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Analyst sees "material" re-rating opportunity in big tobacco

“The market has taken the view that the model is breaking down or soon to break down due to perceptions of worsening cigarette volumes, reduced risk disruption and regulatory headwinds among others”

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The market has been wrong about tobacco stocks like Imperial Brands PLC (LON:IMB) and British American Tobacco PLC (LON:BATS) for some time and investors should take the chance to buy bargains, analysts at Jefferies have suggested.

With share price valuations at the same level seen at the litigation scares in the late 90s/early 2000s, “we see a material multi-year sector re-rating opportunity”.

In a detailed note on the sector sparked by renewed client interest, the Jefferies analysts defended the Big Tobacco operating model.

“The market has taken the view that the model is breaking down or soon to break down due to perceptions of worsening cigarette volumes, reduced risk disruption and regulatory headwinds among others.”

But the model “is fine”, the analysts argued, pointing to “robust” delivery throughout the recent period and even with conservative assumptions for the coming four years, they forecast average sector growth of 3.5% sales, 5.0% underlying profit (EBIT) and 6.9% earnings per share, all excluding currency effects.

“There's a chance of material upside to this should [reduced-risk products, aka RRP] drive greater usage/non-smoker penetration which we think is a strong possibility.”

The first leg of the “multi-year” opportunity would be for evidence to come from the companies that the model is not broken.

“To this, while unhelpful the last two years, data points are finally turning more supportive,” the Jefferies spreadsheet jockeys said.

“Second leg is increasing evidence that with RRP, total nicotine trends can be more supportive than the past which means more favourable terminal growth rates than old.”

The valuation of Imperial Brands, where the share price has pretty much halved over the past three years, is currently “the cheapest across the space” due to recent years of missed guidance and uncertainty around who will replace Alison Cooper as CEO and what this means for strategy and the dividend.

But the analysts think the market is misunderstanding IMB’s ability to compete in RRP, with “better products than given credit for” and that US fears around vapour, are “weighing excessively” on its core European combustibles operations that make up around 45% of profit.

Jefferies trimmed its share price target for IMB to 2,300p from 2,400p but kept its ‘buy’ rating.

BATS is the sector “top pick”, with a trimmed target price of 4,700p from 4,800p.

“It has the best growth outlook across the space, its total nicotine share is the most impressive, yet its valuation remains depressed, pricing in misplaced fears.”

While Jefferies is bullish on the whole sector in the long-term, the analysts urged caution on Philip Morris International Inc (NYSE:PM) and Altria Group Inc (NYSE:MO) on a 12-month view.

Quick facts: Imperial Brands

Price: 1274.5 GBX

LSE:IMB
Market: LSE
Market Cap: £12.06 billion
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