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Reynolds American (RAI) has registered satisfactory financial performances over the years, but at its current valuations, forward P/E of 14.7x and with a PEG of 2.05, I believe the stock is slightly overvalued. Also, analysts are forecasting the next five years growth rate to be 7.7% per annum. The projected growth is lower than growth projections for Philip Morris (PM) and Lorillard (LO) of 10.6% and 12.5%, respectively. Therefore, I believe investors should wait for a better entry point to buy the stock.

Financial Performance
RAI reported a satisfactory financial performance for 2Q2013. Net sales for the recent second quarter were $2.18 billion, up 0.1% YoY, in line with analyst expectations. RAI posted adjusted earnings per share of 84 cents in 2Q2013, up 6.3% YoY. The company experienced notable margin expansion in the quarter, mainly due to higher pricing and cost control efforts. The following table shows gross, operating and net margins for 2Q2013 as compared to 2Q'12:

 

2Q'12

2Q'13

Gross Margin

49%

54%

Operating Margin

33.5%

36.5%

Net Margin

20%

21%

Source: Quarterly Report and Calculations

Shipment volumes for RAI declined by 6% in 2Q2013 as compared to the corresponding period last year. The drop in the shipment volumes for the quarter came primarily a result of growth in the alternate cigarette category, ongoing economic challenges, and higher retail prices. As volumes of traditional cigarettes are decreasing, the company has been increasing prices to achieve sales and bottom line growths. It increased prices by almost 4% in the recent second quarter. RAI expects the traditional cigarette category's volumes to be down -4% to -5% in 2013, moderating to -4% in the years beyond. As volumes declined by 6% in the quarter, the retail market share for RAI decreased to 26% in 2Q'13 as compared to 26.3% in 2Q'12.

Dividend and Share Repurchases
The company currently offers a high dividend yield of 5%. RAI has been increasing dividends consistently over the years; in the last 3 years the company has increased dividends by 10.5%. Over the years, the company has generated strong operating cash flows in relation to annual dividend payments; the relation reflects on the sustainability of the dividends. The following table shows the dividend coverage ratio, dividend per share, payout ratio, and ROE for RAI.

 

2010

2011

2012

2013

Dividend Coverage Ratio (CFO/Dividend)

1.20x

1.17x

1.20x

-

Dividend Per Share

$1.84

$2.15

$2.33

$2.52*

Payout Ratio

76%

76%

78%

80%*

ROE

21.5%

26%

30%

-

Source: Company Reports and Calculation

To boost its bottom line, the company has been aggressively undertaking share repurchase initiatives. RAI repurchased 3.1 million shares for an amount of $150 million in 2Q2013. Under its ongoing share repurchase program, the company has repurchased 41.7 million shares for $1.8 billion. RAI's ROE is likely to increase as the shares outstanding will decrease.

Outlook
The company reaffirmed its 2013 earnings per share guidance range of $3.15 to $3.30, representing an increase of 6% to 11% as compared to 2012 earnings. In contrast, analysts are anticipating an EPS figure of $3.23 for 2013 and a decent next five years growth rate of 7.70%.

Key Catalysts
A key stock price catalyst for RAI is the e-cigarette market. E-cigarette provides attractive growth opportunities for RAI in the long run, which are likely to offset the drop in traditional cigarette volumes. The company is well positioned to tap the growing e-cigarette market. The company has started selling its e-cigarette product, VUSE, in Colorado. The product is already in 500 outlets and the company's management is committed to rapidly expand distribution.

Other important value determinants of RAI's value are the pace of the cigarette volume decline, the company's ability to maintain its market share, the scale of the future share repurchase program, and cost control initiatives.

Conclusion
Despite the fact that the company has delivered healthy financial performances over the years, I believe RAI's stock remains unattractive on relative valuations. Therefore, I believe investors should wait for a better entry point to initiate a position in the stock.

The company has a higher PEG of 2.05, indicating that the company offers expensive growth in comparison to its peers. Also, the company has a lower next five years growth rate of 7.70% and a lower return of investment (ROI) of 14.1% in contrast to its competitors.

 

RAI

Philip Morris

Altria (MO)

Lorillard

Forward P/E

14.7x

14.5x

13.9x

12.5x

PEG

2.05

1.50

2

1.10

Next 5 years growth rate est.

7.7%

10.6%

7.5%

12.5%

ROI

14.1%

41%

-

107%

Source: Yahoo finance and Calculations

Source: Patience Key In Finding Entry Point To Buy Reynolds American