Is the 7% dividend yield safe at Neil Woodford favourite Imperial Brands plc?

FTSE 100 stalwart Imperial Brands (LSE: IMB) was the largest holding in fund manager Neil Woodford's Equity Income Fund at the end of 2017.

But this defensive stock's 28% decline over the last 12 months will have dented the value of many dividend portfolios.

Imperial shares now trade on a forecast P/E ratio of 10, with a prospective yield of 7.1%. If this payout is sustainable -- as my fellow Fool Rupert Hargreaves believes -- then this stock could be too cheap to ignore.

Why are the shares falling?

Imperial certainly faces some challenges. The group's 'stick equivalent' volumes fell by 4.1% or 11.3bn last year, as declining consumption in mature markets outweighed growth elsewhere.

Excluding the benefit of shifting exchange rates, the revenue from tobacco sales fell by 2.6%, while adjusted earnings fell by 2.2% to 267p per share. Although the group is investing in new areas such as vaping and tobacco heating, these don't yet generate a meaningful amount of profit.

Indeed, one potential concern is that while tobacco cigarettes are cheap to make and can be sold at very high profit margins, the products which replace them may be less profitable.

To combat falling levels of smoking, tobacco companies have been merging and combining. Doing this creates fewer, larger producers and cuts costs. This has been a fairly successful strategy, but acquisitions have left Imperial with net debt of £12.1bn.

This mountain of debt required interest payments of about £550m in each of the last two years. Some investors are now asking if this could threaten the safety of the dividend. To find out more, I've taken a closer look at the firm's 2016 and 2017 accounts.

A cash machine?

One of the attractions of the tobacco business is that it doesn't require much spending on research and development. The only time major investment is required is usually when an acquisition is made.

As a result, Imperial's profits have been converted fairly consistently into free cash flow. This is what's enabled the group to increase its dividend by 10% each year for the last nine years.

Looking at the group's accounts for the last two years, I calculate that in 2016, free cash flow was £2,419m. Of this amount, £1,428m was paid out in dividends.

The situation got a little tighter in 2017, when free cash flow fell to £2,230m and the group paid out £1,577m in dividends.

My view

Free cash flow has fallen in each of the last two years, while dividend growth has been maintained at 10%. This has reduced the amount of cash available for debt reduction.

We don't yet know how 2018 will turn out, but broker consensus forecasts suggest to me that surplus cash could fall again. The group's adjusted net profit is expected to fall from £2,606m to £2,467m this year. If this decline is reflected in free cash flow, then the level of surplus cash available for debt reduction could shrink for a third consecutive year.

I think there's a reasonable chance that this dividend will be maintained for the foreseeable future. But I think the high 7.1% yield indicates the falling quality of this payout. This share wouldn't be at the top of my list of income buys.

5 defensive dividends I would buy

Imperial Brands' high yield is tempting. But I believe long-term investors could do much better elsewhere in the FTSE 100.

That's a view shared by the Motley Fool's top income analysts, who have selected five defensive dividend stocks which they rate as potential lifetime income buys.

I can't reveal the names of these companies here, but you can find full details of all five stocks plus suggested buy prices in our exclusive report, 5 Shares To Retire On. This free, no-obligation report is available to download now. To get your copy, just click here.

Roland Head has no position in any of the shares mentioned. The Motley Fool UK has recommended Imperial Brands. 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.