Shares in tobacco manufacturer Imperial Brands (LSE: IMB) are out of favour right now. After trading above 4,100p shortly after the Brexit vote, the stock has now fallen to around 3,000p today. That’s a decline of nearly 30%.
Why the fall? Well, there have been several drivers. One was the FDA’s announcement in July that it wants to cut nicotine levels in cigarettes. More recently, the CEO of larger rival Japan Tobacco stubbed out talk of a potential acquisition.
The last time Imperial shares changed hands at this level was mid-2015. That leads me to believe that the shares now offer a compelling opportunity for dividend investors. Here are a few reasons why.
Let’s start with the prospective yield for FY2018. At 6.2%, this is one of the highest in the FTSE 100. Occasionally, a high yield can signal trouble. You have to be a little careful as a dividend cut could be on the horizon. Yet, in Imperial’s case, this does not appear to be the case. In my view, the stock just looks genuinely oversold.
One reason I believe Imperial’s payout isn’t at risk is the company’s recent dividend growth. In November, Imperial raised its dividend by 10%. To my mind, that’s a signal of confidence from management.
If companies anticipate tough times ahead, they often freeze their payments, or limit growth to a few percent. For example, both Royal Dutch Shell and HSBC have frozen their payouts in recent years. In contrast, a 10% dividend hike suggests management believes the outlook is positive. Furthermore, the company reiterated in November that it plans to keep increasing its payout by 10% per year in the medium term so expect more growth ahead.
Imperial’s dividend coverage looks satisfactory for now. The payout ratio last year was 64%. With analysts forecasting earnings of 263p per share for FY2018, cover is expected to be around 1.4 times. While that’s not a high ratio (ideally it would be closer to 2), it’s also not one to be particularly concerned about.
The stock’s valuation also looks extremely attractive right now. Imperial’s forward-looking P/E is just 11.5. In contrast, rival British American Tobacco has a P/E of 16.1. Neil Woodford believes the valuation is unjustified, recently stating that the current share price “just looks like the wrong price.” The portfolio manager has been adding to his holding recently, as have I.
Of course, shares in Imperial Brands aren’t without their risks. One such is the threat of government regulation. Another is the long-term decline in smoking rates.
Yet for now, Imperial is still generating plenty of cash flow and its dividend looks safe. The best time to buy high-quality companies is when they’re out of favour. In Imperial’s case that’s now, in my view.
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Edward Sheldon owns shares in Imperial Brands and Royal Dutch Shell. The Motley Fool UK has recommended HSBC Holdings, Imperial Brands, and Royal Dutch Shell B. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.