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Why You Might Think Of Investing In This FTSE Underdog: Imperial Tobacco Group PLC

Contrarian investors like to find stocks that are out of favour with the market. When sentiment is negative then the true value of a stock can easily be overlooked. I’m trawling the underdogs of the FTSE to identify which of them may not deserve their sub-market PE ratings.

Imperial Tobacco (LSE: IMT) (NASDAQOTH: ITYBY.US) is very much in the shadow of fellow FTSE 100 member British American Tobacco. Imperial’s shares have underperformed its rivals, falling 1% this year whilst BATS has seen a 9% rise. Even after that, Imperial is valued on a prospective PE of 10.8, a 30% discount to BATS’ 15.7.

Imperial is relatively more exposed to mature, declining tobacco markets and less to those emerging markets where the industry’s revenues are still growing. 70% of Imperial’s sales come from the European Union where health concerns, social pressure and government disapproval have combined with austerity to push down tobacco consumption. Some smokers have traded down to lower-priced products or joined the growing numbers buying illegal, untaxed cigarettes.

Response

The company’s response is to push up prices, cut costs, spend to increase market share, and invest in the growing e-cigarette segment. It has restructured its operations into ‘Growth markets’ and ‘Returns markets’. In the former it’s targeting increasing market share, volumes and revenues.  It’s milking the latter for profits and cash. And it has recently acquired the Chinese firm that invented e-cigarettes, arguably playing catch-up in this embryonic business.

That’s all good stuff, but largely reflects industry trends. It won’t get Imperial re-rated closer to BATS.

That doesn’t mean it’s a bad share to hold. It’s a logical strategy in a mature industry to harvest cash and return it to shareholders. Imperial pays out half its profits to shareholders, producing an attractive 5.5% yield, and it has a substantial share buy-back programme, too.

Consolidation

Another thing typically happens in mature industries: consolidation.  It saves costs, and prolongs the jobs of the management making the acquisitions. Imperial has the attraction — from an investor’s viewpoint — of being the smallest of the big four global listed tobacco companies. It’s the subject of recurrent bid rumours, with a break-up by Japan Tobacco and BATS the most-cited scenario.

The big tobacco companies might make a successful transition into e-cigarette substitutes. But if they don’t, four will likely become three before the industry goes into terminal decline. So Imperial’s shareholders have a safety-net.

High yield

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> Tony owns shares in Imperial Tobacco and BATS but no other shares mentioned in this article.