Suchat longthara/iStock via Getty Images

Suchat longthara/iStock via Getty Images

Market sell-off since the start of the year has highlighted that tobacco is a good place to hide whilst benefiting from a high dividend yield. The market is suffering from high inflationary expectations, restricting monetary policies, supply chain issues and the war in Ukraine. The S&P500 is down 13% YTD meanwhile Imperial Brands ( OTCQX:IMBBY) is up 4% and offers an 8% dividend yield. As we discuss below we see IMBBY as a good place to keep your money to avoid the threats that the wider market faces whilst benefitting from a strong dividend yield.

IMBBY's management is focused on the key markets and products that the company has to offer, improving the company's financial position and identifying pockets of growth that the company can explore. As we can see below full-year results for 2021 prove that the notion of dying tobacco industry is flawed and 2022 has proven tobacco industry exposure can help during uncertain times.

As we can see from the graph above the top and bottom line of the company has been stable with the bottom line rising at a faster pace. Over the last five years, the company had an average 2% growth in its sales, 7% growth in its operating income and 14% in net profit respectively. This is clear that the company is not dying, at worst is a stable company as indicated by the top-line growth. The operating profit and net profit margins have improved over the recent years and at the end of the last year's full results stood at 10% and 9% respectively, up from 8% and 5% since 2017.

This is also reflected in the earnings per share which increased by 15% year on year since 2017 with marginal contribution from shares outstanding decreasing slightly. At the same time, the company has improved its financial position by reducing total debt and improved interest coverage ratios. Total debt was reduced by 5% on average for the last 5 years from £12.5bn to £9.8bn and management is continuing to de-leverage the balance sheet which should allow the company to become more flexible and reward shareholders in the near future.

We see the above results as an indication that the company is not dying and the most recent H1 2022 results highlight that the company is moving to the right direction. Key highlights from their recent earnings are that the adjusted EPS was up 7.7% in constant currency terms to 115.2p, tobacco revenue was stable at 0.1% growth and non-combustible revenue grew by 8.7% in constant currency terms. In addition, the company generated £2.4bn in free cash flow and for the last 12 months and management de-levered the company further to £9.2bn. In addition, as we have previously discussed we see IMBBY as being behind the competition in NGPs however, there is progress with new products and trials being launched and revenue growth picking up. Our views align with management's priorities towards a disciplined approach to stabilize combustibles, de-lever the balance sheet and where possible exploit growth opportunities in NGPs. Shareholders stand to benefit from this approach as we discuss below and as indicated by the fourth capital allocation priority below.

A disciplined approach to de-lever the balance sheet and stabilize the combustibles means that the company's dividend will be safer. At 8% the company is paying a dividend that can benefit shareholders given high inflation expectations. The growth of 1% is small to attract dividend growth investors however, at current levels we believe the dividend is safe as the cash dividend payout ratio stands at 47% and the cash flow payout ratio at 54%. At 139.1p dividend, 1% growth rate and a discount rate of 7% the company has an upside capital appreciation of 30%. Following the dividend cut in 2020, the dividend seems to be well covered from earnings and cash, hence we expect IMBBY to continue to pay a progressively higher dividend.

We have argued in the past that share buybacks can unlock value for tobacco companies. Tobacco stocks are not favored by investors, fall outside ESG focused funds and operate in a declining industry. However, as British American Tobacco p.l.c. (BTI) proved the combination of low price multiples and share buybacks leads to shareholder value.

This unfavorable sentiment leads to low price multiples, high dividend yields and continuous negative momentum. However, IMBBY and other tobacco firms are well aware of the situation and as indicated above the management is following a disciplined approach to stabilize the company and de-leverage over time. Management stated that once leverage levels reach in the region of 2x-2.5x (debt to EBITDA) they will re-evaluate how capital can be used to benefit the company and shareholders. The company based on the H1 2022 results sits at 2.4x leverage levels so we expect share buybacks to follow soon as they will have more capital allocation flexibility and given the depressed stock price value will be unlocked.

To illustrate the effect that share buybacks could have let's assume that dividends are suspended and instead are used for share buybacks. As we mentioned above the company is expected to pay £1.40 per share. The current number of shares outstanding stands at about 947.5m. This means that the company is expected to pay dividends of around £1,326.5m. for the year 2022. Assuming a market cap of £17,055m and the current price of £18 to remain stable (keep in mind that if the dividend is suspended the share price will tank) IMBBY could purchase 100% of its shares back in approximately 13 years. With the company deleveraging, a cost of debt of 4.0% in 2021 and a dividend yield of 8.0% management might consider buying back shares using its own cash flow or by borrowing. We believe that share buybacks could be on the table for IMBBY for the years to come alongside dividend payments and shareholders stand to benefit.

As we mentioned above the market is currently pricing IMBBY with negative market sentiment. As the relative valuation below shows we think that the company is cheap, and correct management execution could lead to price multiple expansion and hence, price appreciation.

Altria Group Inc. (MO) and Philips Morris International Inc. (PM) both seem to be relatively overvalued compared to their UK counterparts. Comparing IMBBY with BTI, IMBBY is undervalued by a minimum of 22% and a maximum of 66%. We do expect IMBBY to trade at lower multiples than BTI, MO and PM for example due to lower NGP success or potential however, these are very low levels. In addition, IMBBY's P/E multiple is at historic lows highlighting the negative sentiment in the market. As the graph suggests a more normal P/E ratio would be 10x an upside of around 20%. The EPS growth and potential multiple expansion to 10x offers a significant potential upside. Management's discipline and stability in market share should lead to price multiple expansion. In addition, given the compressed price multiple, we see IMBBY as less susceptible to the inflation and tightening risks as price multiples are already well compressed.

The greatest risk for IMBBY is the regulatory threats. We have seen recently governments taking a more active role in markets with a recent example of the UK government imposing a windfall tax on energy companies. We expect IMBBY will face increased regulatory threads globally moving forward. For example in 2021 the FDA announced that they were planning to ban menthol flavours in cigarettes and regulate nicotine levels. Increased regulatory intervention is bad news for IMBBY. However, the company and industry, in general, showed that they can challenge decisions in courts and delay implementations for many years. Given the negative sentiment around the company and industry in general we believe that these risks are already priced in.

IMBBY offers a safe 8.0%+ starting dividend yield and is relatively undervalued. Management is doing a good job at stabilizing combustibles and deleveraging the balance sheet. Leverage levels are entering the range that management signaled that would trigger capital allocation re-evaluation. Shareholders stand to benefit from share buybacks and a high starting dividend yield. IMBBY is a strong buy during this environment as it has proven to be resilient, has a compressed price multiple and we expect management to unlock value for shareholders through share buybacks.

This article was written by

Disclosure: I/we have a beneficial long position in the shares of IMBBY, BTI either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.