Imperial Brands' (IMB) market repeatable model has been the guiding hand behind its recent strategy, and Morningstar equity analysts think the firm has executed well. Imperial's stated aim is quality market share growth through six pillars, which it describes as: simple market-focused portfolio, sustainable brand investments, always on pricing strategy, core range everywhere all the time, tailor custom solutions, and honest accurate learning.
In portfolio optimisation, the company has made great strides, reducing its total brand count by 32% by the end of fiscal 2017, and targets a total reduction of 50% by 2020. Execution on the brand migration program has been impressive, with a consumer retention rate of around 95%. The streamlined portfolio should allow for more focused brand investments, and sustainable cost reductions.
We think the success or failure of Imperial's strategy, and the reason for its recent valuation discount, lies in its choice of targeted profit pools. Geographically, we like the 2015 acquisitions of assets in the US, because we believe the core combustible market offers multiyear opportunities for price/mix driven growth. In its next generation product portfolio, however, Imperial's focus remains firmly on vaping, a category that we believe is commodified with fairly low barriers to entry.
Competitors have invested more heavily in heated tobacco, a category that we suspect may have more success in attracting quitting smokers and could be more profitable. Nevertheless, we think given its distribution capabilities, particularly in Europe, Imperial could regain lost ground if it entered the heated tobacco category, and the company has announced plans to test market heated tobacco products in the near future.
Imperial achieves best-in-class tobacco margins in the mid-40% range, as well as over 90% free cash flow conversion and has a medium-term target of 10% annual dividend growth. While it has lost ground to competitors in heated tobacco, we believe Imperial's wide economic moat, derived from brand equity and distribution capabilities, should allow it to catch up in this important profit pool and continue to deliver these metrics in the medium term.
How Analysts Value Imperial
Our valuation is based on three key drivers: volume, pricing, and margins. We forecast reported revenue to fall slightly in fiscal 2018, with the currency tailwind of last year becoming a modest headwind this year. On an organic basis, we expect revenue to eke out a slim 1% gain, with tax hikes in the Middle East continuing to weigh on growth.
Our mid-cycle estimate of sales growth is 3%, driven entirely by pricing offsetting volume declines in line with the global market. This is slightly below our estimates for both British American and Philip Morris International, due to lower pricing power.
Strong intangible assets at the premium end of its portfolio are at the core of Imperial Brands' wide economic moat. In addition, the company's broad platform of nicotine and tobacco products, which is being extended to include next generation products, particularly in vaping, gives the firm economies of scope and scale that make it difficult for new entrants to overcome.
Finally, the addictive nature of tobacco products makes demand fairly price-inelastic, and with few substitute products outside the portfolios of the Big Tobacco firms, a favourable industry structure exists for the largest players in which pricing, for the most part, is rational.
