Is It Time to Buy Reynolds American Stock?

Much attention has been focused on Reynolds American (NYSE: RAI  ) since it announced plans to acquire rival cigarette maker Lorillard (NYSE: LO  ) in a $27.4 billion deal. The merger will combine the No. 2 and No. 3 U.S. tobacco companies and change the competitive landscape. Reynolds American shareholders have already reaped gains from the proposed deal; the stock is up about 18% since rumors of the merger hit the market in February. However, past returns do not indicate future results. Investors must evaluate the facts to determine whether Reynolds American still represents a good investment at its higher price. Let's take a look.

Strong competitive position

Before valuing a company, it is important to determine how industry dynamics might affect future earnings. Reynolds American has a strong competitive position that has historically given it stable earning power. After the Lorillard merger closes, which is expected to happen in the first half of 2015 if all approvals are granted, Reynolds American will have the second-largest share of the domestic cigarette market, with 34.1%. That's less than Altria Group's 50.6% cigarette share and more than U.K.-based Imperial Tobacco's 10% share of the U.S. cigarette market (after Imperial Tobacco acquires several brands as part of the Lorillard transaction). No other tobacco company comes close to matching the size of the big three.

Moreover, a significant portion of Reynolds American's business does not overlap with that of Altria and Imperial Tobacco. Altria's 51% market share is largely made up of nonmentholated cigarettes, while much of Reynolds American's cigarette sales will come from menthol cigarettes after the merger closes.

Last year, Lorillard captured a 40% share of the menthol cigarette space and Reynolds American's Camel brand captured 4%. If market share remains the same, about 44% of the combined company's cigarette sales will come from menthol cigarettes.

Don't get burned

High and stable market share, combined with strong product economics, makes it more likely that Reynolds American's earning power will grow in future years as long as menthol cigarettes remain competitive in the marketplace. And while it would be difficult for a competitor to dethrone Reynolds American as the leader in the menthol market, regulators may move to eliminate the market altogether.

If given the chance, the U.S. Food and Drug Administration appears eager to remove menthol cigarettes from the market. A 2011 FDA tobacco committee report concluded that the "removal of menthol cigarettes from the marketplace would benefit public health in the United States." A judge later ruled that the committee was biased, thereby stalling regulation based on the committee's report.

However, the FDA has shown that it is leaning toward pushing for removal of products that will represent close to half of Reynolds American's post-merger sales. Whether it happens suddenly or gradually, Reynolds American's earning power is set for a decline if the FDA gets its way.

In addition, Reynolds American's stock return could be hampered by a high debt load. After the deal closes, Reynolds American will have $14.9 billion in debt and a 3.6 debt-to-EBITDA ratio, which is much higher than it has historically maintained. The company will need to spend about $2.5 billion over the next 2-3 years to pay down debt, diverting money that could have been distributed to shareholders. Spread over three years, that's about 17% of annual operating earnings that must go to servicing debt instead of into shareholders' pocketbooks.

Follow Buffett's advice

Reynolds American stock is cheap if it can maintain its earning power. The company says it will earn $5 billion in annual operating income after the merger with Lorillard is completed. That translates to $7.86 per share in operating profit and roughly $4.72 per share in after-tax earnings. Reynolds trades near $58 per share, or 12 times estimated earnings for the combined entity. At a 75% payout ratio, that would be a 6.1% dividend yield -- as big as you'll find at any large, stable company. In announcing the deal for Lorillard, Reynolds American said it is committed to a strong dividend policy, targeting a dividend payout ratio of 75%

But investors can't ignore the threat to menthol cigarettes.

One of Warren Buffett's favorite maxims is that investors don't have to swing at every pitch -- there's no penalty for waiting for a fat pitch. Reynolds American is a wide-moat company -- it is unlikely to ever cede significant market share -- but its competitive advantages won't do it much good if menthol cigarettes get the ax. It is possible -- and perhaps even probable -- that Reynolds American's earning power remains intact and its shareholders get a high return. However, with the regulatory overhang facing the company, Reynolds American is not the "fat pitch" that Buffett-type investors are looking for.

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