Imperial Brands (IMB) generates the highest operating margins among the large-cap tobacco manufacturers – but that does not mean the outlook is all positive.
We forecast a 10% dividend-growth rate until 2020
Morningstar analysts are mindful of the firm's weaker volume trends, slightly lower quality brands, and the fact that it has yet to enter the promising heated tobacco market. Nevertheless, we believe Imperial's pricing power, largely driven by the addictive nature of the product, give it a competitive advantage, and rate it as having a wide economic moat.
Imperial's strategy to maximise shareholder returns revolves around cost optimisation and disciplined capital allocation. Despite generating best-in-class tobacco margins, Imperial has an opportunity to expand margins further.
This is via rationalisation of stock-keeping units, or SKUs – meaning that it is cutting down the number of products it offers in the name of efficiency. So far, this strategy has worked well, with a 95% retention rate moving consumers from small, low-margin brands to core brands.
Management has restructured the company to differentiate "Growth" from "Returns" markets, and investment is concentrated on those markets that offer growth. This focused investment should allow for both continued dividend growth and debt repayment, and we forecast the firm to sustain a 10% dividend-growth rate until 2020.
We believe the fall in share price over the past six months is largely linked to its absence from the heated tobacco category, lagging behind competitors. Philip Morris International (PM) has invested heavily in this emerging adjacency, and has reported strong uptake in some markets, most notably Japan.
With competitive products from British American (BATS) and Japan Tobacco now in the early stages of commercialisation, Imperial appears to have been left behind in the heated tobacco market, preferring to make investments in vaping. However, we are sceptical that any first-mover advantage has been ceded, and we believe Imperial could step into the category within months if growth is replicated in markets outside of Japan.
Profile
Imperial Brands is the world's fourth-largest international tobacco company, excluding China National Tobacco, with total fiscal 2015 volume of 285 billion cigarettes sold in more than 160 countries.
The firm holds a leading global position in the fine-cut tobacco and hand-rolling paper categories and is a leading seller of cigars in several countries. Recent acquisitions in the United States make Imperial the third-largest manufacturer in that market.
