Imperial Brands: Capitulation On Dividend And Next Gen Products
Summary
- FY20H1 results disappointed with a 9.2% EPS decline, and management finally cut the dividend and scaled back Next Gen Products plans.
- Despite COVID-19 consumer stockpiling, Tobacco net revenues were only up 0.9%, with a price/mix that was much lower than in prior years.
- Next Gen Products saw revenues fall 43% as they failed to gain traction, and efforts in both e-vapor and heat-not-burn are being reduced.
- Fears about Imperial Brands' poor cigarette markets and Next Gen Products are materialising; FY20 EPS is guided to fall mid-single-digits.
- At 1,530p, while the valuation is superficially attractive, there are deep strategic challenges that are difficult to be offset by the share price.
(We previously wrote about tobacco stocks as "Blue Sky Capital")
Introduction
Imperial Brands (OTCQX:IMBBY) (referred here as "IMB") announced their FY20H1 (ending 31 March) results on Tuesday morning, and shares in London are down 7.4% as of 2 pm local time. Since we initiated our Neutral rating on IMB in July 2019 ("Imperial Brands: Worst of the Big 4 Tobacco Stocks"), the shares have lost 12.0% of their value (in pounds, after dividends), far underperforming its U.K. comparable British American Tobacco ("BAT") (BTI):
| IMB Share Price vs. BAT & FTSE All-Share (Since 02-Jul-19)
Source: Yahoo Finance (19-May-20). |
We believe the FY20H1 results were noteworthy in showing poor recent trading and guiding to a worse second half, and also in management finally capitulating on IMB's dividend and Next Gen Products ("NGP") plans.
Poor H1 Results & Dividend Cut
The key P&L items for IMB's FY20H1 are shown below. For the half-year, Tobacco & NGP EBIT fell 8.5% year-on-year excluding currency, and Distribution EBIT fell 4.9%, leading to adjusted EPS falling 9.2%:
| IMB P&L (FY20H1)
Source: IMB results press release (FY20H1). |
Poor earnings and a persistent high net debt (which actually rose year-on-year) contributed to management's decision to “rebase” the dividend by cutting it by a third, and redirecting the cash to debt repayments.
Management attributed almost the entire decline in group adjusted EBIT in FY20H1 to NGPs, which suffered higher trading losses, inventory write-downs and impairments. However, the Tobacco-only EBIT still showed a £12m year-on-year decline, as the low (0.9%) revenue growth was outpaced by operating cost growth. Note also that these figures are after an 1% benefit to group profits from COVID-19-related stockpiling and a stock profit in Australia; the real decline in Tobacco EBIT was likely worse than the £12m figure:
| IMB Group EBIT Evolution (FY20H1)
NB. “Distribution” shown as a positive profit driver due to lower eliminations than prior-year, which included more IMB NGP. Source: IMB results presentation (FY20H1). |
Weakness in Tobacco
The performance of IMB's Tobacco and NGP businesses is shown below:
| IMB Tobacco & NGP Volume, Revenues & EBIT (FY20H1)
Source: IMB company filings. |
IMB's year-on-year volume decline of 0.5% was actually reasonable when compared with Altria’s (MO) 1.6% decline and Philip Morris' (PM) 3.2% decline (including Heated Tobacco Units; otherwise 6.3%) for the same 6 months. However, this came with a much lower price/mix of +1.4% for the group. The low price/mix means Tobacco-only revenue only grew 0.9% year-on-year (ex. currency) for the group, including up 0.5% in Europe and flat in Americas.
These price/mix figures were significantly worse than prior years, which was +6.5% in FY19H1 and +5.7% in FY18H1:
| IMB Price/Mix by Region (FY20H1 vs. PY) (ex. FX)
Source: IMB company filings. |
Price/mix figures by region were similarly unimpressive, being at +3.5% in Europe and +2.5% in Americas, and a negative -1.1% in Africa, Asia & Australasia. The deterioration in Americas was particularly significant, as price/mix was +9.8% in FY19H1 (and, in FY18H1, it was +11.7% for the U.S. under a different regional organisational system). Factors cited by management to explain FY20H1's lower price/mix included adverse mix in markets (e.g. German private label) and in products (e.g. U.K. downtrading).
These datapoints reinforce our fear that IMB's exposure to mostly mature cigarette markets means it is likely to face stronger headwinds than peers.
The risk to IMB's cigarette business is heightened by the continuing progress of Heated Tobacco Units ("HTU"), which we believe to be the best substitute for cigarettes for existing adult smokers. As we described in our review of Philip Morris' 20Q1 results, their IQOS product has reached double-digit share of the tobacco market in many cities in Eastern and Southern Europe (Europe is about half of IMB's tobacco and NGP profits):
| Philip Morris HTU Off-Take Share in Key Cities (20Q1)
Source: PM results presentation (20Q1). |
Retreat from NGPs
During FY20H1, IMB’s NGP revenues continued their sequential decline in both Europe and Americas; they also fell in Africa, Asia & Australasia after a strong FY19H2. Part of the revenue decline came from de-stocking, and IMB wrote down inventory in U.S. favours (now banned by the FDA) and other products:
| IMB NGP Revenues by Region (FY18-20H1)
NB. Figures as reported, and include the impact of currency. Source: IMB company filings. |
We believe IMB's NGPs remain uncompetitive. In e-vapor, BAT data shows that IMB has remained far behind BAT and Juul in key markets such as the U.S. and the U.K. (see below); in heat-not-burn, Philip Morris continues to dominate the market in Japan, with BAT a distant second, and IMB even further behind.
| U.S. E-Vapor Market Share by Value
Source: BAT investor day (Mar-20). |
| U.K. E-Vapor Market Share by Value
Source: BAT investor day (Mar-20). |
With FY20H1 results, IMB management announced they have “right-sized our NGP investment”, and that “investment in vapour has been significantly scaled back”. The strategy is now “prioritising tobacco”, including refocusing resources to defend this business in priority markets. Within NGPs, IMB will focus its investment in areas with quicker payback, which means less spending on heat-not-burn or on e-vapor customer groups that are expected to be "less loyal".
IMB was never likely to be a winner in NGPs, as it had spent less money and started later in the game, once it had allowed Lorillard's blu to fall behind after IMB acquired it. However, with most of IMB's competitors pushing e-vapor and/or heat-not-burn products in the U.S. and Europe, the risk to IMB's existing cigarette business is high.
Mid-Single-Digit FY20 EPS Decline
As part of FY20H1 results, management guided down expectations on FY20 EPS, from the 2% (ex. currency) decline implied by consensus estimates to a potential mid-single-digit decline, citing the potential impact of COVID-19 on downtrading, on its travel business, and on its production; sale of the premium cigar business and IP asset write-down will subtract 1% from EPS growth:
| IMB FY20 Outlook Comments
Source: IMB results presentation (FY20H1). |
Valuation
At 1,530p, relative to last-twelve-month (ending 31 March) financials, IMB trades at a P/E of 5.9x and a Free Cash Flow ("FCF") Yield of 13.9%:
| IMB Net Income, Cashflow & Valuation (FY17-20H1A)
Source: IMB company filings. |
The Dividend Yield is 9.0%, taking the rebased dividend of 137.7p per share. Management stated IMB will follow a "progressive" dividend policy.
IMB's net debt of £13.5bn is almost as large as its market capitalisation (£14.5bn). Net Debt / EBITDA likely stands above 3x. The approx. £1bn proceeds from the sale of the premium cigar business will be used to pay down debt and reduce Net Debt / EBITDA by 0.2x. Management further expects to spend substantially all of its post-dividend FCF on debt repayments, and will take until the end of FY22 to reach the target 2.0-2.5x range. (So there will not be any share buybacks until then.)
While the valuation seems superficially attractive, we believe IMB faces deep strategic challenges that are difficult to be offset by the share price.
Conclusion
IMB's FY20H1 results were disappointing, with EPS falling 9.2% (ex. currency), dividend being cut by a third and management scaling back their NGP plans.
Our longstanding concerns about IMB's mature cigarette businesses and its poor NGP line-up are materializing. We believe that the mid-single-digit EPS decline guided for FY20 may just be the start of more protracted declines.
At 1,530p, the valuation is superficially attractive, but IMB faces deep strategic challenges that are difficult to be offset by the share price. We would continue to avoid this stock, and re-iterate our Neutral rating.
Note: A track record of my past recommendations can be found here.
This article was written by
Disclosure: I am/we are long MO, PM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.