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.
