Thus far, management has done a good job of simplifying and focusing its portfolio by reducing brand count by over one-third. By the end of next year (2020), it expects to have reduced brands by roughly half since the start of the portfolio pruning initiative. Meanwhile, even as it has aggressively consolidated its portfolio, the company has managed to retain ~95% of its customers, an impressive feat. Moving forward, this strategy should enable management to reduce fixed cost investments, thereby improving margins and free cash flow generation (which is already at an enviable 90%+ level). This in turn will feed its second pillar by making brand investments more efficient and therefore sustainable.
The company’s pricing strategy is boosted tremendously by heavy barriers to entry in the U.K. market, giving them industry-leading margins in the mid-40%s and its U.S. business faces a sizable pricing power runway thanks to the relative cheapness of cigarettes in the country alongside the industry’s remarkably strong brand loyalty.
Of course, Imperial Brands is not immune to the volume declines hitting the entire cigarette industry, either. As a result, the company reported a 3.6% volume decline during fiscal 2018 and a 4.5% volume decline in the first half of fiscal 2019. However, a silver lining was that the company outperformed the broader industry decline of 5.0%. In addition to refining its portfolio, Imperial Brands is hoping to drive future growth through its next-generation product line.
Primary products include vapor and heated tobacco products, in particular, its blu brand. The company recently launched the new myblu product in five large markets and has more market launches scheduled in the near future. In addition, the company is developing heated tobacco products which, if successful in clinical trials, could come to market in the near future as well. Finally, the company is launching an aggressive cost reduction program with the hope of achieving up to $2.6 billion in cost savings over the next few years to help drive further earnings-per-share growth.
Last, but not least, we believe that Imperial Brands trades at a compelling valuation with a price to earnings ratio and share price that is near the low end of recent history. Even more important is its dividend yield of over 10.6%. Combining these factors together with its low-to-mid single-digit earnings-per-share growth outlook, the company appears poised to easily deliver double-digit annualized total returns to investors over the long term.
Investors do need to remember that the investment is not risk-free. The company does carry a fairly high debt load (net debt of over $15 billion), litigation and regulatory risk is ever-present, its investments into the vaping industry remain in question and could end up being misallocated capital and tagging investors with losses, and the company will have to continue innovating to offset declines in cigarettes. This was evident in the first half of 2019 as divisional tobacco net revenue fell by 4.5% on a constant currency basis. At the same time, the company is very recession-resistant, which makes it fairly low risk overall, especially given the late stage of the economic cycle.
Combining the numerous competitive advantages which give it very stable profits with the innovative growth strategy, Imperial Brands appears set to sustain its very attractive dividend yield. Adding in the fact that it is very recession-resistant makes it a very appealing place to allocate capital at this point in the business cycle.
Final Thoughts
While investors should not overconcentrate their portfolios into the stock given the declines in its core business, we do view the stock as an attractive buy at current prices. In particular, investors looking for strong current income backed by a moated and recession-resistant business model will find much to like here.
Imperial Brands (LON:IMB) is a leading cigarette manufacturer and tobacco company based in the United Kingdom.
The company’s competitive advantages include the stickiness and addictive nature of its products, significant barriers to entry, and economies of scale. Imperial Brands’ products are highly addictive in nature due to the fact that cigarettes contain nicotine. Furthermore, its customers have proven to be highly loyal to its brands, as the addictive nature of the product becomes closely correlated with the brand itself. These qualities make Imperial Brands an attractive high-yield stock for income investors.
Durable Competitive Advantages Lead To Growth
The industry also enjoys enormous barriers to entry thanks to strict government regulations in the marketplace. In particular, severe restrictions on tobacco advertising in the U.K. makes it very difficult for new tobacco brands to compete with established, widely recognized brands from producers like Imperial Brands. It also makes it easier for established brands to fatten margins since they are less likely to come under competitive pressure from peer competitors and do not have to allocate substantial funds towards marketing campaigns. Furthermore, the lack of new competition or discount marketing campaigns enable companies like Imperial Brands to charge premium pricing for their products, fattening profits even more.
The final competitive advantage enjoyed by Imperial Brands is its economies of scale. While its operating leverage is not as great as some larger competitors, it is still higher than others. This enables it to drive smaller costs per unit than up-and-coming competitors who would try to steal its market share. As a result of these three factors, we feel very confident in the stability of Imperial Brands’ profitability for the foreseeable future.
The second big reason why we find Imperial Brands to be a buy today is due to its growth potential that it pursues through its “six pillars” strategy. This involves pursuing high-quality market share growth with (1) a simple market-focused portfolio, (2) sustainable brand investment, (3) pricing strategy, (4) core range everywhere all the time, (5) tailor custom solutions, and (6) honest accurate learning.