Imperial Brands has an 8.3% yield – but what’s the catch?

On the face of it, Imperial Brands (LSE: IMB) looks to be one of the most attractive income stocks in the FTSE 100.

Refinitiv analyst estimates have the company paying a dividend per share of 140p for 2022, giving a prospective dividend yield of 8.3%. What’s more, the stock also looks cheap, trading at a forward price/earnings (p/e) multiple of 6.9. But investors shouldn’t take these figures at face value.

Based on these numbers, Imperial is around 50% cheaper than the FTSE 100, (the index has an average p/e ratio of 14.1) which in my view is a red flag. It suggests investors have almost given up on the business, doubting its ability to achieve sustainable earnings growth and create value for shareholders. 

I certainly don’t have to look far to find evidence to support the conclusion that Imperial Brands is struggling to build value. 

Net income excluding extraordinary items has barely budged since 2014. Net income did jump in the financial year ending September 30, 2021, although this was mainly down to a favourable financing charge. Excluding this positive development, adjusted group operating profit rose just 0.5% after stripping out the contribution from the now sold cigar division. 

The dividend cut hurt sentiment towards Imperial Brands

As Imperial’s peers, British American Tobacco (LSE: BATS), Philip Morris, Altria and Japan tobacco have become known the world over for their cash flow and dividend credentials, Imperial itself has struggled. In order to meet investor concerns about the overleveraged state of its balance sheet, the firm cut its dividend by a third in 2020.

This cut rebased the dividend to a more sustainable level. In the four years prior, dividend cover averaged just 0.6. To put it another way, Imperial Brands had been consistently paying out more than it could afford. 

In my opinion, the company‘s decision to slash its dividend by a third was the right one. It had been bridging the gap between profits and dividends with borrowing, straining its balance sheet. A lower payout will not only help the business to cut borrowings, but will also help the group deal with rising interest rates. 

At the end of March, the FTSE 100 company’s net debt to earnings before interest, tax, depreciation and amortisation (Ebitda) ratio was 2.4 times, at the higher end of management’s target of between two and 2.5 times. Once leverage has been brought sustainably under control, management has said that it will look to return any additional capital to investors. 

Unfortunately, I think Imperial’s lack of growth and decision to slash its dividend in 2020 decimated investor confidence.

That’s one of the reasons why the stock has struggled to move higher over the past decade. It could also explain why the market does not seem to have much confidence in its current dividend and valuation. 

Still, the company’s management is pushing on with its transformation strategy and 18 months in, Imperial is entering the “strengthening phase”. In this phase the FTSE 100 tobacco giant aims to develop and reinforce its position in its main markets, namely the US, UK, Australia, Spain and Germany. In the six months to the end of March, the company increased its market share by 25 basis points in these primary markets, a notable development after an extended period of underperformance.

The business also wants to capitalise on its position as a relatively small challenger brand. Unlike its larger peers, such as Philip Morris, it can move swiftly to capitalise on market trends in different markets. 

For example, the company has launched new value cigarette brands in Spain and Australia while developing new so-called next-generation products, the category that includes e-cigarettes, heated tobacco and snuff products. During the six months to the end of March, adjusted operating losses from next-generation products improved by 50%. 

Imperial Brands is making progress, but it has lots of work to do 

Falling debts and market share growth are both positive developments for the FTSE 100 company. However, as Imperial has disappointed so many times before, I’m really struggling to see how it could be different this time round.

Imperial faces much stronger competitors in its key markets, including Philip Morris and Altria, which own the rights to the Marlboro brand internationally and in the US respectively. In another market, Australia, it is also facing pressure from regulators in what is becoming one of the most tightly-controlled tobacco markets in the world. 

Then there is the prospect of additional regulations in the UK and across Europe. As these are Imperial’s key growth markets, there is a significant threat to its operating business. 

Granted, the prospect of a regulatory crackdown is a threat all operators in the tobacco sector have to deal with. But British American, Altria, Philip Morris and even Japan Tobacco have stronger balance sheets, more diversified international footprints and stronger brand portfolios than Imperial Brands. 

That’s why I hold British-American in my portfolio, even though it is more expensive and has a lower dividend yield than its smaller FTSE 100 peer. I’m planning to steer clear of Imperial until the company can prove it’s on a sustainable growth trajectory. 

Disclosure: Rupert Hargreaves owns shares in British American Tobacco.