“Defensive is expensive” is the phrase I would use to describe most tobacco stocks at the moment. Even though the tobacco sector is constantly under the cosh of legal, tax and medical authorities around the world, it has nevertheless outperformed most benchmarks by rising 90% in the past three years.
Turkey of the week:Imperial Tobacco (IMT: 1,877p), tipped as a BUY by The Times and The Daily Telegraph
Take Imperial Tobacco, for example. It was recommended as a buy last week in both The Daily Telegraph and The Times. Imperial Tobacco is the world’s fourth-largest cigarette manufacturer, the UK’s biggest operator with a 40% market share, and global leader in roll your own tobacco. Its main brands include Embassy, Rizla, Lambert & Butler and Regal, with 80% of its profits coming from declining European countries and only around 20% generated from emerging markets.
Last year, turnover rose by a pedestrian 1% to £3.2bn, generating earnings per share of 122p and a dividend yield of 3.3%. On this basis, I would value Imperial Tobacco on a 2006 p/e ratio of around 12, but at 1,877p, the shares trade on a punchy 15.3 times – more than 25% overvalued.
What seems to be happening is that fund managers are again showing
their herd instincts and following the stock’s upwards momentum by pushing Imperial Tobacco ever higher. But the shares are already so high that, unless a bid materialises for the firm, then the shares look vulnerable. There have been rumours of a takeover for some time, with many pundits pointing towards Marlboro maker Philip Morris – Imperial Tobacco distributes Marlboro cigarettes in the UK. But a deal of this scale would almost certainly face substantial competition issues in Europe.
As well as the “toppy” valuation, there are several strategic issues shareholders need to consider. Firstly, the number of cigarettes sold each year in Imperial Tobacco’s two biggest markets, the UK and Germany, is falling by around 3% and 7% respectively. In the UK, this trend may well accelerate next year, when a ban on smoking in public places is introduced in England and Wales. The Government is also actively trying to cut the number of UK smokers to 21% of the adult population – down from 26% in 2002. The Department of Health claims it is “well on track” to hit this target, which it hopes will reduce the £1.7bn the NHS spends every year on treating smoking-related diseases.
Secondly, management have said they are soon planning to launch their brands into the fiercely competitive US market – which has proved a graveyard for many a UK corporate.
Finally, something that was not discussed by the two newspapers is that the European Commission is currently reviewing how minimum tax rates are
set for tobacco products. This is significant for Imperial Tobacco because it generates around 20% of profits from roll your own tobacco products, which presently enjoy favourable tax rates. If duties are harmonised across all tobacco products in the EU, then a much higher tax rate could be imposed on the Rizla brand, which would undoubtedly hit earnings.
Recommendation: TAKE PROFITS at 1,877p