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3 Reasons Reynolds American Stock Could Rise

By Dan Caplinger – Mar 6, 2016 at 6:58AM

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The tobacco company is benefiting from its smart strategic moves lately.

Image: Reynolds American.

Tobacco giant Reynolds American (RAI) has been on top of the industry lately, posting outsized returns of 38% over the past year. Yet despite excitement about the company's results, Reynolds American is only beginning to reap the benefits of its recent strategic moves, especially the acquisition of longtime rival Lorillard. Let's take a look at three reasons why Reynolds American could climb even further from here.

The Newport brand
The most important asset that Reynolds American got in the Lorillard deal was its Newport cigarette brand. Newport is the undisputed leader in menthol cigarettes, and its popularity is a vital part of Reynolds American's strategy for the entire company going forward.

In its most recent quarter, Newport kept demonstrating its value to Reynolds American. Newport's growth actually accelerated in the fourth quarter of 2015, posting volume growth of nearly 5% and capturing a market-share increase to 13.6% of retail shipments. CEO Susan Cameron attributed that performance to the greater availability of Newport products in retail locations as well as the execution of Reynolds American's marketing team. She also pointed to growth in both the premium menthol styles as well as the Newport Red label as a net positive in its efforts to engage customers further.

To take advantage of that popularity, Reynolds American expects to come out with various styles under the Newport brand in the near future. As those roll out, investors will be able to see just how important Newport is to Reynolds American's growth, and that could transform the company as customers start to tie that key name to the company behind it.

Dividend growth
Reynolds American has a good track record of rewarding investors with dividends, and its current yield of 3.3% is well above what the typical stock pays. Yet what many investors don't realize is that Reynolds American's payouts are currently depressed, and gains further down the road could reinvigorate the stock.

Reynolds American's acquisition of Lorillard cost the company about $27 billion, and roughly three-quarters of what former Lorillard shareholders received was in cash. That required Reynolds American to take on substantial debt, and getting that debt paid down became a priority that competed with the existing capital allocation decision-making framework. The sale of some of Lorillard's brands to third parties assisted in improving the cash flow, but as of the end of 2015, Reynolds American still had almost $17 billion in long-term debt, up from less than $5 billion the previous year.

Reynolds made paying down the debt a priority and said that it would wait until it could get its debt-to-operating earnings ratio below 3. Until that happens, Reynolds American has committed to keeping a dividend payout ratio of around 75%. However, as CFO Andrew Gilchrist said in Reynolds' conference call last quarter, the company could revisit a change in the ratio once the company reduces the leverage on its balance sheet below what it considers acceptable levels.

A boom for Vuse
Reynolds American has worked aggressively in developing tobacco alternatives like vapor products, and its Vuse brand will be an essential part of its growth strategy going forward. The company has been performing well in retail channels, and four new flavors introduced at the end of September, including Crema, Mint, Berry, and Chai, have been received well by adult tobacco users.

Innovation has been a key for Reynolds American in making Vuse the leader in the vapor category, but the product is still in the developing stages. As marketing efforts take hold and try to capture users of competing tobacco products, Reynolds American hopes that Vuse will be the answer to the long-term decline in cigarette smoking that has held back the tobacco giant from reaching its full growth potential.

Reynolds American's returns have been superb, but there's still potential for more. Given its new competitive stature, Reynolds American stock could climb further, even after its impressive gains lately.

Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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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