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Are the tobacco giants running out of puff?

Imperial Tobacco’s recent dividend warning caused many investors to reach for a calming cigarette.

Imperial Tobacco’s wobble on its dividend last week shocked some analysts, calling them to ask whether tobacco stocks are losing their edge as income stalwarts.

But the sector has always had its ardent fans, most famously Invesco Perpetual’s Neil Woodford.

Imperial, whose brands include Golden Virginia and Davidoff, reported a loss of £184 million over the six-month period to March, compared to a profit of £326 million the previous year. The firm said acquisition costs relating to its takeover of Altadis in late 2007, and the impact of falling sterling, had cancelled out growing sales and revenues. Falling sterling was also blamed for adjusted net debt growing to £14 billion, up from £11.5 billion at the end of September.

The firm did, however, note a 54% increase in turnover to £12.4 billion for the six months to the end of March.

Arguably the most significant element of Imperial’s half-year results on 14 May, according to the market, was management’s suggestion that future dividend growth could be reduced in order to take into account the restructuring costs of its Altadis acquisition.

This led to speculation that the full-year total dividend might be closer to 70p per share, rather than the 80p some analysts had expected, still up from last year’s full-year dividend which was 63.1p per share. Meanwhile, the firm’s interim payout stood at 21p per share, pretty much flat on a year ago. As a result, the firm’s share price fell by 25p to £15.67 on the day.

With a forecasted dividend yield of around 4%, Imperial Tobacco, alongside fellow sector heavyweight British American Tobacco (BAT), which has a forecasted yield of 5%, has long proved a favourite among equity income investors.

But income-seekers now need to consider whether short-term cashflow and debt issues will jeopardise Imperial’s ability to deliver on much relied upon dividend growth. Moreover, as the global recession deepens, will down-trading in the West and potentially lower consumption in the emerging markets, alongside increases in excise duties, challenge the seemingly defensive nature of the sector?

Chris White, who currently holds Imperial Tobacco in his Threadneedle Monthly Extra Income fund, believes that Imperial’s management team did not communicate their message about their final dividend very well, which may result in short-term share price weakness.

Nonetheless, he sees the stock as a cheap consumer staple and is encouraged by progress with the Altadis acquisition, particularly in terms of employee negotiations and the restructuring of manufacturing.

White says: ‘The synergy has been realised and will come through. The real disappointment has been that dividend expectations have been downgraded in the market. I feel that Imperial Tobacco has to sit on the naughty step for a while, but it will recover. I expect share price performance to lag BAT for a short period.’

He adds: ‘I envisage the yield still growing over the next few years, albeit from a lower base.’

Rensburg UK Equity Income manager Colin Morton, who is Citywire A-rated, also puts market confusion down to a mis-communication by Imperial’s management.

Morton says: ‘It has been confusing as management didn’t put the point across very well that the full-year dividend is still growing and is going to be in line or slightly above last year.’

He expects the charges relating to the Altadis acquisition to result in a final dividend payment which is 5-6p below expectations and also points to another charge in 2010, which could further affect dividend growth. Nonetheless, he expects the firm’s dividend to pick up in 2011 and said his longer term dividend growth forecasts remain intact.

Morton says: ‘Once exceptional costs drop out for Altadis, we should get a dramatic increase in dividend, which will be roughly the same as expected but just differently phased.’

As Morton remains confident on the underlying profitability of Imperial and its resilience in the economic environment, he is considering increasing his position in the company, which he sees as ‘substantially undervalued’.

He is bullish on the tobacco sector, pointing to what he sees as reliable growth, ‘reasonably assured profitability’ by very cash-generative businesses, despite the challenging economic environment.

Elaine Coverley, a divisional director and analyst at Brewin Dolphin, is unconcerned about a potentially smaller full-year dividend and points to Imperial’s double-digit dividend growth for the year.

She currently favours Imperial over BAT, highlighting more synergy savings and opportunities to cut costs, which she says will come through at a later point. She is forecasting a dividend pay-out ratio of 48%, just below the firm’s current 50% policy.

Coverley says: ‘I’m not really that concerned as it is not the type of company that is going to disappoint on dividend. It is just trying to be prudent with cash costs.’

Coverley has, however, downgraded the tobacco sector as she is not expecting outperformance from defensives in the foreseeable future.

Tina Cook, an analyst at Charles Stanley, describes the market reaction to Imperial’s dividend statement as ‘overdone’, pointing to subsequent comments made by CEO Gareth Davis that it would be an incorrect conclusion to assume the dividend ratio will be cut. Although Imperial has higher gearing levels than British American Tobacco, she highlights that the debt is manageable and longer term the firm will have a broader portfolio.

Alex Crooke, manager of the Henderson High Income trust, is encouraged by the firm’s underlying profits, which he says are still driving dividends and creating some potential for dividend growth.

Clash of the tobacco titans: Are investors backing BAT or Imperial Tobacco?

Chris White, Threadneedle Monthly Extra Income

‘I prefer British American Tobacco over Imperial Tobacco because it is better diversified across a wide range of geographies and has a higher dividend yield. It has a substantial cost-cutting programme and a track record of delivering.’

Prefers BAT over Imperial Tobacco but holds both

Simon Gergel, Allianz RCM UK Equity Income

‘I have traditionally favoured BAT partly because of its growing emerging market presence, where it has seen growth, and a higher dividend yield. It probably has more scope to cut costs and restructure, but Imperial Tobacco has a strong market presence in the UK, where it has very high margins. As of today it is a closer call because Imperial Tobacco looks cheap on cashflow yield.’

Holds BAT but does not hold Imperial Tobacco

Alex Crooke, Henderson High Income trust

‘I slightly prefer Imperial over BAT, but both are showing defensive earnings in this sort of market. It is a better place to be over cyclicals.’

Prefers BAT but holds Imperial Tobacco

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Neil Woodford
Neil Woodford Average Total Return:
91/91 in Equity - UK Equity Income (Performance over 3 years)
Simon Gergel
Simon Gergel Average Total Return:
17/91 in Equity - UK Equity Income (Performance over 3 years)
Chris White
Chris White Average Total Return:
70/91 in Equity - UK Equity Income (Performance over 3 years)
Colin Morton
Colin Morton Average Total Return:
23/91 in Equity - UK Equity Income (Performance over 3 years)

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