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Why I think the doomsters are wrong about this 7%-yield FTSE 100 stock

After a big slump in its share price over the last couple of years, FTSE 100 tobacco group Imperial Brands (LSE: IMB) currently sports a running dividend yield of over 7%. Some of my Motley Fool colleagues are worried about falling demand and increasing regulation, and about debt and dividend sustainability.

However, I’ve a far more upbeat view of the company’s prospects than the doomsters. Here are the reasons why.

Volumes and revenues

Overall, annual global cigarette volumes are in decline. But let’s put this into context. The table below shows Imperial’s volumes and net revenues for the last five years.

  2014 2015 2016 2017 2018 Increase/decrease 2014-2018
Volume (billion stick equivalents*) 294.4 285.1 276.5 265.2 255.5 -13.2%
Net revenue (£bn) 6.42 6.25 7.17 7.76 7.73 +20.4%

* Stick equivalents reflect combined cigarette, fine cut tobacco, cigar and snus volumes.

Imperial’s volumes have fallen 3-4% a year, with a total decline of 13.2% over the period. However, revenues have increased — not every year — but by a total of 20.4%.

This shows the pricing power of Imperial’s addictive products. It’s been able to increase prices at a faster rate than volumes have fallen. Looking to the future, I think top-line growth can be supported by continued price increases. But also by new revenue streams.

Imperial’s sales of next-generation products (e-cigarettes etc) are set to crank up in the immediate future, even if these products do face the kind of regulatory headwinds traditional combustibles have endured for decades.

Further ahead, the company is continuing to explore other potential avenues of growth. For example, it’s taken an equity stake in UK Home Office-licensed Oxford Cannabinoid Technologies through which it’s building a deeper understanding of the cannabis market.

Free cash flow

When it comes to debt and dividend sustainability, Imperial’s accounting profits are a poor measure (for reasons I haven’t space to discuss here). Free cash flow (FCF) is king, as shown in the table below.

  2014 2015 2016 2017 2018 Total
Net profit (£bn) 1.45 1.72 0.67 1.45 1.43 6.72
Gross dividend (£bn) 1.17 1.30 1.43 1.58 1.75 7.23
FCF (£bn) 1.77 2.49 2.42 2.34 2.55 11.57
Period end net debt (£bn) 8.55 11.95 13.32 12.49 11.90 n/a

As you can see, cumulative accounting net profit for the past five years (£6.72bn) hasn’t covered the total gross dividend (£7.23bn), with the dividend being uncovered by net profit in each of the last three years.

However, FCF has easily covered the dividend each and every year (by an average of 1.6 times). As such, a cumulative total of £11.57bn means Imperial has generated an FCF surplus of £4.34bn after dividends. Post-dividend FCF in the last couple of years has been used to reduce net debt towards a more comfortable level, after peaking at £13.32bn in 2016.

In spite of declining volumes, Imperial appears to me to have the wherewithal to continue growing revenues, FCF and dividends in both the near-term and for many years to come.

Dividend matters

I’m not expecting a continuation of the company’s record of 10 consecutive years of 10%+ dividend growth. Since 2014, the dividend has increased 49.3%, which is somewhat ahead of FCF growth of 43.8%

I think dividend growth is set to moderate somewhat, particularly as the company omitted what had become a familiar line — “our policy of growing dividends by at least 10% per year over the medium term” — from its last results. Nevertheless, I see dividend increases continuing at a decent rate.

For all the reasons discussed, I believe Imperial could be one of the biggest bargains in the market. As such, I have no hesitation in rating it a ‘buy’.

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G A Chester has no position in any of the shares mentioned. 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.