Buy Imperial for income

True, the tobacco industry is in a state of flux. Declining volumes, contraction in established western markets and a foggy regulatory landscape for next-generation e-cigarettes are just a few of the challenges it faces. But Imperial’s pursuit of the lucrative US market provides it with significant opportunities. As part of the high-profile merger between US tobacco giant Reynolds and Lorillard, Imperial will pay $7bn for the Winston, Salem, Kool and Maverick brands. By doing so, Imperial will push its US market share up to around 10 per cent from its current share of 3 per cent. This should make Imperial the third largest tobacco company in the US. What's more, its acquisition of the blu e-cigarette brand as part of the deal will put it at the forefront of this exciting and fledgling market. Indeed, blu is already the leading US e-cigarette brand, with roughly 50 per cent of the convenience store market already under its belt.

While many see e-cigarettes as the big hope for tobacco companies, Imperial is saying pro-active with its traditional tobacco business in the meantime. This year it dropped costs by £60m and says it’s on track to save a total of £300m by 2018. What's more, the partial float of its non-core, European logistics business Logista on the Spanish stock exchange in July generated £395m, which went directly towards paying down company debt. Overall debt fell by £1bn in the year to the end of September. Imperial still owns about 70 per cent of Logista and therefore stands to benefit from any upside from shares in the highly cash-generative business - the shares are currently 10 per cent ahead of their €13 float price.

Imperial should also now stand to benefit from a recently completed stock optimisation programme, which weighed on volume, revenue and profit growth last year. The programme should improve Imperial's long-term supply stream by reducing the level of stock held by distributors in certain markets. With the programme complete, there will now be more cash to invest in future growth, and Imperial says it's a 'stronger business' going into 2015.

Until the Reynolds/Lorillard merger completes, which subject to regulatory approval should be in the early part of next year, Imperial’s business seems to be chugging along. Many tobacco companies are facing challenging conditions in established western markets where regulatory and consumer sentiment is largely against them. But last year Imperial did well in Australia, as well as Germany, Portugal and the Ukraine which made up for weaknesses in Spain, France and parts of North Africa.

Meanwhile, Imperial is also doing well in its 'growth markets', which are regions in which it thinks it can substantially boost its market presence as well as, in many cases, offering favourable market conditions. Last year, its share in "growth markets" there rose a modest 10 basis points to 5.8 per cent, volumes rose 11 per cent and underlying net revenues jumped 7 per cent. As well as the US, "growth markets" include Iraq, Saudi Arabia, Taiwan, Cambodia and Vietnam among others.

But the regulatory outlook for both e-cigarettes and traditional tobacco is a source of uncertainty. The World Health Organisation (WHO) has warned side effects from electronic devices cause similar damage to traditional tobacco products (both to smokers and passive bystanders). By contrast, the FDA released a surprisingly lenient set of initial guidelines despite its tough stance on regular cigarettes.