Imperial Brands' (IMB) latest full year results today demonstrated on a number of levels why the firm is Morningstar equity analysts’ pick of the European consumer staples group. Modest outperformance on the top line, the surprise announcement of an entry into heated tobacco, respectable performance in challenging markets, and continued capital discipline all support our investment thesis. Analysts continue to believe Imperial is undervalued.
We have raised our sales forecasts higher and made our margin assumptions slightly lower and retain our £39.00 fair value estimate. The immediate market reaction has been positive but muted, which probably reflects concerns over short-term profit margins, after the firm announced incremental investments in next-generation products, and also some irrational scepticism over Imperial's growth opportunity in its broader portfolio despite being late to the game in heated tobacco.
We believe Imperial's brand and supply chain, the sources of its wide economic moat – or significant competitive advantage – should allow it to make up for lost ground if heated tobacco gains traction in its core market of Europe.
When we added Imperial Brands to the Best Ideas list last month, we argued that the company could step into the heated tobacco category at fairly short notice because the barriers to entry for the large-cap tobacco manufacturers are fairly low. Heated tobacco is a new technology where a mini-cigarette is placed into an electronic device and heated, not burned, which tobacco companies claim is healthier than ordinary cigarettes. Imperial announced that it is to test multiple platforms of heated tobacco products, though management opted not to provide details.
We expect trial markets to focus on Europe, with the strategy to be to expand the brands if the category gains traction. However, with significant share gains made in the second half of last year in Japan – Imperial's volume grew 15% in a market that contracted close to 12% – we would not rule out a test run in select Japanese markets.
This move justifies our belief that the huge valuation premiums given to the manufacturers with the greatest exposure to heated tobacco for most of this year have been unjustified, and we believe it will contribute to a gradual multiple convergence with larger competitors Philip Morris International (PM) and British American Tobacco (BATS).
Nevertheless, the strategy comes at a cost. Imperial will invest an incremental £150 million, or 1.7% of this year's net sales, next year in next-generation products. This includes its large vaping portfolio, including the recently acquired Nerudia, a UK-based manufacturer of vaping liquids, but given that the company has spent in £400 million over the course of the past five years or so on its next-generation portfolio, we think it signals a rather significant push into heated tobacco.
We are trimming our medium-term profit margin forecasts to reflect the ongoing investments in these emerging categories, but as these investments are likely to support incremental sales growth, it does not materially affect our fair value estimate. Our medium-term sales growth assumption is now 3.2%, roughly in line with peers.
The dividend grew 10% in the full-year. We expect another year of double-digit dividend growth this year, but then anticipate that dividend growth will converge with earnings growth in the low single digits thereafter. Nevertheless, the growing cash flow, already yielding 5.3%, is attractive relative to the rest of the group at around 4%.
