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Will 2016 Be Reynolds American Inc's Best Year Yet?

By Leo Sun - Jan 19, 2016 at 4:00PM

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Will the domestic tobacco giant’s impressive rally continue this year?

Shares of Reynolds American (RAI) have rallied 38% over the past 12 months, easily outperforming rival Altria's (MO -0.46%) 8% gain and the S&P 500's 7% decline. But even after those big gains, Reynolds still trades at a reasonable 18 times earnings, compared to Altria's P/E of 22 and the industry average of 19. Looking ahead, could 2016 be Reynolds' best year yet?

Source: Pixabay.

Why Reynolds could keep rising
Since most of Reynolds American's sales come from the U.S., it's well insulated from currency fluctuations and economic turmoil overseas. Lower gas prices, which put more cash into consumers' pockets, have also been boosting cigarette sales.

Between 2005 and 2014, the adult smoking rate in the U.S. has fallen from 21% to 16.8%. While that might seem like bad news for Reynolds and Altria, both companies still have room to raise prices to offset volume declines. The average price of a pack of cigarettes across all U.S. states, including taxes, is just $5.51. By comparison, smokers in Australia and the U.K., which both have smoking rates comparable to that in the United States, pay well over $10 per pack.

Reynolds and Altria haven't dramatically raised prices lately, since shipment volumes have been positive. Last quarter, Reynolds' shipments surged 29.5% annually, mainly due to its acquisition of rival Lorillard. With the addition of Lorillard's Newport brand, Reynolds' domestic market share (adjusted for the Lorillard acquisition) rose from 33.7% in the prior year quarter to 33.9%. Altria's total cigarette shipments rose 0.1% annually. Its market share, mainly supported by Marlboro, rose from 50.9% to 51.3%. Reynolds' revenue grew 41% annually last quarter, while Altria's sales improved 4.7%.

Growth in non-cigarette markets
Reynolds American is the market leader in the menthol and e-cigarette markets. Lorillard's Newport is the best-selling menthol cigarette in America and the second most popular cigarette brand after Marlboro. Reynolds' Vuse e-cigarettes, snuff, and nicotine gum round out its non-cigarette portfolio, which generated 10% of sales last quarter. Altria's non-cigarette portfolio -- which consists of cigars, wine, a stake in SABMiller, and e-cigarettes -- accounted for 12% of its sales last quarter.

Reynolds' Vuse e-cigarettes. Source: Reynolds American.

Last summer, Nielsen reported that Reynolds' Vuse had captured 36% of the U.S. e-cigarette market. Its closest rival, Imperial Tobacco Group's Blu, only controlled 23% of the market, while Altria's MarkTen claimed a single digit share. Reynolds also recently launched a new division, RAI Innovations, to develop next-generation vapor and nicotine products.

Research and Markets estimates that the global e-cigarette and vaping market will grow at a compound annual growth rate of 22.4% between 2015 and 2025. If that forecast is accurate, Reynolds' e-cigarette revenues could surge and offset long-term concerns regarding its core cigarette business.

Expectations and headwinds
Over the next five years, analysts expect Reynolds American to grow its annual earnings at 13%, compared to 8% growth for Altria. That forecast gives Reynolds and Altria respective 5-year PEG ratios of 1.8 and 2.4. Since a PEG ratio under 1 is considered undervalued, neither stock can be considered especially cheap. However, Reynolds' lower P/E, PEG, and earnings growth forecasts suggest that it's a better buy.

However, investors should also mind the headwinds that could knock down Reynolds in the coming year. Menthol cigarettes have been constantly targeted by anti-tobacco regulators, with accusations that they are more addictive than regular cigarettes. The FDA is also expected to pass new regulations against e-cigarettes later this year, which could throttle Vuse sales.

President Obama's proposal to nearly double the federal excise tax on a pack of cigarettes to $1.95, along with higher state taxes, could throttle Reynolds and Altria's ability to raise prices. The $29 billion Reynolds spent on Lorillard also caused its long-term debt to soar 266% annually to $17 billion last quarter, and its free cash flow to turn negative. Those factors could impact Reynolds' ability to repurchase stock or raise its dividend.

Will 2016 be Reynolds' best year yet?
In my opinion, Reynolds' gains in 2016 probably won't be as impressive as its 45% rally in 2015. However, I still believe that Reynolds will have a decent year and remain a fairly safe way to weather the barrage of headlines related to the strong dollar, weak oil, Fed rate hikes, and the economic turmoil in China.

Leo Sun has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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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