Tobacco group Imperial Brands (LSE: IMB) currently supports one of the highest dividend yields in the FTSE 100, at 8.7%. The stock also trades at forward P/E of just 8.8, a discount of around 30% to the rest of the market.
Usually, I would be excited to acquire such a high-quality income stock at such a low valuation. However, I’m starting to become worried about Imperial’s future and, based on current trends, I think its dividend yield could be living on borrowed time.
There are two main reasons why I am worried about the company’s potential. Firstly, operating profit is not growing. Excluding the impact of currency fluctuations, adjusted operating profit for the year ended 30 September 2018 only rose 0.1%. Reported unadjusted earnings per share declined to 0.7%. Despite this, management still increased the group’s dividend for the year by 10%.
At the same time, Imperial has a lot of debt. Even though the company managed to reduce net debt by £0.8bn during the year, it’s still an elevated 2.9 times EBITDA. I’m cautious of any enterprise that has a debt-to-EBITDA ratio of more than 2. At the current rate of pay off, it will take the firm more than 15 years to eliminate its deficit.
But management has promised further dividend increases, which suggests Imperial’s debt reduction efforts are going to take a backseat. If earnings continue to stagnate, the company isn’t going to have the financial flexibility to both increase its distribution and pay down debt. Indeed, dividend cover was only 1.3 times for 2018, a ratio that tells me the business has little financial headroom.
Looking at these numbers, I think it’s only a matter of time before Imperial’s dividend is reduced to free up more capital for debt reduction. Until the company finally admits this, I reckon the shares will continue to trade at a discount the rest of the market. And when it does, the shares could slump as income investors flee.
Paying out too much
Another company that I am sceptical about with regards to its dividend is SSE (LSE: SSE).
The power provided has been one of the most dependable dividend-paying shares since it was privatised three decades ago. But dividend growth has outpaced earnings growth in recent years, so much so that the dividend cover has declined from 1.8 in 2008, to just 1.1 today.
Like Imperial, SSE also has a weak balance sheet. Over the past decade, as the company has paid out almost all of its earnings from operations to shareholders, net debt has soared and now stands at just under £10bn, more than three times the level reported for 2008. In my opinion, the company cannot continue on this path.
I can’t tell you exactly when management will decide to reconsider SSE’s payout policy. However, I can say with confidence is that SSE can’t repeat its dividend policy of the last decade during the next 10 years. That would leave the business with nearly £20bn of debt and, unless regulators suddenly let the utility deliver a massive increase in prices to customers, a dividend payout that isn’t covered by earnings per share.
When SSE does finally admit it can’t sustain its current 7.4% dividend yield, I expect the share price to crash.
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Rupert Hargreaves owns Imperial Brands. The Motley Fool UK has recommended Imperial Brands. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.