EUR 850.00 For Business Accounts Only

Morningstar | Investors Maul Imperial Over NGP Revenue Miss; Sentiment Low but Material Value Exists

Investors reacted negatively to Imperial Brands' results for the first half of fiscal 2019, but we think the gap down is an overreaction and an indication of how the market is punishing every piece of bad news in the out-of-favor tobacco sector at present. Results were broadly in line with expectations, and we assume the market is concerned with the NGP revenue miss which implies that full year guidance of 1%-4% constant currency revenue growth is now unlikely to be attained at the high end of that range. This is immaterial to the intrinsic value of the stock, however, and we are reiterating our GBP 37 fair value estimate. We believe tobacco stocks, and Imperial in particular, are significantly undervalued, although it seems investor sentiment will have to improve for the upside to be realized.

First-half constant currency revenue growth of 2.5% was not brilliant, and it narrowly missed expectations, but it is no worse than some other lower-margin large-cap consumer product companies currently trading at materially higher multiples. In fact, 4% organic growth in both the Europe and Americas segments, which in aggregate account for three quarters of Imperial's net revenue, is respectable, and driven by strong price/mix. On the other hand, tobacco volumes in the Africa, Asia, and Australasia segment fell 10%, steeper than our forecast, and pricing was insufficient to offset the decline. Divisional tobacco net revenue fell 4.5% on a constant currency basis in the first half. Management indicated that the volume decline may have been exaggerated by shipment timings, so it seems likely that the market was reacting to slightly disappointing NGP revenue growth. Reported NGP net revenue of GBP 148 million missed the company-compiled consensus estimate of GBP 176 million. The differential is less than 1% of first-half net revenue. Nevertheless, it may highlight the difficulties of capturing share in a competitive market with lower barriers to entry than cigarettes.

Management stated that it had taken steps to address a lack of penetration in the vaping shop channel, but underwhelming growth in the U.S. vaping category could also imply that Juul remains difficult to dislodge as the market leader, despite recent regulatory tightening by the FDA.

Imperial this month launched a city trial of Pulze, its heated tobacco product, in Fukuoka, Japan. It will likely be several quarters before a national rollout has an impact on the financial performance of the business, and we do not harbor ambitious hopes for the brand. Category share has plateaued at around 20% in Japan, and Philip Morris International's iQOS is the clear market leader. As a late entrant to the market, we expect the Pulze devices to be barely profitable, which will weigh on margins. However, any market share gained will likely be entirely incremental to Imperial. West has performed well in recent months, but Imperial's share in Japan remains a little over 1%. Therefore, even small share gains could provide some relief to the weak volumes seen in the region in the first half.

Other metrics relevant to our investment thesis were generally in line with expectations. The tobacco and NGP adjusted operating margin of 42% was around 150 basis points below last year, but was depressed by investments in My Blu, while Imperial remains on track to achieve 90% cash conversion this year. The board approved a 10% dividend increase, and with the stock now trading at an annualized dividend yield of 9%, we believe shareholders will be paid to wait for market sentiment around tobacco to turn.