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How Will Imperial Tobacco Group Plc Fare In 2014?

For most shares in the FTSE 100, 2013 was a good year and investors have likely enjoyed capital gains and rising dividend income.

That makes me nervous about investing for 2014 and beyond, and I’m going to work hard to adhere to the first tenet of money management: preserve capital.

To help me avoid losses while pursuing gains, I’m examining companies from three important angles:

  • Prospects;
  • Risks;
  • Valuation.

Today, I’m looking at cigarette and tobacco producer Imperial Tobacco Group (LSE: IMT) (NASDAQOTH: ITYBY.US).

Track record

With the shares at 2,304p, Imperial Tobacco’s market cap. is £22,329 million.

This table summarises the firm’s recent financial record:

Year to September 2009 2010 2011 2012 2013
Revenue (£m) 26,517 28,173 29,223 28,574 28,269
Net cash from operations (£m) 3,569 2,859 2,556 2,119 2,352
Adjusted earnings per share 161.8p 178.8p 188p 201p 210.7p
Dividend per share 73p 84.3p 95.1p 105.6p 116.4p

1) Prospects

Tobacco industry volumes are in long-term decline and that seems to reflect in Imperial Tobacco’s slipping financial performance, as shown in the table. The recent full-year results for 2013 showed a 1% fall in revenue, a 7% fall in product volumes and a 0.6% rise in adjusted operating profits. The firm seems to prefer quoting adjusted profit figures as opposed to reported profit figures. The adjusted figure adds back figures deducted for amortization and impairment of acquired intangibles, and restructuring costs.

The argument goes that adjusted figures lead to a better appreciation of the underlying business performance. However, in a declining market environment, I’m not so sure about the validity of that reasoning, as the likes of restructuring costs, for example, can become a regular feature, and therefore just another cost. For perspective, in 2013, restructuring costs came to about 20p per share.

Despite weakness in the top line, Imperial’s cash flow is holding up whilst adjusted earnings and the dividend have been growing. Perhaps that result is down to the firm’s restructuring and cost-saving efforts. Around £30 million of savings crystallised in the 2013 accounts, but the firm expects to ramp savings up to £300m per annum by the end of 2018.

2) Risks

Although Imperial is seeing some opportunities and has categorised some of its products as ‘growth brands’, the firm is operating against a backdrop of deteriorating industry volumes. In the EU, austerity measures, unemployment and competition from illicit trade is wreaking havoc, and there has been weakness in some of the company’s other main markets, such as Russia. It’s telling that volumes in the ‘growth brand’ category declined 2% compared to the year-ago figure.

Raising prices and cutting costs to squeeze out profits has a finite course to run in my view. Eventually product volumes and top-line revenue must grow if earnings growth is to continue. With the general market for tobacco products declining in many areas around the world, I can’t help feeling that share-price advancement is going to be hard to achieve in the long run.

The firm is doing all it can with share buy-backs and dividend returns to reward investors. However, P/E compression could occur if forward earnings growth remains low and if Imperial Tobacco’s defensive credentials fall out of favour with investors.

Meanwhile, net debt is running at almost five times the level of operating profits. The company relies on its consistent cash flows to keep up with interest payments.

3) Valuation

City analysts expect adjusted earnings to advance by about 3% in 2014. Those earnings will cover the expected dividend around 1.7 times. At today’s share-price level the forward dividend yield is about 5.4%.

Meanwhile, the forward price-to-earnings ratio is running at about 11, which seems to fully account for earnings-growth and yield expectations.

Conclusion

Right now, cash flow is sufficient to fund that attractive-looking dividend. However, I feel uncertain about the growth prospects for Imperial Tobacco’s business so will look elsewhere to invest for 2014 and beyond.

If not Imperial Tobacco, where should I invest? Well, I'm keen on an idea from one of the Motley Fool's top value investors who has discovered what he believes is a solid income-generating share-play on the London market.

There's little chance of this particular company's market declining or of its customers kicking the product-using habit.

He sets out his three-point investing thesis in a report called "The Motley Fool's Top Income Share", which I recommend to you for your own research and due diligence.

The report, sets out his 'buy' case for this dividend-generating star, but also discusses future conditions that would cause him to sell the company. It's available now by clicking here.

> Kevin does not own shares in Imperial Tobacco Group.