Why I’d buy Neil Woodford’s top holding after today’s news

Imperial Brands (LSE: IMB) is star fund manager Neil Woodford’s favourite income investment. It’s the largest holding in the Woodford Equity Income fund, accounting for 8.3% of assets under management (AUM), and the second largest holding in the Woodford Income Focus fund (8.5% of AUM), after Newriver REIT (8.9% of AUM).

But despite Woodford’s support, this tobacco giant has struggled to attract investors to its offering over the past 10 years. Indeed, over the decade, the stock has underperformed the FTSE 100 by around 1% per annum, including dividends. Over the past three years, the performance gap is nearly 13% per annum.

However, I think this unloved tobacco company is due for a comeback, and today’s news could be the catalyst that starts the revolution.

Menthol ban

Overnight, the United States’s Food and Drug Administration (FDA) announced that it’s going to ban menthol cigarettes and flavoured cigars, and restrict the sales of sweet-flavoured e-cigarettes. This is a mixed blessing for Imperial. Unlike its peer, British American Tobacco (BATS), Imperial’s exposure to the US tobacco market is relatively limited. It has a market share of less than 9%, and sales to the US account for around fifth of total group revenue. In comparison, analysts estimate that sales of menthol cigarettes account for approximately one-third of BATS’s bottom line.

Imperial has more exposure to e-cigarettes, owning the blu brand, acquired from Reynolds American when it was bought out by BATS several years ago. 

Imperial’s management has welcomed the news of the ban because it will mean that in non-age restricted retailers — like convenience stores — only certain types of e-cigarettes can be sold. Its biggest competitor in the US market is JUUL, the manufacturer of flavoured e-cigarettes. JUUL has been able to dominate the market through viral marketing. But this has had an unintended side effect, with the brand becoming exceptionally popular among underage smokers. 

As a result, the FDA’s clampdown could decimate JUUL’s business. And Imperial is exceptionally well positioned to grab market share as its peer tries to re-focus its business model.

Good news? 

Responding to the FDA announcement today, Imperial said: “We welcome” the FDA’s “moves to prevent youth access to tobacco and vapour products.” The company goes on to say that it already uses age verification for visitors to blu.com and is developing several products with “device locking technology,” in line with the FDA’s desire to “accelerate development and review of vapour products with child protection features.

With its largest competitor in the US hobbled, I reckon the future is bright for Imperial’s so-called reduced-risk products, which include e-cigarettes. Management expects this category to be profitable in 2019, after sales doubled to £200m in the last financial year.

Reduced-risk product sales growth is critical for the company’s long-term survival, and if it can prove that growth in the segment is sustainable, then I believe investors will return, pushing the shares back to previous highs.

As the stock is trading at a discount of around 30% to the rest of the global tobacco sector, I record the upside, when confidence returns, could be substantial. And while we wait for the recovery, the stock supports a dividend yield of around 8%.

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Rupert Hargreaves owns shares in Imperial Brands and British American Tobacco. The Motley Fool UK has recommended Imperial Brands. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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