Tobacco Stocks Are Cheap. But the Selloff in Imperial Brands Was Overdone.

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Tobacco stocks are cheap, and

Imperial Brands

is just about the cheapest.

The British cigarette maker (ticker: IMB.UK) trades around 6.8 times projected 2022 earnings, significantly lower than the sector average of 11.4 times. There are quite a few reasons that the sector is so cheap, including regulatory concerns, falling cigarette sales, and the difficulties faced by cigarette makers in meeting environment, social, and corporate governance, or ESG, investing criteria.

But investors may be neglecting the positives and allowing a potential buying opportunity to go up in smoke.

For starters, tobacco stocks can be a good hedge against inflation, as higher prices typically don’t hurt demand. Plus, a lot of the bad news is priced in, hence the valuations.

That’s where Imperial Brands comes in. The stock fell 15% in the first 10 days of Russia’s invasion of Ukraine, having hit two-year highs earlier in February. Russia is the fourth largest cigarette market in the world by volume, so a reaction was understandable.

But it was overdone, and since the owner of brands including Davidoff and Winston announced a full exit from Russia, the stock has bounced back—although it’s still 10% off its recent high. The company said Russia and Ukraine represented just 0.5% of adjusted operating profit in 2021. With the Russia risk alleviated for now, it’s a big year for the company. In 2022, it will complete the first phase of CEO Stefan Bomhard’s five-year turnaround plan—investing in key markets and next generation products, or NGPs.

Tobacco companies have been pushing into cigarette alternatives, including heated tobacco and e-cigarettes. In November, when the company’s full-year earnings were released, Bomhard said that the focus would be on “the acceleration of returns and sustainable growth in shareholder value.” The company reported earnings per share of 246.5 pence ($3.24) in 2021, and analysts covering the stock estimate it could reach 283.9 pence by 2024, according to FactSet data.

The company’s trading update on April 6, and first-half results set to be released in May, could be near-term catalysts for a stock boost.

J.P. Morgan

analysts said they expect a positive update, particularly after the company said on March 25 that it was gaining traction in the U.S. market.

A possible share buyback announcement also is on the horizon. The company has a target leverage toward the lower end of a two-to-2.5 times net debt to earnings before interest, taxes, depreciation, and amortization, or Ebitda, range, before initiating potential share buybacks. At the end of September 2021, it stood at 2.2 times.

“While it is still early in his tenure as CEO, we believe Bomhard’s solid first year at the helm should reassure investors, with a valuation multiple expansion likely throughout the year as confidence builds ahead of a likely share buyback announcement in November,” said J.P. Morgan analysts.

The analysts forecast a double-digit earnings-per-share compound annual growth rate in the medium term, versus mid- to high-single digit rates for its peers. The analysts cite more-targeted NGP investment, tobacco margin expansion, and the boost from buybacks.

J.P. Morgan has a price target of 21 pounds sterling ($27.62) on the stock, implying a 29% upside to Tuesday’s price.

“In the case of tobacco, we are unequivocally of the view that share buybacks will be a good thing for shareholders,” said RBC Capital Markets analyst James Edwardes Jones, adding that it was “essential to unlocking” Imperial Brands’ undervaluation. He has a Buy rating and £20 price target.

Imperial Brands’ stock is at a stalemate. But the smoke may be about to clear.