It is no secret that investors love dividends and that they love somewhat defensive segments. One of those is the tobacco industry. Despite all the negative long-term trends, investors have cleaned up owning tobacco stocks in recent years. And now the valuations are at a serious premium to their historic levels.

If Jefferies is right, there is still upside in tobacco. Owen Bennett of Jefferies sees very strong upside in Reynolds American Inc. (NYSE: RAI), and it has the highest rating of the big-three tobacco stocks. Altria Group Inc. (NYSE: MO) was still given upside to its price target, but Bennett’s official rating remains cautious on the surface. Philip Morris International Inc. (NYSE: PM) was actually given a price target that is under the current share price.

Bennett had several driving forces for the tobacco investing group:

• Cigarette trends should remain robust.
• Vaping is becoming a significant contributor.
• The true underlying EBIT should see strong acceleration.
• Regulatory outlook is favorable.
• Litigation risk is much reduced.
• The multiple can be justified/e-vapor implications.

Still, Jefferies did acknowledge several risks to its views. A sector P/E ratio of 19.1 is well above the average 16.2 P/E ratio seen in the past five years. There is also a risk of heightened price competition and what was called “down-trading.” Then there are of course risks of federal tax increases, a menthol ban, and that the growth in the vapor market could slow.

Jefferies said:

We are positive on the US domestic sector and see combined sector 12-month TSR of over 20%. We believe this is the start of a new era with industry value drivers fundamentally more favorable than in the past. On this basis we believe valuations can be justified and look attractive (even cheap) on an underlying number.

Reynolds American was given the top billing in Bennett’s report. It was started as Buy with a $61 price target, which would represent a whopping 28% upside from the prior closing price of $47.66 — and that doesn’t even take into account the total return including a dividend yield of nearly 4%.

In Reynolds, Jefferies sees organic EBIT development as a peer best, with cost saving and vapor developments helping further. The firm also sees a re-rating with a buyback and higher dividend yield. Market share gains also are expected to drive earnings in 2017.

Reynolds has a 52-week trading range of $41.91 to $54.48, and the consensus analyst price target is $54.70. Investors might want to take note that the prior street-high price target was just $58.

Altria was started as Hold at Jefferies. Still, we did note that Bennett was calling for upside. The official price target is $70, close to 10% higher than the $62.97 prior closing price.

Jefferies sees more near-term pressure than usual. The firm expects Marlboro share pressures to hold back EBIT development over the next 18 months, although it noted that the heightened share buyback with the SAB cash and accretion from the holding in a larger ABI should mean earnings remain robust and should limit a de-rating risk. All in all, Jefferies sees Altria’s earnings multiple progression as being limited from here.

Altria has a 52-week range of $53.68 to $70.15 and a consensus price target of $69.11. Its street-high analyst target is $74.

Philip Morris was started with a Hold rating and assigned a $96 price target (versus a $99.21 prior close) at Jefferies. It was given the least coverage of the three big tobacco stocks, but there was one interesting view from Jefferies based on a negative litigation risk being lower now: “[W]e believe that at some point in the future, both Philip Morris International and British American Tobacco will look to re-enter the U.S. market after previously leaving.”

Philip Morris has a consensus price target all the way up at $106.71. Its 52-week range is $78.03 to $104.20.

Calling for 10% upside in Altria is not exactly a huge call, but most analysts and investors were not expecting a drop in Philip Morris. The call that stands out the most is for Reynolds American to have a total return of over 30% in the coming 12 months or so. That is way above consensus, and the strongest call, of all tobacco analysts.

Here is how these three shares have performed of late:

• Reynolds American is up 6% year to date and up 15% from a year ago. It is down 5% in the past month.
• Altria is up 11% year to date and up 19% from a year ago. It is down 4% in the past month.
• Philip Morris is up 15% year to date and up 26% from a year ago, but it is down less than 1% in the past month.

Stay tuned.

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