Reynolds Is In It for the Long Haul

Reynolds American (RAI) has been taking initiatives to strengthen its cigarette portfolio, mainly with its growth brands. The company also seems to be on track to expand its presence in the fast-growing e-cigarette (e-cigs) category to offset the impact of dropping conventional cigarette volumes. The company has been aggressively spending to boost its presence in the e-cigs market. Altria Group (MO 1.91%) and Philip Morris (PM 2.82%) are also working to expand their presence in e-cigs and other alternate tobacco-product markets.

Mixed fundamentals for Reynolds
Reynolds has the second-highest retail market share of 26.7% in the U.S. tobacco market, lagging behind Altria with a market share of about 50%. Reynolds has been lagging behind its peers and the industry in terms of sales volume growth. In the first quarter of 2014, the company observed an adjusted sales volume drop of 5.2%, in contrast to the industry volume decline of almost 4%. Sales volume under-performance for Reynolds, in comparison to the industry, is likely to continue in the near term; however, the trend should improve and the gap is expected to contract as the company continues to benefit from brand-building efforts behind its growth brands.

The brand-building efforts that the company has undertaken to strengthen its growth brands, including Camel and Pall Mall (two of the best selling cigarette brands in the U.S.), seem to have been productive as volumes for growth brands were up 1.2% year-over-year, led by a 2.5% volume growth for Camel and flat volumes for Pall Mall in the first quarter of 2014. Also in the quarter, the company was successful in expanding the market shares of Camel and Pall Mall by 0.4 basis points and 0.3 basis points from the year-ago quarter to 10% and 9.5%, respectively. The performances of the company's growth brands appear to be satisfactory and important, as they account for 70% of its cigarette portfolio.

In contrast to growth brands, the performance of other (discount) brands remains a concern. Other brands account for about 30% of the company's cigarette portfolio. The company has been consistently losing market share and has been experiencing sales volume drops for its other brands. In the first quarter of 2014, other brands' retail market share dropped by 0.60 basis points to 7.2% and sales volume was down 12.9%.

The performance of other brands is likely to remain a drag on Reynolds' earnings in upcoming quarters. However, as growth brands keep growing and other brands become a smaller part of its cigarette portfolio, the total sales volume trend for Reynolds should improve in the medium-to-long term, which will bode well for the company's profitability.

Price increase
As the sales volume trend for the tobacco industry remains weak, price increases remain an important tool for supporting revenue growth. Tobacco companies have been consistently increasing their prices to offset the impact of weak sales volume trends, reflecting a long-term focus on profitability growth. The table below displays price increases undertaken by tobacco companies in the first quarter of 2014.

Next-generation products
Tobacco companies continue to invest in the development of e-cigs and other alternate tobacco products. Reynolds has plans to ramp-up production of its e-cigs brand, VUSE, within the next four years. The company has been investing millions of dollars to expand the production and distribution of VUSE. Reynolds plans to expand its manufacturing facility in Tobaccoville. Also, the company remains committed to expanding VUSE's distribution nationwide in 2014. The aggressive efforts by the company to expand the distribution of VUSE nationwide in the current year will put pressure on earnings in the short term; however, this augurs well for the company's performance in the long term. 

Altria also remains focused on the development and growing presence of its e-cigs brand Mark-Ten. Consistent with its efforts to expand the market presence of its e-cigs, it took over Green Smoke, an e-vapor company, in the beginning of the ongoing second quarter of 2014. In addition, Altria plans to launch Mark-Ten nationally by the end of the first half of 2014.

Philip Morris continues to work aggressively on its "next generation products," or NGP, initiative, which it has divided into three platforms (stages). In the last three years, Philip Morris has invested $650 million in this and now plans to increase spending by $100 million per annum to develop NGP. The company has plans to launch the first device under Platform One at the back end of 2014 or early 2015. After the launch of the Platform One device, the company has targeted the introduction of more devices under its NGP program. Also, Philip Morris has been building a facility in northern Italy that will cost $680 million with the capacity for manufacturing tens of billions of cartridges for its next-generation products.

Final take
In a challenging business environment where volumes for conventional cigarettes are dropping, Reynolds has been working to improve its cigarette portfolio and develop e-cigs. The fundamentals of the company remain mixed, as its sales volume continues to under-perform the industry and the performance of its 'other brands' deteriorates. However, the company's brand-building measures seem to be productive as its 'growth brands' continue to grow in terms of sales volume and market share, which likely bodes well for the company's sales volume in the medium-to-long term. Also, the company's aggressive efforts to develop and expand the presence of VUSE augurs well for its performance in the long term.