Imperial Brands (IMB) Share Purchase – 10% Dividend Yield Covered By Free Cash Flow

Regular readers of this website will know that I am a huge fan of Imperial Brands. So much so that it is the largest stock position in my portfolio at close to 10%.

But the price of IMB has been falling of late. This is in contrast to the underlying business performance where revenues, profits and dividends have been increasing!

So why have shares in IMB dropped so much. Below are a few of the reasons I think why.

1.Big money is becoming more ethical. By this I mean that the large pension funds, sovereign wealth funds, insurance companies and fund houses do not want to hold sin stocks such as tobacco. In fact, they have been divesting their stakes in the Tobacco sector – when large swathes of money don’t want to invest in a particular sector, it depresses the share price. As the biggest players on the stock market cannot own tobacco stocks, valuations of companies in the industry are low (due to low demand). Low valuations lead to high free cash flow and dividend yields. And high dividend yields, compounded over decades, add up to massive returns.

2. Death of big Tobacco. A number of investors are worried by tighter rules and regulations going forward. But history has shown than regulation has been good for the tobacco industry. Every time a new regulation was brought in, it turbo charged tobacco company profits. I wrote about this before in a post titled ‘Investing in the Tobacco Industry – why regulation will not curb the great investor returns ‘ and the post is definitely worth a read.

3. Disruption. There is an argument that traditional cigarette sticks are being disrupted by new forms of nicotine delivery such as Vaping. This is a genuine cause of concern as the vaping market is saturated. There are hundreds of players in this market meaning that even if the big tobacco companies were to switch users from traditional cigarets to vapes or other reduced risk products, it wouldn’t be as profitable. Big tobacco’s stranglehold on the industry is loosening with this new disruption and the monopoly profits of yesteryear might not carry on in the future.

4. High Debt – Imperial Brands has a high debt load as a result of an acquisition binge it went on a few years ago. In the current climate, investors appear to be shunning highly indebted companies due to rising tensions, rising interest rates and grey clouds forming on the horizon of the global economy.

5. Sale of cigar business – Imperial Brands recently announced plans to dispose of its premium cigar business. A number of investors were in this stock due to the special situation of the company owing 50% of Habanos- the maker of Cohiba, Diplomaticos and Montecristo . The thesis was that once the lucrative USA market opened up to Cuban cigars, sales would sky rocket. . This hasn’t materialised as yet and thus Imperial is looking to sell this business.

6. Dividend cut – Like Imperial, both Vodafone and Royal Mail were yielding close to 10% before there dividends got slashed. Looking at Imperial’s earnings, it doesn’t appear to be sufficient to cover the dividends. Thus it is easy to see why investors are scared of IMB. But I did a piece recently titled ‘ Understand Accounting To Be A Better Investor – Earnings Vs Free Cash Flow’ showing why Imperials earnings may be distorted. Have a read of that and make up your own mind as to wether Imperial Brands dividend is safe. For what its worth, Imperial Brands increased its half year dividend by 10% recently – the 11th straight year of 10% dividend increases!

7. Woodford selling out – Neil Woodford has been one of the biggest investors in Imperial Brands. But due to the underperformance of his fund, investors have pulled money out thus forcing Woodward to sell assets (stocks) in order to fund these redemptions. Now this is where it gets interesting. Everyone knows that Woodford has become a forced seller and due to his transparency everyone knows what he owns. I think the hedge funds have shorted stock in companies Woodford owns in order to profiteer from Woodfords demise. Looking at Woodfords funds, Imperial Brands used to be the top portfolio holding of the Income focus fund. Now it doesn’t even appear on the list. It seems that Woodford has been heavily selling Imperial Brands stock over the last few weeks. And because everyone knows Woodford needs to meet client redemptions, they can bid the price down and Woodford would still have to sell even if it looks like he is doing so far below intrinsic value. In short, there is a forced seller around selling stock not because they think the business is bad, but because they have to return money back to clients.

Whilst they are a number of factors going against Imperial Brands right now, there is one major factor going in its favour, the industry it operates in is a fabulous wealth greater.

Credit Suisse published a report in 2015 detailing the performance of every major American industry from 1900 to 2010.

One dollar in the average American industry was worth $38,255 by 2010. That’s an annual return of about 10% per year. Some did far better: $1 invested in food companies was worth about $700,000 by 2010.

Then there’s tobacco, which was in a league of its own.

One dollar invested in tobacco stocks in 1900 was worth $6.3 million by 2010. That’s 165 times greater than the average industry.

In fact, the single best performing stock over the past 50 years has been Phillip Morris, a tobacco stock.

There is good reason for tobacco being the Number 1 wealth generator. The industry has the highest Return On Capital Employed (ROCE) figures. Tobacco has a ROCE of 46.6% – far in excess of the next loses industries, Information Services 36.4%, Advertising 32.3% and Healthcare and Support Services at 31%.

Why is ROCE so important is determine success?

Lets look at a simple example in order to understand this.

Say you have the option of buying two houses, house A and house B. The houses are equal in all aspects. Both are selling for £100,000. The only difference is that house A has rental income of £40,000 a year and house B has rental income of £20,000 a year.

Which house would you buy.

It is pretty obvious. You would go for house A as your return would be twice as much as you would have bought house B.

Same way in business, those that make investments with higher returns will end up reliving more wealth for shareholders.

That is why Tobacco stocks have far outpaced the market over the long term. The MSCI World Tobacco index returned an impressive 1,437% from the end of 1999 through 2015, compared with just a 72% return for the broader MSCI World index.

My Purchase of Imperial Brands (LON:IMB)

At present, shares in imperial Brands are hated. Imperial trades on a one year forecast rolling PE ratio of just under 7 and offers a dividend yield of more than 10 per cent, while profits, free cash flows and dividends are expected to keep on growing for the next three years.

I have found this offer too tempting to pass up.

I thus bought 119 shares of IMB at £19.35 each.

Sure the share price might keep falling but at this price I am sure that I have bought a stock that will outpace the market over the medium and long term.

As Joel Greenblatt said “ Unless you buy a stock at the exact bottom (which is next to impossible), you will be down at some point after you make every investment. Your success entirely depends on how dispassionate you are towards short term stock price fluctuations. Behavior matters.”

This purchase brings my IMB exposure close to 10% of my entire portfolio. This is far in excess of any other stock I own. I am worry of my position size but I have left just enough room for one more large purchase of IMB should the valuation remain compelling as and when I have more cash to invest.

Looking at last years dividend of £1.87 a share, these 119 shares add £222 in annual dividends to my portfolio.

But I am expecting much more than this. Much much more.

You see Imperial has been increasing their dividends by 10% a year for the past 10 years. This trend has continued as Imperial lifted its half year dividend by 10%. It is able to do this due to the prodigious free cash flow it produces.

Taking into account this half year raise, these 119 shares will throw off £230 in dividend income. If the end of year dividend is raised, I expect this number to rise even further.

In addition to these 119 shares, I am already an existing owner of 260 shares in IMB. The recent half year dividend increase mean these shares will throw off an extra £16 in annual dividend income.

In total, I am the proud owner of 379 shares in IMB. These shares produce an annual income of £732. That is £2 every single day. It’s a wonderful feeling knowing this money will be thrown my way irrespective of what I do.

Looking at my portfolio as a whole, it is now expected to generate a £3,550 in annual purely passive dividend income. Another milestone ticked off. My dividend snowball is in action. And it feels great.

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