Shares digital

Just like the products they make, shares in alchohol and tobacco companies could provide welcome relief for investors

by John Marshall

After a stressful day’s trading, many investors reach for a glass of beer, a shot of spirits or even a crafty gasper. They might also want to reach for drink and tobacco shares as the UK’s leading companies in these areas should provide steady portfolio performance just when it is needed the most. British American Tobacco (BATS) in particular will be a solid performer whatever the economic conditions given its emerging markets exposure and focus on four key brands. Similar positive characteristics should drive earnings and dividend growth at drinks group Diageo (DGE) and brewer SABMiller (SAB). All companies look sensible core holdings during the current market volatility.

BAT is broker Citigroup’s ‘top long-term pick in the European [tobacco] sector’ with a price target of £21.55, for a 15% upside. The group’s success has been based in part on a marketing drive behind its four main brands – Dunhill, Kent, Pall Mall and Lucky Strike, which enjoy better margins than other BAT brands. The results have been spectacular. In the first half of this year the four ‘drive’ brands increased their sales by 20% with Pall Mall up 29%, Kent 26%, Lucky Strike 10% and Dunhill 7% higher.

Emerging markets

One of the reasons for BAT’s rapid growth is the group’s commitment to emerging markets such as Latin America, Asia and Eastern Europe. In these markets cigarettes are a form of conspicuous consumption and demand should grow as real incomes continue to rise. Following the Rothmans merger, BAT has adopted an aggressive approach to costs. Several factories have closed and more closures are likely as the group is operating well within capacity. BAT’s strong balance sheet and robust cash flow mean it can fund a progressive dividend policy. Even after a hike in the payout from 38.8p in 2003 to 66.2p in 2007, dividend cover is still 1.5 times. Acquisitions have also been made in Sweden and Turkey, while a modest but earnings-enhancing share buyback programme has also been introduced.

With very limited sales in the UK the group is relatively unaffected by the government’s campaign against the industry. It is however a prime beneficiary of sterling’s recent weakness. A price/earnings ratio (PE) of 13.5 for 2009 and 5% yield both look attractive. Given the prospects for double-digit growth in earnings and dividends over the next two years further outperformance looks assured.

Imperial Tobacco (IMT) is much more committed to the mature markets of Western Europe, particularly after the £11 billion acquisition of Altadis, which owns the Gauloise and Gitanes brands. A £4.9 billion rights issue to help fund the deal was successful but paper supply problems have held shares back in the past six months – particularly relative to BAT.

Imperial is due to update the market next week (24 September). Adam Spielman of Citigroup believes Imperial will indicate trading is in line with market expectations. The company may also update investors on its response to an Office of Fair Trading inquiry into possible breaches of competition law, in addition to presenting to analysts on the French and Spanish markets. In Spain Altadis’s market share is ‘about steady’ but Imperial’s is falling. In France both are gaining share. Spielman believes this is a ‘temporary phenomenon’ as Marlboro is currently stuck at a disadvantageous price point.

With two-thirds of sales in the mature markets of Europe and North America, earnings growth has to come from cost control rather than sales growth and progress is likely to be more modest than at BAT. A prospective PE of 11.4 for 2009 and prospective yield of 4% both look attractive for a stock unlikely to be affected by the credit crunch.

Strong drinks

Diageo has a strong collection of spirit brands with both Smirnoff and Johnnie Walker enjoying sales of over £1 billion. Other key brands are J&B, Guinness, Gordon’s, Tanqueray, and Captain Morgan. With just 15% of sales in the UK the group is a major beneficiary of the weakness of sterling and it is strongly committed to emerging markets. A move toward premium brands is also helping.

A strong balance sheet and good cash flow underwrite a progressive dividend policy and permit earnings-enhancing share buybacks, even if the group has warned growth may decelerate modestly in 2008. Consensus estimates pencil in 10% earnings growth and a premium rating of 14.2 times prospective earnings is justified by the group’s outstanding brand portfolio, which should enable it to continue to grow in real terms. Further outperformance can be expected and the stock should be a core holding in any portfolio.

SABMiller is a truly international player. The £17.9 billion cap has used its UK quote as a means of diversifying away from its South African roots and now generates only 19% of sales in South Africa, where it enjoys 98% of the beer market. Geographical diversification has fuelled compound annual earnings growth of 24% since 2003.

SABMiller’s most important market is Latin America, which represents a quarter of group sales. Broker Dresdner Kleinwort believes there is scope to improve margins there by some 600 basis points over the next three years. A prospective PE for 2009 of 13.4 looks good value in view of the company’s strong growth record and the above average prospects from its commitment to emerging markets.

The writer holds shares in BAT and Diageo