I believe that Imperial Tobacco Group (LSE: IMT) is skating on increasingly thin ice, prioritising short-term shareholder returns at the expensive of long-term prudent financial management.
In this article, I’ll explain why.
Falling volumes
It’s no secret that overall volumes are falling in the tobacco industry, but the scale of the decline might surprise you.
Imperial’s total tobacco volumes fell by 2.7% in 2012, 7% in 2013 and have fallen by 5% during the first quarter of this year, compared to the same period last year. In any other business, this would be a serious problem, but for tobacco firms like Imperial, which reported an adjusted operating margin of 42% last year, it’s business as usual.
Imperial has managed to grow its revenue and profits in the face of falling sales by boosting prices and cutting costs, while earnings per share have been boosted by a rolling £500m per year share-buyback programme. Regular government duty increases in many developed markets make it easy for tobacco manufacturers to increase prices, without smokers complaining.
Despite this, Imperial’s net revenue from tobacco sales was flat last year, at £7bn, as was the adjusted operating profit from its tobacco division, which was unchanged at £3bn.
Pushing the limits
Imperial’s cash flow is being stretched tight by its obsessive focus on shareholder returns, and I’m concerned that this might lead to a cash crunch.
Overall, Imperial generated operating cash flow of £2,352m in 2013, of which just £316m was spent on capital expenditure, leaving £2,036m for debt repayments and shareholder returns.
Although this is a generous amount by any standards, it wasn’t enough for Imperial — total dividend, interest and share buyback costs came to £2,106m, while borrowings increased.
More than £3bn of Imperial’s borrowings are due for repayment this year, and while I suspect they will be able to refinance these at attractive interest rates, I believe the firm’s management should be taking a more prudent approach. Imperial’s net gearing is a whopping 166%, and I believe this should be reduced to a less demanding level, while the firm is flush with cash.
A better alternative?
Imperial’s high debt levels mean that its shares aren’t as cheap as their forecast P/E 12.1 might suggest. Imperial’s interest payments swallowed 22% of its operating cash flow last year, and in my view, this figure is likely to rise, unless money is diverted from shareholder returns to debt reduction.