Imperial Tobacco has been a fantastic investment in recent years, with highly addictive products leading to extremely consistent dividend growth.
Not only that, but many investors feel an aversion to tobacco investments and that has kept the shares on a low rating; at least relative to other companies with such impressive growth records. As a result, those who are willing to invest in tobacco have received a higher dividend yield as well as high rates of dividend growth.
The chart below shows how Imperial Tobacco’s dividend growth rate has been consistent in a way that most companies can only dream of.
Today, Imperial Tobacco’s shares can be purchased with a dividend yield of around 4%, which is about the same as the yield on the FTSE 100 (with the index at 6,200). That is despite the fact that Imperial Tobacco’s dividend has been increasing by more than 10% a year while the FTSE 100’s dividend growth has failed to beat inflation.
That impressive record of above average growth may be set to continue thanks to the company’s recent £4.6 billion acquisition of a range cigarette brands and other assets from Reynolds American.
It all sounds very positive, but there are risks.
The chart above shows that revenues have been either flat or declining since the company’s last major acquisition in 2008/9. Back then the acquired company was Altadis, a major Spanish tobacco company, and its purchase cost Imperial Tobacco about £10 billion.
That acquisition was funded partly by debt and partly by a rights issue, which seems sensible enough, but the additional £7 billion or so of debt left the company very heavily indebted and with enormous interest payments.
After the acquisition Imperial set about “releasing value” from the acquired business by improving efficiency and “capturing synergies”. This is partly why profits and dividends have managed to keep going up in recent years even though revenues have gone nowhere.
At some point though efficiencies are maximised and synergies are fully captured. Ultimately, profit or dividend growth cannot be sustained without growing revenues, and that’s where the recent Reynold American acquisition comes in.
This time the acquisition is entirely debt-funded, with new borrowings of £4.6 billion. That takes the company’s total debt pile to just over £14 billion, more than 7-times its profits, which in recent years have averaged about £2 billion.
That is simply too much debt for my liking.
To get to what I would call a prudent level of debt for a defensive sector company (where debts are less than 5-times average profits) its profits would have to increase from £2 billion to about £3 billion. That seems unlikely, even if the additional profits from those newly acquired brands are factored in.
If I wanted to I could put on some rose-tinted glasses and see a bright future for Imperial Tobacco. Interest rates could stay low and its enormous interest payments could remain manageable. It could also pay back those debts and then perhaps makes another debt-fuelled acquisition a few years from now, to once again get around the problem of declining revenues.
When it comes to investing though I prefer to be a pessimist rather than an optimist, focusing on what could go wrong rather than what could go right.
For Imperial Tobacco, a list of things that could go wrong would include rising interest rates, faster declines in revenue, an inability to drive further efficiencies, tightening government regulation and perhaps the widespread take up of “plain packaging” laws, to name but a few.
All of these potential problems would be amplified by the company’s current strategy of using large amounts of debt to buy up other tobacco companies.
As a result, until its ratio of debt to profit comes down significantly, I will not be investing.
The Dividend Drive says
Very interesting post, John.
Imperial’s debt load has been a worry for me as well. Since 2009 they have managed to decrease their debt load by over £2 billion. However, I am unsure that is entirely fast enough especially–as you note–with an additional debt burden heading their way after the recent acquisition. I don’t doubt their ability to manage the debt, merely to extract any effective level of growth with that debt behind them. On the other hand, the deal seems a very sound one which may even make Imperial look even more attractive as the acquired rather than the acquirer!
I have held Imperial since the start of the year but have not topped up (and I am unlikely to do so I suspect) chiefly due to the debt and the general shifting trends. That being said, I am happy to sit on my Imperial shares for now. Their dividend remains robust and growing and they seem able to (along with their peers) manage a structural decline remarkably effectively.
We will see! Thanks for putting the post together.
John Kingham says
Hi DD, my gut feeling is that you’re right; they will handle the debts and the environment will remain helpful (i.e. rates will stay low). But I have my rules and £14bn IS a lot of debt, and you never know. Will be interesting to see how it plays out, as long as Imperial isn’t taken over by someone else before then.
It’s all very real the debt, however, it’s somewhat academic since the fight to consolidation is still ongoing and Japan Tobacco and BATS will have a hard time walking away from IMT once one starts the bidding. which is looking imminent.
It’s probably a good idea to buy into IMT heavily right now since the bid could come within weeks and at £35-36 this will be small beer compared to the £44+ either party will need to pay to get a result. Just like the SabMiller acquisition.
Interest rates will not move fast in the immediate term and even if the bid takes a while to arrive there is a fat dividend in January to collect while you wait.
John Kingham says
Hi LR, you’re probably right. I wrote this piece and only then noticed the talk about an IMT takeover (shows you how well insulated I keep myself from the daily news noise!).
I hate to invest based on bid speculation so I tend to ignore it anyway. So if I thought IMT was good value I would buy it, regardless of the odds or not of an expected bid taking place. But if I didn’t think it was good value then I wouldn’t buy it, also regardless of any expected bids.
Hi John, I’m riding my luck, not a great value investment principle I know, but I got in really early on IMT and having studied the movements in the ciggy industry quite closely, being a holder of Reynolds and BATS, I’m looking at another leg up here. If and when it happens (I’ll give it a few months), I’ll pair some of the gains and look at deploying a goodly amount of the ill-gotten gains (that’s what they are I suppose in this industry) into something else more ethical.
I do have a couple of ethical investments, I try hard to find them. Treatt is one of them, it’s a small company, but could be a long term success in the making, as is Advanced Medical Solutions, another one that I’m backing as a 10 bagger (you don’t get many of these anymore). There you go, I’ve revealed a lot — how useful it’ll be who knows — I’m very confident on the last two. Doesn’t mean I’m right of course — this is the stock market 🙂
It’s getting hard to find the something else isn’t it?
John Kingham says
I’m quite interested in the whole ethical thing, but don’t currently take account of it in my investments.
As for difficulties finding something else (by which I assume you mean attractive opportunities), for me I would say not really. I have a relative valuation approach, so there will always be some stocks that are relatively cheap, some that are relatively average and some that are relatively expensive, regardless of the level of the market (although I think the overall market is actually quite cheap at the moment as well).
I used to do absolute valuations such as only buying stocks below book value, but that was hard once the market moved out of the crash zone of 2009/10 and that’s why I switched to relative valuations. It’s much more flexible but could in theory leave me exposed to holding during irrationally exuberant markets, but we shall see.
The problem with “special situations” like this is owning both the taken over company and the company which takes it over.
It happened to me with SabMiller as I was owing the US brewer as well. Most of the time, what you make on the takeover company you lose on the company that buys it one year later.
Now I own both IMT and Japan Tobacco so I just hope it will not happen. I have sold 2/3 of the IMT holding today. The management of Japan Tobacco (JT) are cautious managers and also JT has some cash available, but I do not think they will overpay for IMT.
However American tobaccos companies could become desperate and borrow to the hilts to get IMT. US greedy investment banks will arrange for them the sale of bonds needed for the aquisition.
The only thing that could stop US tobacco companies is the fact they have many shareholders who own both companies. People like Neil Woodford would not like to end up with a pile of cash and a very indebted company on the other hand.
As John said above at £36 per share, the company seems fully valued if not overvalued. It was time for me to let most of the shares go. I have already made 50%+ on them in the last 2 years. The last thing to do: I have to thank you the investment manager who brought this share to my attention 2 years ago – unfortunately he was not bold enough to own more than 3% in his fund.
John Kingham says
Hi Eugen, I think historically this sort of merger arbitrage has been mostly profitable for those who are willing to do it. It’s not quite my cup of tea though.
As for IMT, it’s certainly had a good run up and is now much higher than when I sold it. But you never know, if none of the rumoured deals go through then perhaps the price will fall to where it’s attractive again.
Michael Broom Smith says
Interesting post but I do think it is a shame that you invest in tobacco companies. Seeing as their profits are gained from a deliberately addictive product that kills the purchaser and that most of its profits are generated off the less than well off in the developing world, I can see no investing case that would justify purchasing shares in a tobacco company.
I know that ethics is a tricky area (for example are supermarkets off limits because they are larger sellers of cigarettes, probably not but I certainly think they should be encouraged not sell them) but for more than any other area the case against investing in cigarettes is so clear, I really don’t think it is a tricky decision at all.
I hope that this post my encourage you to revisit your investment in tobacco.
My quick screen on Stockopedia gives a good selection of solid high yielding stocks to choose from.
Michael Broom Smith
John Kingham says
Hi Michael, as you say ethics is a tricky area. I think the argument against cigarettes can be summarised as 1) they are addictive and 2) they can kill the smoker and even non-smokers who happen to share the same air-space over a prolonged period.
Obviously neither is desirable from a societal point of view and so both factors should (and I assume are?) governed by regulation. I would welcome tighter regulation on both the addictiveness and health impacts, but those factors are not strong enough for me to want to avoid tobacco as an investment.
I smoked from the age of about 15 to 30, although no more than about 10 a day. One day I did a cost/benefit analysis and decided to give up. So giving up is possible, but I do think much tighter regulation on cigarette addictiveness is needed (why is it legal at all? Surely food manufacturers cannot add chemicals to make their products addictive?).
As for the health side effects, they’re a secondary consideration in my opinion to addictiveness. If cigarettes were not addictive then the health benefits wouldn’t be a major issue. People could just give up. Beer, fast food and many other things are just as damaging to your health if you consume them excessively.
The key issue is addictiveness.
As for profiting from poor people in the developing world, that is true throughout many industries (food, clothing, technology, etc) so it is virtually impossible to avoid unless you bend over backwards to do so. This is also a complex issue with many arguments for and against on both sides.
Having said all that, I totally understand why you and many other investors choose to avoid tobacco and other ethically questionable sectors.
I do not have a problem to invest in tobaccos. Compared with many other products and services which are addictive or not, but could damage your heath in a way or another, this product has a risk warning on the front of each packet.
If the product is banned, it will surface on the black market bringing crime with it.
It is a better way to deal with this issue using regulation and raising taxes.
Ethical investing has a negative alpha. The more screening you add, the less will be your investment return.