Reynolds American (RAI) has been on the rise since posting solid second-quarter earnings. The Q2 report showed market share gains for each of its key brands, and management raised the low end of full-year earnings0per-share guidance from $3.30 to $3.35. Still, there are reasons to be concerned about the stock's future returns. Aside from its high stock price, Reynolds American faces significant challenges to its long-term earning power. Investors should take these concerns into account before buying the stock.
Limited growth opportunities
Reynolds American faces a challenge to grow revenue as volumes fall. Historically, the company has exploited its pricing power to raise prices faster than volumes fall. Last year, Reynolds American's cigarette volume declined 6.2% while its revenue declined less than 1%. However, the state of the cigarette market could limit Reynolds American's ability to maintain or grow revenue in the future.
The percentage of U.S. adults who smoke cigarettes is in a secular decline. Rising taxes, stricter regulations, and greater awareness about the health risks associated with smoking tobacco will probably promote this trend in the coming years. When you add in the rise of e-cigarettes as a new substitute, U.S. cigarette volume seems destined for a sharper decline in the next decade. That will create a massive drag on Reynolds American's revenue.
The CDC is targeting 12% smoking prevalence by 2020. Source: CDC.
It's not as if Reynolds American can expand overseas, either. The company sold the international rights to its brands in a 1999 deal with Japan Tobacco (JAPAF 4.32%) As a result, it has little remedy for the declining U.S. market.
Restrictions on menthols
Menthol regulation is the biggest risk facing the company. After completing its acquisition of Lorillard (LO.DL), Reynolds American will derive over 40% of its cigarette volume from menthol cigarettes. However, the category could be in for a big decline.
Regulators could move to curb, or even eliminate, sales of menthol cigarettes. NPR reports that the Food and Drug Administration is considering greater restrictions or an outright ban on menthol cigarettes because of its belief that the ingredient makes cigarettes more addictive and encourages underage smoking. The FDA has already moved against flavored cigarettes; a ban went into effect in 2009. Something similar could happen to menthols.
Reuters reports that the FDA tried to use a biased committee report to move against menthol cigarettes. A judge ultimately tossed the report and said the federal agency could not use it in making new rules. Despite the legal setback, the FDA's actions indicate its intent to clamp down on one of Reynolds American's most important product categories. If the FDA follows through, Reynolds American's earning power will be severely hampered.
Higher taxes
The final major threat to Reynolds American's stock price comes in the form of rising taxes. Last year, 32% of Reynolds American's revenue was attributed to excise taxes. That's up from 23% of revenue accounted for by excise taxes in 2004. Excise taxes on cigarettes generated $31 billion in tax revenue for federal, state, and local governments in 2013. With the increasing strain on state budgets and a reluctance to raise taxes on the middle class, future tax increases on cigarettes could be in order. Doing so would price more consumers out of the market for Reynolds American's premium cigarettes, pushing them down to the lower-margin discount category. This would have a material impact on Reynolds American's revenue and earnings potential.
Takeaway
Reynolds American has effectively navigated the declining cigarette market for decades, but it may not be so nimble in the future. It's stuck in the U.S. after selling its international rights to Japan Tobacco, and menthol cigarettes could get the ax. Moreover, higher taxes could be in order to shore up ailing state budgets. As a result, there's a real possibility that Reynolds American's stock price is due to fall.
