EUR 850.00 For Business Accounts Only

Morningstar | Imperial grossly undervalued as market overlooks strength of core business.

Imperial Brands' market repeatable model has been the guiding hand behind its recent strategy, and we think the firm has executed well. Imperial's stated aim is high-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 it 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 U.S., 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 commoditized 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 consumer-test heated tobacco products in 2018.Imperial achieves best-in-class tobacco margins in the mid-40% range, as well as 90%-plus free cash flow conversion, and it 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.