Has Reynolds American Become the Perfect Stock?

Every investor would love to stumble upon the perfect stock. But will you ever really find a stock that provides everything you could possibly want?

One thing's for sure: You'll never discover truly great investments unless you actively look for them. Let's discuss the ideal qualities of a perfect stock, then decide if Reynolds American (NYSE: RAI  ) fits the bill.

The quest for perfection
Stocks that look great based on one factor may prove horrible elsewhere, making due diligence a crucial part of your investing research. The best stocks excel in many different areas, including these important factors:

  • Growth. Expanding businesses show healthy revenue growth. While past growth is no guarantee that revenue will keep rising, it's certainly a better sign than a stagnant top line.
  • Margins. Higher sales mean nothing if a company can't produce profits from them. Strong margins ensure that company can turn revenue into profit.
  • Balance sheet. At debt-laden companies, banks and bondholders compete with shareholders for management's attention. Companies with strong balance sheets don't have to worry about the distraction of debt.
  • Money-making opportunities. Return on equity helps measure how well a company is finding opportunities to turn its resources into profitable business endeavors.
  • Valuation. You can't afford to pay too much for even the best companies. By using normalized figures, you can see how a stock's simple earnings multiple fits into a longer-term context.
  • Dividends. For tangible proof of profits, a check to shareholders every three months can't be beat. Companies with solid dividends and strong commitments to increasing payouts treat shareholders well.

With those factors in mind, let's take a closer look at Reynolds American.

Factor

What We Want to See

Actual

Pass or Fail?

Growth

5-year annual revenue growth > 15%

(1.3%)

Fail

 

1-year revenue growth > 12%

(2.7%)

Pass

Margins

Gross margin > 35%

48.3%

Pass

 

Net margin > 15%

17.3%

Pass

Balance sheet

Debt to equity < 50%

67.4%

Fail

 

Current ratio > 1.3

0.74

Fail

Opportunities

Return on equity > 15%

23.1%

Pass

Valuation

Normalized P/E < 20

15.80

Pass

Dividends

Current yield > 2%

5.4%

Pass

 

5-year dividend growth > 10%

8.2%

Fail

       
 

Total score

 

5 out of 10

Source: S&P Capital IQ. Total score = number of passes.

Since we looked at Reynolds American last year, the company has kept its five-point score for the third year in a row. The stock has seen a decent gain of about 10% over the past year despite encountering falling revenue.

Tobacco has long been a cash cow for Reynolds American, which is the company behind the Camel brand of cigarettes. Yet the tough economic conditions of the past few years have led to some headwinds for sellers of premium brands, with both Reynolds and Altria (NYSE: MO  ) having to cut jobs in order to keep margins higher. By contrast, lower-end cigarette manufacturer Vector Group (NYSE: VGR  ) has benefited from its specializing in discount brands, and Lorillard (NYSE: LO  ) has bucked the trend to some extent with its Newport brand as well as some lower-priced alternatives.

Still, the major problem for Reynolds and its peers remains the combination of negative advertising, regulation, and legal attempts to restrict smoking. Even though Lorillard and Reynolds American managed to avoid the full brunt of FDA labeling regulations that would have required huge graphic warning labels on cigarette packs, it's clear that the trend is moving toward further pressure.

One interesting though somewhat outlandish growth avenue for Reynolds American and its peers might come if marijuana gets legalized at the federal level. As Fool Million Dollar Portfolio advisor Charly Travers explained earlier this week, Reynolds American and Altria have the infrastructure and distribution network already established to make marijuana production financially viable. The chances aren't necessarily all that good, but the potential profits make it worth at least thinking about.

For Reynolds to improve, it needs to find new avenues for growth while improving its balance sheet. If it can't fight back against the anti-smoking tide, it's hard to see how Reynolds will move toward perfection anytime soon.

Keep searching
No stock is a sure thing, but some stocks are a lot closer to perfect than others. By looking for the perfect stock, you'll go a long way toward improving your investing prowess and learning how to separate out the best investments from the rest.

Can Reynolds outlast Altria?
As interesting as Reynolds is, Altria has been the best-performing stock of the past 50 years. But with all the pressures against the industry, is Altria still a buy today? To find out whether everyone's love-to-hate dividend stock is a savvy investment choice or a hazard to your portfolio, simply click here now for access to The Motley Fool's new premium research report on the company.

Click here to add Reynolds American to My Watchlist, which can find all of our Foolish analysis on it and all your other stocks.


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