Is Reynolds American a Buy?

Lorillard appears to be a better investment than Reynolds and Philip Morris today.

Jan 3, 2014 at 10:18AM

With tight economic conditions and overall pressure on the tobacco industry, many tobacco companies are struggling these days. However, a look at the third-quarter report of Reynolds American (NYSE:RAI) shows that the company did pretty well despite all that.

Let's have a look at Reynolds American in detail, and also analyze two other players in the tobacco industry, Philip Morris International (NYSE:PM) and Lorillard (NYSE:LO).

Third quarter report
In the third quarter, Reynolds American reported earnings per share of $0.86. Earnings increased by 8.9% year over year as they stood at $0.79 per share in the comparable quarter last year, and were in line with analysts' consensus expectations. Net sales also increased from $2.12 billion to $2.14 billion, representing a 0.9% year-over-year increase. The sales increase stemmed from higher demand of smokeless products and a higher pricing mix used by the company.

Segment Analysis
R.J Reynolds Tobacco had a mixed quarter as it saw a 1.9% decline in revenue, a 4.3% decline in volume, and a 0.5% decline in its total market share. This was partly due to a tough economy and changes in consumer preferences as people move toward smokeless products. The good thing was that even though overall volume declined, the company's major brands Pall Mall and Camel showed resilience and gained market share of 0.3% and 0.4%, respectively.

American Snuff had a decent quarter as its revenue stood at $185 million, increasing 6.2% from the year-ago quarter. This increase in revenue was attributed to strong sales volume, which increased by 7.1%. As demand for smokeless tobacco increased, Grizzly's (dipping tobacco) volume jumped by 8.3%.

Santa Fe Natural Tobacco saw its revenue reach $160 million, a 28% increase from the comparable quarter last year. The revenue growth was due to strong volume gained by its premium brand, National American Spirit.

Like all major players in the tobacco industry, Reynolds American is also expanding its electronic-cigarette business, which has been recognized as an industry catalyst by many analysts. The company recently introduced its electronic cigarette, Vuse, in Colorado, and it has already captured 55.6% of the retail market share in the state..

The company plans on launching Vuse in Utah by mid-January, which is a step toward a nation-wide rollout of e-cigarettes that will take place in mid-2014. To create more brand awareness among smokers, the company also has plans to invest heavily in its e-cigarette marketing campaigns.

As the market for e-cigarettes is expected to grow, Vuse will definitely help the company make up for its sluggish performance. However, some caution must be exercised, as widespread acceptance of electronic cigarettes and regulations surrounding it are still in question.

The tobacco industry has turned into a dividend industry with companies giving out higher and higher dividends. Reynolds American has the highest dividend yield and the highest payout ratio when  compared to its competitors. However, the company has the lowest free cash flow per share at $2.20 as compared to Philip Morris and Lorillard, which have free cash flow per share of $5.10 and $3.23, respectively.

This suggests that Reynolds has high levels of debt and is paying out dividends through borrowed capital. If the company continues down this path, the cost of borrowing is bound to increase, which casts uncertainty on the company's future. This makes investing in the company a difficult decision.

However, during the last six months, insider selling at Reynolds American has almost been negligible. This points out that the management is hopeful about the future prospects of the company. 

The tobacco industry
Philip Morris International, like all tobacco companies, continues to feel the pressure. The company has thrice revised its earnings guidance, once upward and twice downward, within the same fiscal year, indicating that the management is not certain about the growth of the company.

In the most recent quarter, the company posted earnings per share of $1.44, an increase of 4.3% as compared to the year-ago quarter. But this increase stemmed mainly from higher-pricing policies. The management believes that the e-cigarette market has a lot to offer to Philip Morris International, which is why the company plans on entering its market in 2014. The CEO has called the next year a transitional year as the company will be investing heavily into research and development for e-cigarettes to reap the maximum benefits from a developing e-cigarette market.

Lorillard had a decent third quarter with earnings per share rising to $0.83 as compared to $0.72 in the comparable period last year. The company also posted impressive revenue of $1.8 billion, which represents a 10% year-over-year increase.

The company benefited from its e-cigarette category, which grew by 10.5% from the previous quarter. The company also increased its retail market share for cigarettes and the menthol category by 0.5% and 0.8%, respectively. Furthermore, the company recently agreed to acquire UK-based e-cigarette company SKYCIG, which will help it in gaining market share in Europe.

Final thoughts
Reynolds' overall volume has increased very modestly, mainly driven by the company's core brands. After successfully launching Vuse in Colorado, the company is seeking to benefit from e-cigarettes as it plans a national rollout.

The insider trading has been negligible for the company, which shows that management is positive about its future prospects. But financially, Reynolds does not look very strong as the company has the lowest free cash flow per share compared to its competition.

As a result, the company has accumulated a lot of borrowed capital compared to other players in the industry, which makes it a less attractive investment. The company has also revised its earnings guidance lower due to an overall slow economy. Considering all of this, I will rank Reynolds as a "Hold" rather than a "Buy." 

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Zahid Waheed has no position in any stocks mentioned. The Motley Fool owns shares of Philip Morris International. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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