Even after a disastrous 2016, in which banks and miners slashed their dividends to conserve capital, the FTSE 100’s average yield as of the end of December still stood at a very impressive 3.65%. But, should income-hungry investors looking for above-average yields be tempted by cigarette maker Imperial Brands (LSE: IMB) 4.18% yielding dividend?
Long-term income potential
Well, in the short term Imperial Brands is undoubtedly about as safe an income investment as they come. While the company’s focus on developed markets means its experiencing little top-line growth, it also means incredibly high cash flow as impressive pricing power and an addictive product lead to fairly stable revenue and profits.
In fiscal year 2016 the company generated £3.1bn in net operating cash flow, an increase of 14.9% year-on-year thanks to cost-cutting and acquisitions. Management is directing this high cash flow into three categories — dividends, debt reduction and acquisitions — all of which bode well for the company’s long-term income potential.
On the income front, £1.4bn of cash generated was returned to shareholders via dividends. Meanwhile, a further £1bn was used to reduce net debt, although adverse currency movements saw headline net debt still rise to £12.8bn. Imperial was quiet on the acquisition front this year as its still digesting the $7.1 purchase of several American brands from Reynolds back in 2014. But, once net debt begins to come down to a more manageable level, don’t be surprised if the company makes further moves.
So, what does all this mean for income investors? Well, with a dividend payout ratio of 62% there is still a bit of room for Imperial to continue increasing shareholder returns. But, income investors certainly shouldn’t expect massive dividend increases to continue forever, as organic revenue growth stagnates and the company begins to run out of cost-cutting measures to take. But over the medium term Imperial Brands is certainly a fairly safe dividend option and at 13.7 times forward earnings, its shares aren’t exactly over-priced.
Who needs growth with dividends like these?
A future of low growth but steady dividends is what shareholders of Royal Mail (LSE: RMG) are likely consigned to as well. But this isn’t necessarily the end of the world, as the company’s 5.51% yielding dividend is safely covered and forecast by analysts to continue increasing over the medium term.
Of course, just like Imperial Brands and its cigarettes, Royal Mail is facing a secular decline in demand for its core product, in this case ‘snail mail’. In the half-year to September letters still accounted for a full 46% of overall revenue, so the steady 2-3% annual decline in letter volumes is a major concern for the company.
On the bright side, Royal Mail is also benefiting from UK’s consumers growing love affair with online shopping. In H1 of 2016 revenue from parcels shipped in the UK rose 3% year-on-year, which wasn’t enough to offset falling revenue from letters but isn’t to be ignored. And, the company isn’t only dependent on the UK as its European parcel delivery business, GLS, saw a 9% increase in year-on-year sales and 25% jump in operating profit during the period.
With earnings still covering dividend 1.86 times last year, the company has plenty of room to continue increasing shareholder returns. While the inevitable decline in letter usage will offset growth from parcel deliveries in the coming years, income investors could do much worse than Royal Mail over the medium term.
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Ian Pierce has no position in any shares mentioned. The Motley Fool UK has recommended Imperial Brands. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.