Tobacco stocks are seriously out of fashion. Many investors see them as ethically dubious. There’s also the underlying reality that the market for traditional cigarettes is in long-term decline.
Shares in the two main UK-listed tobacco companies have fallen by about 20% over the last year, even though their profits have remained stable.
My top pick from this sector is FTSE 100 firm Imperial Brands (LSE: IMB), which is now trading with a 2019 forecast dividend yield of 9.9%. In this article I’m going to take a look at the risks and potential rewards for investors and explain why I’ve recently bought more shares in this company.
What could go wrong?
When the market prices a profitable FTSE 100 stock with a 9.9% dividend yield, the message is unmistakeable: this payout may not be sustainable.
So why might Imperial boss Alison Cooper be forced to cut the dividend? I can see a couple of reasons.
Smoking decline: Tobacco stocks fell suddenly at the end of May after reports that US smoking rates were falling faster than expected.
Imperial says that the rate of decline this year is expected to be 4.5% to 5%, broadly unchanged. The firm says it’s gained some market share over the last six months. It’s hard to say at what point declining smoking volumes will start to hit profits — a lot depends on the uptake of new alternatives such as vaping and on smoking rates in emerging markets.
Debt: Imperial has a lot of debt — net debt was £13bn at the last count. Although interest costs and the dividend have been consistently covered by free cash flow in recent years, the firm’s generous payouts haven’t left much capacity for debt reduction.
This has now become a key area of focus for the firm, which is aiming to raise £2bn through asset sales by May 2020. So far, progress has been limited. The latest results show that just £280m from divestments. However, press reports have suggested that IMB’s premium cigar business, which is currently for sale, could fetch upwards of £1bn.
The May 2020 deadline is significant because the group has more than £7bn of debt that will need to be repaid or refinanced between May 2020 and May 2022. I suspect Ms Cooper is keen to reduce the group’s borrowing levels before that time, in order to cut borrowing costs and protect the group’s investment-grade credit rating.
Why I’ve been buying
There are some valid reasons to be cautious about investing in Imperial. But I think that there’s a good potential opportunity here.
In the meantime, sales of next-generation products such as blu vapes rose by 245% to £148m during the six months to 31 March. Rising revenue from such products is now starting to offset falling revenue from tobacco.
Operating profit margins for the group remain high, at more than 30%. With the shares now trading on just 7.5 times forecast earnings, I think a lot of the risks are reflected in the price. Even if the dividend is cut, it’s worth remembering that a 50% cut would still give a yield of almost 5% — above the FTSE 100 average of 4.5%.
In the meantime, IMB’s 9.9% yield has a firm place in my portfolio. I continue to view the shares as an income buy.