Tobacco stocks have taken a beating in the year to date, both here and across the Atlantic. This isn't altogether surprising given the secular decline in traditional cigarette volumes and faltering institutional support. Then there is the relentless international regulatory drive to cripple the industry. And the trading outlook, while not exactly bleak, does depend to a certain degree on our willingness to swap one vice for another.
Yet for anyone seeking cash returns, ‘Big Tobacco’ still has its attractions. This was made clear last month when leading investors in British American Tobacco (BATS) called on the group’s new chief executive, Tadeu Marroco, to reinstate its share buyback programme. BATS launched a £2bn share repurchase programme in February 2022 but opted not to renew it earlier this year, causing the share price to slip.
The tobacco giant is looking to reduce its net debt to within a range of two to three times cash profits. One imagines, however, that capital expenditure may also be prioritised because it could be argued that its US industry rivals have stolen a march in terms of new-category products. Vapes, heated tobacco products and the like accounted for £2.89bn in revenues during 2022, a 37 per cent year-on-year increase, but that still only represents 10.5 per cent of the group total.
The situation isn’t dissimilar at Imperial Brands (IMB), although its net debt position is certainly a more pressing issue given the risk of higher refinancing costs. Nonetheless, management still feels it prudent to cancel up to 5.3 per cent of its equity base as part of a £1bn share buyback programme running until September.
Some investors may worry that the move has been designed to mask strategic missteps, especially given that adjusted losses from its “next-generation products” increased by a third at the interim mark. But the reality is that tobacco companies typically generate lots of cash, so they’re in a better position than most to pursue the practice, while driving distributions. They certainly afford more visibility on cash returns than many other sectors, which is part of the reason why they have been one of the mainstays of equity income portfolios.
Judging by their share price performance over the past five years, most of the big US and UK tobacco stocks have been resolutely out of favour, no doubt a partial reflection of the spread of environmental, social and governance (ESG) mandates. And short of another impending legal judgment in the US for one of BATS’ products, it is difficult to identify any near-term share price catalysts.
The outlier in terms of share price performance is Philip Morris International (US:PM), which has seen its market valuation increase by 13.1 per cent over the past five years – hardly earth-shattering, although it still offers a 5.6 per cent dividend yield.
| Dividend payout ratio (%) | Net debt/Ebitda | Dividend coverage ratio | FCF per share | PER | Dividend yield | Price change YTD (%) | Price change 5-year (%) | Market cap (£mn) | |
| Imperial Brands (IMB) | 85.1 | 2.07 | 2.11 | 2.56 | 9.7 | 8.22 | -16.2 | -37.0 | 15,798 |
| British American Tobacco (BATS) | 98.4 | 2.69 | 1.68 | 3.7 | 9.1 | 8.42 | -18.6 | -31.0 | 59,553 |
| Altria Group (US: MO) | 115.4 | 1.4 | 1.33 | 4.46 | 14.4 | 8.42 | -2.4 | -19.8 | 64,305 |
| Philip Morris Intl. (US: PM) | 86.68 | 2.95 | 1.33 | 6.27 | 16.2 | 5.6 | -10.2 | 13.1 | 113,611 |
| Source: FactSet, Refinitiv | |||||||||
The rest of the cohort is yielding upwards of 8 per cent, normally a sign that the market has taken fright. But this is the tobacco sector, so it’s probably worth examining whether future distributions are likely to be adequately covered by cash generation.
The first thing worth mentioning is that none of the three companies appear to have adequate assets to meet short-term liabilities, with quick ratios ranging from 0.4 to 0.5 times. Then again, they’re tobacco stocks, so they enjoy lofty cash margins, leaving them better able to organically fund near-term expenditure. This is a point worth considering given that ESG ratings are increasingly a determinant where the granting of corporate credit lines is concerned.
So, despite the short-term funding issue, none of the net debt-to-cash profit multiples would set alarm bells ringing, although long-term debt for Philip Morris increased by 41 per cent through 2022. Again, however, the group has been steadily increasing its free cash flow per share, so its heavy investment in alternative tobacco products is unlikely to stifle its ability to fund distributions. Indeed, S&P Global gives an A-minus credit rating on a stable outlook.
The sector’s dividend coverage, while hardly stratospheric, allows some headroom, especially in the case of the two UK companies. And save for a slight hiccup in the first year of the pandemic, dividend growth rates are heading in the right direction. So, with few signs of inflation flagging, the potential income on offer probably warrants a second look, particularly as it wouldn’t take all that long to recoup your principal investment with those ‘red flag’ yields.
