Governments around the world have been pushing through regulations on tobacco companies, in order to reduce consumption. Apart from obligating tobacco companies to include precautionary labels on cigarette packages, the U.S. Food and Drug Administration (FDA) is focused on banning menthol-flavoured cigarettes, while the European Parliament passed a regulation in February 2014 stating that e-cigs most prove their preventive qualities in order to be approved. Also, e-cigs with over 20 milligrams of nicotine per millilitre will now require authorization as a medicine.
These measures will undoubtedly out a strain on tobacco firms like Altria Group Inc. (MO, Financial) and Lorillard Inc. (LO), but shareholders seem confident about Reynolds American Inc. (RAI, Financial), and several investment gurus like Paul Tudor Jones (Trades, Portfolio) and David Dreman (Trades, Portfolio) have been buying the firm’s shares this past quarter. So, let’s see what this company’s strategy looks like going forward and if it will continue to reap profits.
A new focus to offset sales declines
Since its appearance in the tobacco market in 2004, Reynolds’ has made profits as a manufacturer under the R.J. Reynolds Tobacco Company, American Snuff Company, Santa Fe Natural Tobacco Company, and Niconovum AB segments. And while its cigarette brands Kool, Camel, and Pall Mall are amongst the best-selling brands in the domestic market, management has been smart in shifting its focus towards product innovation, thereby responding to changing consumer demands. The company’s new mint flavoured cigarettes, Camel SNUS, along with the organic premium brand, Natural American Spirit, have been growing at a fast pace. The Niavonovum subsidiary has also developed Zonnic Gum, a nicotine replacement product targeted to relieve smokers of tobacco’s harmful effect, and the product gained immediate popularity since its launch in fiscal 2013.
However, it’s the e-cigarette business segment that looks the most promising to Reynolds future profitability. While competitors have each launched their own version of the vapour product, Reynolds’ Vuse version holds an advantage, as it is the first digital cigarette, with an installed computer chip. The chip not only modulates the products performance, but also delivers consistent flavour. Thus, the first product launch in Colorado this past July was very successful, gaining over half the market share. And after the positive results in Utah, the company has scheduled Vuse’s nationwide distribution for the first half of fiscal 2014, which should significantly boost top line growth. Furthermore, management’s plan to reduce costs and labour, saving an annual average of $70 million by 2015, should contribute to brand strengthening and keep product innovation on track.
Valuation
Now, despite the additional advertising and promotional costs associated with the new e-cig brand, I’m bullish that Reynolds’ will continue to deliver solid results in the long term future. Increases in cigarette and moist snuff prices led to an EPS of $3.1 for 2013, which is expected to jump to approximately $3.35 by 2014. And while Tobacco sales have declined by 4.8% to $1.6 billion in Q4 of fiscal 2013, due to shifts in consumer preferences, the Camel and Pall Mall brands managed to increase their market share to 9.0% and 9.1%, respectively. Furthermore, operating margins have grown substantially over the past year, jumping from 26.6% in 2012 to a current 38.0%, which speaks in favour of management’s effort to increase efficiency.
On another note, the company’s $1.9 billion share repurchase program has been smoothly executed so far, purchasing 3 million shares for $150 million during the first quarter of fiscal 2014, leaving the current dividend yield at a very healthy 4.8%. Along with the 33.25% return on equity and 8.6% EBITDA growth, I believe investors will gain solid profits looking forward. Also, Reynolds’ current stock trading price of 17.2x trailing earnings is barely above the 16.9x industry average, making it a very reasonable purchase.
Disclosure: Patricio Kehoe holds no position in any stocks mentioned.
