Stockwatch: is this unloved sector’s recovery rally sustainable?

The two main London-listed tobacco stocks are up around a third since April, with charts in strong uptrends. But does this affirm recent gross under-valuation with further capital upside despite high yields, or have two fundamentally high-risk stocks been caught in a major shift from “growth” to “income” which can only run so far?

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Interestingly, it is Imperial Brands (LSE:IMB) that sports the better gain – up 33% versus 29% for British American Tobacco (LSE:BATS) – despite being less advanced in vapes, which arguably constitute the future for smoking-related companies. The re-ratings have been since 10 and 15 April, as if mainly sector than stock-related.

A five-year context conveys BAT engaging mean-reversion following a nasty drop during 2023 when governments initiated stiffer regulations against tobacco and vapes.

Source: TradingView. Past performance is not a guide to future performance.

Imperial has become a momentum stock, and it was notable yesterday how BAT rose 1% to over 2,970p, specifically when the US started trading. Perhaps investors in the States see UK stocks as better value than for example Philip Morris International Inc (NYSE:PM) which trades on a forward price/earnings (PE) multiple in the high teens and 5.2% prospective yield.

Imperial has re-rated from a 12-month forward PE of 5.5x and yield of 9.3% at the 1,680p April low, to 7.0x and just over 7% with the stock at around 2,255p.

Source: TradingView. Past performance is not a guide to future performance.

From BAT’s simultaneous low of 2,270p, it was on a PE of 6.3x and remarkable 10.8% yield, to 6.3x and 8.2% yield at 2,970p now – showing how, in the short term at least, an ultra-high yield does not necessarily mean a company going bust.

This was partly why I drew attention to asset manager and life insurer M&G Ordinary Shares (LSE:MNG) last time, yielding almost 10%, as you would think its activities would be less risky in the long run. It can be tricky to embrace an unloved big-name stock, yet over time the market is more a weighing than voting machine.   

As expectations have shifted over the summer towards interest rate cuts, it appears the huge yields offered by smoking stocks created an inflection point. George Soros used to say: one “self-reinforcing trend” gets replaced by another and, despite the new Labour government’s early challenges, possibly international investors increasingly view London-listed equities as a relative haven.

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While UK small-caps might see profit taking in weeks ahead by investors sitting on big capital gains ahead of Labour’s 30 October budget, FTSE 100 stocks like these are dominated by institutions paying no tax.

Otherwise, the strength of re-rates is surprising versus the UK government seizing on Rishi Sunak’s objective to ban the sale of tobacco products, temporarily sunk by the general election thwarting this bill’s progress to law. Yet while this would represent the world’s toughest smoking ban, the UK is modest revenue in these multi-nationals’ global reach.

I therefore think the market has twitched from long-term fears, meaning these stocks festered to a 20-year low for Imperial and 14 years for BAT, now to a keen sense that dividend yields look robust for the next few years at least and remain attractive with interest rates set to reduce.

Operational and financial progress has been mixed  

Imperial’s re-rating coincided with a 9 April update in respect of the first half to 31 March asserted “in-line” trading, although you could say a yield above 9% implied pricing for a worse-case scenario – hence a relief-rally was possibly triggered.

Group revenue appeared stodgy, with gains in the US, Spain and Australia “broadly” offset (as if not exactly) by declines in Germany and the UK. Affirmed guidance did however include a “step-up in adjusted operating profit growth” helped by price increases.

The mid-May interim results helped sustain the stock rally, citing price rises near 9% in tobacco more than offsetting a 6% slip in those volumes. Meanwhile, “new generation products” (vapes) grew revenue nearly 17% but represented only 7% of group revenue versus 13% at BAT.

Adverse foreign exchange movements meant a 2% slip in reported group revenue, but the market accepted how smoking products are proving more resilient than perhaps it had been pricing for.

But how sustainable is relying on price rises, despite the product’s addictive nature?

Also, how fair is it for Imperial to adjust for foreign exchange to re-present a 3% operating profit slip as a 3% gain? And working capital movements again compromised interim operational cash flow, resulting in £59 million absorbed. Paying out over £1 billion as dividends and £600 million deployed for buybacks, looked quite a balancing act versus the cash left.

I concede not to fully appreciate how buybacks were said to help adjusted earnings per share advance nearly 8%, given Imperial’s market value now nears £19 billion. Some 9% of the share capital has been repurchased since October 2022 but that obviously goes back a while. Total buybacks remain targeted at £1.1 billion for the current financial year to 30 September, so perhaps they have helped push the market price higher. The interim dividend rose 4%, affirming a “progressive” policy.

Attention will therefore be on a next trading update in respect of the full-year results to 30 September, as to whether the rally is clipped or sustained.

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On 5 September, Imperial’s chief supply chain officer sold over £290,000 worth at 22,342p, although it’s hard to know whether this is a value judgment or cash needed for say for other personal reasons. It does not help how such announcements no longer appear to require the total holding to be mentioned, which would convey context.

The market’s harsh treatment of smoking stocks during 2023 leaves me wary that sentiment will not at some point twitch to fear again, especially if other governments follow the UK and further price rises will hurt revenues. But for now, I do not “fight the tape” versus a yield above 7% still. “Hold” and heed the update.

BAT numbers even more complex than Imperial

BAT’s dilemma was business sales in Russia and Belarus conspiring with foreign exchange headwinds to impact revenue by 8% in its first half to 30 June. Even organic revenue adjusted to constant exchange rates slipped nearly 1% - said due to US investment and negative wholesaler inventory movements. You would think such are part of normal business experience.

BAT’s highlighted motto is “building a smokeless world” with 18% of its revenue so far deriving from smokeless products. Quite whether that equates with Labour’s resolve to stamp out what ultimately compromises the NHS is unclear.

Reported operating profit fell 28% fall due to higher amortisation on US combustibles and lack of Russia/Belarus contribution; and even at the adjusted level it slipped 1%.

Slashing net finance costs by two-thirds, plus a radically higher contribution from associates and joint ventures, rescued reported interim pre-tax profit to a 6% advance – after which there was a lower tax charge also. It all shows how tricky are the moving parts within multinational tobacco groups to be able to forecast dependably.

In BAT’s favour is its adjusted operating margin sustained at 45% versus Imperial at 11%, helping sustain interim net cash from operations over £3 billion hence dividend payouts near £2.7 billion – plus some reduction in debt and buybacks.

I am therefore inclined to favour BAT of the two, with the caveat it is impossible to say when regulatory concerns may again hit sentiment. It appears that enough investors are prepared to take the dividends and not worry. According to 2023, there will not be another trading update until early December. Hold.

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.