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Why Imperial Brands’ share price is too cheap for me to ignore

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Tobacco group Imperial Brands (LSE: IMB) has the highest dividend yield in the FTSE 100, at just over 9%. The shares have performed badly in recent years, but Imperial Brands’ share price has now risen by nearly 30% from its 52-week lows and is unchanged on a 12-month view.

Despite the risks facing the tobacco industry, I think Imperial shares are too cheap. In my view, further gains are likely.

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A bargain in plain sight?

I’ll start by saying I own Imperial Brands shares in my portfolio. The reasons for this are simple enough. As the owner of brands such as JPS, West, Davidoff and Gauloises, this tobacco group has a big share of the cigarette market in countries including the USA, UK, Germany and Spain.

Despite all the obvious risks to this business, it remains large and highly profitable. Sales rose by 1% to £7,985m last year, excluding tobacco duty. Although operating profit fell 5% to £3,527m, this still gave the business an underlying profit margin of 44%. That’s exceptionally high.

Indeed, the tobacco business ticks all the boxes for a reliable, defensive business. It has many customers who make regular, small purchases and are loyal to their chosen brands.

Spending on new product development is generally low and cash conversion is high — this business is a cash cow that generates around £2.5bn of surplus cash each year.

The 9% dividend may seem risky, but it actually looks very affordable to me.

So why is Imperial’s share price so low? Let’s take a look.

A bad reputation

There’s no escaping the obvious problem with Imperial Brands’ main product range — it’s addictive and unhealthy. This leads to other potential risks I have to consider as a shareholder.

Tobacco sales are already regulated in most developed markets, so the impact of this is known. But it’s possible that regulations will change in the future and become more restrictive. This could hit Imperial Brands’ share price hard, potentially without warning.

Another risk is that global smoking rates are in decline, especially in the developed markets where Imperial makes most of its money. The firm is addressing this by focusing on a smaller number of its strongest brands. These are said to be gaining market share. This helps to offset the declining market.

Finally, there’s one other pressure on Imperial’s share price. Growing pressure on fund managers to adopt ESG (environmental, social and governance) policies, means that some large investors have ruled out owning tobacco stocks altogether.

I think Imperial Brands’ share price could rise

There are lots of reasons to dislike and avoid this business. But the reality is that everything has its price. Imperial makes big profits which it converts to cash and returns to shareholders. I don’t see this changing in the near future.

At the current share price of under 1,600p, Imperial Brands trades on just 6.5 times forecast earnings and offers a 9% dividend yield that’s comfortably covered by earnings.

If equity investors don’t want to pay more for this stock, then I think, at some point, a private buyer will.

New-ish chief executive Stefan Bomhard has brought fresh discipline and focus to the business. I’m happy to keep collecting the yield and await further developments.

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Roland Head owns shares of Imperial Brands. 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.

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