Stockwatch: What's not to like about this blue-chip?

Check out interims on Wednesday 4 May from FTSE 100-listed tobacco group Imperial Brands. The stock, until February known as Imperial Tobacco, may continue rising. After falling from a long-term high of 3,860p to support at 3,570p, the shares have topped 3,700p after Goldman Sachs and Deutsche Bank upgraded at the end of last week ahead of the figures.

The brokers noted a modest discount to other international tobacco companies and "catalysts" by way of the results and an 8 June investor day. We shall see. Irrespective of near-term dynamics, Imperial Brands can boast an impressive record of double-digit dividend growth and prospects, to attract professional investors.

Indeed it remains the fourth largest holding of Fundsmith, a revered fund led by Terry Smith which has achieved annual compound returns in the high "teens" of percentages during its five years' existence.

With just 25 holdings, he has cut this record by investing quite like Warren Buffett in the sense of prioritising global consumer brands able to maintain consumption despite economic uncertainty. He would not be so exposed if the yield reflected pricing for cyclical risks.

Earnings valuation full but cash flow and yield appeal

A 12-month forward price/earnings (PE) ratio of 15 looks over-priced considering the earnings growth rate is currently forecast to slip back to single figures. British American Tobacco, for example, trades on 17.5 times earnings anticipating 26.5% earnings growth in 2016, moderating to 11.2%. So I doubt Goldman's claim in terms of the chief London-listed comparison. Yes, the stock is on a modest PE discount, but in earnings terms it's not a value discount.

More positively, the table shows cash flow per share ahead of earnings and capital spending modest in context, which powers a robust dividend profile. With a global market share of 13.3%, Imperial is targeted to generate £13 billion free cashflow over the next five years, i.e. over 36% of its current market capitalisation. That's just the kind of credential likely to make Terry Smith retain Imperial as a core holding and make other institutions consider anew.

A 4.4% prospective yield is nothing special in a market where it is not hard to find 5% and higher, but, in terms of capital prospects and after a modest setback in 2013/14, the management speaks in terms of having achieved "foundations for a year of strong delivery".

The interim results and operating review will, therefore, be interesting, recalling how management declared at last November's prelims Imperial was "in a transition phase, optimising the brand portfolio and marketing approach, effectively managing cost and cash: these initiatives are strengthening the business".

Quite whether the progress can in due course justify upgrades to the modest forecasts currently is unknown, Goldman and Deutsche being straws in the wind.

First quarter results (covering the final three months of 2015) showed tobacco net revenue up 16.6% at constant currency or a 10% actual rise, with growth/specialist brands accounting for 57% of this.

Cash conversion of operating profit remained over 90% in support of the dividend, while debt reduction after net debt soared 43.6% to £11.6 billion by end-September 2015. That was due to the £4.6 billion acquisition of various cigarette brands owned by Reynolds and Lorillard Inc.

This meant net gearing reached just over 200%, although the last annual figures showed net finance costs covered nearly 12 times by operating profit, i.e. higher interest costs can be accommodated in the short term. It appears a prime example of how low interest rates have lured global firms into acquisitions to boost growth credentials.

Imperial's first-quarter update held out another carrot, by way of management actions able to benefit the longer term: "a greater focus on quality revenue growth, simplifying the product portfolio and prioritising profit". The interims or outlook statement ought to show what substance is evolving.

Director buys £682,936 stake

At the end of March, recently-appointed non-executive director Steven Stanbrook bought the equivalent of 17,972 shares at about 3,800p via American Depositary Shares. That's a substantial cash commitment and the kind of trade investors like to see - rather than a token purchase to meet expectations for directors to own stock.

A highly-experienced American CEO, he should have a decent nose for value. It would seem Imperial's US acquisition has garnered more American interest given the way Goldman Sachs is drawing attention with a 3,950p target and JP Morgan Cazenove has raised its own from 3,600p to 3,780p.

The chart has quite powered ahead in the last two years, reflecting not just underlying improvement after a dip in 2013/14, but that, despite ethical issues, tobacco is a relatively dependable, if mature, industry - versus so much else that is uncertain.

As if trying to shed the industry's shabby image versus healthcare costs and needs, the group re-named in February from "Tobacco" to "Brands" - as if also to convey intangible values. Its £18.7 billion of intangibles on the balance sheet explains the record of negative net tangible assets, so don't be perturbed by this - but in the context of a rich PE it emphasises cash flow/dividend valuation.

Global revenue profile implies risks and rewards

I have drawn attention to Imperial a few times before e.g. initially at 2,200p in May 2011 on the basis of a 5% prospective yield and solid brands, an approach which didn't set out for capital gains, but evidently made its own luck. The stock has likely benefited also from an ultra-low interest rate environment, emphasising a search for yield and Imperial offering less by way of cyclical risks.

Mind that tobacco's drive for new smokers in developing countries meant they effectively contributed half of group revenues in the last financial year, versus only 6%, for example, from the US (but will now rebalance after the acquisition).

I make this point in the sense it implies a chief risk is potentially an emerging markets financial crisis, say, if the US gets forced into raising interest rates sooner and more sharply than expected - considering the extent of dollar-denominated debts run up during very low rates offered. It's the kind of shock capable of dealing a blow to consumer spending, if as yet only an off-chance.

With only 18% of revenue derived from the UK in its last year, Imperial is also likely a good choice to bear in mind in the event of a Brexit vote in June causing jitters for stocks and sterling.

A final point for income investors: Imperial has begun quarterly dividend payments to provide shareholders with more regular cash returns.

For more information see their website.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.