On Wednesday morning, Imperial Brands (OTCQX:IMBBY) disappointed their shareholders by warning that their first half results for 2020 net income will likely be down approximately 10% year on year. This caused their share price to slump with them closing down 7.05%, even though they believe they can recover some of this weakness later in the year. When combined with their sliding share price from the last few years, it has pushed their dividend yield to around a massive 11%. Naturally, this new development raises questions regarding the sustainability of their dividend payments.
When assessing dividend coverage, I prefer to forgo using earnings per share and use free cash flow instead since dividends are paid from cash and not from “earnings”. The graph included below summarizes their cash flows from the last three years:
Image Source: Author.
Whilst they have always been able to cover their dividend payments with free cash flow during the last three years, it still has been deteriorating. Fortunately, this is largely due to higher dividend payments and not worsening free cash flow, which has itself remained broadly flat during this same time period. This indicates that their dividend payments are consistently funded through their organic financial performance and not from accessing debt markets.
Notwithstanding this decent historical performance, there are still reasons to be concerned going forward, as their dividend coverage of 116.76% in 2019 leaves minimal room to cover their dividend payments if their financial performance deteriorates. If they are unable to reverse their forecast 10% net income decline for the first half of 2020, their dividend coverage will fall to approximately only 105%, assuming the decline in net income translates to an equal decline in free cash flow. Even if their free cash flow only declines by a smaller amount, it still sets the scene for their dividend payments to be reduced in the short to medium term.
When assessing their free cash flow, it is important to remember that unlike their North American peers, the accounting standards on the other side of the Atlantic Ocean allow for their interest income and expense to be included as investing and financing activities respectively. This means that if an investor simply subtracts their capital expenditure from their operating cash flow, it ignores their net interest expense and thus paints an inaccurate image of their dividend coverage. The extent that this impacts the results naturally depends on indebtedness, and this time, it makes a material difference, with their 2019 dividend coverage increasing to 142.41% if their net interest expense were to be ignored.
Since their dividend coverage has become slightly stretched lately, it is important to consider their financial position, as it will be instrumental in ensuring their current dividend payments can be maintained. The two graphs included below summarize their financial position from the last three years:
Image Source: Author.
Overall, their financial position has modest strength and has been staying broadly unchanged throughout the last three years. Nevertheless, they still have minimal scope to safely fund dividend payments through debt even if their earnings were to remain static. This indicates that if their dividend coverage were to deteriorate further, then it becomes quite likely they will reduce their dividend payments to ensure that their financial position remains stable.
If their net income were to decrease by 10% and this were to translate equally to their EBITDA, then their net debt to EBITDA would expand to 3.59. Whilst these financial metrics would normally be considered adequately safe for a tobacco company thanks to the inelastic demand for tobacco, they are concerning if their earnings are coming under downward pressure. The bigger risk facing their financial position, and thus dividend payments, stems from the concern that these weakening earnings are only the beginning, as their industry is facing a secular decline and attacks from the anti-smoking campaign.
Ultimately, only time will tell whether this latest earnings warning marks a turning point or just a bump on the road. Nevertheless, I believe that 2020 will be a make or break time for their dividend payments, with deteriorating financial performance likely spelling the end of their double-digit dividend yield. Whilst it appears as though they may be capable of maintaining their dividend payments in the short term, investors would be wise to ensure that any potential investment is still desirable even if these dividends were significantly reduced by 25% to 50% in the future.
Notes: Unless specified otherwise, all figures in this article were taken from Imperial Brands’ Earnings Reports, all calculated figures were performed by the author.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.