Robin Geffen

Avoiding dividend risk – Imperial Brands

Robin Geffen

Imperial Brands endured another hefty share price fall last week as it announced a cut to both its sales and profits guidance, adding to what has been a highly painful few years for the company. The tobacco major continues to be beloved by many UK equity income investors, despite the (now well-known) fact that global cigarette volumes are declining far faster than first anticipated.

Imperial Brands: an income fund stalwart 

Source: Bloomberg, 27.09.2019. These are Liontrust views and as such this document is deemed to be impartial research. We do not undertake to advise you as to any change of our views. References to specific securities are for illustration purposes only and should not be taken as a recommendation to buy or sell these securities.

Both management and long-term investors accept this problematic issue but point to e-cigarettes as the major offsetting force that will turn Imperial Brands’ fortunes. We have not bought into this view (we sold the stock in January 2018 alongside BATS), and it is interesting to note Imperial Brands’ poor update was driven by the deteriorating backdrop for the vaping market, with the company having already spent a huge amount on its Blu device.

Our decision to sell the stock from an operational point of view (apart from declining sales for its core products) was twofold. First, we believed the vaping hype was considerably overdone; not only were the company cannibalising its own core product, but we foresaw more stringent regulatory scrutiny. Second, the vast expense of these “next generation” products meant the company’s debt levels were becoming excessive. Ultimately, therefore, we felt its dividend was under serious pressure.

Imperial Brands has blamed the slowdown in US demand for e-cigarettes for its lower guidance, and this is no surprise when you consider the fact that cities and states have started banning them (India has done the same), the FDA has clamped down on the advertisement of vaping products and, worse still, the news of e-cigarette-related deaths.

Despite this, Imperial Brands remains popular with UK equity income funds. Indeed, some 61% of all funds in the IA UK Equity Income sector own the stock, with the company alone generating 5.4% of the total peer group’s yield. We find this baffling, but, in our view, it perfectly encapsulates the inherent risk within the UK equity income sector today: chasing yield.

Exposure to Imperial Brands within IA UK equity income sector 

Source: Morningstar, 31.08.2019. These are Liontrust views and as such this document is deemed to be impartial research. We do not undertake to advise you as to any change of our views.

Imperial Brands has been popular because of its high yield and, by holding it, UK equity income funds’ own yields look high. The crux of the issue, though, is that by holding a company like Imperial Brands to prop up your own yield, you are callously ignoring both your investor’s capital and income. For example, when we sold the stock in January 2018, the dividend yield was 5.3%. This has since risen to around 10% because the share price has since fallen by close to 40%. 

The writing has been on the wall for Imperial Brands for a long time now. Its earnings peaked in 2012 and have since declined by 6%, yet over the same period (in order to continue to attract investors), the company has increased its dividend by 77%. The net result has been that Imperial’s dividend cover has fallen from 1.7 times in 2012 to just 0.9 times today.

Imperial Brands dividend risk 

Source: Bloomberg, 31.08.2019. These are Liontrust views and as such this document is deemed to be impartial research. We do not undertake to advise you as to any change of our views.

Barring an immense improvement in earnings (which, for the reasons listed above, we think is highly unlikely), we believe it is therefore almost certain the stock will cut its dividend over the coming years. But many of our peers have wilfully ignored this, with the average weighting to the stock increasing over recent months. Of course, the stock could rebound over the short term, but the fundamental issues remain and we believe Imperial Brands poses a severe risk to investors’ income and capital.

The problem of a high yield yet lowly covered dividend is not limited to Imperial Brands but we see it as a perfect example of the dangers facing UK equity income investors in the current environment. Indeed, the average yield across the sector is 4.4%, which appears attractive, but 25% of that yield is powered by companies that have uncovered dividends.

We believe our industry needs to work harder to illustrate the dangers lurking within the UK equity income market and our approach is clear – yes, generate an attractive yield, but make sure you are not eroding capital to fund it and the dividends alluded to in those yields are actually going to be paid. 

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Wednesday, October 2, 2019, 12:28 PM