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Why I think this company’s share price and 7% dividend yield may make it the bargain of the FTSE 100

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The Imperial Brands  (LSE: IMB) share price ended last week at 2,618p. This is 37% below its all-time high of 4,139p made in August 2016. As a result of the decline, I believe the tobacco stock could now be the bargain buy of the FTSE 100. Here’s why.

Dirt cheap

The first thing to note is that other tobacco companies’ shares are also trading well down from their previous highs. This applies not only to Imperial’s London-listed peer British American Tobacco, but also to overseas giants Philip Morris, Altria and Japan Tobacco. In other words, there are industry-wide reasons, as opposed to company-specific reasons, for why Imperial is currently unloved by the market.

As a business, it continues to perform well. When its shares were at their all-time high two years’ ago, it was set to post annual earnings per share (EPS) of 249.6p, and a dividend of 155.2p. When it releases its latest annual results tomorrow, City analysts are expecting EPS of 267p, and a dividend of 188p.

The combination of the rise in earnings and dividends and the decline in the share price means that while Imperial was trading on a price-to-earnings (P/E) ratio of 16.6, and a dividend yield of 3.7% when its shares were at their high, it’s now trading on a P/E of just 9.8, with a whopping 7.2% yield.

This compares favourably with British American Tobacco’s P/E of 11.4 and yield of 6%. But, in truth, both stocks appear dirt cheap by their historical standards and compared with other defensive businesses in the broad consumer goods sector.

Headwinds

For decades, tobacco companies have faced headwinds of increasing regulation and health education in the developed world. However, they’ve been able to mitigate the effect of this on sales volumes and revenues by consolidation in the industry, expansion in emerging markets, and the ability to increase prices in line with, or ahead of, inflation.

The development of lower-risk next generation products (NGPs) is likely to be another important tool in the armoury going forward. Imperial has begun the international rollout of its blu e-vapour brand. A current-year annualised exit run-rate of around £0.3bn revenue is set to accelerate in 2019 and beyond. The expected pace is reflected in management incentives to deliver compound annual growth of 35% to 150% over the three years to 2020. In addition, the company recently announced plans to launch Pulze, a heated tobacco product, early next year.

Rerating potential

The weakness in the share prices of Imperial and its peers seems to be due not only to the ongoing regulatory headwinds for traditional tobacco products, but also to uncertainty about how NGP markets will develop. For example, will ‘vaping’ products ultimately face the same restrictions as cigarettes, as some, like the World Health Organisation, are calling for?

On balance, I believe Imperial and others are likely to be able to meet future regulatory challenges and find ways to continue growing their earnings and dividends, as they have done in the past.

We’ve been in the situation before when market sentiment has dragged down the valuations of tobacco companies, only for sentiment to thaw and the stocks to rerate. On the view that there’s every chance history will repeat itself and that the rewards for investors would be substantial if it does, I’d be happy to buy shares in Imperial today.

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G A Chester 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.