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British American Tobacco Plc And Imperial Tobacco Group PLC: Where There’s Smoke, There’s Buyers

For many investors, tobacco stocks are addictive. They couldn’t do without a puff of Imperial Tobacco Group (LSE: IMT) (NASDAQOTH: ITYBY.US) or British American Tobacco (LSE: BATS) (NYSE: BTI.US) in their portfolio. Most investors see them as a great long-term hold, but should recent results make you a buyer?

Mint Imperial

Investors in Imperial Tobacco have been fretting lately, wondering whether it can reverse falling volumes and maintain margins in Europe. They can breathe more easily following its interim statement for the nine months to 30 June, which confirmed management’s full-year expectations, and reported “significant progress” in plans to optimise long-term growth. It has also found £30 million of cost savings.

The share price rose a heady 3.5% on the day, despite a 5% drop in cigarette stick volumes and 1% fall in revenues. Smoking is a declining habit in many countries. Legal cigarettes are also out of favour, as cash-strapped consumers in southern Europe turn to fake, smuggled or roll-up ciggies. Imperial Tobacco has partly offset this by boosting performance in fine cut tobacco, premium cigars and snus.

Ash cash

Imperial Tobacco’s share price has been in decline, down 11% over the past 12 months, against a 9%-plus rise in the FTSE 100. It has returned just 20% over three years, marginally lower than the FTSE’s 23% gain. Today, you can buy it for £21.77, at a tempting 10.9 times earnings. That’s a discount to the tobacco sector P/E of 13.6 times earnings. Its yield is a healthy 4.8% against 4.4% for the sector, and that is forecast to hit 5.3% later this year.

Forecast earnings per share (EPS) growth looks solid enough, at 4% to September 2013 and 7% in the subsequent 12 months. But Imperial Tobacco is an income rather than a growth stock (only 10 FTSE 100 stocks yield more), as reflected in Bank of America’s recent decision to cut its target price from £23.80 to £23, around 5% above today’s share price.

Take BAT!

British American Tobacco’s recent half-year results showed a 4% rise in profits to £2.9bn, mainly due to strong pricing momentum. Adjusted group profit from operations increased by 6%, at constant exchange rates. Yet cigarette volumes were lower, falling 3.4% to 332bn. This industry may be in decline, but BAT has continued to increase cigarette market share in its top 40 markets. Management said the business is performing well despite fragile economic conditions, and investors should see another year of good earnings growth. It upped the interim dividend 7% to 45p.

BAT has had a better share price run rather than Imperial, having grown 57% over the past three years. Meagre growth of 2% over the past 12 months is still better than Imperial’s 11% slump. It costs more as a result, trading at 16.3 times earnings, and yields less, at 4%. Yet forecast EPS growth is only slightly higher at 6% to 31 December 2013 and 8% next year. Brokers favour this stock, Citigroup and Goldman Sachs are both buyers, with target prices of £40 and £42.80 respectively. That offers plenty of growth potential from today’s share price of £33.33.

Woodford’s Woodbines

The smoke signals say this is an industry in long-term decline. Emerging markets may still dig the weed, but will surely go the way of the West in time. Tobacco companies are countering this by moving into new products, such as e-cigarettes and snus (it’s everywhere in Scandinavia). The growth potential may be ultra-light, but just inhale the income. Where there’s smoke there’s buyers, and that won’t change for years.

Ace dividend investor Neil Woodford is a big fan of tobacco is tobacco stocks. Find out what else he likes by downloading our special in-depth report Eight Top Blue Chips Held by Britain’s Super Investor. This updated report is completely free and shows where Invesco-Perpetual’s dividend dazzler believes the best high yield stocks are to be found. It won’t cost you a penny, so download it now.

> Harvey doesn’t hold shares in any company mentioned in this article.