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Are Imperial Tobacco Group Plc & British American Tobacco Plc Running Out Of Puff?

Despite its unpopularity with governments and international organisations globally, the portion of the world’s population that smokes remains stubbornly high, even after years of tax increases and unilateral health initiatives that have all attempted to bring down this number.

It is the addictive nature of smoking that provides tobacco companies with resilience throughout the economic cycle, thereby affording them the cherished, defensive status within London’s community of listed companies.

It is this status, along with a strong performance within the underlying businesses, that has consistently propelled Imperial Tobacco (LSE: IMT) and British American Tobacco (LSE: BATS) to new highs during recent years.

However, today I write to urge caution to those investors that are hoping for continued gains from these shares — as it could be that this period of outperformance is about to come to a halt for both companies.

Below I explain why.

Balance sheet leverage could soon become an issue

An extended period of ultra low interest rates, in addition to sustained earnings and dividend growth, has enabled the expanding balance sheets of Imperial Tobacco and British American Tobacco to go largely unchecked.

Now, with an increase in both US and UK interest rates just around the corner, both companies may soon need to think about deleveraging.

At present, debt/equity sits at 1.93x and 2.48x for BAT and Imperial Tobacco respectively, while gearing comes in at 69% and 59% respectively.

Even for defensive companies, these numbers are slightly disconcerting, particularly when considering that annual earnings growth is often confined to the low-mid single digits for tobacco firms.

Dividend cover is also a potential cause for concern

In addition to slightly overweight balance sheets, an extended period of generous dividend growth has now begun to reduce the level of dividend cover offered by BAT and Imperial Tobacco to uncomfortably low levels.

Dividend cover at British American Tobacco is the lowest of the two companies, coming in at just 1.2x DPS, while consensus projections for earnings suggest that EPS growth will remain in the single digits out until at least 2017.

However, in its defence, the group has made no prior commitment to a set rate of dividend growth here. Instead, management have repeatedly stated the while increasing the payout is a priority, this will only happen as and when its is possible to do so.

Dividend cover is much more pertinent issue for Imperial Tobacco, who have pledged to grow the payout by 10% per annum over the medium term, even though cover was just 1.15x in 2014.

Furthermore, consensus earnings projections for Imperial Tobacco indicate that it will fare little better than BAT when it comes to EPS growth over the coming years, as the annual pace of expansion here is also expected to remain in the mid single digits until 2017.

This places a considerable question mark over the viability of further dividend increases over the medium term and I now believe it is possible that shareholders may find themselves being left disappointed at some time between now and the end of the above forecast horizon.

Summing Up

In summary, while it may certainly be possible for both companies to maintain the current per share distribution over the next 24 months, further growth is looking increasingly unlikely over the near term.

This will make it difficult for the shares to record further gains from here and, as such, it probably means that the lengthy period of outperformance that both companies have enjoyed is now coming to an end.

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James Skinner has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don’t all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

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