A glance at the portfolio holdings of Neil Woodford’s Equity Income fund reveals that the largest holding is tobacco manufacturer Imperial Brands (LSE: IMB). At the end of April, Imperial had a weighting of 7.1% within the fund, suggesting that the portfolio manager is clearly bullish on the FTSE 100 stock.
Should you follow Woodford and buy Imperial Brands for your own portfolio? Let’s take a look at the investment case.
Business description
The £25bn market cap firm is an international business that specialises in tobacco and non-tobacco brands. Its core business is built around a tobacco portfolio that offers a comprehensive range of cigarettes, fine cut and smokeless tobaccos, papers and cigars. Its tobacco brands, which include names such as Davidoff, West and Winston, are sold in 160 markets worldwide. However, in recent years, Imperial has also been building up its portfolio of Next Generation Products (NGPs) such as vapour and heated tobacco products, which offer smokers alternatives to combustible tobacco products. The company’s strategy is to focus on its growth brands and its NGPs going forward.
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Since its demerger from Hanson in 1996, Imperial has delivered strong long-term returns to investors and has been a fantastic dividend stock, regularly increasing its payout.
Bull case
The tobacco industry offers many attractive investment characteristics for long-term investors. For example, companies benefit from high barriers to entry and strong pricing power. This enables them to generate high profit margins and significant cash flow. While smoking rates may be declining in the Western world, smoking is still prevalent in developing countries. Furthermore, Imperial’s focus on NGPs provides growth opportunities going forward.
Looking at the numbers, there’s a lot to like about the shares right now. For starters, after a near-30% share price decline over the past 12 months, the stock now trades at a very attractive valuation. City analysts expect the group to generate earnings of 263p per share for the year ending 30 September, which places Imperial on a forward-looking P/E ratio of just 9.9. In contrast, rival British American Tobacco currently trades on a forward P/E of 12.5 and the FTSE 100 index has a median forward P/E ratio of 14.6. So on a relative basis, Imperial appears to offer strong value at present.
The stock also looks extremely attractive from a dividend investing point of view. Analysts expect the group to reward its shareholders with a payout of 188p per share this year, which at the current share price, equates to a high yield of 7.2%. Sometimes, a yield that high signals trouble. Yet in Imperial’s case, the dividend looks safe, as on a 12-month basis, the dividend payout ratio is 68%, suggesting that the company can afford to pay its dividend. It’s also worth noting that Imperial has recorded nine consecutive dividend increases of 10% now, which is a phenomenal achievement. The group recently reaffirmed its commitment to lift its payout by 10% this year.
Imperial also generates a high return on equity (ROE), which is an attribute that Warren Buffett pays particular attention to. Over the last five years, ROE has averaged a high 22.5%.
Bear case
Of course, Imperial Brands shares are not without their risks. A look at the balance sheet reveals that the company has quite a high amount of debt. At 31 March, the group had adjusted net debt of £12.7bn on its books. In contrast, total equity on the balance sheet was £5.4bn, resulting in a debt-to-equity ratio of 2.4. A ratio that high is not ideal from a risk perspective. However, Imperial recently announced that it will be selling £2bn worth of assets in the near future so this should help pay down debt.
It’s also worth considering declining smoking rates and the effects that political intervention, such as plain packaging rules, will have on the company in the future. A lot could depend on the success of NGPs going forward.
A top dividend stock
Weighing up both the bull case and the bear case, I believe Imperial Brands offers an attractive risk/reward profile at present. With a prospective dividend yield of 7.2% on offer, I think the stock is one of the top dividend plays in the FTSE 100 right now.
Having said that, tobacco stocks are not for everyone, so, if you’re looking for more dividend ideas, take a look at the free report below, which lists five more FTSE 100 dividend stocks.
