The Imperial Brands (LSE: IMB) share price has fallen by more than 30% over the last year. The stock now offers a dividend yield of 11.6%.
Impressively, this payout is still covered by free cash flow. So why do investors hate the stock so much? And should income-seeking contrarians be buying before the price goes up?
I’m going to look at the latest numbers from Imperial and explain why – ethical issues apart – I think the share are worth considering as an investment.
Why are the shares so cheap?
Imperial’s share price has fallen by 50% over the last three years, but the company’s profits have only fallen by 25%. As a result, the stock now trades on just 6.5 times 2020 forecast earnings, with a dividend yield of more than 11%.
What’s more, the company’s free cash flow – the amount of spare cash it creates each year – has remained largely unchanged, at about £2.3bn, after interest payments. This is enough to cover the dividend. So why are investors worried?
One concern is the continued global decline of tobacco smoking. Big firms like Imperial are managing this problem by concentrating their efforts on fewer, larger cigarette brands. But the total number of cancer sticks sold by the firm last year fell by 4.4% to 244.2bn.
Next-generation products (NGPs) such as vapes were meant to be picking up the slack. But expansion of this category in the key US market is facing new regulatory risks after reports that vaping may be linked to serious lung disease.
Although Imperial’s next-gen sales rose by 50% to £285m last year, this was less than expected. It’s also just a drop in the ocean compared to tobacco sales of £7.7bn.
Why I’d buy IMB
This situation isn’t without risk. To be honest, I think a small dividend cut would be sensible. But I don’t expect a collapse. I reckon Imperial’s financial performance suggests that this business has plenty of gas left in the tank, and could be cheap at current levels.
Tobacco and NGP revenue rose by 3.9% to £7,998m last year, as price increases plus a changing mix of brands helped to offset lower smoking volumes. Operating profit from these operations fell by 0.7% to £3,531m, but this figure includes additional investment in the loss-making NGP division.
Imperial’s figures show that without the extra costs of investment in NGP, tobacco profits would have risen last year. As it was, the company still generated an operating margin of 44% from tobacco and NGP products.
Management expects the core tobacco business model to remain stable and I suspect they will be right, at least in the medium term. The reality is that globally, more than 1bn people still smoke. Such a large customer base isn’t going to disappear overnight.
A tough call
2020 looks likely to be a difficult year for Imperial. The company expects a higher tax rate and some restructuring costs. Uncertainty for shareholders is likely to be made worse by the search for a new chief executive. The departure of veteran Alison Cooper was announced in October, but it’s likely to be some months until a replacement is found.
I think that Imperial could be a classic contrarian buy. There are lots of reasons to dislike the stock. But its financial performance remains strong, and the shares look cheap.
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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.