Is Reynolds a Good Long-Term Bet?

As more consumers quit smoking, most of the tobacco giants are raising their prices to offset the volume decline. In addition, cigarette companies like Reynolds American (NYSE: RAI  ) , Lorillard Tobacco  (NYSE: LO.DL  ) , and Altria Group (NYSE: MO  ) are investing heavily in smokeless products and e-cigarettes to cope with the volume decline in traditional cigarettes.

Quarterly earnings
As a result of lower-than-expected volume for traditional cigarettes, Reynolds reported adjusted earnings per share of $0.72 -- flat compared to the prior-year quarter. Higher cigarette prices offset the volume decline and increased investment in the company's e-cigarette segment.

Net sales grew 2.8% year-over-year to $1.93 billion, and revenue beat the Zacks Consensus Estimate by 2.1%. Adjusted operating margin dropped 2.6% due to higher cost of sales.

Let's see how Reynolds' subsidiaries performed during the quarter.

R.J. Reynolds Tobacco: R.J. Reynolds didn't do that well due to lower demand for traditional cigarettes and the economic slowdown. As a result, its revenue ticked up just 0.3% to $1.6 billion while volume dropped by 3.8%.

American Snuff: Volume for American Snuff jumped 10.3% thanks to growing demand for the company's Grizzly brand. Revenue also climbed 10.2% to $184 million.

Santa Fe: Santa Fe also did a pretty good job as its revenue increased 17.4% to $135 million, backed by its premium brand Natural American Spirit's volume growth of 10.7%.

What's in store for the future?
Going forward, Reynolds expects a lot from its e-cigarette segment. Given that VUSE did great in Colorado and Utah, it's expected to capture a substantial market share across the US in the coming years. In fact, VUSE's performance has exceeded Reynolds' expectations as well. During early June, the company will be launching VUSE in Wisconsin and Indiana before introducing it in more than 15,000 regional stores across the country in late June.

As Reynolds continues to spend on VUSE, this is bound to affect its earnings for the second quarter. That's why it expects adjusted earnings per share to grow by just 3.5%-8% in the next quarter.

Apart from VUSE, Grizzly will also prove to be a catalyst for the company's growth in the future. As the brand continued to generate strong growth, its market share increased 4 percentage points to 31.5% during the first quarter. Plus, its volume jumped by more than 12%.

Reynolds projects that its Grizzly's Wide Cut Wintergreen style will gain more market share this year as the brand has seen excellent results with its new pouch style, which is the fastest-growing style in the moist-snuff segment these days.

There are also rumors going around regarding the possible merger between Reynolds American and Lorillard. If the companies make this deal, it will establish the second-largest tobacco company in the US after Altria Group. The companies haven't commented on this as yet.

Altria Group and Lorillard
Altria Group's first-quarter earnings grew 5.6% behind its smokeless segment's strength. On the other hand, the smokeable segment's adjusted operating income grew by 6.4% but its growth was mainly driven by higher pricing rather than increased volume. The company has reaffirmed its guidance for this year's earnings, as it expects EPS to fall in the range of $2.52-$2.59; this represents growth of 6%-9% from the last year. Altria yields a dividend of 4.70% and has provided a year-over-year capital return of 14%.

As a result of stock repurchases and higher pricing, Lorillard's earnings per share increased 4.5% during its recent quarter. The company is investing heavily in the UK, where it's rebranding its product from SKYCIG to blu, so it will incur more marketing costs in the second quarter. However, as blu has created a lot of brand value in the US, it will certainly bring the company more revenue from the British market as well. Lorillard has a dividend yield of 4.10% and its capital appreciation stands at 42%.

Bottom line
Reynolds' first-quarter earnings took a hit as the company kept investing in the expansion of VUSE. However, these investments will pay off in the future so investors shouldn't be worried. With a year-over-year return of 24%, Reynolds remains one of the better investments in the tobacco industry. Over the years, Reynolds' iconic brands Camel and Pall Mall have largely contributed to its success. Though these two brands are still growing their market shares, their growth rates aren't the same as they used to be. As consumers become more health-conscious, Reynolds' smokeless products and e-cigarettes will drive its growth in the years to come.

Furthermore, VUSE has already established considerable market share in Colorado and Utah, which bodes well for its future in the US. Moreover, Grizzly will make sure the company keeps generating incremental revenue in the moist-snuff market. On the whole, Reynolds looks to be a good long-term buy. However, as I said earlier, Reynolds' second-quarter earnings will also be trimmed down due to spending on VUSE, so it isn't a great short-term buy.

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6/12/2015 4:05 PM
LO.DL $0.00 Down +0.00 +0.00%
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RAI $40.83 Down -1.05 -2.50%
Reynolds American,… CAPS Rating: ****