Is This a Buying Opportunity for Tobacco Stocks?

Despite looming margin pressure, disappointment with heated tobacco performance is creating opportunities

Philip Gorham 7 August, 2018 | 9:46AM
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Rarely can the mood swings of the stock market have been so apparent in tobacco, historically a defensive industry, as they have been in the past 12 months, as investors have struggled to value the businesses amidst the biggest changes the industry has seen in decades.

Last year, tobacco was the darling of consumer staples; this year, heated tobacco growth has slowed, and investors have run for the exit. We have surveyed smokers and used Bass model analysis to measure the impact of next-generation nicotine products.

While the impact on revenue appears minimal, there are likely to be secular pressures on long-term margins from unfavourable mix, higher customer acquisition costs, and an eroding cost advantage, which appear to have been overlooked by the market's frothy valuations six months ago.

On the other hand, the market now appears to be overlooking the potential of pipeline products to reignite growth. Our new analysis increases our conviction that the sell-off has been so steep that there is value in the group. Our pick is Imperial Brands (IMB), which has been egregiously punished by the market.

At 10.6 times 2019 earnings and paying a 7% dividend yield, Imperial is trading at multiples below its peers, below its historical averages and 20% below our £37 fair value estimate, reflecting investors' overly pessimistic outlook. We think Philip Morris International and Japan Tobacco are also undervalued.

Imperial is Analysts' Sector Pick

We are lowering our fair value estimates for British American Tobacco (BATS), Imperial Brands, and Philip Morris International (PM) by 10%, 2%, and 5%, respectively, after making less optimistic assumptions about medium-term margin expansion.

We still believe there is value in the stocks, however, particularly in Imperial and Philip Morris. After some wild swings in its valuation, the tobacco industry appears out of favour, and the stocks are trading on lower multiples than we think is justified in the longer term.

In the short term, Imperial's tobacco volumes look likely to outperform its larger peers with a slightly below-average decline, as the firm cycles a 4% decline the previous year and thanks to some strong execution on brand migrations.

Nevertheless, challenges remain in some key markets, including the UK, France, and the Middle East, and in the medium term, we are comfortable modelling a volume decline rate in line with the market.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
British American Tobacco PLC3,152.00 GBX-0.65Rating
Imperial Brands PLC1,740.50 GBX0.81Rating
Philip Morris International Inc102.16 USD0.02Rating

About Author

Philip Gorham