Tobacco stocks have taken a beating over the last couple of years. With the rise in ethical investing, structural changes in consumer habits and a race to capitalise on emerging ‘Next-Generation Products’ that are seemingly facing the prospect of regulatory intervention in the US courtesy of Donald Trump, it’s understandable why we’ve seen a sharp decline in valuations across the sector globally.
The fallout of this market overreaction has seen the share price of Imperial Brands (LSE: IMB) enter classic value territory. The forecast dividend yield of over 12% would ordinarily jump out as a red flag, but I’m of the opinion that the underlying free cash flow projections are supported by the business’s market position as the world’s fourth largest international tobacco company, as well as the strong volumes that come with such an enviable position.
Imperial sells around 255 billion cigarettes a year in more than 160 countries, and despite the fact that the market is shrinking, I believe the prospect of declining volumes will be more than compensated through price rises that can be absorbed by the notoriously sticky customer base. Let’s remember the barriers to entry are significant, with arguably no requirement for marketing spend.
This should alleviate any near-term concerns surrounding NGP revenues, and Imperial has become more selective with its capital investment programme in this area, until the wider political environment stabilises.
Imperial is trading at an attractive price-to-earnings (P/E) ratio of six times earnings, which is significantly below its 10-year average of 19.1x. On an absolute and relative basis, I think the business justifies further attention. Assuming zero growth in the share price, purely maintaining cash flow over the next three years will deliver an unparalleled income opportunity, with material upside on offer should the share price mean revert.
Imperial also currently trades at a discount to its peer group. With currently trading at 10.1 x earnings versus a 10-year average P/E of 16x. the sector is clearly out of favour, despite the strong underlying short- to-medium term drivers. With the global outlook remaining bleak, and frothy valuations signalling we’re approaching the peak of the record 10-year long bull run, investors should take comfort in the defensive characteristics and track record of Imperial Brands. Throughout the recession of 2008 through to the recovery, the business remained in rude health.
Much of the discount attached to Imperial’s valuation owes to the halt of the historic annual 10% dividend hikes, and will likely remain until it finds a suitable replacement for the exiting CEO Alison Cooper. But in the meantime, I struggle to see the valuation falling below this level, especially given that the income potential is well supported with a comfortable leverage and free cash flow profile from its established tobacco brands.
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Dexter Burt 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.