Competitors Steal Reynolds American's Thunder, Provide Better Investment Opportunities

Oct.31.13 | About: Reynolds American, (RAI)

Reynolds American (NYSE:RAI) is among the leading U.S. tobacco companies. RAI has been posting a satisfactory financial performance in the recent past; however, I believe at current valuations (PEG of 2 and forward P/E of 15x), the stock is overvalued. I believe Philip Morris (NYSE:PM), Altria (NYSE:MO) and Lorillard (NYSE:LO) are better investment options as compared to RAI. Click the following links to read my recent articles on PM and MO.

Financial Performance
RAI recently reported mixed financial results for 3Q2013. The company reported net sales of $2.14 billion, up 0.9% as compared to the corresponding period last year, in line with the consensus estimate. Net sales for the quarter were adversely affected by declining sales volume of traditional cigarettes, which dropped almost 4.3% for RAI during the recent third quarter. The sales volume decline during 3Q2013 for RAI outpaced its competitors, as MO experienced a volume decline of 3.5% and LO sales volume was flat year-on-year. The sales volume for the tobacco industry has been decreasing due to tougher regulations, higher retail prices and growth in the alternate cigarette category. Tobacco companies have been increasing prices to offset the impact of declining sales volume and to fuel their top and bottom line growth. To offset the impact of declining sales volume, the company increased net pricing during the recent third quarter, which had a positive impact of 3.2% of net sales.

The company reported healthy bottom line results for the quarter. RAI reported an adjusted EPS of $0.86, in line with consensus estimates, representing an increase of 9% as compared to 3Q2012. RAI's bottom line result for the quarter was primarily positively affected by a price increase of 3.2% during the quarter and lesser Master Settlement Agreement [MSA] payment. MSA payment for RAI decreased, as it won the case, which means the company does not have to make payment to six states for health costs. Due to higher prices, lower MSA and other expenses, RAI enjoyed notable margin expansion in the quarter. The following table shows margins for RAI.



Gross Margin



Operating Margin



Net Margin



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Source: Company Report

Despite the fact that the sales volume for the company decreased during the quarter, RAI's flagship brands, Pall Mall and Camel, experienced market share gains of 0.3% and 0.4%, respectively.

The company's management narrowed its full year (2013) EPS guidance range to $3.17-$3.27 from the prior EPS range of $3.15-$3.3. I believe the management has narrowed its guidance range due to a possible increase in promotional and advertisement spending in the ongoing final quarter of 2013. Analysts are anticipating RAI to deliver an EPS of $3.23 and have projected a next five years growth rate of 7.70%.

Key Stock Price Catalysts
RAI's attractive dividend yield and impressive share repurchase program remain among the key stock price catalysts. The company currently offers a healthy dividend yield of 5%, backed by its solid cash flows. The company has increased its regular dividend by 8% in the last five years on average. The following table shows RAI's solid cash flow position, indicated by the dividend coverage ratio.
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Source: Company Reports

Also, the company has been undertaking a share repurchase program, which will portent well for the company's future EPS. During the recent third quarter, the company repurchased $150 million worth of common shares. Under its ongoing share repurchase program, the company has repurchased $1.9 billion worth of common shares. Given the company's solid balance sheet, I believe the company will expand its share repurchase authorization in the near future. The share repurchases will have a positive impact on RAI's EPS and ROE as we move forward.

As sales volume of traditional cigarettes is on a decline, e-cigarettes provide robust growth potential to RAI. The company has been taking initiatives to expand its e-cigarette market. The company's e-cigarette brand 'VUSE' was launched in Colorado in the recent third quarter, and RAI is committed to quickly expanding its sales nationwide. Commenting on the recent launch of VUSE in Colorado, during the recent earnings call, the company's CEO, M. Delen, said: '

We are excited by the enthusiastic response to VUSE from consumers and retailers in Colorado. VUSE has already captured market leadership in the state, which bodes well for the brand's national expansion plans.

The company is likely to provide more details on the launch during the investors' day conference on November 18, 2013.

Despite the company's financial performance remaining satisfactory in the recent past, I recommend a neutral rating on the stock due to its unattractive current valuations. RAI has a high PEG of 2, which reflects that the company offers expensive growth in comparison to its peers. Also, the company has a high forward P/E of 15x, in comparison to MO's forward P/E of 14.5x and LO's forward P/E of 14.3x. Also, the company has a lower ROA of 12% and a lower next five years growth rate of 7.7% in comparison to its peers, as shown in the table below.










Forward P/E










Next 5 Year Growth Rate





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Source: Yahoo Finance

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.