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Why You Shouldn't Buy Reynolds American Today

Reynolds American (NYSE: RAI  ) is the US' second-largest cigarette company in terms of market value. However, at present levels, the company is a poor investment. Here's why.

For a start, Reynolds is expensive at current prices. In particular, right now shares of Reynolds are trading at a trailing-twelve-month, or TTM, P/E of 20.8. Over the past five years, Reynolds has traded at an average TTM P/E of 16.4 and the wider tobacco industry currently trades at a TTM P/E of 18.

Now a reason exists for this high valuation. Reynolds is in the process of taking over Lorillard (NYSE: LO.DL  ) . I say "in the process" as the two companies have openly admitted to being in talks, but the sticking point seems to be the price.

The deal
Estimates indicate that Reynolds will be able to achieve around $400 million in cost-savings from a merger, although many issues remain to iron out.

For example, a combined Reynolds-Lorillard would control around 40% of the US' domestic tobacco market. This means that around 90% of the market would be controlled by two companies, Altria and Reynolds-Lorillard; this transaction would be sure to attract the attention of the FTC.

To get around this, analysts expect that Reynolds will sell some of its smaller brands, effectively leaving the combined Reynolds-Lorillard with three main brands -- Pall Mall, Camel, and Lorillard's Newport.

This is a portfolio of strong brands, although Newport is predominantly a menthol brand of cigarette and the FDA's position regarding menthol products is still unknown.

The sticking point
As I mentioned above, the sticking point of the deal between Lorillard and Reynolds has been the price, and this could be the deal breaker for Reynolds.

Due to the merger rumors, Lorillard itself is trading at an all-time high and a five-year-high valuation. Lorillard currently trades at a P/E of 19.6, compared to a five-year average of 14. This makes Lorillard an expensive acquisition; $22 billion, in fact.

Reynolds already has a net debt-to-equity ratio of around 70% and an additional $22 billion in debt would cripple the company's balance sheet.

Nevertheless, it is assumed that Reynolds' 40% owner British American would step in to help the deal go through, potentially assisting with funding. Still, even if Reynolds paid half of the $22 billion price tag, the company's net debt would jump by 300%.

With this being the case, ratings agency Standard and Poor's has threatened to downgrade Reynolds to junk status if the deal goes ahead.

Falling volumes
Reynolds is facing another problem, as the volume of cigarettes sold by the company is sliding faster than the industry average.

Specifically, during 2013 the total volume of premium cigarettes sold by R.J. Reynolds within the domestic market declined 6.6%, compared to the wider industry decline of 3.9%. What's more, the volume of value cigarettes sold by Reynolds declined by 7.1%, compared to the industry average of 6.3%. All in all, the total volume of cigarettes sold by Reynolds declined 6.8%, while industry volume only slid 4.6 %.

Slumping cigarette sales are the reason that Reynolds is looking to buy growth through Lorillard. Unfortunately, with sales volumes slumping, the company is going to find it harder to sustain its debt and dividends.

Foolish summary
Due to the bid rumors, Reynolds is currently trading at a five-year-high valuation. However, Reynolds looks expensive at this level. What's more, if the deal does go ahead Reynolds will have an uncertain future due to the extra debt it will take on. If the deal does not go ahead, Reynolds' valuation could quickly fall back to earth.

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Rupert Hargreaves

Rupert has been writing for the Motley Fool since December 2012. He primarily covers tobacco and resource companies with a passion for value-oriented investments. .

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