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Reynolds American Inc. (NYSE:RAI) is the second largest tobacco company by market share in US. The company manufactures and sells cigarettes and smokeless tobacco products throughout the US. Like many of its tobacco peers, Reynolds offers an above average dividend yield of 5.7%. The stock is currently trading for $41.74, about 8% off from its year high of about $45.00.

(click to enlarge)

Reynolds' stock price is highly correlated to its dividend. Since 2008, the stock price for Reynolds has risen by about 35% while its dividend has gone up by 39%. This can be seen on the chart below:

RAI Chart

RAI data by YCharts

The TTM P/E for Reynolds is currently 16.63. The P/E for Reynolds is off of its highs, but is still high compared to where it was in 2011. The higher P/E for Reynolds may be due to the stock price being elevated due to the higher dividend.

RAI Chart

RAI data by YCharts

The dividend payout ratio for Reynolds has been relatively high over the last 5 years. The payout ratio is currently at about 90% of earnings. For much of 2009 and 2010, the payout was over 100% of earnings. While this metric has improved for Reynolds, it is worrisomely high. Future dividend increases for the company will most likely be tied to earnings growth.

RAI Chart

RAI data by YCharts

One way Reynolds has been growing eps has been by buying back shares. Shares outstanding for the company have declined by 3% in 2012. Reynolds has bought over $625 million of its shares this year, or 15 million shares.

RAI Chart

RAI data by YCharts

Looking at EBITDA, we can see how Reynolds has been able to become more profitable by improving margins. Since 2004, headcount has been reduced by 35%. Cost cutting and margin expansion have been key to Reynolds earnings growth.

RAI Chart

RAI data by YCharts

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Source pg 44

Looking at the balance sheet for Reynolds, we can see that long-term debt has declined 44%, to $2.5 billion, since 2008. Interest expense has also declined 31% to $56 million per quarter.

RAI Long Term Debt Chart

RAI Long Term Debt data by YCharts

Reynolds has been able to repay debt, pay high dividends and buy-back stock since 2008. This is primarily due to strong operating cash flows and low capital expenditures. Operating cash flows have remained steady since 2008.

RAI Cash from Operations TTM Chart

RAI Cash from Operations TTM data by YCharts

Reynolds has been able to improve its eps by cost cutting, margin improvements and share buybacks. While this speaks to high quality management and good execution, it does hide the fact that revenues for Reynolds have declined 8% from $9 billion to $8.30 billion over the past 5 years.

RAI Chart

RAI data by YCharts

Reynolds, in my opinion, is a second tier tobacco stock. Its reliance on cigarette sales is its weakness, it is not as well diversified as Altria (NYSE:MO) (which owns a wine business and a large chunk of SABmiller (OTCPK:SBMRY)). Nor does it have the international potential of Philip Morris International (NYSE:PM). Reynolds should trade for a higher yield than Altria. I would wait for Reynolds to reach the 6% yield mark, $39.33, before considering buying the stock.

Source: Reynolds American Offers A 5.7% Yield, But Is Currently Overvalued