Description

Quick Investment Case 

I would buy Imperial Brands around 1470p. This is really a valuation call more than anything – I think that, on a P/E of about 6x adjusted EPS, (10.8x IFRS EPS) and with a normalised EV FCF yield of about 10% and normalised equity FCF yield of 16.5% (I normalise by using 2022 numbers as 2020/21 are swung around by WC movements that should normalise by next year), you will probably not lose too much money buying the shares here. 

It is not really a compelling story in terms of competitive positioning or growth prospects, so it is kind of a cigar butt, for lack of a better expression. The company probably has the worst management team in the sector (limited talent, delusional), and I think they have the worst product portfolio (mostly exposed to mature markets, a distant 4^th in market share globally ex-China, nowhere in reduced risk products (RRPs), with that situation unlikely to change). It has been almost comically bad in terms of the number of profit warnings, the delusion they have around strategy, the regional markets the are exposed to, the decisions they have made on RRP’s. 

However, we are at a valuation level now where I think it will likely be hard for them to mess it up for shareholders much more than they already have, and it is unlikely that you lose money buying the shares. I think that if one were to be unaware of the industry in which this company operates, and simply look at: 

·         Organic growth profile (even recently)

·         Gross margins (69%), operating margins (25%), ROIC (~10%)

·         Cash generation (equity FCF generation averages about £2.3bn)

·         Wider market valuations (FTSE 100 on about 143x, FTSE 250 on about 15x) 

One would not conclude that the right multiple for this business is 6x adjusted EPS, 10.8x IFRS EPS. 

If I put what I think is an undemanding but reasonable 9.5x multiple on 2025 IFRS EPS (would be about 6x the adjusted EPS they report), I get to an “ongoing” value of about 1475p for the business; the shares have a 9.4% dividend yield (the dividend was cut last year and is now covered 1.75x by FCF), while they have committed to a progressive dividend policy from here; dividends received would thus be about 720p, and you would realise an IRR of about 9%. I think that you have additional potential sources of upside from: 

·         The company admitting defeat in RRP’s and walking away from that £400m cost base (about 15% of group operating profit)

·         New strategy unveiled to get a little bit closer to their accounts could improve the organic growth outlook a bit

·         Potential for share buybacks as the current FCF can more than cover the dividend and planned deleveraging to below 2x net debt/EBITDA

·      Not a core part of the thesis, but I think the company is an ideal target for an activist. I view it as broadly similar to GSK – both have decent historical performance and ROIC, both generate a lot of cash, much of which is paid out but trades on a high yield due to fears around the business, both have overpaid/complacent management, both wasting money on growth projects with questionable economics. Elliott took a stake in GSK last week – I can imagine what they playbook will be – something like Imperial would make an ideal target along the same lines, I think 

There is a well-documented risk of disaster with this company, but I have been through it quite a bit (albeit this is an exercise in fun with spreadsheets) and I can’t see it, so my view is that there fairly low risk of losses at this valuation level, realistic shot at double digit IRR. 

Key risks to the investment would be: 

·         Continuing ESG outflow tsunami

·         Mostly poor positioning – either in markets with very poor volume growth, or not a market leader

·         Organic growth profile likely to continue to be poor, and people care currently more interested in high growth

·         Company are nowhere in RRPs and that is unlikely to change, however if they admit defeat (hinted at it in recent CMD) then that is £400m of annual costs they are currently incinerating that will go away over time

·         Quite levered at 2.8x net debt (but quite a stable business so they can handle it, and they are looking to delever)

·      Poor management team – numerous profit warnings, CEO recently quit, new CEO unimpressive. He is a graduate of the prestigious University of Middlesex (not sure how one denotes sarcasm in a VIC post) and previously ran Inchcape – the stock was down 28% over his tenure with FTSE 250 flat. His surname is fairly appropriate – Stefan Bomhard – Inchcape bombed fairly hard over his tenure

·       Aside from the ESG stench, for me at least, there is also a bit of a management stench in terms of the games they play with numbers. Interest costs are moved out of CFO into CFF in their financial statements (pet hate of mine), restructuring charges excluded from adjusted numbers they give (they have reported charges in 10 out of the last 10 years – not really sure how something qualifies as non-operating if it happens 100% of the time over a decade), etc, etc

Company Detail 

Some summary financials are as follows

They are a UK-based cigarette company with the number 4 position globally, ex-China, behind Philip Morris, BATS and Japan Tobacco, with a market share of about 6.5% ex-China, with the three larger companies commanding shares of 25%, 21% and 15%, respectively, meaning the top four players command a share of about 70% in total, so a good degree of consolidation. They have about £9bn of sales, of which £8bn is the tobacco business and the rest is fees from their distribution business. 

The company enjoys strong market shares in many larger European markets including the UK (40%), Spain (29%), Germany (21%), and France (18%), while they are also strong in Australia (33%) and Saudi Arabia (17%). In most of the other markets, they are either a second-tier player (i.e. US 9%, Russia 8%) or an also-ran. Their biggest markets are the US (£2.4bn sales) and Germany (£1bn), followed by the UK (£800m), Spain (£350m) and Australia (£250m). These five large markets account for just under 70% of tobacco sales and just over 70% of EBIT. There are then a tail of markets which are much smaller, many of which where they enjoy strong share (more the case in African markets such as Ivory Coast, Morocco, Burkina Faso than in Eastern European markets where they are weaker), most of which require limited investment and generate cash. 

While the company do have some brands that I would describe as strong, bordering on iconic (John Player Special, Davidoff, Gauloises, Lambert & Butler, Rizla, Golden Virginia), they also have more than their fair share of either second tier or failing brands (blu e-cigs, for example). 

Common to their industry peers, the company has experienced very modest growth in top line in recent years, with the now familiar pattern of low to mid-single digit volume declines being offset, or slightly more than offset by price increases, which has driven a modest expansion in operating margins. Since 2011, the trend has been annualised volume declines of 4.3% slightly more than offset by annualised price increases of 5.2%, which has driven an adjusted operating margin expansion from about 40% in 2010 to about 42% by 2019 - adjusted operating income has grown at a modest 2.3% CAGR over that period. 

Their adjusted operating profit has a few adjustments that I think are suspicious, so when analysing returns, I tend to look at the IFRS operating income, and on that metric, the company has generated a stable and acceptable ROIC of about 10% over the last 10 years, without huge peaks and troughs. The company is heavily indebted, with a net debt of £13.5bn against a market cap of about £14bn, but the cigarette business is, of course, fairly stable, and the net debt to EBITDA is manageable at about 3.2x. The company generates about £2.3bn of FCF per annum, of which about £1.8bn was used to pay out dividends prior to the recent dividend cut. In the next couple of years, the plan will be to use savings from the recent dividend cut, together with the £1.3bn proceeds from the sale of the cigar business to reduce debt down to below 2x net debt/EBITDA. 

Since the summer of 2016, the shares have performed very poorly, with the share price being cut in half, the EV/EVIT multiple falling from 14.5x to 7.5x, while the P/E has fallen from 12x to a staggeringly low 6x, with the market seemingly pricing in the company ceasing to be a going concern within the next decade. 

In terms of what has driven this decline, there are a couple of major factors. 

Firstly, organic growth has slowed - from 2010 to 2016, it was around +1.2%, but since then it has slowed to 0.3% - volume declines have been quite consistent, and the trend has actually slightly improved since 2016, however they have been losing share in a couple of key markets (Germany and UK), and price/mix has slowed from just under +6% to about 2.5% per annum, as downtrading has become a fixture in some markets and Imperial has lost some share, eventually forcing them to participate in lower-priced segments. 

Second, the company's foray into reduced risk products has been a failure. In the peak year of 2019, the company made just £285m in RRP revenues, less than 5% of the group total, vs. PMI's ~$5.5bn, while the RRP portfolio was loss making (and has seen heavy investments which have brought down group margins – the company say the cost base associated with RRPs is about £400m). 2020 sales of £155m were down almost 50% from 2019. The reason for the failure has been that the company has bet mainly on vaping, which is popular in the UK and the US, less so elsewhere, while PMI has focused more on HNB tobacco. First, IMB lost share in the US to juul, then, obviously all vaping products were hit by negative headlines. 

At the recent CMD, they announced a modified strategy around RRP’s which will involve an increased focus on heated tobacco in Europe, where they claim that their Pulze product compares well to IQOS (faster heating time, you can smoke 20 sticks in a row), and a more refined turnaround strategy in vapour in the US, with more focused marketing and better distribution. I think that the strategy has almost no chance of success as Philip Morris has spent something like $8bn-$10bn developing IQOS and have generally eaten the competition. It seems unlikely to me that a UK-based profit warning machine with the former CEO of a car parts distributor in charge and ¼ of the revenues of PM is going to topple them, but one can live in hope, I suppose. 

The positive that I got from the comments on RRPs at the CMD was that they went out of their way to specify that any investments they make from here on out will be data-driven and dependent upon the success of current initiatives. A couple of quotes from the Q&A after their presentations:

“it's not a blind investment, a sustained commitment to scale across Europe if the market doesn't materialise. It's a pilot approach to demonstrate the viability and the economics before we look to scale up and increase, significantly, investment.” 

“We’re not going to roll out propositions if we do not have the confidence level that they can achieve the targets that we're setting ourselves. Now what would happen in this case, as you asked very specifically, this proposition would then not be rolled out. We would be finetuning this proposition, and see. At the same time, there's enough data generated in the last couple of months across a number of European markets that give us some confidence that actually our proposition – there’s a consumer segment where what we can offer consumers is appealing” 

“…the pilots are going to be the thing we’ll use to determine the pace and speed of rollout thereafter. If the pilots fail, then we'll need to reset as to where we go next with it.” 

“…our NGP strategy will only trigger any meaningful CAPEX investments once we are really convinced that we actually have a product market mix route to market for a specific market ready with success. So there are – so it is going to be a very prudent and very rigorous approach on this front.” 

It is not quite the clear, unqualified promise to, say, abandon the NGP adventure if it is still loss making after a certain number of years that I would ideally like to see, and a cynic would look at the phrasing around their commitments and say that they have left themselves enough wiggle room to drag this out for a while, but my take is that the new CEO has spent some time talking to key investors and understands that it’s important that cash is preserved. 

As an aside on management delusion around what is happening in their markets, I grabbed the following slide from the CMD where they go through expectations on NGP penetration in their markets by 2025 – it only takes 5 points of share, in their view – crazy that they think that given the adoption curves in Japan and South Korea, and what is happening in some of the big European cities. Philip Morris, by comparison, have talked about the possibility of RRPs being half of the market within the next decade. An activist giving them a kick up the backside would make a large difference to the share price, IMHO.

The final driver behind the underperformance has been the combination of the financial leverage and the management quality/liberties they take with accounting. I have mentioned the interest reclassification and restructuring adjustments above. In addition, they have repeatedly changed the reporting structure, and the long-term incentive schemes for management have been based 50% off adjusted EPS. 

In spite of all of the headwinds mentioned, the financial performance has been fairly solid, all things considered – the company have grown revenues, gross profit and operating profit over recent years:

Over the last 10 years, they have averaged an acceptable ROIC of about 10%, and it is not meaningfully different over the last three years or one year – it is fairly stable and well above their cost of capital. In terms of my expectations going forward, I am modelling volume declines in the combustible business of about 3.5% per annum, with price/mix positive by the same amount, a combination of which should be a modest tailwind for gross margins.

The steady top line and operating profit performance should mean that they are able to honour their commitment to a progressive dividend policy, while also delivering from 2.8x to well below 1.5x in the absence of any buybacks. In reality, the P&L may not look exactly how I model it, particularly below the operating profit line, as they will probably not use all of the cash after dividends to retire debt, however they do have about £1.9bn maturing in 2022, on which they pay 9% currently, then there’s a £600m bond maturing in 2024 on which they pay 8.125%, so the interest costs will certainly be lower.

Valuation 

In terms of valuing the business, I look at it in a few different ways. I think that a good outcome for the company on a five-year view would be operating profit about flat on the £2.7bn they reported in 2020. I am actually going for £2.5bn by 2025, so down about 8%, as opposed to the optimistic guidance given at the recent CMD. By that time, due to the very strong FCF generation, you will have received about 50% of your money back in dividends. In addition, the company will have delevered by about 1.5x turns of EBITDA), which should markedly reduce interest costs and support net income and EPS. I have net income and EPS at £1.47bn and 155p, respectively, vs. the 2020 numbers of £1.5bn and 158p, respectively. Unless the market is putting an IFRS P/E multiple on the business of below 5x by then (would translate to an adjusted EPS multiple, which is what Bloomberg consensus uses to produce historical P/E ranges, of about 3.2x, I think), you are not going to lose money. The business is quite clearly a melting iceberg (and the company are a bit too optimistic about their outlook, I think), but it is not so bad as to warrant that kind of multiple, in my view. Volume headwinds accelerating and ESG flows have been a theme for several years now, and over the last five years the multiple has ranged from 4.5x-11x adjusted EPS. I think that an IFRS EPS multiple of about 9.5x is reasonable, which implies a fair value of the ongoing business in 2025 of about 1475p, i.e. where the share price is now, but you will have received about 720p in dividends for a total value of 2195p, a gain of just under 50% and an IRR of about 9%. The IRR here is conservative I think, as the historical valuation range is based on Bloomberg consensus, which uses the company definition of adjusted EPS. IFRS numbers are typically about 30%-40% below adjusted numbers. So by using a 9.5x multiple, I am effectively valuing the business at 6.2x-adjusted EPS vs the historical range of 4.5x-11x, which I think is conservative enough. 

One could alternatively look at the historical dividend yield for clues on fair value. From 2011-2017 when fears first started to grow about organic growth and the sustainability of the dividend, the yield ranged from 4% to about 8%-9%. It then really blew out to as high as 16% when the market was pricing in the eventual dividend cut. We now stand at around 9%. It is slightly finger in the air, but if the market gets comfortable that no organic revenue growth and flattish operating profit growth with very strong and stable FCF is realistic, then I’d say that a 7% dividend yield is realistic when one works through what that implies as a FCF yield. DPS this year should be about 138p, and I have that growing to 141p in 2022 and 147p by 2023. A 7% yield on 2023 DPS implies about 2050p as fair value. +35%.

Appendix 

IFRS to Adjusted Operating Profit Reconciliation

Catalyst

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