Imperial Tobacco published its preliminary results on November 5th, with the news that its dividend would go up by 10%.
That’s a nice increase, and it’s in line with the company’s policy to increase the dividend by 10% each year over the medium term. With the shares around 2,350p, the dividend yield is close to 5%, so are these shares a buy, a hold or a sell?
Let’s say Imperial Tobacco increases its dividend payments by 10% a year for the next five years. At that point, the dividend would be 187p which, if the share price remains unchanged, would make the dividend yield almost 8%.
If the dividend does increase at that rate, an investor today is either going to get a very good dividend or, what I think is more likely, the shares will appreciate as the dividend goes up.
That’s a nice fantasy, but does it have any basis in reality? Does Imperial Tobacco really have the ability to grow its dividend at 10% a year?
A solid dividend growth record
One of the best ways to see if a company has the potential to pay a consistently growing dividend is to just look at the past. If the company hasn’t already got a history of consistent dividend growth, then it’s reasonable to assume that it may not be able to produce one in the future.
The chart above shows how Imperial’s revenues, earnings and dividends have grown over much of the past decade. The important bit for now is that Imperial has a 100% record of dividend growth in every one of those years.
It hasn’t been slow growth either, with the dividend growing at almost 12% each year, far and away above inflation. Another reason to be cheerful is that the dividend has been covered quite comfortably by earnings.
A more prudent check is to look at cash flows compared to dividend payments, and here, once again, Imperial’s dividend seems to be well covered. In the period above, Imperial’s total free cash flow has been more than double the dividends paid out. The dividend was also covered by free cash flow in every one of those years, so there appears to be no shortage of cash to pay out to shareholders.
So the company’s past history of paying a sustainable and growing dividend is about as good as you’re likely to find, but what about the future?
It is a defensive business, but there are no guarantees
As a tobacco company, Imperial has a relatively captive audience who tend to smoke the same brand for many years. At the same time, smokers don’t usually quit just because there’s a recession, so the company’s cash flows are little affected by minor things like a global financial crisis, as the dividend history shows.
But just because smokers will continue to smoke for the foreseeable future, it doesn’t mean that Imperial will just magically produce the results that it wants. Times are tough, and recessions do have an impact if they are bad enough. Australia now has plain packaging, and the idea is spreading (although revenues and profits were still up in Australia, despite that restriction).
However, my guess (and it can only ever really be a guess, however educated) is that Imperial will continue to grow dividends at their 10% target, and if they don’t, it won’t be far off that level.
Simply (one of) the best
With a current yield of 5% and the prospect of a 10% annual increase in dividends, not to mention the relatively safe and defensive nature of the company, Imperial looks attractive. But is it? Just because an investment looks good, it doesn’t automatically mean it’s a good buy.
There are hundreds of other companies out there, so it isn’t just how good Imperial looks in isolation, but how it compares to all the other options that are out there.
This is a key part of my own investment process, and it’s why I set up a defensive value stock screen a few years ago, which now has an online and interactive version too. It compares a variety of key factors like growth rates and growth “quality”, along with price-to-earnings and dividend ratios, which are adjusted to remove the vagaries of the business cycle.
Today, Imperial currently ranks at number 17 out of the 219 companies that I track, all of which have consistent records of dividend payments over a number of years.
So even among this group of consistent dividend-paying companies, Imperial stands out as an above-average company at a below-average price. That’s why, at 2,350p, I would definitely be a buyer.
Disclosure: I already own shares in Imperial, so I won’t actually be buying today, but if I weren’t, I would.
Disclaimer: As I’m sure you’re aware, this is just my opinion, so please do your own research before making any decisions.
I have held this in my ISA for the past couple of years and, as you say, there are few to match its dividend pay-out record – although the cover seems to be reducing in recent years.
I also hold quite a few income investment trusts, many of which also hold IMT in their portfolio, so I just need to take care not to get too dependent on tobacco for my monthly income.
The share price has risen quite strongly in recent months and I am sure it will track the increase in dividends over time.
Hi diy investor, the rising payout ratio is intentional. From memory they’re expecting single digit EPS growth in the medium term and double digit (targeting at least 10%) dividend growth. This relates to the lack of investment opportunity (or the lack of a need to reinvest cash – i.e. cigarettes don’t need much R&D) so they’re increasing the payout and share buybacks.
I have held IMT for a number of years and intend to continue to hold. If the divi grows at 10% and cover stays around 1.5 then it could reach a price of around £30/share, maybe !
I think £30 per share is very likely, and perhaps sooner than people might think.
Good post as usual John.
However aren’t you concerned about Imperial Tobacco’s debt? Financial Times has average income before taxes as 1.5 billion and interest bearing debt at 11 billion. Revenue looks flat, cash flow and earnings are patchy and cover looks like its declining.
If you were to consider tobacco wouldn’t British American Tobacco make more sense? Financial Times has BATS average income before taxes of 4.5 billion and debts of 10.7 billion. 14.7 forward PE vs 10.8 for Imperial tobacco but 15% earnings growth as opposed to 7% for Imperial. Added to this the earnings growth curve looks more predictable for BATS. They have more exposure to emerging markets where smoking is not in decline so that is another plus.
Hi Andrew, yes Imperial has quite high levels of debt but it’s within the limits of what I consider reasonably prudent.
As for BAT, I own that as well so of course I agree with the points you made!
£30 / share, that’s a lot!
I will be happy to get reed of them at £25 on some ‘good news’ but I am not going to wait too long. It looks to me these European people gave up smoking in this recession. That’s worrying for me.
The debt level is a worry because I expect that China will privatise their tobacco industry in the next year or so. That won’t come cheap, it will cost the buyer £20bln+ but it will be one in the lifetime opportunity. The buyer will have to borrow the lot and even a rights issue, but it will be worthwhile.