Generating income of any kind when interest rates are zero is why the FTSE’s ugly sisters, British American Tobacco (BATS) and Imperial Brands (IMB), continue to hold investor interest at a time when ethical and social concerns are rapidly defining the investment landscape. The bottom line still counts when it comes to dividend pay-outs, and the tobacco giants are just too big and important in this respect to simply be sidelined.
What income investors will find trickier is making an accurate distinction between the companies when it comes to the quality of their earnings and the support this provides for underlying dividends. But choices must be made and BATS remains our favourite dividend major in the tobacco sector.
On the face of it, there is barely a fag paper width between BATS and IMB when it comes to dividend yield. Both shares hover north of 8 per cent on a rolling one-year average and pay outs have been consistent, if not entirely blemish-free. It is fair to say that both companies are in a strange middle ground, in having a yield that would flash warning signs in any other context or industry, but which consistently pay out.
However, our choice of BATS is based on the simple mathematics of the dividend working in the company’s favour. Though it is not always well-received (see chart), BATS has posted a rising pay out for twenty-one unbroken years, whereas during the same period IMB cut its final dividend in 2020 for the first time in favour of paying down debt.
On a compounded annual growth rate (CAGR), BATS has also returned a dividend average of 6.6 per cent over the past decade, more than 2.6 percentage points higher than the FTSE 100 average. This makes it one of only fifteen companies currently on the market that have not cut dividends during that period, down from 24 before the pandemic hit. The dividend is well covered, with earnings 1.5 times above the payment.
BATS’ dividend is underpinned by a notably conservative balance sheet gearing. At 64 per cent, it is one of the lowest gearing ratios belonging to any of the big income payers on the London market. Huge operating margins topping 38 per cent also help. It is important to remember that tobacco shares tend to move each time there is a new settlement with regulators over the use of its products – on average about every seven years, or so - and the dividend yield will inevitably rise in response to the latest restrictions.
BATS benefits from its broader geographical spread outside of the mature developed markets where IMB predominates, if only for the broader regulatory regimes it encounters that are sometimes less stringent than in developed economies, though these inevitably will catch up.
Guarding against long-term restrictions has been a priority for BATS since it settled major lawsuits in the US in the late 1990s. Interestingly, that experience spurred it into an early push into diversification strategies away from its contentious core product. Admittedly, at one point this became eccentric – a travel agency in Asia, the BAR F1 racing team, a mail-order catalogue business selling branded home furnishings, coffee bars in Malaysia – but these days it is focused on the rapidly expanding non-tobacco vaping market, as well as cannabis product companies.
By contrast, Imperial Brands’ concentration in mature markets is the main source of weakness for the company. Although it has attempted to diversify its business, the big-ticket acquisitions have still focused on tobacco products in mature markets. In 2014, for instance, it paid $27bn for the acquisition of Lorillard in the US. The resulting gearing level of over 230 per cent, meant the company needed to manage its balance sheet carefully, hence the dividend cut in 2020 and the disposal of its premium cigar business for €1.22bn in the same year.
So, with stability the key to its success, BATS has clearly earned its place among the dividend aristocrats and the outlook for the next to three years is that dividends will continue to rise by a steady 3 per cent annually, and it remains our pick of the tobacco shares.
See our other Income Majors: