Are Imperial Tobacco Group Plc & British American Tobacco Plc Running Out Of Puff?

Here is why I believe that the tide could be about to turn for British American Tobacco Plc (LON: BATS) and Imperial Tobacco Group Plc (LON: IMT)

| More on:

The content of this article was relevant at the time of publishing. Circumstances change continuously and caution should therefore be exercised when relying upon any content contained within this article.

When investing, your capital is at risk. The value of your investments can go down as well as up and you may get back less than you put in.

Read More

The content of this article is provided for information purposes only and is not intended to be, nor does it constitute, any form of personal advice. Investments in a currency other than sterling are exposed to currency exchange risk. Currency exchange rates are constantly changing, which may affect the value of the investment in sterling terms. You could lose money in sterling even if the stock price rises in the currency of origin. Stocks listed on overseas exchanges may be subject to additional dealing and exchange rate charges, and may have other tax implications, and may not provide the same, or any, regulatory protection as in the UK.

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More.

Despite its unpopularity with governments and international organisations globally, the portion of the world’s population that smokes remains stubbornly high, even after years of tax increases and unilateral health initiatives that have all attempted to bring down this number.

It is the addictive nature of smoking that provides tobacco companies with resilience throughout the economic cycle, thereby affording them the cherished, defensive status within London’s community of listed companies.

It is this status, along with a strong performance within the underlying businesses, that has consistently propelled Imperial Tobacco (LSE: IMT) and British American Tobacco (LSE: BATS) to new highs during recent years.

However, today I write to urge caution to those investors that are hoping for continued gains from these shares — as it could be that this period of outperformance is about to come to a halt for both companies.

Below I explain why.

Balance sheet leverage could soon become an issue  

An extended period of ultra low interest rates, in addition to sustained earnings and dividend growth, has enabled the expanding balance sheets of Imperial Tobacco and British American Tobacco to go largely unchecked.

Now, with an increase in both US and UK interest rates just around the corner, both companies may soon need to think about deleveraging.

At present, debt/equity sits at 1.93x and 2.48x for BAT and Imperial Tobacco respectively, while gearing comes in at 69% and 59% respectively.

Even for defensive companies, these numbers are slightly disconcerting, particularly when considering that annual earnings growth is often confined to the low-mid single digits for tobacco firms.

Dividend cover is also a potential cause for concern

In addition to slightly overweight balance sheets, an extended period of generous dividend growth has now begun to reduce the level of dividend cover offered by BAT and Imperial Tobacco to uncomfortably low levels.

Dividend cover at British American Tobacco is the lowest of the two companies, coming in at just 1.2x DPS, while consensus projections for earnings suggest that EPS growth will remain in the single digits out until at least 2017.

However, in its defence, the group has made no prior commitment to a set rate of dividend growth here. Instead, management have repeatedly stated the while increasing the payout is a priority, this will only happen as and when its is possible to do so.

Dividend cover is much more pertinent issue for Imperial Tobacco, who have pledged to grow the payout by 10% per annum over the medium term, even though cover was just 1.15x in 2014.

Furthermore, consensus earnings projections for Imperial Tobacco indicate that it will fare little better than BAT when it comes to EPS growth over the coming years, as the annual pace of expansion here is also expected to remain in the mid single digits until 2017.

This places a considerable question mark over the viability of further dividend increases over the medium term and I now believe it is possible that shareholders may find themselves being left disappointed at some time between now and the end of the above forecast horizon.

Summing Up 

In summary, while it may certainly be possible for both companies to maintain the current per share distribution over the next 24 months, further growth is looking increasingly unlikely over the near term.

This will make it difficult for the shares to record further gains from here and, as such, it probably means that the lengthy period of outperformance that both companies have enjoyed is now coming to an end.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

James Skinner has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

More on Investing Articles

Investing Articles

Could the JD Sports Fashion share price double in the next five years?

The JD Sports Fashion share price has nearly halved in the past five years. Our writer thinks a proven business…

Read more »

Bus waiting in front of the London Stock Exchange on a sunny day.
Investing Articles

If interest rate cuts are coming, I think these UK growth stocks could soar!

Falling interest could be great news for UK growth stocks, especially those that have been under the cosh recently. Paul…

Read more »

Investing Articles

Are these the best stocks to buy on the FTSE right now?

With the UK stock market on the way to hitting new highs, this Fool is considering which are the best…

Read more »

Petrochemical engineer working at night with digital tablet inside oil and gas refinery plant
Investing Articles

Can the Centrica dividend keep on growing?

Christopher Ruane considers some positive factors that might see continued growth in the Centrica dividend -- as well as some…

Read more »

Smiling family of four enjoying breakfast at sunrise while camping
Investing Articles

How I’d turn my £12,000 of savings into passive income of £1,275 a month

This Fool is considering a strategy that he believes can help him achieve a stable passive income stream with a…

Read more »

Person holding magnifying glass over important document, reading the small print
Investing Articles

2 top FTSE 250 investment trusts trading at attractive discounts!

This pair of discounted FTSE 250 trusts appear to be on sale right now. Here's why I'd scoop up their…

Read more »

Smiling young man sitting in cafe and checking messages, with his laptop in front of him.
Investing Articles

3 things that could push the Lloyds share price to 60p and beyond

The Lloyds share price has broken through 50p. Next step 60p? And then what? Here are some thoughts on what…

Read more »

Young female business analyst looking at a graph chart while working from home
Investing Articles

£1,000 in Rolls-Royce shares a year ago would be worth this much now

Rolls-Royce shares have posted one of the best stock market gains of the past 12 months. But what might the…

Read more »