Historically, tobacco stocks have been great defensive plays in times of crisis because smokers still light up during a recession. In fact, over the past two years the sector has outperformed the FTSE 100 by a whopping 50%. However, much of this has been due to its attraction as a “safe haven”, rather than improvements in the underlying industry. That makes me think it’s time for investors to take some profits.
British American Tobacco (BATS), rated a BUY by The Independent
British American Tobacco is a case in point. The firm is the world’s third-largest cigarette maker with a 15% market share, generated from its iconic Lucky Strike, Dunhill, Pall Mall and Kent brands. It reported its first quarter results last week. While sales and profits beat City hopes and were up 14% and 18% respectively on last year, it was telling that 8% of this was down to one-off currency gains due to the weaker pound.
Worryingly, total volumes were flat year-on-year. Stronger growth in emerging markets was entirely offset by declines in Western territories. Performance in these mature markets has been in a downtrend for some time as rising prices, health concerns, smoking bans, higher taxes and advertising restrictions all crimp demand.
The City expects 2008 sales and adjusted EPS of £11.4m and 122.6p respectively, with the company paying a dividend yield of 3.9%. Given concerns over future litigation, I would value British American Tobacco on a forward p/e ratio of about 12, generating a fair value for the stock of less than £15 a share – or around 25% lower than today. Net debt is also a hefty £7bn, so there is minimal margin for error.
On top of the “smokey” valuation, there is a persistent danger that Western governments will step up anti-smoking measures. Several Canadian states recently passed legislation designed to help their provinces sue the company for billions of dollars using reduced levels of proof.
Finally, it is worth noting the rumours that two larger shareholders, Remgro and Richemont, who together own a 30% stake, are considering selling their stock. That could put a natural brake on any further price rises. And if they decide to sell, then as informed parties, this should be an alarm bell for investors, since it suggests they feel the shares are over-valued. I would advise shareholders to bank some profits: there seems to be far more downside risk than upside potential.
Recommendation: TAKE PROFITS at £19.93
• Paul Hill also writes a weekly share-tipping newsletter, Precision Guided Investments