TheChek News Flow

Valuation now hard to resist: IMT up to Buy/on CL; BAT Buy

Sentiment (and valuation) at lows; a buying opportunity
Since July 2012, the MSCI Europe tobacco index has underperformed the MSCI Europe index by 30% and the staples sector by 19%, highlighting: 1) a low investor appetite for defensive stocks during the ‘hope’ phase of the cycle; 2) unfavourable volatility of key currencies; and 3) challenging consumer conditions driving above-average cigarette volume declines, particularly in the EU where investors are also concerned about the volume impact from smokers migrating to e-cigarettes. BAT and IMT now trade on significant P/E discounts of 29% and 45%, respectively, to the European-based staples multinationals. We do not share concerns over growth sustainability as over 80% of cigarettes sold globally still retail for less than $2/pack of 20 (versus >$10 in the UK), providing significant profit pool growth opportunities for the tobacco industry. Over the next five years, we expect CROCI to expand by 230 bp for EU cigarette makers, compared with a 20 bp average decline for EU food, HHPC and alcohol producers. We believe the pull-back offers an attractive investment opportunity.

Imperial Tobacco is our top pick; new PT is 2840p (28% upside)
We upgrade our rating on IMT to Buy (from Neutral) and add the stock to our Conviction List, with a new 12-month price target of 2840p (from 2545p). We believe IMT is now at the end of the earnings downgrade cycle, as encouraging unemployment trends in Western Europe drive an improvement in organic growth. We also expect the company to distribute £8.8 bn of cash over the next four years, representing 34% of the current market cap, and we do not rule out IMT being viewed as an attractive M&A target. Our valuation now incorporates an M&A weighting.

BAT remains Buy despite FX headwinds; new PT 3420p (15% upside)
We remain positive on BAT, which in our view remains well positioned to the key drivers of long-term shareholder returns. However, we lower our 12-month price target to reflect EM currency risk (c.10% earnings drag in 2014E); as a result, our FY14 EPS forecasts are 6% below Reuters consensus estimates. We note the stock is down 13% over the last 3 months.

Key risks
Rising unemployment, intensified competition, regulatory changes affecting investor sentiment, currency volatility.