Description

Investment thesis

1) At 7.2x current earnings and a 7.3% dividend yield, Imperial Brands (IMB LN or IMBBY) is an attractive investment in all economic and market scenarios.

- Imperial is the 6th largest global tobacco company and trades at the cheapest valuation within the industry.

- The tobacco business is highly stable and defensive; inelastic demand and pricing power results in consistent earnings growth in most economic periods including recessions and inflationary periods.

2) Tobacco remains one of the best and most unique businesses in the world. Big Tobacco returns almost all earnings back to shareholders as dividends or share buybacks yet keeps growing its earnings consistently.

- Demand is price inelastic as cigarettes are highly addictive and consumers are brand loyal.

- Advertising restrictions and regulations prevent new competitors from entering the marketplace.

- Total costs (manufacturing and SG&A) are less than $0.50 per package and less than 15% of the final retail price.

- Tobacco companies benefit from tremendous operating leverage as the majority of revenues pay for local excise taxes. On average these taxes increase less on a per-unit basis than wholesale list prices.

- Price increases have offset volume declines resulting in growing revenues with declining costs and no incremental capital investments. All free cash flow has been used for dividends, buybacks and acquisitions.

- Two well-known case studies further illustrate the durability of the tobacco business and how its pricing power overcomes almost any adverse development.

- First, the US tobacco industry entered into the Tobacco Master Settlement Agreement (MSA) in 1998 agreeing to pay a minimum of $206bn over 25 years in order to settle its lawsuits with US states for tobacco-related healthcare costs.
The industry and Philip Morris paid for the annual charge (roughly $5bn/year for PM) through price increases. From 1998 to 2000 PM raised its list price from $1.35 to $2.14, an astounding increase of 59%. Volumes were not significantly affected, allowing PM to roughly double its pre-MSA EBIT and increasing its EBIT post MSA charges from $5.2bn to $5.4bn (see below for detailed analysis).

Philip Morris domestic tobacco (now called Altria smokable products) before and after MSA

- Second, Australia introduced plain packaging for cigarettes in 2012. Branding and logos were removed from packages and replaced with nondescript font for the brand names.
Despite this potential impairment of brand equities, the leading tobacco companies (Imperial, British American, Philip Morris) continued to grow pricing and profits in Australia in the following years.

3) Global tobacco valuations have significantly decreased since 2017 due to competitive concerns around smoking alternatives. However vaping growth has slowed in the US and it is not clear that the fundamental outlook and the long-term economics of tobacco will worsen even if global volume declines worsen by one or two percentage points.

- From 2016 to 2019 US cigarette volume declines worsened from 2% to around 4-5% annually.

- These worsening volume trends seemed to be the result of a shift from smoking to vaping.

- Higher price increases made up for the worsening volume trends resulting in Imperial’s US segment EBIT CAGR’ing at 6% from 2016 to 2019 and industry leader Altria CAGR’ing EBIT at 5% over the same time period.

- The FDA has announced a review of all vaping products given the rise in youth vaping. These cumbersome reviews are leading to certain product bans and the large tobacco companies consolidating control of the market.

- Vaping volumes declined in 2020 and now seem to be growing at single digit rates.

- Market share leader Altria estimates that cigarette volumes in the US declined at 0.0% in 2020, 5.5% in 2021 and 7.5% for 12 months ending September 2022. I think it makes sense to average these three years as 2020 was an unusual year. This average comes out to a decline of 4.3%. I think US revenues and US earnings will still grow in such a scenario as pricing offsets volume declines

- Global volumes ex US should decline even less.

4) Imperial’s brands have high local market shares and the company is well diversified geographically, which limits regulation risks in any one market.

- 42% share in the UK, 19% in Germany, 29% in Spain, 18% in France, 5% in Italy, 32% in Australia, 8% in Russia, 19% in Saudi Arabia and 10% in the US.

- In the US the company owns a portfolio of discount brands that are currently taking share as inflation is causing some customers to trade down.

- While there are always regulation and litigation risks in the tobacco business, current threats are benign in comparison to past threats in the industry.

- Governments implement regulations to reduce smoking rates but are hesitant to destroy the tobacco business as it generates significant tax revenues. This risk is further reduced through Imperial’s geographic diversification.

5) Imperial’s earnings growth has been lackluster over the last years but will improve going forward as investments into regaining market share level out, vaping losses are reduced and as the company implements its GPB 1 billion buyback.

- In July 2020 Stefan Bomhard joined Imperial as new CEO.

- The company cut its dividend and sold its premium cigar business for 11.8x EBITDA (10.5x post tax).

- This helped the company de-lever to 2.0x EBITDA. With no further leverage reductions required, this should leave over GBP 1bn (5% of mcap) of excess cash flow after paying the dividend of GBP 1.3bn.

- Hence the company announced that they would implement a GBP 1bn share buyback in October 2022 to be implemented over the following 12 months. While the company hasn’t formally committed to a multi-year buyback, I think management comments and the excess free cash flow indicate strongly that this will be a yearly buyback as long as the company continues to trade at its current valuation.

- Another headwind that has turned into a tailwind is the company’s Next Generation Products (NGP) segment. Past management and equity research obsessed over myblu (Imperial’s vaping product) and the NGP segment. Earnings calls focused almost exclusively on trends in this segment which is puzzling as the division generated GBP 208m of revenue in FY22, only 2.7% of tobacco revenue. Its products do not seem to be serious competitors to Vuse/Juul in the US and IQOS internationally, the leading smoking alternatives.

- From FY17 to FY20 the NGP segment contributed to a GBP 302m decrease in EBIT that masked organic growth in the core cigarette business (see detailed EBIT bridge below).  The division generated an adjusted EBIT loss of GBP 328m, GBP 144m and GBP 89 in FY20, FY21 and FY22 respectively.

- New management has re-focused on the core tobacco business and will drive earnings growth by reducing NGP losses. Further upside could be driven by divestitures of more challenged products or regions as they would be highly accretive to earnings and organic growth given the current valuation discount. 

FY 2017 to FY 2020 adjusted EBIT bridge – NGP losses peaked in FY 2020 

6) Absent a multiple re-rating, I expect annual returns of 12% consisting of the 7% dividend yield and MSD growth in EPS/DPS. Valuing the company at an 8% earnings yield in 3 years, more reflective of the company’s ability to generate stable and predictable cash flows, would result in an annualized return of 31%.

- Management expects “low single-digit constant currency net revenue growth with constant currency adjusted operating profit growth accelerating to deliver mid-single digit CAGR over the next three years.”

- With the buyback reducing the share count by about 5% per year at the current valuation, this would suggest EPS growth of 10%. If we leave some room for guidance shortfalls and FX headwinds, I think we can expect at least 5% of annual EPS growth.

- The dividend was reduced a years ago and now has room to grow with a current payout ratio of 53%.

Key financial information

Catalyst

- Share buyback
- EPS acceleration