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Reynolds American Winning in Smokeless Tobacco

By Michael Lewis - Feb 18, 2014 at 10:02AM

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The traditional tobacco cigarette business is decaying, but Reynolds doesn't need it in the long run. This company's substantial presence in smokeless tobacco will keep investors and nicotine addicts happy for years to come.

Reynolds American (RAI) isn't a stock that leaves you warm and fuzzy inside, but it's hard to deny its appeal. With a 5.6% dividend and new, high-growth segments getting up to speed, the company can appeal to both income-seeking investors and those who favor capital appreciation. In its recent earnings announcement, Reynolds actually missed analyst estimates, but the tremendous tailwinds of segments like e-cigarettes and chewing tobacco should assuage concerns that the company will struggle to find growth -- not to mention the earnings were still a nice double from the prior year's. Here's why you should take a closer look at Reynolds American.

Blown estimates
Reynolds is the second biggest tobacco company in America and is the company behind giant brands such as Camel and Pall Mall. Still, the U.S. smoking market isn't what it used to be (and likely never will be again) -- cigarette volumes shrank 9% in the company's fiscal fourth quarter to 15.6 billion. The two main brands mentioned above performed slightly better (though they were still down in the mid single digits), but brands such as Kool and Winston exhibited a 15% drop in volume. Natural American Spirits, an all-natural product, saw its sales continue their upward trajectory and hit 1 billion sold in the quarter

In the meantime, alternative smoking products continue to gain traction. Snuff brands Grizzly and Kodiak saw 8% volume gains and represent a chunky one-third of the entire market.

The market was unimpressed with the numbers as Reynolds' cigarette volume declines were faster than the market at large. Forward-looking guidance was within the expected range, though not particularly impressive, either.

The future of tobacco
Investors interested in buying cigarette companies should look no further than Philip Morris International. The company has a great presence in emerging markets, where smoking is still on the rise and existing smokers are puffing like chimneys.

Reynolds American today is a different story.

As mentioned above, Reynolds has a great hold on the North American smokeless tobacco products (like Grizzly and Kodiak). In developed markets, these are the high-growth tobacco products that address a more health-conscious public and stigmatized industry. In the European Union, the percentage of the population that smokes was recently as high as 40%. These days, that number is less than 30%. While the alternative categories are still tiny by comparison, the growth in snuff, snus, electronic cigarettes, and other alternatives remains very compelling.

Many of these products, especially e-cigarettes, are ahead of the regulation game, too. Reynolds has advertisements on television for its Vuse e-cigarette. Cigarette ads on television have been banned for decades. E-cigs are perceived as healthier alternatives, or even quitting devices, as well as a more socially acceptable method of nicotine delivery. Reynolds' Vuse product began its rollout just recently and is on a rapid track for national availability.

Reynolds trades at just over 13 times its expected earnings. It's less expensive than Philip Morris International (15.2 times) and slightly more expensive than Altria (12.89 times) and Lorillard (12.53 times). Reynolds has the highest dividend yield of the four. In the long run, we will see the more affordable, more socially acceptable smokeless alternatives take over the traditional tobacco business. Reynolds should remain among its peers as a top player and reward investors along the way.

Michael Lewis has no position in any stocks mentioned. The Motley Fool owns shares of Philip Morris International. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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