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Reynolds American: Healthy Capital Return Policy Through Dividends and Repurchases

November 27, 2012 | About:
Reynolds American Inc. (RAI) is the parent company of R.J. Reynolds Tobacco Company; American Snuff Company LLC, Santa Fe Natural Tobacco Company Inc. and Niconovum AB. R.J. Reynolds Tobacco Company is the second-largest U.S. tobacco company. The company’s brands include many of the best-selling U.S. cigarette brands: Camel, Pall Mall, Winston, Kool, Doral and Salem. American Snuff Company LLC is the nation’s second-largest manufacturer of smokeless tobacco products. Its leading brands are Grizzly and Kodiak. Santa Fe Natural Tobacco Company Inc. manufactures Natural American Spirit cigarettes and other additive-free tobacco products. Niconovum AB markets innovative nicotine replacement therapy products under the Zonnic brand name in Sweden.

Valuation

RAI is currently trading at a trailing 12 months P/E of 16.31 and a trailing 12 months EV/EBITDA of 9.81. RAI's current P/E valuations represents a 14% premium over its five-year average P/E of 14.20. RAI delivered a ROE of 24.35% over the past 12 months and a five-year average ROE of 19.01%.

Financial and Business Risks

RAI has a moderate gross debt-to-equity ratio of 67% and a net gearing of 45%. This is partly mitigated by a strong interest coverage of 11.7x. If we use earnings coverage ratios, RAI's debt-to-EBITDA is at 1.7x. RAI's debt maturities are manageable with average maturity of 12 years and less than 20% of total debt maturing in any year. RAI has $12.5 billion worth of off-balance liabilities related to tobacco-related litigation.

RAI’s operating subsidiaries could be subject to substantial liabilities and bonding difficulties from litigation related to cigarette products. The Engle Progeny cases have resulted in increased litigation and trial activity, including an increased number of adverse verdicts, and increased expenses. As of Dec. 31, 2012, RJR Tobacco has been served 6,561 cases on behalf of approximately 7,852 plaintiffs.

RJR Tobacco is dependent on the U.S. cigarette market, which is on a decline because of restrictions on advertising and promotions, increases in regulation and excise taxes, health concerns and a decline in the social acceptability of smoking. RJR Tobacco sold substantially all of its international rights to JTI in 1999.

Business Quality and Capital Allocation

Increased regulation will further de-normalize smoking and brands forcing smokers to re-evaluate premium brands. The value segment of the cigarette market has been gaining significant market share over the premium segment in recent years, with its market share rising from below 30% in 2006 to 41.5% now. This puts RAI in a good position, as it has 40.8% of the market share in the value segment of the cigarette market, compared with 27.6% market share of the entire cigarette market.

Consumers are searching for brands which provide a richer, more intense and more pleasurable smoking experience. RAI's Pall Mall brand of cigarettes burns slower and last longer than other competing brands. RAJ is also aligning with consumer preferences and society’s expectations for new alternatives and harm reduction by introducing products like heat-not-burn cigarettes, electronic cigarettes and nicotine replacement therapy.

Since the merger in 2004, RAI has reduced total headcount by 34%, lowered product conversion cost by 26%, and doubled adjusted operation margin to 34%. Other cost management initiatives include the outsourcing of non-core functions, and RAI Services providing back-office support across the organization.

RAI has paid dividends every single year since 1999 with a current dividend yield of 5.48% and a corresponding dividend payout ratio of 86%. Dividends are paid quarterly and have increased almost 150 percent since the merger. RAI's $2.5 billion program runs through mid-2014, with total share repurchases of 25.7 million shares for $1.1 billion through the third quarter of 2012.

Conclusion

Valuations for RAI remain attractive, backed by strong dividends and share repurchases.



Disclosure


The author does not have a position in any of the stocks mentioned.

About the author:

Mark Lin
Mark is a private value investor and runs the Cheapskate Investing website which borrows from the wisdom of value investing giants, using a systematic quantitative screening approach to filter the global stock markets for cheap cigar-butts and wide-moat compounders. He is also a regular contributor to various value investing communities.

Visit Mark Lin's Website


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