EUR 850.00 For Business Accounts Only

Morningstar | IMBBY Updated Forecasts and Estimates from 07 Nov 2018

We are encouraged by Imperial Brands' second half performance. The company pushed through very strong pricing in the second half, is accelerating next generation products, or NGP, sales, and again grew the dividend by 10% this year. Although we recently became slightly less bullish on margins for the tobacco group, we think Imperial's current market valuation undervalues its future cash flows and we are retaining our GBP 37 per share fair value estimate, and our wide moat rating.

The big story of from Imperial's preliminary 2018 results is the 8% price/mix in the tobacco business, almost all of which was realized in the second half of the year. This was significantly better than we had anticipated, and better than most multinational competitors are likely to achieve in 2018, and sets the firm up for a strong first half to fiscal 2019, although it did nudge volumes (down 3.6% in the year) by slightly more than we had expected, although implied price elasticity remains within the normal range. This solid performance was achieved against the backdrop of significant disruption in some markets, with France and the Gulf region remaining challenged.

One performance metric for investors to watch is the EBIT margin. Our valuation is dependent upon a sustainable tobacco EBIT margin of 45%, and although the adjusted margin slipped by almost 20 basis points year over year, we retain conviction in our thesis that even in an environment of permanently higher investments, Imperial's cost-saving programs should allow it to return to that level of profitability over the next few years. The NGP portfolio generated around GBP 200 million in sales during the year and is loss-making. As Imperial invests behind pod sales, however, we believe margins can improve through scale efficiencies. An incremental GBP 100 million in NGP investment will weigh on EBIT growth in the first half of next year, but should help stabilize revenue and EBIT in the medium term.

Imperial is to accelerate its commercialization of pipeline NGP products in early 2019. In Japan it will launch Pulze, a heated tobacco product, and elsewhere it plans to commercialize Nixx, a tobacco-infused vaping device similar to Japan Tobacco's PloomTech. Imperial's entry to the heated tobacco category justifies our thesis that it had been prudent to take a wait-and-see approach to category development, and that it could commercialize within a year if it made sense to do so. With the heated tobacco category having slowed abruptly in Japan, and with a slew of competitive products coming online in the next few months, including upgraded to Philip Morris International's iQOS devices and Japan Tobacco's heated tobacco launch, we expect Pulze to be commercialized at a competitive price point to try to attract later adopters, which may lead to the devices making material losses. Imperial's roll out is likely to be hindered by its limited distribution in Japan. We do not believe the firm possesses an economic moat in Japan, as it does not have the entrenched key account relationships that it has in other markets such as Western Europe. Significant investment will be required, therefore, in customer acquisition, which will also weigh on short-term margins. The upside to this challenge, of course, is that any shelf space gains by Pulze will be incremental, and cannibalisation of Imperial's brands will be very limited. As the fourth player in the global industry, something similar can be said for most markets, and we think Imperial's long-term opportunity to leverage the migration to NGPs is significantly underappreciated by the market.