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 of 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 make 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.