3 Reasons Reynolds American's Stock Could Rise

As the second-largest company in the shrinking tobacco industry, Reynolds American (RAI) does not have the wind at its back. Many people would like to see the company go out of business because of its products' negative health effects. That animosity hasn't kept Reynolds American from thriving, however. Its stock price is up 30% over the last year and could go higher still. Although nothing is certain, there are three main reasons Reynolds American's stock price could continue its rise.

Pricing power drives earnings growth
Despite a shrinking cigarette market, Reynolds American should continue to grow earnings per share for the foreseeable future. If its merger with Lorillard (LO.DL) closes as planned, the combined company will derive over 40% of its cigarette sales from menthol cigarettes. Unlike the overall cigarette market, menthol cigarette volumes are relatively robust. Total menthol volume grew as a percentage of overall cigarette volume from 27.4% in 2006 to 31.4% in 2013. Over the same period, menthol volume fell by 16.7% compared to a 27.3% decline for the overall cigarette market.

Reynolds American's brands should have enough pricing power to offset future volume declines. Smokers are addicted not just to the nicotine, but also to the nicotine delivered by a specific brand. The menthol found in Newport menthols and Camel menthols gives smokers a cooling sensation that may produce enhanced brand loyalty. Therefore, Reynolds American's pricing power may increase after it acquires menthol-heavy Lorillard.

Source: Company filings.

To top it off, Reynolds American uses its rising free cash flow to repurchase shares. Excluding changes in working capital, free cash flow rose from $1.5 billion in 2011 to $2.1 billion in 2013. The company returned nearly all of it to shareholders through dividends and share repurchases. Continued repurchases at modest prices will drive up earnings per share and create shareholder value in the years ahead.

Greater capacity for paying dividends
Tobacco stocks have long been a staple in dividend investors' portfolios. Reynolds American and its peers tend to offer a 4% to 6% dividend yield. Reynolds American currently trades at a 4.6% yield -- the mid-to-lower end of its typical yield range.

However, the trailing dividend yield is misleading. If Reynolds American successfully merges with Lorillard, the annual dividend will likely be higher. Management says it will target a 75% payout ratio after the combination. Even though this is lower than Reynolds American's current 80% payout ratio, the combined earnings of both companies will end up making the dividend higher even at the lower payout ratio.

Moreover, the lower payout ratio gives the company room to increase it in the future. After the deal goes through, management plans to pay down debt until its debt-to-EBITDA ratio falls below 3 from the projected post-deal 3.6 debt-to-EBITDA ratio. After that, management may be able to raise the payout ratio on a higher earnings base, thus growing the dividend higher than it could before the merger.

Since tobacco stocks often trade based on their dividend yield, a higher dividend will likely result in a higher stock price. As a result, Reynolds American shares may be due for an additional rise.

E-cigarette growth
Lorillard plans to divest its popular Blu e-cigarette brand as part of its merger with Reynolds American. On first blush, this seems like a big loss; Blu is the market leader with a 41% e-cigarette share. However, the divestment indicates that Reynolds American has tremendous confidence in its own e-cigarette brand, Vuse.

In fact, Vuse may achieve similar stature in the market as Blu within the next year. Altria Group's (MO 0.49%) MarkTen e-cigarette brand demonstrated the power of retail relationships and marketing dollars when it achieved a leading share of the Arizona e-cigarette market within a few months. Reynolds American has similar distribution and marketing capabilities as Altria, so it should be able to attain a similar growth trajectory as MarkTen.

With continued growth, e-cigarettes could soon become a material contributor to Reynolds American's success. Most estimates peg the U.S. e-cigarette market at about $1.5 billion. If Reynolds American captures a 30% market share, it would derive $450 million in sales from e-cigarettes. Reynolds American projects $11 billion in annual revenue after it completes its merger with Lorillard, so e-cigarettes would add just 4% to that total. However, 20% annual e-cigarette sales growth would contribute another full percentage point to Reynolds American's sales growth -- a significant figure for a company that has struggled to grow sales.

Takeaway
Reynolds American is a market leader with significant pricing power to offset volume declines. The company' acquisition of Lorillard will boost its ability to pay dividends, and its Vuse e-cigarette brand adds growth potential. These three factors could play into a rising stock price in the years to come.