Imperial Brands has an 8.3% dividend yield – but what’s the catch?

On the face of it, Imperial Brands (LSE: IMB) looks to be one of the most attractive income stocks in the FTSE 100 with a prospective dividend yield of 8% for 2022 and 8.1% for 2023.

Refinitiv analyst estimates also have the stock trading at a forward price/earnings (p/e) multiple of 6.9.

However, I wouldn’t take these figures at face value; in my opinion, Imperial’s stock looks cheap – but it is cheap for a reason.

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Over the past ten years, Imperial has failed to create any substantial value for investors. The shares have returned 2.6% a year including dividends, compared to 6.2% for the FTSE All-Share Index.

What’s more, net income excluding extraordinary items has barely budged since 2014. Net income did jump in the financial year ending 30 September, 2021, although this was mainly down to a favourable financing charge. Excluding this positive development, adjusted group operating profit rose just 0.5% after stripping out the contribution from the now sold cigar division.

The dividend cut hurt sentiment towards the FTSE 100 company

While British American Tobacco (LSE: BATS), Philip Morris, Altria and Japan Tobacco International have become known the world over for their cash flow and dividend credentials, Imperial has struggled. In order to meet investor concerns about the overleveraged state of its balance sheet, it cut its dividend by a third in 2020.

This cut rebased the dividend to a more sustainable level. In the four years prior, dividend cover averaged just 0.6. To put it another way, Imperial Brands had been consistently paying out more than it could afford.

In my opinion, the decision to cut the dividend by a third was the right one. It had been bridging the gap between profits and dividends with borrowing, straining its balance sheet. A lower payout will not only help Imperial to cut borrowings, but will also help it deal with rising interest rates.

The decision to rebase the dividend is part of the new CEO’s growth plan.

In 2021 CEO Stefan Bomhard unveiled a five-year strategic plan to concentrate investments on the markets and regions where Imperial has the edge; the plan also acknowledges that it is a follower, rather than a leader in most markets, so it should focus on driving cash generation and returns for investors rather than trying to fight off bigger competitors with deeper pockets.

Unfortunately, while I believe the decision to cut the dividend was the right one, I think it decimated investor confidence. It could also explain why the market does not seem to have much confidence in its current dividend and valuation.

Still, Imperial’s management is pushing on with its transformation strategy and 18 months in, it is entering the “strengthening phase. ” In this phase it aims to develop and reinforce its position in its main markets, namely the US, UK, Australia, Spain and Germany.

In the six months to the end of March, Imperial increased its market share by 25 basis points in these primary markets, a notable development after an extended period of underperformance.

Nevertheless, there’s no denying the business faces a huge uphill struggle in the years ahead. As well as fighting off competitors, management is also going to have to deal with increasingly stringent tobacco regulations around the world.

Launching new so-called next-generation products, the category that includes e-cigarettes, heated tobacco and snuff products, is part of this strategy. During the six months to the end of March, adjusted operating losses from next-generation products improved by 50%.

Imperial Brands is making progress, but it has lots of work to do

When I am looking for dividend stocks to add to my portfolio, I tend to concentrate on businesses with robust balance sheets, a strong track record of creating value for investors and growth potential. If a company is not growing and paying more than it can afford to shareholders, sooner or later it will suffer the consequences.

To give Imperial its credit, it seems to have realised it was heading in the wrong direction. However, it’s going to take a lot to convince the market the business is back on the right track.

Then there is the fact that it faces much stronger competitors in its key markets, including Philip Morris and Altria, which own the rights to the Marlboro brand internationally and in the US respectively.

The company has acknowledged that it is a follower, not a leader, Which makes sense from a strategic planning point of view. However, as an investor, I’m not really looking to invest in corporations that are second best. Why would I? With thousands of companies to choose from around the world, I focus on finding market leaders.

That’s why I hold British-American in my portfolio, even though it is more expensive and has a lower dividend yield than Imperial. I’m planning to steer clear of Imperial until it can prove it’s on a sustainable growth trajectory.

Disclosure: Rupert Hargreaves owns shares in British American Tobacco.