Income seekers have had a rough ride since the pandemic broke, but very generous dividends are available at this generous pair of blue-chips. Here’s what our companies analyst thinks.
Last February, I examined high single-digit yields on Imperial Brands (LSE:IMB) and British American Tobacco (LSE:BATS). Dividend yields of 8% and 9% respectively, appeared over-generous if these companies’ restructuring towards tobacco substitutes proves successful, hence stock prices would mean-revert upwards.
A parallel exists between big tobacco and big oil, another “sin” sector applying cash flow from an old industry to new.
Yet apart from useful payouts, these stocks have traded volatile-sideways through 2021: Imperial largely between £15 and £16, and BAT between £25 and £28. On recent consensus projections, yields are 9% and 8.2% respectively.
Is any change in stance warranted?
‘Growth versus value’ has continued to weigh
A market bias similar to the 1998 to spring 2000 boom in technology, has persisted this year while interest rates remained exceptionally low favouring growth stocks.
“Value” was a catchphrase for those well-established companies in their industries albeit lacking growth appeal, hence they are priced for attractive yield.
If interest rates are now at an historic turning point higher – central banks having mis-judged inflationary risks – then 2022 could see an aspect of portfolio rotation from “growth” to “value”.
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I do not suggest history will repeat, but after the 2000 tech stock rout, Imperial rose six-fold and BAT over eight-fold, up to 2016. This was despite tobacco stocks being written off by many commentators amid litigation by US states around the millennium. They sought compensation for soaring public health costs, which culminated in the $366 billion (£276 billion) Tobacco Master Settlement Agreement.
Both stocks then de-rated by two-thirds as the market feared tobacco’s decline and was sceptical that vaping could prove an adequate substitute. BAT is the firm leader in new products marketing, where Imperial has cautioned slightly in its 2022 outlook about investment spend checking profit growth.
Stronger financial profiles than most industrial/cyclical stocks
The tables show very robust financial performance continuing, despite contrasts such as Imperial on a near 10% operating margin, versus nearer 40% for BAT. Imperial has however sported twice BAT’s return on capital employed.
The challenge is growth. BAT expects broadly flat tobacco volumes in 2022, with improvements in Indonesia and elsewhere offsetting a 6% fall in the US. As yet, “next generation products”, or NGP’s, represent a tiny percentage of Imperial and BAT’s total revenue.
New Zealand is interesting because it shows even a tobacco ban – by 2025, having increased the legal smoking age each year - may drive substitution for nicotine. Surveys show nearly 20% of high school students vape daily, the majority with high nicotine, versus 3% of those aged 15-17 in 2018 or 13% who smoked tobacco a decade earlier.
A reason for medium-term caution is that legal tobacco sales have been supported by lockdowns and tough border control, compromising the black market in tobacco and also fake products. If the pandemic eases once we get over the Omicron hill, then slightly weak 2021 tobacco volumes would seem able to slip further. It is unclear quite whether Imperial’s hope for international duty-free to resume would be sufficient counter-balance?
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Low-single-digit revenue growth is currently anticipated for both companies in 2022, albeit mid-single-digit earnings growth from cost-cutting and product price increases. Managers say they are confident of mitigating input cost inflation.
Admittedly, the situation remains similar to last year when I said: “Patience will be needed for much re-rating until there is a sea-change in sentiment, meantime you should be well-compensated.”
The crux, as I see it, is potential for growth/value re-balancing by investors and a firmer narrative on new products; which could conflate for upside in 2022.
Imperial invests for a relative catch-up in new products
Due to a 30 September year-end, Imperial reported its annual results in November, whereas BAT released a trading update earlier this month in respect of its second half-year to end-December.
Imperial’s revenue edged up 0.7% to £32.8 billion, helped by raising prices over 4% while sales volumes eased nearly 3%. A similar modest advance is expected in 2022 at constant exchange rates.
Adjusted operating profit rose nearly 5%, helped by higher distribution profits, while a 15% rise at the reported level reflected selling the premium cigar division. The 2022 outlook profits outlook comes across as flat due to increased investment.
Imperial speaks NGP’s such as heated tobacco being trialled in the Czech Republic and Greece, and in the US a dedicated vapour product, “blu”. It is concerning how 2021 NGP revenues fell 16% at constant currency due to increased competition and greater discounting – as if industry players are piling in, to establish share.
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A new CEO is one year into the role, saying the NGP pilots are “on track” in context of a transformation programme underway for the group overall, with sharper focus on Imperial’s top five markets. 2022 will be “the second year of strengthening phase, towards a subsequent acceleration of returns and sustainable growth in shareholder value.”
Despite this step-up in investment, continued debt reduction is promised where the cash flow statement shows a £2.2 billion repayment besides £1.3 billion paid out as dividends. At 30 September, Imperial had £8.5 billion net debt, although investment income exceeded its interest charge.
Normalised earnings per share (EPS) soared 63%, but curiously Imperial included foreign exchange gains and a £281 million gain from the cigar business disposal in this figure. Free cash flow per share fell 44% albeit chiefly due to working capital movements – i.e. short-term and probably exceptional. All such may help explain why the total dividend edged up only 1p to 139p versus “organic adjusted” EPS of 247p.
Imperial’s trailing in new product development leads me to favour BAT at this point. Yet with a relatively new CEO and medium-term re-vamp of the group under way, plus the stock’s robust yield, I contend a “hold” stance.
Imperial Brands - financial summary
Year-end 30 Sep
|Turnover (£ million)||27,634||30,247||30,066||31,594||32,562||32,791|
|Operating margin (%)||8.1||7.5||8.0||7.0||8.4||9.6|
|Operating profit (£m)||2,229||2,278||2,407||2,197||2731||3,146|
|Net profit (£m)||631||1,409||1,368||1,010||1,495||2,834|
|Reported earnings/share (p)||66.0||147||143||106||158||299|
|Normalised earnings/share (p)||94.3||178||150||163||187||305|
|Operating cashflow/share (p)||330||320||323||337||420||229|
|Capital expenditure/share (p)||17.1||23.2||41.2||44.6||47.4||21.1|
|Free cashflow/share (p)||313||297||282||293||372||208|
|Covered by earnings (x)||0.4||0.9||0.8||0.5||1.2||2.2|
|Return on total capital (%)||9.9||11.3||12.3||10.4||13.7||17.2|
|Net Debt (£m)||12,664||11,925||11,220||11,348||10,325||8,786|
|Net assets per share (p)||554||595||605||519||515||566|
Source: historic company REFS and company accounts
BAT professes ‘a pivotal year in our transformation journey’
Quite whether these are just fine words, or a genuine inflection point for the business remains to be seen. However, a 7 December update cited “continued strong new category performance (which is) now a sizeable contributor to revenue growth and our £5 billon revenue target by 2025.”
BAT’s “Vuse” brand now global leader in vapour with a 34% market share and is approaching US leadership with a 31% share. New products are overall tipping into profit.
The “glo Hyper” brand recently achieved a 7% share in Japan and is now present in 22 of 24 global markets for heated cigarettes.
British American Tobacco - financial summary
Year-end 30 Dec
|Turnover (£ million)||13,104||14,130||19,564||24,492||25,877||25,776|
|Operating margin (%)||34.0||32.2||151||38.2||34.8||38.1|
|Operating profit (£m)||4,453||4,554||29,547||9,358||9016||9,820|
|Net profit (£m)||4,290||4,648||37,485||6,032||5,704||6,400|
|Reported earnings/share (p)||230||249||1,360||260||247||273|
|Normalised earnings/share (p)||234||239||251||284||316||328|
|Operating cashflow/share (p)||253||247||261||449||393||426|
|Capital expenditure/share (p)||32.3||36.1||47.7||41.1||35.6||32.9|
|Free cashflow/share (p)||221||211||213||408||357||394|
|Covered by earnings (x)||1.5||1.5||13.6||1.3||1.2||1.3|
|Return on total capital (%)||19.8||16.3||23.6||7.2||7.4||8.0|
|Net Debt (£m)||15,003||17,276||45,649||44,259||42,243||40,088|
|Net assets per share (p)||263||439||2,649||2,853||2,786||2,732|
Source: historic company REFS and company accounts
Revenue growth for 2021 was guided over 5% at constant currency, with mid-single-digit EPS growth - despite foreign exchange headwinds and a £260 million impact from excise changes in Australia and New Zealand. Over 90% of adjusted operating profit is converting to cash.
At the end of last June, BAT had £42 billion net debt relative to £63 billion net assets, propped by £114 billion intangibles. The net interest cost shaved 15% of operating profit and the recent update re-affirmed leverage on a reducing trend.
Also, in terms of applying cash flow: “We recognise the clear value of a share buyback at the current valuation.”
While offering less financial detail lately than Imperial, I retain a “buy” stance on BAT due to its lead in new products.
Both stocks continue to merit consideration for a more defensive environment for equities, potentially, in 2022.
Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.
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