City broker Liberum has initiated coverage of FTSE 100 tobacco retailers British American Tobacco plc (LON:BATS) and Imperial Brands PLC (LON:IMB) at ‘Buy’ ratings, saying there is significant upside despite increased regulatory risks to the sector, particularly as new products move in the companies favour.
Analysts at the broker said BAT was currently trading at its largest discount to the consumer staples sector in 15 years as well as boasting a “quality brand portfolio” and the highest gross margins in the broker’s sector coverage at over 85%.
Liberum attributed the margin expanse to BATs “strong portfolio of brands and the addictiveness of the product, which drives strong pricing power and continued margin improvement”.
However, the broker also highlighted “significant regulatory risks” for BAT in the US market, from which it forecasts 42% of the firm’s 2018 operating profits, with advanced notice of proposed rulemaking from the Food & Drug Administration regarding a possible nicotine standard which could reduce the concentration in cigarettes to 0.5mg per rod from 15mg.
Liberum noted that in its modelling, the market was expecting a US nicotine standard in 2021, with BATs US profits immediately dropping to zero. However, they added that this outlook was too bearish and instead expected a standard to be implemented, if at all, in 2023 which would lead to a margin decline of 1300 basis points. If no standard is implemented, the broker said its current 4,100p target price could exceed 5,500p.
The analysts concluded that BAT’s largest opportunity was in Next Generation Products (NGPs), more specifically tobacco heated products, which have strong demand from markets in Japan and Korea while also earning higher gross margins than combustibles (e.g. cigars, cigarillos etc).
Regarding Imperial Brands, Liberum’s analysts said it was also trading at a steep discount to the rest of the consumer staples sector, however they drew growth confidence from a 2013 strategy refresh which saw Imperial reduce its brand number to 161 from 249 and expected the move to result in “profitable share gains” and an improvement in earnings over the medium to long-term.
They added that investors were currently “ascribing little to no value to IMB's NGP portfolio”, although the company was staying on trend with its myblu nicotine salt formulation and investor confidence could be restored with an effective commercialisation strategy while expectations were low.
Liberum also expected IMB to address its portfolio gap in tobacco heated products by launching in Japan and Korea in 2019, with a successful NGP strategy having the potential to generate £3bn of upside, or 10% on the brokers target price of 3,100p.
In mid-morning trading Tuesday, BAT shares were up 2.9% at 3,799.5p, while Imperial Brands shares were up 3% at 2,704.5.