Lorillard vs Reynolds: Which One Should You Choose for Income and Growth?

Tobacco companies are well known for their defensive nature, conservative management teams, and shareholder returns. However, there are many tobacco companies on the market, and trying to decide which one deserves your money can be a headache.

Reynolds American (NYSE: RAI  ) and Lorillard (NYSE: LO  ) are two of the smaller listed tobacco companies and both have similar qualities; both are domestic cigarette companies and neither has much in the way of international exposure. What's more, for the most part, both companies are exclusively tobacco and cigarette companies, unlike some of their peers.

So, if you had to choose between Reynolds and Lorillard, which one should you pick?

The growth question
When it comes to the question of growth, Reynolds' first-quarter results gave investors plenty of reasons to celebrate. The company reported that sales ticked up 2.8% year-over-year, although the volume of cigarettes shipped by Reynolds decreased by 3.8% year-over-year.

That being said, the company's growth brands, specifically Camel and Pall Mall, actually reported a 1.2% year-over-year rise in their volume of cigarettes shipped.

Elsewhere, Reynolds' smokeless-snuff and moist-snuff sales performed well, with overall sales rising 10.7%. In addition, the company's subsidiary, Santa Fe Natural Tobacco Company, reported a 10.7% jump in sales of cigarettes sold.

As a subsidiary, Santa Fe's cigarette sales are not consolidated into Reynolds' total cigarette sales volumes. Santa Fe Natural Tobacco Company manufactures and markets Natural American Spirit 100% additive-free natural tobacco products, including styles made with organic tobacco.

Nevertheless, Reynolds' overall volume of cigarettes shipped declined, but this is something Lorillard is not worried about. Unlike many other tobacco giants, Lorillard's cigarette sales and market share of the cigarette market continue to expand. During the first quarter of this year, Lorillard's domestic retail market share increased 0.3% from the year-ago period to 15.2%, its highest level ever and first full quarter over 15%.

According to Lorillard's management:

...Gains in Newport's domestic retail market share were primarily attributable to the continued strengthening of Newport Menthol in its core geographies...the volume impact resulting from the introductions of Newport Smooth Select and Newport Non-Menthol Gold in 2013...

As a result, during the past four years Lorillard's gross profit has jumped 29% and the company's gross margin has risen from 36% to 39% over the period. 

The income question
When it comes to the question of growth, then, Lorillard looks to be better-positioned than Reynolds.

That said, the recent takeover interest in both companies implies that the two have promising futures. However, one question remains: which company offers its investors the best returns?

Well, looking at the 2013 numbers, Lorillard returned a total of $1.6 billion to investors through both buybacks and dividends. Based on the number of shares in issue at year-end, this works out at around $4.30 per share, equal to a yield of 7.3% at present levels.

On the other hand, once again based on 2013 numbers, Reynolds returned a total of $2.1 billion to investors throughout the year. Based on the number of shares in issue at year-end, this works out to around $3.80 per share, equal to a yield of 6.8% at present levels -- 0.5% below Lorillard's returns.

The similarities don't stop there. Both companies trade at similar valuations as well. Lorillard trades at a forward P/E of 15.6, while Reynolds trades at a P/E of 15.5. It's extremely difficult to choose between the two companies with this consideration.

Hang on a minute
However, before I come to a conclusion, there has been speculation recently that Reynolds was arranging a bid for Lorillard. Without a doubt, Reynolds' rumored swoop on Lorillard surprised many. Still, a combination of Reynolds and Lorillard would be likely to achieve somewhere in the region of $341 million in cost synergies for the two companies

However, it's not as simple as it first appears. You see, the Anglo-American tobacco company British American Tobacco owns 42% of Reynolds American. When British American originally acquired its holding in Reynolds, the company signed a standstill agreement that prevented it from increasing the size of its holding for ten years; this 10-year period ends during July of this year.

This has led to speculation that British American could make an offer for Reynolds. Citi's analysts have reiterated this case, stating, "[T]he fundamentals of Reynolds' business increase the company's attractiveness." In analyst-speak, this means that Reynolds is a well-run, profitable business with good long-term prospects.

Specifically, Reynolds has good relations with its customers and an attractive electronic-cigarette segment, which would complement British American's existing offering and global presence.

However, Citi believes that a joint venture between Reynolds and British American is more probable than a takeover, as this would allow British American to access Reynolds' e-cig technology without having to jump over regulatory hurdles.

Foolish summary
Aside from the takeover speculation, it would appear as if Lorillard is the better company for investors who seek both capital growth and income.

Lorillard's sales and income both continue to expand while the company is returning cash to investors at a high-single-digit rate.

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