While the chatter about a double dip has died down compared to three months ago, economists are still, by and large, expecting sluggish GDP growth. In this weak climate, tobacco provides an opportunity to generate passive streams of income with minimal risk. In this article, I will run through my DCF model on Reynolds American (RAI) and then triangulate the results against a review of the fundamentals compared to Altria (MO) and Philip Morris International (PM). I find that tobacco stocks have an attractive risk/reward.
Let's begin with an assumption about the top line. Reynolds finished FY 2011 with $8.5 billion in revenue, which represented a 0.1% decline from the preceding year. I model 7% per annum growth over the next half decade or so.
Moving on to the cost side of the equation, there are several items to consider: operating expenses, capital expenditures, and taxes. I model cost of goods sold as 52% of revenue vs. 18% for SG&A and 2% for capex. Taxes are estimated at 38% of adjusted EBIT (i.e., excluding non-cash depreciation charges to keep this a pure operating model).
We then need to subtract out net increases in working capital to get free cash flow. I model this figure hovering around -1.1% of revenue over the explicitly projected time period.
Taking a perpetual growth rate of 2.5% and discounting backwards by a WACC of 9% yields a fair value figure of $51.85 for 27.5% upside. The market seems to be factoring in a WACC of 10.5%, which is much too high for a stock that offers a stellar dividend yield of 5.8% and a beta of 0.6.
All of this falls within the context of a challenging quarter:
[T]he promotional environment was very aggressive in the first quarter. To be clear, promotion on value-priced line extensions on competitive premium brands intensified significantly. While competitors increased their focus on the value category, R.J. Reynolds maintained its focus on balancing market share and profitability. And while volumes were negatively impacted, the company saw improvement in both its premium mix and operating margin.
From a multiples perspective, Reynolds is also attractive. It trades at a respective 17.9 times and 12.8 times past and forward earnings vs. 19 times and 13.4 times for Altria and 16.7 times and 14.3 times for Philip Morris.
Consensus estimates forecast Altria's EPS growing by 7.8% to $2.21 in 2012 and then by 6.8% and 6.4% in the following two years. Assuming a multiple of 17 times and a conservative 2013 EPS of $2.33, the stock would hit $39.61 for an impressive 25.2% upside. Management provides an impressive dividend yield of 5.2%, and the stock is less than 50% as volatile as the broader market.
Consensus estimates for Philip Morris' EPS forecast that it will grow by 8.4% to $5.29 in 2012 and then by 11% and 10.2% in the following two years. Assuming am multiple of 17 times and a conservative 2013 EPS of $5.81, the stock would hit $98.77 for 17.3% upside. While the stock has a lower dividend yield than that of Reynolds and Altria at 3.6%, this weakness is easily made up by the firm's emerging market focus. Since Philip Morris does not target domestic markets, it is not directly exposed to domestic regulatory pressures.
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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.