Turkey of the week: overbought tobacco group

By Paul Hill Feb 20, 2009

Paul Hill

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With global stockmarkets approaching six-year lows, it might seem odd to worry about bubbles. But one sector that looks heavily overbought is tobacco. Take British American Tobacco, the owner of iconic brands such as Lucky Strike, Dunhill, Pall Mall and Kent. It is the world's third-largest cigarette group, with a 12.5% market share, behind Phillip Morris (15.7%) and the China National Tobacco Corp (39.1%). At the last trading update in October, chief executive Paul Adams was in bullish mood, saying that "2008 is shaping up to be a vintage year". The board seems to assume that the addictive nature of the product will insulate them from deteriorating economic conditions.

British American Tobacco (LSE:BATS), tipped as a BUY by Investec

But I detect a whiff of complacency. Consumers will tighten their belts as the recession bites. Sales in developed countries, which are already declining, face major threats from anti-smoking lobbyists. In December the Department of Health said that it intends to remove cigarette displays from shops and restrict access to vending machines. That's a move that could be replicated in Europe. And in a recent test case for thousands of plaintiffs, a jury in Florida concluded that a smoker's death had been caused by nicotine addiction. The claim is now proceeding to a potential damages award.

One silver lining for the industry has been its success in emerging markets, where so far there has been little evidence of consumers trading down to cheaper brands. Indeed, just over half of British American Tobacco's operating income comes from these markets, notably eastern Europe, Africa and Latin America. Nonetheless, the firm's high valuation is a worry. As Warren Buffett has said, "in the short term Wall Street is a voting machine, but in the long term it's a weighing machine" – meaning that a company's share price over time should reflect its profitability. Therein lies the danger for the group. Over the past nine years, its earnings per share (EPS) has risen 123%, yet its share price has risen by more than 600%. This looks unsustainable, given earnings are predicted to rise only 10% a year. I'd rate the group on an eight times earnings multiple, equivalent to about £12 a share, or 30% lower than today's valuation.

Furthermore, I suspect that the industry will not buck the recessionary trend. This was acknowledged by director Michael Prideaux in October: "We don't tend to see customers down-trading unless there are high levels of unemployment."

Preliminary results are due out on Thursday 26 February.

Recommendation: SELL at £17.70

• Paul Hill also writes a weekly share-tipping newsletter, Precision Guided Investments.

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