Imperial Brands: A Weak Pulze

It has been quite an eventful year for tobacco purveyor Imperial Brands. Not only did Imperial cut its dividend for the first time ever as a public company, but it also saw a nearly complete overhaul of its senior leadership. Long-time CEO Alison Cooper has made way for Stefan Bomhard, formerly of Inchcape, and new appointments of a chief financial officer and a chief consumer officer were also recently made. 

In addition, the company has finally managed to close the long-awaited sale of its premium cigar business to a consortium of buyers from Asia. The sale of the premium cigar business was part of former management’s commitment to raise approximately £2 billion from asset sales, the proceeds of which were intended to strengthen the balance sheet and to put additional investment behind next generation products such as vaping devices and heated tobacco products.

The fact that the company fell substantially short of its divestment target is but a minor example of its failure to deliver on promises under former CEO Alison Cooper. When pressure from disgruntled investors started building a couple of years ago, there was little room for more disappointments. 

When the company’s US vaping sales were caught up in the fall-out from the EVALI uproar and the FDA’s subsequent crackdown on vaping products, Alison Cooper did not have enough credit left to ride out the storm. One week or so after the company warned on profit in the fall of 2019, the CEO’s departure was announced.

A man with a plan

More than a year later the company’s new CEO has recently presented a new strategy, which he believes will set Imperial Brands on the right track again. In my opinion, the new management team offered a very clear analysis of the company’s current shortcomings, which they primarily relate to its lack of a data-driven marketing approach, insufficient focus on key markets, and the distractions caused by next-generation products. As indicated in the presentation below, too many times in the past business decisions have been made without sufficient data to back them up, leading to subpar performance and significant market share losses in many markets.

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Key items detailing the new team’s assessment of past lackluster performance

Management’s analysis of Imperial’s business failures was followed by a detailed plan for how they will seek to improve the company’s marketing operations, and how this will gradually improve the company’s performance. The plan they shared was quite detailed and, as far as I can tell, it should be within the new management team’s capabilities to execute on it. Yet for me, the thoughts that lingered were not related to the plan on how to get the combustible business back on track, but rather the question of how the company intends to move forward with regard to next-gen products. And how difficult it will be for them to close the gap with its competitors.

If the world of tobacco was anything like it had been for decades, the plan management presented might well have met a more welcoming reception from investors. Instead, Imperial’s share price has languished near multi-year lows as investors were left to contemplate whether the new strategy will put the company back on track. In my opinion, navigating Imperial out of its troubled state and onto a more rewarding course will be a tough process for two reasons: 

  1. its development and commercialization of next-gen products is lagging significantly behind all of its major competitors
  2. turning the focus back to cigarettes and fine cut tobacco may deliver better economic results in the medium term, but goes against society’s decreasing acceptance of cigarette products

Regarding the first issue; Imperial Brands is so far behind the competition in next generation products that a significant consolidation of its efforts in vaping products has been deemed necessary by its new management. The leadership team under Mr. Bomhard intends to focus on a smaller number of vaping markets going forward, while keeping its oral nicotine products focused on markets with a preexisting habit of oral nicotine consumption. 

CEO Stefan Bomhard has referred to the  company’s blu vaping products as having previously been expanded too quickly, into too many markets, and without proper insights on consumer needs. The implication of this observation seems to be that these products are failing to gain significant traction in the marketplace, racking up substantial losses for Imperial, while lacking a clear path to profitability.

Retrenchment in next-gen may be the most obvious option available to the company, but admitting this has also highlighted Imperial’s NGP weakness. And while its larger competitors are racing to launch more new products into more markets, Imperial is proposing to move largely in the opposite direction. This  can only mean that the new management team has recognized how weak the hand is they are playing in these new categories. And although the decision might seem rational, the question investors should ask themselves is why they would want to join this management in playing a weak hand?

Imperial’s weak Pulze

Imperial’s heated tobacco product seems to be in even worse shape than its vaping products, where the company at least has a widely-recognized product in the market. Mr. Bomhard has referred to the heated tobacco product as showing promise, and having received too little prioritization under previous management. It is important to note that Imperial’s Pulze tobacco heater and accompanying tobacco sticks have barely put a dent into the Japanese market, which is currently the most important market for this type of product.

Compare this with Philip Morris’s IQOS product, which already has a presence in some 65 markets, or British American Tobacco’s Glo, which is currently present in 17 or so markets. When we add Japan Tobacco’s hnb product Ploom and KT&G’s lil, both of which currently have fairly limited but still meaningful geographic footprints, the inevitable conclusion is that Imperial is at best contending for a fourth or fifth place in this growing segment. 

Contending for fourth place is usually not a great position in any consumer product category but, given the unusual economic returns of the tobacco business, being a moderately sized contender has historically been a more than decently profitable position. It is not at all clear that this would be true for heated tobacco products as well. 

The amount of R&D dollars that Philip Morris has already spent on developing and commercializing IQOS strongly suggests that only those companies with significant market positions will be able to afford the expenditures that are required to develop and scale a successful heated tobacco device and still make a good return on investment. Aiming for fifth place, which in my opinion is really all Imperial can hope to achieve in this segment, is therefore a business strategy with a highly uncertain payoff.

Feeling blu

Imperial will likely withdraw its blu vaping products from certain countries where there is either poor demand for vaping products or blu currently holds a weak position. Instead of spreading its operations far and thin, as it did under Mrs. Cooper, from now on Imperial will focus on those markets that are already well-developed or show a very promising outlook. Consolidating its efforts on just a few important battlegrounds, such as North America and Northern Europe, seems sensible as these markets currently account for the overwhelming majority of vaping sales (outside of China). Gaining a strong market position in these markets will be key to building scale and a profitable business.

However, it is not a foregone conclusion that Imperial can turn its chances around, even if it is competing in a smaller number of markets. Imperial’s vaping products business is in particularly urgent need of improving its position in the US, a market where blu has long been an established player. In recent years the brand has lost a lot of ground to competitors Juul and Vuse though. Imperial’s pods-based vaping product MyBlu is estimated to currently hold a #4 position, at a very substantial distance to the dominant players. Stefan Bomhard has blamed the poor development of blu’s position in the US in part on insufficient retail support, and disruptions caused by the transition from Lorillard’s sales force, its previous owner, to ITG’s sales network (ITG is Imperial’s US subsidiary). 

The problem is that, even if Imperial increases sales support for blu and manages to increase its retail distribution, blu will likely still operate at a substantial disadvantage. Market leader Juul enjoys the benefits of its size in the market, and also has ties to the market leader in US cigarettes, Altria. Number 2 Vuse is owned by Reynolds, BAT’s US subsidiary, which occupies a strong number 2 position in US cigarettes, and benefits from its tobacco sales force. ITG on the other hand, has a weak number 3 position in US cigarettes, which means blu is unlikely to ever match its competitors’ strengths in distribution.

Another point of weakness is the fact that vaping is more of a scale business than conventional tobacco is. Just like heated tobacco devices, the amount of R&D expenditures involved in the development and marketing of vaping products is quite significant. The dominant players will increasingly benefit from their ability to charge large R&D and marketing expenditures against a much larger number of devices and refills sold, and will therefore benefit from having lower marginal product costs. Those savings can be put to productive use in regulatory compliance for instance, to an extent smaller competitors like blu simply cannot match.

Tobacco in an ESG world

While innovation is a very important driver of economic value (and value destruction) in any economic activity, the tobacco industry does not solely have an economic reason for innovating and trying to move beyond combustible products. It also has an increasingly urgent social acceptability problem with regards to its traditional business. The serious health consequences of tobacco consumption mean that tobacco stocks are increasingly avoided by investors looking for a financial as well as a social return on their capital. 

The rise of purpose-driven investment has been quite profound in recent years, in part because of increasing concerns over environmental impact, and is usually referred to as ESG (environment, social, governance) investing. With regards to tobacco companies this trend can be witnessed clearly in the increasing numbers of signatories to such initiatives as Tobacco Free Portfolios, which is a pledge institutions can sign to divest all tobacco-related investments from financial portfolios.

The decline in social acceptance has gone hand in hand with increasing regulation, thereby casting doubts over the tobacco industry’s future. While the industry has, from an economic standpoint, generally been quite effective in navigating these challenges, the risk of regulation has in recent years had quite a detrimental impact on public tobacco company valuations. The combination of decreasing social acceptance and increasing regulatory risk make the effort to develop products that are less harmful not just a matter of thriving in a competitive market, but also of earning a ‘license to operate’ from society. 

It is quite evident in today’s market that companies with rapidly increasing sales of ‘reduced-risk’ products, such as Swedish Match and Philip Morris International, are valued at substantially higher multiples of earnings than companies that have been slower to move in this direction. Imperial Brands unfortunately fits in with the latter group; fixing its conventional tobacco business may make perfect sense, but if society becomes even less forgiving towards its main business, it may not lead to an much improved share price at all.

Disclosure: the author owns shares of British American Tobacco.

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