I originally recommended R.J. Reynolds (RAI) stock on August 12th. It is up 34% since then, excluding the dividend it pays which is currently yielding 3.5%. When I purchased the stock I promised myself I wouldn't sell it. There is a natural temptation to invest in exciting companies over steady companies such as Reynolds. I violated this promise as my worries about whether the merger with Lorillard would be accepted or rejected got the better of me. Now that the merger has finally been approved, I recently purchased the stock once again recommitting myself to not sell it. As I detailed in my article in August, the merger was brilliant as Reynolds now has a great portfolio of growth cigarette brands (Pall Mall, Camel, and Newport) along with the top vaping brand on the market in Vuse.
Vuse has proven the claims by Reynolds to be true as it has vaulted itself to the top of the growing e-cigarette category. According to Nielsen as of May 16th Vuse has 35.7% market share in America. Reynolds has stated it expects the digital cigarette brand to become profitable in the second half of the year. If you haven't noticed the trend towards vaping in your everyday life, you can look at the Google Trends chart below which shows parabolic growth in the number of searches for this product.
In essence Vuse was able to piggy back and then accelerate the trend in vaping. To clarify Vuse is in the electronic cigarette category. Vaping is a subcategory. This is important because the incumbent competitor blu (owned by Imperial Tobacco) is marketing itself as an electronic cigarette. The trends in search this category have peaked as smokers have tried products like blu and have rejected them.
Clearly consumers weren't satisfy with the offerings available which is why Vuse was able to take so much share in the category. It uses a SmartMemory chip which adjusts the temperature up to 2,000 times per second.
The chart below shows the ground vusevapor.com has gained on blucigs.com as it takes market share. If the chart was updated to include the metrics from May, I would expect it to show Vuse overtaking blu.
The biggest question with Vuse is whether it will be able to stave off the competition as there are many new devices constantly entering the space. The top contenders are GreenSmoke, MarkTen, V2, and NJOY. The biggest differentiating factor for Vuse is the technology behind it and the ability of the cartridge to connect to the battery magnetically opposed to having it screw on. This allows air to flow throw and make it easier to draw the tobacco. Vuse also has one of the highest amount of nicotine (4.8%) out of any e-cig on the market. This may mean it is positioned as less of a quitting tool and more as a separate category from cigarettes. NJOY products range from 2.4% nicotine to 4.8%. GreenSmoke ranges from 0% to 2.4%. MarkTen ranges from 1.5% to 2.5%. V2 ranges from 0% to 2.4% nicotine. Morally I would suggest it bad for Vuse to have the highest amount of nicotine, but in terms of profits, making a highly addictive product has obvious benefits. The other advantage Vuse has over some other products is it has an LED light at the tip which flashes different colors which tell the user when it is fully charged, when the battery is about to die, and when you are about to run out of fluid.
There is no clear winner in the category because what makes or breaks the products is taste. I can't formulate an opinion because I have not tried any of the products, but I would say that the reviews I have read/watched run the gamut from ranking Vuse the best to ranking it the worst tasting product on the market.
From an investor's perspective I would expect Vuse and MarkTen to do the best because they are owned by the tobacco giants as Altria owns MarkTen. Although there are some consumers who hate Big Tobacco and will boycott these brands, I expect this to not be a significant factor as most consumers probably don't know or care who owns the e-cig brand they use. As is constantly mentioned on Shark Tank, distribution is important; these two companies have the relationships necessary to get and keep their product in all convenience centers where cigarettes are sold. I think Vuse's technology advantage should be able to keep it ahead of Mark Ten.
I believe a good analogy to the electronic cigarette market is Facebook and Myspace. Myspace and blu were the first companies into the marketplace, but they were overtaken by more innovative products which are Facebook and Vuse respectively. Facebook still dominates the space even though there are many other social networks. The same should happen for Vuse. For some users, social networks can be as addictive as e-cigarettes which furthers the analogy.
The overall market for cigarettes is currently very positive as low gas prices have put more money in the consumers' pockets. Nielsen is currently tracking a decline in volumes of .1%. This would be great year over year improvement as volumes were down 4.5% Q2 2014.
The actual numbers as to how Lorillard will fit in with Reynolds should be released in the next quarter which will be the first quarter where they report as one company. Newport should continue to grow its market-share. Clearly giving up brands which were losing market share to purchase Newport was a brilliant decision.
To give some context as to the possible performance of the stock after this merger, I looked at the performance after the last major M&A activity. The last activity occurred when R.J. Reynolds merged with the U.S. operations of British American Tobacco on July 30th 2004. In the ensuing 2 years the stock went up 76%. I'm expecting a similar performance in the stock the next 2 years.
In a recent Bloomberg article the CEO, Susan Cameron, stated the industry is looking more "like the old days" as the number of lawsuits brought upon by smokers have declined due to recent court decisions. This is a tailwind for the industry.
The top two risk factors in my opinion are litigation and poor press regarding e-cigarettes and interests rates rising. Because the technology is so new there are often news reports which mislead consumers. For example, there was a story which claimed there to be excessive levels of formaldehyde in e-cigs which ended up being false. If new studies do find e-cigs to be worse than initially anticipated, the FDA could issue punishing regulations. The government also could decide to tax e-cigs at the level of regular cigarettes.
If interest rates rise, there becomes more competition for conservative investors looking for high yield securities. Reynolds is in competition with bonds. If bond yields rise, some investors will sell it and move to bonds. Personally, I believe there is never a bad time to own a dividend paying stock. This is why I own Reynolds for the long term.
