High-yield tobacco stocks: City has a new favourite

The fading of tailwinds behind the summer re-rating of EU tobacco stocks today prompted a City bank to switch support from British American Tobacco (LSE:BATS) to FTSE 100 rival Imperial Brands (LSE:IMB).

Morgan Stanley thinks fundamentals will be back in focus over the next year after the sector’s run of outperformance due to the preference of investors for defensives over cyclicals.

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The bank has switched BAT from Overweight to Underweight and lowered its price target from 2,850p to 2,500p, with Imperial Brands now Overweight with an improved price objective of 2,300p.

Imperial, which is due to post a year-end trading update on Tuesday, rose 12p this afternoon to 2,154p while BATS weakened 23p to 2,684p.

The high-yielding pair have re-rated by 15-20% so far this year, even though Morgan Stanley noted no sign of improving fundamentals. Near term it sees better visibility on earnings and cash flows at Bristol-based Imperial than BAT.

Its previous Overweight stance on BAT was based on Next Generation Product (NGP) exposure supporting higher growth as smokers increasingly transition.

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The bank is now more sceptical on this front and also expects weak US cigarette volumes to persist as smokers downtrade.

It added: “We no longer see BAT benefiting near term from transitioning smokers, given the lack of regulatory enforcement against illicit disposable e-cigarettes, resulting in low-single-digit percentage declines to its US business in 2025/26.”

While admitting that Imperial’s NGP positioning could hinder growth over the longer term, it believes the company’s near-term earnings visibility is better as it has less of a premium cigarette portfolio and has lower exposure to US NGPs.

The bank also highlights Imperial’s superior buyback capability that equates to a potential 25% of its market cap over the next three years, compared with 5% at BAT. This is accompanied by greater certainty around returns due to lower leverage and less near-term litigation risk.

Morgan Stanley concluded: “Following a period of outperformance, our equity strategists are more cautious on defensives. Less top-down support further reinforces being selective on stock allocation, strengthening our preference for Imperial Brands over BAT.”