returns on capital, a function of the fact smokers are addicted and willing to stump up premium prices for brands.

However, millions of smokers around the world have been switching from combustible tobacco to NGPs (vapour, heated tobacco, oral nicotine) in a structural shift that has seismic industry implications.

Sentiment has also suffered from the threat of adverse regulation in the US, where the Food & Drug Administration has issued statements about potential changes to tobacco and vapour regulations and has e-cigarettes in its crosshairs.

Threats include possible restrictions on menthol and the level of nicotine in cigarettes, changes to the regulation of cigars, an increase to the nationwide minimum age for purchase of tobacco and vapour products as well as other measures to prevent youth access.

Also weighing on sentiment has been San Francisco’s decision to ban the sale and distribution of vaping products altogether.

Poor execution on NGPs and a balance sheet that needs to continue reducing debt in order to maintain its investment grade rating have also worried investors.

Volume trends are concerning and in contrast to British American Tobacco, Imperial has limited exposure to faster growing emerging markets currently.

CAN EARNINGS WAFT HIGHER?

Although tobacco volumes fell by almost 7% in the first half ended 31 March, Imperial Brands’ NGP revenues rocketed 245% higher to £148m thanks to sales of its myblu vape brand.

NGP revenue growth was driven by expansion in Europe, Japan (where it is trialling a heated tobacco product called Pulze in Fukuoka) and continued growth in the US, although Imperial has seen a slowdown stateside with category growth tempered by regulatory utterances.

It should be noted that Cooper believes Imperial Brands has the most to gain and the least to lose from any cannibalisation of combustible tobacco by NGPs given the relative size of its global cigarette market share versus rivals.

WHAT DOES THE DIVIDEND POLICY CHANGE MEAN?

Bristol-headquartered Imperial Brands large and growing dividend has long been the key attraction of the stock. However, debt reduction and buybacks have now shifted up the list of priorities at Imperial, whose divestment programme, including the sale of its Premium Cigars business, is on track.

The tobacco manufacturer has said it will no longer deliver annual 10% growth over the medium term. Instead, it will adopt a ‘progressive’ dividend policy, which really means growing the shareholder reward in line with earnings.

So whereas management reaffirmed the 10% growth in the final dividend for the year ending 30 September 2019, thereafter, ‘the revised dividend policy will be progressive, growing annually from the current level, taking into account underlying business performance’.

The new policy strikes a balance between recognising the company’s continued strong cash generation and the importance of growing dividends for investors, while also providing greater capital allocation flexibility for management.

The company now has greater freedom to buy back shares at what might be regarded attractive prices at present while funding the growth of the business, particularly NGPs, and paying down debt. Imperial Brands also said it will return up to £200m to through a buyback by the end of the current calendar year.

The ongoing divestment programme is on course to generate proceeds of up to £2bn before May 2020, with the group targeting a net debt to EBITDA ratio of between two and two-and-a-half times.

Investment bank Liberum forecasts Imperial Brands will finish full year 2019  on a net debt to EBITDA ratio (before the disposal of premium cigars) of around 2.7-times.

However, once the group sells premium cigars, a unique luxury business with a different customer base and route to market relative to the core operations, this leverage ratio would fall to 2.3-times, at least based on the broker’s £1.5bn base case price tag.

WHAT WOULD HAVE HAPPENED IF THE POLICY REMAINED UNCHANGED?

In a note issued back on 13 June, Liberum had urged Imperial Brands to revise its dividend growth policy to grow in line with earnings and outline a strong intention to buy back shares.

The broker argued the dividend policy was unsustainable given its cautious stance on US regulation.

Based on its estimates, if payouts had continued to rise at a rate of 10% per annum, then Imperial’s net debt to EBITDA ratio would have begun   to rise to north of 5.0 times by fiscal year 2028 with earnings coming under pressure.

However, now that Imperial Brands plans to grow the dividend in line with earnings, this net debt to EBITDA ratio can continue to reduce.


SHARES SAYS: While US regulation and declining combustible volumes are concerns, contrarians should investigate Imperial Brands shares, which languish on a single digit forward price-to-earnings ratio of 7.5 with a juicy 9.8% dividend yield.

This rating looks overly pessimistic for a cash generative, dividend paying fast moving consumer goods company with the intellectual property and brands to take share in the growing vapour category.

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