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With escalating fears of a recession, 2008 could at first sight be a favourable year for tobacco shares. Traditionally, Imperial Tobacco and British American Tobacco have provided investors with a safe haven during market downturns not only because these companies generate modest but regular earnings growth, but also because mega caps tend to outperform when risk aversion is high.
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However, investors should bear in mind that defensive shares can also underperform during a bear market. And in this cycle, tobacco shares could certainly get out of breath. One of the major differences with the dot.com crash is that tobacco shares enter this downturn on stretched valuation. Imperial and British American Tobacco trade on 2008 PE ratios of 17.5 and 17.7 respectively, when their historic earnings multiples are normally closer to 10 to 12 times.
Some analysts have justified these valuations given the cost savings expected from Imperial's acquisition of Altadis, the Franco-Spanish cigarette maker. But the argument looks weak given the strong appreciation of BAT's shares. What's more, the Altadis acquisition will also significantly increase Imperial's exposure to the US market, notably in cigars which fall directly into the discretionary spending that is likely to be cut.
And while declining sales are nothing new in mature markets, the rate of revenue erosion could accelerate dramatically. Britain, Italy and Spain imposed a smoking ban in public places last year, and France and eight German states have followed suit this year. And worryingly for the cigarette manufacturers, some emerging markets are also adopting more restrictive legislation. Indeed, Turkey - a country where 40 per cent of the adult population smoke - has recently voted for a ban which is due to come in force next year.
For the time being, emerging markets will continue to help boost the tobacco giants' revenues and profits. And the generous dividend and regular share buybacks will certainly continue to play well with investors. But shareholders should keep a watchful eye on signs of share weaknesses, to make sure that the gains generated during the past five years do not end up in smoke.
| Company name | Price (p) | Mkt val. (£m) | P/E ratio | Div. yld (%) | 12M price chng.(%) | Last IC view |
|---|---|---|---|---|---|---|
| BRITISH AMERICAN TOBACCO | 1802 | 36,357 | 17.1 | 3.26 | 20.13 | Fairly Priced, 1842p, 01 Nov 2007 |
| IMPERIAL TOBACCO GP. | 2300 | 15,582 | 16.8 | 3.02 | 12.91 | Good Value, 2447p, 31 Oct 2007 |
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-IC-1.5.4a-prod - 31/10/2008 13:11:34 - carlos.princz
