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Imperial Brands: balancing distribution and innovation

The company is developing "next generation products" such as vapes, but the majority of profits still come from tobacco
Imperial Brands: balancing distribution and innovation

Policy: Imperial Brands is committed to continuing to grow its dividend by at least 10 per cent a year over the medium term

Yield: 7.03 per cent

Payment: Twice a year, declared and paid in sterling

Last Cut: The dividend has only ever gone up since the company was spun out of Hanson and listed on the FTSE 100 in 1997

IC TIP: Buy at 2,879p

Will Imperial Brands’ (IMB) dividend case one day rely on the reefer? Regardless of where investors stand on the debate over legalising marijuana or its medicinal use, there’s no denying the cash-generating potential it presents for companies that can produce complementary products. The FTSE 100 group smells an opportunity. Through its Imperial Brands Ventures subsidiary, the company recently bought a stake in Oxford Cannabinoid Technologies (OCT), which focuses on the medical uses of cannabis, and which following the cash injection will research how cannabinoids can be used to treat pain, inflammation and gastrointestinal issues.

This is Imperial Brands’ first investment in the cannabis market, but not its first brush with the sector. In June last year Simon Langelier, the chairman of Canadian supplier of medical-grade cannabis PharmaCielo, was appointed to the Imperial Brands’ board as a non-executive director. Liberum analysts think that cannabis will continue to attract interest from the tobacco companies over time if and when regulations loosen.

The move is one example of how the tobacco sector is diversifying away from cigarettes and into other product lines. Imperial Brands is in the process of overhauling its portfolio by selling off a number of its brands, aiming to generate around £2bn in proceeds from sales over the next 12 to 24 months. And while chief executive Alison Cooper has been tight-lipped on the details of the disposals, it’s reasonable to assume that some cigarette brands are heading for the chop. Ms Cooper, like many in the industry, see greater growth opportunities in so-called next-generation products (NGPs).

The hope is that NGPs will be able to compensate for declining sales volumes of traditional cigarettes. During the six months to March the volume of cigarettes sold fell 2.1 per cent to 124bn sticks. Imperial Brands’ management has said it believes the market for vapes, one of the most promising areas of NGPs, is currently worth around $4bn, but could be closer to $30bn by 2020. This shift is ongoing, but for now sales, cash flows – and, by extension, dividend funding – are largely dependent on the group’s traditional markets, with around 94 per cent of operating profit generated from tobacco products, according to the latest half-year numbers.

The structural decline in traditional cigarette volumes has yet to force a management re-think on the generous dividend policy. At the half-year mark, Imperial Brands stuck to its promise to increase the dividend by at least 10 per cent, this time with an interim payout of 56.9p, representing a 12-month dividend ratio (to earnings) of 67.8 per cent. The ability to fund the distributions is aided by consistent cash conversion rates, with management targeting a 95 per cent rate for the current financial year to September, the same as in FY2017.

Consequently, analysts at Liberum give an implied dividend yield of over 8 per cent for FY2019, and expect the commitment for double-digit increases to continue for at least another three years. But if the growth in NGPs fails to mitigate the decline in cigarette sales (in cash terms), management may eventually need to re-draw the terms of the payout, particularly as dividend payments constitute a significant proportion of existing cash flows. At the half-year, £1.18bn was paid out to shareholders, compared with £41m spent on the repurchase of shares, £1.12bn on loan repayments, and £305m in interest payments. In FY2018 dividend payments are expected to total £1.63bn, covered by £2.52bn of free cash flows, although this would represent a slight year-on-year improvement in coverage compared with 2017 (see chart).