Stockwatch: two tobacco stocks with strong yields

Investors need to decide their moral stance, but this pair’s risk versus reward profile looks exciting.

Is there a sweet spot in stocks where you can protect against downside risk to the market – lest inflation rises and growth stocks boil over – but also capitalise on a change in investor psychology?

To ensure a balanced portfolio with an aspect of hedging, rather than naively assume the market can party on.  

When a six-year-old dating app – Bumble Inc (NASDAQ:BMBL) – apparently deserves a market value half​ that of BT Group (LSE:BT.A), something has to give.  

A historical perspective on this bull market symptom  

Recalling the late 1990s to 2000s boom and debacle, sentiment became biased against so-called smokestack (heavy manufacturing) industries, hence their stocks offered high yields, amid fascination with earnings growth potential elsewhere.

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Dividend valuation was old hat. Mid-20th century analysts such as Benjamin Graham and David Dodd identified similar behaviour in the 1920s, and ultimately the Wall Street crash.

Perhaps the chief question is whether anything really is different this time, with new era thinking such as “a permanently high plateau” (Irving Fisher’s 1929 remark about US stocks) or “permanently low interest rates” (as now, favouring growth stocks). 

A contemporary equivalent is the way high single-digit yields are established on two tobacco stocks, Imperial Brands (LSE:IMB) and British American Tobacco (LSE:BATS) – as if there is something fundamentally awry with these companies.

At £15.30, Imperial’s prospective yield is 9.5% and BAT at £27.90 offers 8.1%. Yet in the near term at least, both payouts should remain covered about twice by free cash flow. 

Is a discount rating justified for sin? 

Moralists may argue there is something wrong with these businesses, by way of social responsibility, hence ‘big tobacco’ is less likely to feature on institutional buy-lists. A discount for sin should be expected. 

But even respecting that, I think these stocks are priced for fat yields chiefly due to the kind of bias that typifies a mature bull market – with fascination lying elsewhere, for earnings growth prospects. 

There is a good chance of mean reversion in due course, i.e. assuming big tobacco’s payouts are at least maintained, the stocks will rise otherwise be priced for too generous a yield. This will come especially into focus if inflation rises and undermines growth stock valuations, prompting re-allocation from ‘growth to value’. 

Tobacco-related stocks have overcome bias before   

Going back more than 22 years, the consensus view wrote off tobacco for investing after Brown & Williamson – BAT’s US subsidiary – was among the four big US companies in the Tobacco Master Settlement Agreement.

This included a $366 billion (£263 billion) payment to various US states in litigation. Advertising was severely compromised.

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Yet both these companies – BAT currently the larger, capitalised at £62.3 billion with its stock at £27.90, and Imperial at £14.1 billion – grew their dividends. As the market steadily recognised the stocks were priced too low for their yields, there was a long bull market: BAT up from 500p around the millennium, over £40 by mid-2016, Imperial similarly.  

These stocks then lost over two-thirds of their value due to a mix of factors conflating: perhaps characterised as ‘can e-cigarettes genuinely offset tobacco’s decline?’

From advertising restrictions to problems with batteries over-heating, doubts grew. As growth stock fervour intensified with a maturing bull market, however, I suspect they have been shunned similarly as the run-up to 2000. 

Yet the last six years have shown strength 

Summary financial tables for BAT and Imperial show robust strength, especially in free cash flow (money left after capital expenditure needs), even if profits are a bit bumpy at times. It underwrites their payouts, hence extent of yield. That implies a decent chance capital value will improve once it is perceived. These yields are relatively generous, but the companies are not flawed. 

For what consensus forecasts are worth: BAT is expected to achieve mid-single digit earnings per share (EPS) growth in respect of 2020 and 2021, implying a 12-months’ forward price-to-earnings (PE) ratio of around 8x. Imperial is expected to enjoy an EPS rebound by a third, in respect of its financial year to 30 September 2021, then low single-digit growth in 2022. 

Broadly, it is sound unexciting growth but a medium-term ‘buy’ case exists on dividend disparity versus riskier stocks. Patience will be needed for much re-rating until there is a sea-change in market bias, but in the meantime you should be well-compensated. 

What are the risks of dividend cuts? 

Generally, if inflation takes off like I am suggesting, it might compromise personal budgets for ‘sin’ spending. Although, such is the extent of US fiscal stimulus (cash hand-outs) that tobacco-related companies may actually benefit, along with retailers and the like.   

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Free cash flow is substantially higher than earnings for both companies – by a factor of 2x in respect of Imperial and 1.1x for BAT, in their last financial year. Dividend cover relative to free cash flow was 2.7x and 1.8x respectively. Both groups’ business models offer a substantial buffer to at least maintain pay-outs, which I believe is all that is needed – eventually – to push the stocks higher. 

While Imperial cut its dividend by a third, in respect of its last financial year, this significantly followed a policy of a 10% annual increase, which was unsustainable.

BAT appeared to cut its dividend from 169p to 100p in 2017, but this related to changing the frequency of pay-outs to a quarterly basis. Its policy is more performance-oriented than Imperial’s has been, paying out 65% of earnings. Although, in free cash flow terms, historic cover has been more like 2x.   

Both groups’ free cash flow is very robust: Imperial’s grew by 27% to £372 million in its 2020 year and BAT’s slipped by 13% to £357 million in 2019 after a 92% rise in 2018.   

Imperial Brands - financial summary
Year-end 30 Sep

Source: historic company REFS and company accounts

British American Tobacco - financial summary
Year-end 30 Dec

Source: historic company REFS and company accounts

Balance sheets are heavy with intangibles and debt  

To conservative investors, this will be seen as weighing on stock ratings. While debts are structured long term, if inflation ran away to force central banks into significant interest rate rises then it would compromise these stocks as a hedge against that scenario.  

Meanwhile,  and in terms of their last financial years, Imperial’s net interest charge was covered 4.5x by operating profit and BAT’s was 5.6x – ratios both boards might argue was satisfactory. 

At end-June 2020, BAT’s net debt was down 3% to £44.2 billion relative to £69.4 billion net assets – albeit with £126.8 billion intangibles, hence negative net tangible assets. In a pre-closed period trading update last 9 December, management looked for net debt to continue reducing to 3x operating profit by the end of 2021.

Revenue growth is targeted at the high end of a 1-3% range despite a circa 2.5% headwind from Covid-19, with mid-single digit EPS growth.  

Imperial’s final results to 30 September 2020 guided for stronger financial performance in 2021 with low to mid-single digit growth in operating profit. This is despite manufacturing inefficiencies caused by Covid-19 disruption and depressed duty-free channels in airports. A 2.7x year-end target of net debt to operating profit is similar to BAT, while £10 billion net debt compares with £5.5 billion net assets – of which a whopping £18.2 billion constitutes intangibles. Some might say however, that is to be expected from the company and should not be discounted. 

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Both balance sheets are therefore satisfactory enough in terms of security of dividend pay-outs, if tricky to guess if a high debt and intangibles mix may be affecting investor sentiment.    

Current chance to lock in high yields 

Despite these uncertainties – and you will have to decide your moral position on smoking – I believe both stocks present an opportunity to lock in high and sound yields, with medium-term scope for capital appreciation as the market prices yield more competitively. ‘Buy’. 

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.