Imperial Brands: Short-Term Risks Could Be Overstated, but Long-Term Outlook Is Grim

Imperial Brands' (IMBBY)  restructuring hit ahead of new EU rules on cigarette sales overshadowed solid full-year earnings Tuesday but some investors may be ignoring underlying strengths in the world's third-largest tobacco firm.

Shares in the owner of Kools and Blu e-cigarettes fell 2.55% by mid-day in London, making it the biggest decliner on the benchmark FTSE 100 index as market share losses, a £750 million restructuring charge and the looming implementation of plain-packaging regulations across parts of Europe eroded sentiment.

But investors might be overestimating the impact of a push toward mandatory plain-packaging in Europe and underestimating longer term tax-driven affordability risks in some key markets.

Imperial delivered an in-line performance against consensus for the full-year: net revenues were up 9.7% in constant currency terms, at £7.16 billion ($8.9 billion) while adjusted operating profit jumped 16.1% to £3.36 billion. 

But Imperial lost 50 basis points of market share in its 'growth markets' and also said it experienced further share losses in the U.K. and Germany and management booked the £750 million restructuring charge in its effort save £300 million per year and fund future investment. 

"We have established an excellent platform for sustainable quality growth, which will continue to provide growing returns for shareholders," CEO Alison Cooper said.

The frosty response from investors comes as the U.K., France, Ireland and other European nations gear-up to make plain-packaging mandatory for all cigarette sales next year - a move feared by firms given that it could restrict their ability to build and market brands.

The EU's Tobacco Products Directive will limit the sale of cigarettes to quantities of twenty or more from May 2017 and outlaw the sale of menthol and other flavored tobacco products from 2020.

Imperial has the most exposure to the U.K., Europe and pending regulatory changes of the two U.K.-based tobacco giants, according to Factset data, with Continental sales accounting for more than 50% of total revenues, considerably more than the 31% at rival British American Tobacco (BTI) .

But the potential impact of packaging measures may be over-stated by investors.

Australia, the only other country to have implemented plain-packaging, saw cigarette sales volumes decline by an average of 3.5% between implementation in 2012 and the end of 2015.

However, the ban came during a period when the government also hiked excise taxes by a total of 75%, nearly doubling the cost per-packet and making it difficult to determine how much of a deterrant plain-packaging really is.

That said, in the longer term, tax hikes themselves could become more of a pressing problem for tobacco firms. 

Alan Erskine at Credit Suisse recently flagged that tobacco consumers in the U.K. now spend an estimated 15% to 20% of their disposable income on cigarettes, before saying; "In our view this represents something of an affordability ceiling."

In addition to creating pressure on volumes, increased taxes and the resultant down-trading have led to a proliferation of brands in the 'value-segment' of the market, where Imperial has a considerable portion of its exposure. 

According to Credit Suisse estimates, this value segment now accounts for 23% of all U.K. sales, but with this growth has come new threats - to margins and growth over the longer term.

Erskine projects that earnings growth at Imperial Brands could lag that of its primary competitor, BAT, by some 5% annually over the medium-longer term, given its heavy U.K. and Europe exposure.

"This differential is wider than we had previously assumed and in our view warrants a wider PE discount than Imperial's current 11% versus the BAT," he concludes.

A viable escape for Imperial would be to grow in markets where there is a less hostile regulatory regime. But it already missed a trick with Reynolds (RAI) , who it bought most of its U.S. assets from in 2015, and which is now in the process of being taken over by BAT. 

In a world where the profit pool is shrinking and the industry is beginning to cannibalize itself, does Imperial become the hunter or the hunted? 

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