IMBBY - Analyzing The Investment Viability Of Imperial Brands Following Its 5-Year Recovery Strategy

2023-07-28 12:18:30 ET

Summary

• Imperial Brands, a globally recognized tobacco producer, has diversified its portfolio to include next-generation products like e-cigarettes and nicotine pouches, adapting to changing consumer preferences.
• Despite regulatory challenges in the tobacco industry, Imperial Brands has maintained strong financial health, consistently generating robust cash flows and offering an impressive dividend yield of approximately 7%.
• The company's shares are considered a good investment due to its strong cash flow, significant share buyback program, expanding market presence, and a calculated equity value indicating a discount of 39% compared to the current market price.

Investment Thesis

Among the leading names in the tobacco industry, Imperial Brands PLC ( OTCQX:IMBBY )( OTCQX:IMBBF )" stands out as a globally recognized producer of cigarettes, cigars, and smokeless tobacco products. In this article, we will conduct a comprehensive assessment of Imperial Brands' investment potential since the five-year strategy was launched in 2021, taking into account its estimated future performance, market position amongst competitors and the reasons I believe this stock is worth a buy rating.

Company Overview

Imperial Brands and its subsidiaries engage in the manufacturing, importing, marketing, and sale of tobacco and non-tobacco products (next-generation product) in more than 160 countries worldwide. The company is listed on the London Stock Exchange under the primary ticker "IMB" (ADR ticker is "IMBBY" and "IMBBF").

As of the year-to-date period, the share price of Imperial Brands has experienced a decrease of 11.03%, currently valued at £18.38 per share. The company's present market capitalization stands at £16.7 billion.

Market Position and Strategy

Established Global Market Position

Imperial Brands stands out among its peers due to its well-established global market position by operating in over 160 countries, with its revenue stream extending across a wide geographical range, encompassing markets from the United States to Japan. This international presence ensures a stable demand for its products such as Davidoff, Winston, Gauloises, and JPS, contributing to revenue stability. Furthermore, the company's strong brand recognition and loyal customer base provide a competitive advantage and breadth to deal with new regulation changes.

Diversification Strategy

Since 2021, statistics have revealed a noteworthy shift in consumer behaviour, with the proportion of current vaping surpassing that of current smoking . The latest figures show 7.6% were currently vaping compared to 3.6% currently smoking. This transition away from traditional smoking and cigarettes is evident. Acknowledging this trend, Imperial Brands has proactively recognized the necessity of adapting to evolving consumer preferences and the regulatory landscape in the tobacco industry.

Imperial Brands is diversifying its portfolio beyond traditional tobacco offerings by investing in cutting-edge products like myblu e-cigarettes, leveraging advanced technology for nicotine delivery and exploring innovative alternatives like On! nicotine pouches. This expansion showcases the company's commitment to embracing advancements in science and technology to meet evolving consumer demands.

Nevertheless, Imperial Brands faces considerable impacts on its operations and growth prospects due to regulatory changes in the tobacco industry, specifically focusing on advertising, packaging, and product availability. Notably, new regulations have been implemented to address the health risks associated with smoking, such as packaging regulations that aim to discourage smoking and raise public awareness about its adverse effects. Additionally, stringent advertising restrictions have been put in place, limiting the marketing channels available to tobacco companies, potentially hindering their ability to reach potential consumers and promote their products effectively.

Segment Breakdown

Upon analyzing the revenue breakdown, it becomes evident that during the last five years, the net revenue growth was primarily influenced by two key factors: resilient pricing from the Tobacco and Next Generation Products ((NGP)) categories, contributing to 70% of the growth, and distribution, which accounted for the remaining 30%. In the United States, when considering constant currency values, the net revenue for tobacco showed a positive increase of 4.4% from the reported figures in 2021, while in Europe, it experienced a slight growth of 0.2%.

In my opinion, the US and Germany are the two most crucial markets for targeted growth. In both these markets, cigarettes continue to maintain an affordable price range, allowing for potential revenue growth in the future by adjusting pricing strategies. Additionally, there is an opportunity to enhance revenue by increasing participation in premium brands such as Winston and fine cut tobacco. Furthermore, the sales force in both the US and Germany has undergone restructuring to ensure a closer alignment with the company's most promising growth prospects.

Financial Performance

Strong Financial Health and Dividend Yield

Imperial Brands has consistently generated robust cash flows (delivered almost £2.6bn in free cash flow last year), bolstering its financial stability which allows the company to consistently reward shareholders with steady dividends (offering dividends for more than a century and as a result has been a long-running member of FTSE UK Dividend+ Index. Last year, the business distributed a whopping £1.32bn in dividends). As it boasts an impressive dividend yield of approximately 7% , ranking one of the highest in the sector, Imperial Brands offers an attractive proposition for long-term investors seeking supplementary income.

Below shows a time series of the free cash flow and dividend yield for the past 5 years:

Cost-Cutting Measures and Debt Reduction

Imperial Brands has been proactively lowering its debt levels through the divestment of non-core businesses. The net debt-to-equity ratio of the company stands at 155.1%, reflecting a relatively high level of debt. Nevertheless, it is noteworthy that this ratio has shown a positive trend, decreasing from 244.6% to 164.7% over the past 5 years. Additionally, the company's operating cash flow provides substantial coverage for the debt at 24.2%, enhancing its financial stability. The company's debt position remains well within its established parameters, reaffirmed by the announcement that the £1 billion share buyback program will conclude in the second half.

Valuation

The company's value is considered favorable, indicated by its low PE ratio of 9.9, in contrast to the industry's average PE ratio of 19.7. Although its PE ratio is slightly higher than that of its primary competitor, British American Tobacco ADR line "BTI", the difference is not substantial enough to impact the valuation analysis significantly. Moreover, the company boasts a remarkable return on equity (ROE) of 28.87%, outperforming the peer average of 14.15%. Looking ahead, the forecast predicts an even more impressive ROE of 41.5% in three years, signifying a substantial increase.

Below shows a time series of the ROE for the past 5 years :

In evaluating the true value, I utilized the discounted cash flow model, taking into consideration a discount rate of 10%. This rate was derived by adding the current risk-free rate in the UK for 5-year gilts, which stands at 4.36%, to the equity risk premium from S&P Global. To determine the total equity value, I considered 10-year free cash flow estimates from analysts, discounted them back to their present value, and accounted for the projected growth over the next 10 years.

The growth rate was computed based on the estimated revenue growth until 2027, which was averaged at 1.26%. This led to a calculated equity value of £32 per share. At present, this valuation indicates a discount of 39% when compared to the current market price, with a +/-5% error rate. Note - the valuation of the ADR ticker "IMBBY" will be roughly the same as the primary ticker. This is because the price of the ADR line is $24.06 (£18.62). Given the parent line, which is the most liquid/traded, is priced at £18.38, the difference in valuation will only be 1.2%, hardly significant. Which is expected as the spread is only 0.10.

Conclusions

The future prospects appear cautiously optimistic, as Imperial Brands maintains its guidance without any changes and remains on course to achieve its profit targets. Additionally, the company aims to achieve cost savings of £150 million by the end of the year, and progress in this direction is proceeding as planned.

While the tobacco sector may not be considered fashionable, and some investors may choose to avoid it altogether, the shares of Imperial Brands have demonstrated their defensive attributes in challenging market conditions. Moreover, the company's generous dividend yield has provided an added benefit for investors considering it from an investment perspective.

While the tobacco sector has experienced various challenges, evidenced by a 21% drop in BATS shares over the past year, Imperial Brands has performed better. The company's shares have shown a decrease of 12% during the same period.

Despite a few challenges that may slightly impact the outlook, Imperial Brands continues to generate substantial revenues from its core combustible tobacco business, making its dividend yield highly competitive. Moreover, the company boasts strong cash flow, a significant share buyback program, and an expanding presence in its top five markets. Given these considerations, as well as its ample margin of safety, I am convinced that this tobacco giant offers an attractive investment prospect at present.

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