Tobacco stocks, such as Imperial Tobacco (LSE: IMT) (NASDAQOTH: ITYBY), tend to perform relatively well during challenging periods for the wider market.
That’s because tobacco sales tend not to mirror the state of the wider economy and, although smokers may change up or down to a more expensive/less expensive brand depending on their economic circumstances, they are unlikely to cease smoking because it’s less affordable.
With that in mind, it would appear as though tobacco stocks are able to withstand a greater amount of debt, since their revenues (and profits) should be a lot more stable than the majority of FTSE 100 companies. However, has Imperial Tobacco over-extended itself and become dependent on debt? Or is it still a financially sound business that should perform well over the long-run?
With a debt to equity ratio of 197%, Imperial Tobacco is highly leveraged. Certainly, the balance sheet contains a significant amount of financial gearing, with every £1 of net assets (total assets less total liabilities) being matched by £1.97 of debt. However, as mentioned, a tobacco stock such as Imperial can live with higher levels of debt than, for instance, a cyclical company whose income is much more volatile.
Indeed, Imperial’s interest coverage ratio backs this point up, as it shows that Imperial Tobacco could have made the net interest payments on its debt 2.8 times last year. In other words, operating profit was high enough to service its debt nearly three times which, when combined with the relative stability of income, shows that debt levels are not yet a problem for the business. This means that it should be strong enough to withstand future shocks and be with us for the long run.
Furthermore, Imperial Tobacco continues to offer relatively good value for money. It trades on a price to earnings (P/E) ratio of 11.7, while the FTSE 100 has a P/E of around 13.5. In addition, Imperial Tobacco provides a yield of 5.2%, which again compares favourably to the wider index at 3.5%. As a result, Imperial Tobacco looks to be financially sound and all set for a strong performance during the remainder of 2014.
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Peter does not own shares in Imperial Tobacco.