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Building a second income? I’m buying this FTSE 100 dividend stock

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The Imperial Brands (LSE: IMB) share price has been one of the worst performers in the FTSE 100 over the last year, falling 30%. This decline has pushed the tobacco giant’s forecast dividend yield up to 10%, attracting speculation that a cut might be likely.

Last week brought a statement from the company confirming that there will be a change to the dividend policy — but for now at least, it won’t be cut.

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What’s changed?

A statement from the company on 8 July confirmed that Imperial’s policy of increasing the dividend by 10% each year will be scrapped from 2020 onwards. Instead, the dividend will grow annually, “taking into account underlying business performance”.

This decision does not appear to be a sign that IMB’s impressive cash generation is drying up. Instead, the company wants to have more freedom to use cash to repay debt, invest in new products and buy back shares when possible.

Plans to raise £2bn by May 2020 through selling non-core assets are said to be “on track”. A significant part of this is likely to relate to the group’s premium cigar business, which was recently put up for sale.

These new policies are expected to help reduce net debt and protect the group’s investment grade credit rating, without which borrowing costs would rise.

My view

To reassure shareholders that cash isn’t running dry, Imperial plans to use surplus cash to buy back up to £200m shares before the end of 2019.

With the stock at current levels, I’m in favour of buybacks as long as they don’t place debt reduction targets at risk.

Similarly, I agree with the company’s decision to ditch its restrictive policy of 10% annual dividend growth and adopt a more flexible approach.

However, I’m not sure this change will go far enough. My sums indicate that any saving from a reduced dividend increase will be wiped out by the cost of the share buyback. In addition, comments from boss Alison Cooper suggest that Imperial may invest more in vaping and related areas such as cannabis and caffeine.

The current dividend is already expected to account for 75% of earnings this year. When all of this extra spending is taken into account, I feel that a cut may still be necessary at some point.

Buy, sell or hold?

As I’ve said before, I’m happy to accept the risk of a dividend cut in return for owning a slice of this cheap and cash-generative business. Even in a worst-case scenario, I’d expect the stock to continue yielding at least 6% based on the current share price.

In a more positive scenario, I can see the firm developing profitable new next-generation products and gaining share in the growing vape market. Alongside this, I’d imagine the tobacco business will be gradually shifted into run-off mode, producing high levels of surplus cash for many years yet.

With IMB stock trading on 7.2 times forecast earnings and offering a 10% yield for at least one more year, I remain a buyer.

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Roland Head owns shares of 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.