Investors in tobacco giant Reynolds American (NYSE:RAI) had to wait a long time, but they finally got their wish in June, when the merger with Lorillard got final approval. Since then, investors have become increasingly optimistic about Reynolds American's prospects, as it becomes a stronger competitor to its main rival in the domestic tobacco market and plots its future course. Let's take a closer look at what Reynolds American's management team highlighted in its most recent conference calls and what investors should take away as key points in evaluating the tobacco giant's opportunities going forward.
"I'm pleased to say that the integration of the Newport brand is going very well. ... A good deal of work remains to be done, but we have a great track record in executing these kinds of combinations and I'm confident that the process will continue to run smoothly."-- CEO Susan Cameron
One of the key elements of the Lorillard merger was acquiring the Newport brand, which is a market leader in the menthol-flavored cigarette market. When you combine Newport with Reynolds' brands Camel and Pall Mall, the three names make up more than 90% of Reynolds American's total cigarette market share. Combined, these three brands have almost 30% of the U.S. cigarette market share, and Reynolds anticipates not only leveraging the value of Newport's menthol franchise but also introducing new menthol flavors for Camel. All told, Newport has been a huge early win for Reynolds American, and although some regulatory threats remain, Reynolds has high hopes that Newport will remain highly important well into the future.
"VUSE is now in distribution in more than 100,000 retail outlets and has solidified its position as the top-selling electronic cigarette in the C-store channel. ... We will continue to innovate and invest to keep VUSE as the leading, most advanced product in the marketplace."-- Cameron
Despite the importance of Newport, Reynolds American sees value in the transformation of the tobacco industry away from traditional cigarettes toward alternative products. In particular, Reynolds has focused at a rapid expansion of its e-cigarette brand VUSE, which it sees as having strong and distinctive qualities compared to competing products. With extensive marketing campaign resources behind the brand, VUSE has supported retailers who choose to promote it, creating a positive feedback loop that has helped make the brand a category leader. Combined with products like nicotine gum and heat-not-burn cigarettes, Reynolds is working hard to stay on top of trends in the industry.
"American Snuff flagship brand Grizzly performed very well in the second quarter. ... Grizzly's momentum is being driven by its popular pouch style, which is the fastest-growing style of moist snuff."-- Cameron
Smokeless tobacco has been an up-and-down area for Reynolds American, and it's not one where the Lorillard merger has had a marked impact on its business. Nevertheless, Cameron believes that moist snuff has potential, and she pointed to a combination of higher pricing and strong volume in driving the company's snuff business upward. In particular, gains of more than a full percentage point in market share above the one-third mark came largely from the Grizzly brand, and introductions like the Dark Wintergreen style have performed well and added to gains for the division as a whole. Even as consumers shift between various types of tobacco products, Cameron is hopeful that smokeless tobacco will remain important to Reynolds American's overall business well into the future.
"At Santa Fe, performance continues to exceed even our own high expectations."-- Cameron
The drive toward super-premium products across the consumer goods sector has had an impact on the tobacco market, and thanks to its Santa Fe unit and the key Natural American Spirit brand, Reynolds American has tapped into the huge demand for high-quality products. The company boasted operating-income gains of nearly 50%, with strong margin expansion and volume growth of more than a quarter for Natural American Spirit. Reynolds sees its super-premium franchise as having loyal customers who aren't likely to move away from the brand, and with no discounts, pricing power remains strong and should drive continued profit growth as long as demand remains consistent.
"Our near-term focus is to deleverage as efficiently and quickly as possible while maintaining appropriate financial flexibility."-- CFO Andrew Gilchrist
To get the Lorillard deal done, Reynolds American took on substantial debt, both in offering new bonds to complete the acquisition and in exchanging old Lorillard debt for similar Reynolds American debt. As a result, long-term debt is at $17.6 billion, which is fairly high compared to the cash balance of $4 billion as of the end of the quarter.
Still, Reynolds is aiming at cutting debt. Already, the tobacco giant has managed to keep costs under control, with interest rates averaging just 4.5% despite a fairly long average maturity of 12.4 years. Gilchrist said that he anticipates Reynolds paying down debt as it matures, even though he doesn't expect debt prepayments ahead of their maturity schedule. Once leverage levels fall, shareholders can look forward to renewed stock buybacks and other capital-return strategies.
Reynolds American is pleased to have its merger with Lorillard done, but it's now looking squarely at its future. With so many potential victories ahead of it, investors are understandably bullish about Reynolds American's prospects now and in the years to come.