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How Safe Is Your Money In Imperial Tobacco Group PLC?

british american tobacco / imperial tobaccoImperial Tobacco Group (LSE: IMT) (NASDAQOTH: ITYBY.US) is currently making an aggressive move into e-cigarettes — and no wonder. It’s estimated that 10-15% of UK smokers now ‘vape’ some of their nicotine fix, and for the first time in many years, cigarette companies can legally advertise on television!

However, despite the obvious potential, it’s not yet clear whether the e-cigarette market will become big enough to fill the void left by the structural decline in tobacco sales.

Imperial’s stick equivalent volumes fell by 7% last year, but the firm hiked its dividend by 10%. Is this dividend growth sustainable? I’ve taken a closer look at some of the firm’s financial ratios to find out more.

1. Operating profit/interest

What we’re looking for here is a ratio of at least 1.5, to show that Imperial’s earnings cover its interest payments with room to spare:

Operating profit / net finance costs

£1,958m / £697m = 2.8 times cover

Imperial appears to have plenty of headroom to cope with a potential rise in interest rates or a fall in profits. However, it’s worth noting that capital expenditure, interest, dividends and share buybacks totalled £2,422m in 2013, leaving Imperial needing to borrow more to make up the shortfall from its operating cash flow.

2. Debt/equity ratio

Commonly referred to as gearing, this is simply the ratio of debt to shareholder equity, or book value (total assets – total liabilities). I tend to use net debt, as companies often maintain large cash balances that can be used to reduce debt if necessary.

Imperial’s net debt is £9.3bn, while its equity is £5.6bn, giving net gearing of 165%, which is far too high for my liking, given the firm’s lack of growth opportunities. In my view, any increase in interest rates could put Imperial’s dividend growth at risk, as rising interest payments would have to take priority over dividend growth and share buybacks.

3. Operating profit/sales

This ratio is usually known as operating margin, and is useful measure of a company’s profitability.

The news isn’t great here, either. While Imperial’s peer British American Tobacco enjoys an eye-watering 36% operating margin, Imperial’s adjusted operating margin was just 11% in 2013, thanks to the much lower margins provided by its logistics business.

Is your money safe in Imperial?

I believe Imperial will be able to maintain its high-yielding appeal to shareholders for several more years, but shareholders should remember that Imperial’s underlying revenue and profits are flat, and tobacco sales are falling. In my view, Imperial shares aren’t necessarily a safe, long-term investment.

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Roland does not own shares in any of the companies mentioned in this article.