Magic Formula Stock Review: Reynolds American (RAI)
Reynolds American (RAI) is one of the largest cigarette and tobacco products manufacturers in North America, trailing only Altria Group (MO - formerly Philip Morris). RAI commands about 28% of the U.S. tobacco market vs. Altria's 50% share. The company has a wide array of cigarette brands covering every general category such as premium (Camel, Winston), branded menthol (Kool), and discount (Pall Mall, Doral). In 2006, the company acquired Conwood, the second largest manufacturer of smokeless tobacco products, for $3.5 billion, adding popular brands such as Grizzly and Kodiak. Reynolds also runs the Santa Fe Natural Tobacco subsidiary, which produces the American Spirit brand of additive-free cigarettes. The current company was formed in 2004 when R.J. Reynolds merged with Brown & Williamson, the U.S. arm of British American Tobacco (BTI).
Tobacco stocks are a much-maligned group that have nevertheless delivered outstanding long-term returns to shareholders. Wharton professor Jeremy Siegel, in his book The Future for Investors (MagicDiligence review), showed how Philip Morris was by far the best original S&P 500 stock, returning an amazing 19% annually to shareholders over a 50 year period! This is due mainly to the effects of compounding reinvested dividends, especially when combined with the inherent volatility in the share price. When the share price goes down, the dividend yield goes up, and investors that reinvested Philip Morris' substantial and always rising (42 consecutive years) dividend were rewarded handsomely.
Reynolds American profiles very similarly. The stock pays out about 75% of free cash flow to shareholders, resulting in a current dividend yield of about 6.7%. That yield looks safe, too, as Reynolds has been able to maintain stable free cash flow levels since going public. But does the stock make a good Magic Formula investment, where our target holding period is just one year?
Clearly, the domestic cigarette industry is not a growth market. Volume shipments have been declining in the low-to-mid single digits for the last 10 years, and have accelerated into double digit territory this year due to a massive federal excise tax hike (detailed in my Vector Group (VGR) review), combined with some state hikes, smoking bans, and increased regulatory pressure from the FDA. Reynolds has made some moves to mitigate these, such as the Conwood purchase (smokeless is still a growing market) and increased R&D efforts behind alternative tobacco products (like innovative Camel sticks and snus), but organic revenue growth potential is meager at best. Reynolds cannot benefit from international growth, either, as BTI holds a non-compete agreement and Japan Tobacco holds overseas brand rights.
The firm's competitive position is a mixed bag. On the one hand, the U.S. tobacco market is basically an oligarchy consisting of Reynolds, Altria, and much smaller Lorillard (LO). The Master Settlement Agreement (MSA) with state governments in the 90's mandates payments for health claims, which costs Reynolds about $2.8 billion dollars a year. Any new competitors would be bound to this agreement as well, and this overhang combined with the daunting scale and brand equity enjoyed by the incumbents, not to mention tight restrictions on advertising, pretty much shuts out new entrants entirely. Over the long run, limited competition generally helps avoid prolonged and irrational pricing wars.
On the other hand, Altria has proven to be very aggressive in seeking market share, even to the detriment of their own margins. That company purchased #2 smokeless maker UST last year, acquiring the Skoal and Copenhagen brands. In a bid to stem UST's long decline in market share, Altria slashed prices, which could adversely affect Conwood's slice of the pie (currently about 29%). Also, since Altria enjoys dominant market share with their Marlboro brand, Reynolds is forced to price Camel to similar levels. With declining volumes and geographic expansion out, market share becomes the only way to grow, possibly leading to price cutting. This, of course, equals lower sales, lower profit margins, and lower profits for all involved. It is a potential risk over a one-year MFI holding period.
RAI currently has about a 13% earnings yield, which is not extremely cheap for a cigarette company with limited growth prospects and lots of legal and regulatory risks. I find it odd that Altria and Philip Morris International (PM) do not rank higher in MFI, as both of them have earnings yields in the 20% range with similar returns on capital. With MO's scale and share advantages and PM's international growth potential, both of these stocks look like better buys than RAI. MagicDiligence is still giving RAI the "thumbs up" due to its meaty and safe dividend combined with declining near-term legal risks, but I think there are much better opportunities in the MagicDiligence Top Buys list.