Imperial Brands is “almost certain” to cut its dividend in the coming years, according to Liontrust’s Robin Geffen (pictured), who says the rise in vaping will not be enough to halt the tobacco sector’s long-term decline
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The stock is down by more than 14 per cent over the past month after announcing a cut to its sales and profit guidance. This is just the latest piece of bad news to hit the company, with global cigarette volumes declining faster than first anticipated over the past few years.
While Imperial Brands’ management and long-term investors accept this is a problem, they point to the rise of vaping as justification for their continued loyalty to the stock, saying products such as the Blu e-cigarette can prop up the company’s earnings.
However Geffen, who runs the Liontrust Income fund, sold out of Imperial Brands along with British American Tobacco in 2018, saying he doesn’t buy this argument.
“It is interesting to note Imperial Brands’ poor update was driven by the deteriorating backdrop for the vaping market, with the company having already spent a huge amount on its Blu device,” he said.
“Our decision to sell the stock from an operational point of view (apart from declining sales for its core products) was twofold. First, we believed the vaping hype was considerably overdone; not only was the company cannibalising its own core product, but we foresaw more stringent regulatory scrutiny.
“Second, the vast expense of these ‘next generation’ products meant the company’s debt levels were becoming excessive. Ultimately, therefore, we felt its dividend was under serious pressure.”
Geffen said it is hardly surprising that demand for e-cigarettes is declining in the US, with the products banned in many cities and states, the FDA clamping down on their advertisement, and reports of vaping-related deaths.
Yet despite this pressure, Imperial Brands remains popular with IA UK Equity Income managers. More than a third of funds in the sector hold the stock in their top 10, with the company accounting for 5.4 per cent of the peer group's total yield.
“We find this baffling, but, in our view, it perfectly encapsulates the inherent risk within the UK equity income sector today: chasing yield,” Geffen continued.
“Imperial Brands has been popular because of its high yield and, by holding it, IA UK Equity Income funds’ own yields look high.
“The crux of the issue, though, is that by holding a company like Imperial Brands to prop up your own yield, you are callously ignoring both your investors’ capital and income.”
The manager pointed out that when he sold the stock in January 2018, the dividend yield was 5.3 per cent. This has since risen to around 10 per cent, but this is mainly because the share price has since fallen by more than 40 per cent.
He added that earnings have declined 6 per cent since their 2012 peak, yet the company has increased its dividend by 77 per cent over the same period. As a result, its dividend cover has fallen from 1.7 times in 2012 to just 0.9 times today.
“The writing has been on the wall for Imperial Brands for a long time now,” Geffen continued. “Barring an immense improvement in earnings (which, for the reasons listed above, we think is highly unlikely), we believe it is therefore almost certain the stock will cut its dividend over the coming years.
“But many of our peers have wilfully ignored this, with the average weighting to the stock increasing over recent months. Of course, the stock could rebound over the short term, but the fundamental issues remain and we believe Imperial Brands poses a severe risk to investors’ income and capital.”
The manager added that while the problem of a high yield with little cover is not limited to Imperial Brands, it is the “perfect example” of the dangers facing UK equity income investors in the current environment.
For example, while the average yield across the sector is 4.4 per cent, a quarter of this is powered by companies whose dividends are uncovered.
“We believe our industry needs to work harder to illustrate the dangers lurking within the UK equity income market and our approach is clear – yes, generate an attractive yield, but make sure you are not eroding capital to fund it and the dividends alluded to in those yields are actually going to be paid,” Geffen finished.
Liontrust Income (formerly Neptune Income) has made 320.48 per cent since launch at the start of 2003 compared with 280.68 per cent from the FTSE All Share and 256.95 per cent from the IA UK Equity Income sector.
Performance of fund vs sector and index under manager tenure
Source: FE Analytics
The £300m fund has an ongoing charges figure of 0.89 per cent and is yielding 3.5 per cent.