Imperial's Stock Could Be Habit-Forming

Consumer-staples stocks have become the latest addiction on Wall Street. But when it comes to some tobacco stocks, investors have resisted the urge. They should give in to temptation.

Consider shares of Procter & Gamble PG -1.18% and Clorox, CLX -0.90% which have both rallied in recent months as risk-averse investors chased after yield and steady, if only modest, profit growth. Both sport dividend yields of about 3%, and analysts expect earnings to expand by midsingle-digit percentages this year. The stocks both trade at about 19 times forward earnings, the highest level in several years. By some measures, Imperial Tobacco Group IMT.LN +0.94% looks a lot like P&G or Clorox. Imperial, which manufactures cigarette brands like Davidoff and Gauloises, has managed to increase profit by raising prices to offset a long-standing decline in smoking in developed markets. The stock offers a healthy dividend yield of almost 5%, and analysts expect earnings per share to increase 4.5% in the year through September. And yet, Imperial trades at just 11 times 2013 earnings. The problem? Investors are still skittish about Europe, which accounts for roughly 60% of the company's operating income.

A persistent problem in Europe is the unemployment rate, which is in the double digits across the region and has crept above 25% in Spain. At the same time, several governments have raised taxes on cigarettes in order to reduce fiscal strains brought on by the financial crisis. Those factors have added to the pressure pushing down on cigarette sales. While Imperial can try raising prices, this has become harder due to surging sales of illegal cigarettes. These can sell for a fraction of normal prices because they don't include taxes. According to a study by KPMG, counterfeit and contraband sales accounted for 11.1% of European cigarette consumption last year, up from 8.3% in 2006.

The question for investors is whether the illegal-cigarette problem will get worse. As the forgone tax revenue mounts, some governments should take notice, especially in countries such as the U.K. that tax cigarettes heavily. Legal cigarette consumption there dropped by 3.2 billion sticks last year, while illegal sales rose by roughly the same amount, KPMG estimates. Matthew Grainger of Morgan Stanley MS -0.48% says there are a limited number of entry points for cigarette trafficking into Western Europe. That suggests that even a small step up in enforcement efforts could go a long way.

Even if it takes time for Imperial's European woes to ease, it is hard to imagine the stock sinking much further. One reason: Other cigarette companies that also face volume declines may become intrigued by Imperial's low valuation. Combining Imperial with another tobacco conglomerate could lead to ample cost savings in markets where they have overlapping production and distribution. While there might be antitrust issues in some regions, there may be ways to divide the company. As Martin Deboo of Investec points out, Diageo DGE.LN -0.86% andPernod Ricard RI.FR -0.59% overcame a similar obstacle by dividing up several Seagram brands in the early part of the last decade. It is true that tobacco stocks tend to trade at a discount to other consumer staples, given the risk of regulatory changes affecting marketing and advertising. But Imperial rival British American Tobacco, BATS.LN -0.68% which generates roughly 30% of operating income in Europe, trades north of 16 times 2013 earnings a 52% premium. Investors who left Imperial on the shelf may soon find their cravings return.

Source: By JOHN JANNARONE http://online.wsj.com/article/SB10001424127887323398204578489321623762266.html