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Reynolds American: Demography of Adult Tobacco Consumers in the US

Reynolds American’s Update on Developing Broad Brand Strategies

http://finance.yahoo.com/news/reynolds-american-demography-adult-tobacco-162913405.html

On May 16, 2016, Reynolds American (RAI) held an investors meeting in London. The company’s CEO, Susan Cameron, was accompanied by RAI’s chief operating officer, Debra Crew, as well as its chief financial officer, Andrew Gilchrist. The team highlighted the company’s broad strategies for developing brands, its 1Q16 results, and its growth outlook.

Up-Trading-Overview

Currently, there are 50 million adult tobacco consumers in the US—half of these smokers are under the age of 30. The changing preferences of consumers make it difficult for tobacco companies like RAI and peers Philip Morris (PM), Altria Group (MO), and Japan Tobacco (JAPAF) (JAPAY) to seek cigarette alternatives that meet their expectations.

Approximately 46% of all adult consumers look for products that better meet their expectations. Four trends that drive these consumers’ choices are:

  • seeking alternatives to cigarettes
  • preference for menthol
  • demographics
  • value hunting

Current industry dynamics

The cigarette industry’s volume was high in 2015, continuing through 1Q16. Migration and the use of three or more different tobacco forms, up-trading to premium-priced cigarettes, and adult smokers’ preference for menthol has increased significantly in the last several years—1Q16 was no exception.

This is primarily due to positive macroeconomic factors that resulted in increased disposable income for adult smokers. Gasoline retail prices fell by 28% in 2015 and by 23% in 1Q16. Lower gas prices, lower unemployment rates, and higher wages have improved adult smokers’ disposable incomes.

Reynolds American (RAI) expects cigarette volumes to be down, closer to the -2% range for the year, as consumers move into premium brands at the expense of value or discount brands in the US. Premium brands include Natural American Spirit, Newport, Marlboro (PM) (MO), and Camel, which are all priced above the national average price per pack of $5.87.

We will learn more about Reynolds American’s strategies to boost its portfolio of brands in the next part of this series.

On May 16, 2016, RAI comprised 1.9% of the iShares MSCI USA Momentum Factor ETF (MTUM).

Reynolds American’s Drive Brands Comprise 93% of Its Portfolio

Benefits of acquisition

Reynolds American’s (RAI) acquisition transaction with Lorillard and its related divestitures to Imperial Tobacco (ITYBY) occurred in order to shift cigarette volumes into RAI’s drive brands. In 2004, drive brands comprised only 25% of the portfolio.

By the end of 2014, drive brands included Camel, Natural American Spirit, and Pall Mall accounting for 70% of the portfolio. However, after the acquisition and addition of Newport and removal of divested brands comprise 93% of RAI’s cigarette portfolio.

Newports-addition

Retail market share

Newport’s addition to combustibles has increased the retail contract coverage, offsetting declines in the company’s value portfolio and non-support brands. Newport Cigarettes’ year-over-year share has increased from the historical rate of ~30 basis points to ~60 basis points.

Newport’s menthol and non-menthol styles contributed about two-thirds of market share gains in 1Q16. Marlboro Menthol also contributed to share gains for Philip Morris International (PM). Vector Group (VGR), Altria Group (MO), and British American Tobacco (BTI) do not produce menthol-based cigarettes.

Payday Everyday campaign

To further energize its Newport brand, Reynolds American initiated an equity-building program called Payday Everyday. The campaign encourages adult tobacco consumers to use NewportPleasure.com to engage with the brand and each other.

The program offers cash prizes, quizzes, a community message board, and a chance to post pictures of their Payday splurges. This has significantly increased website visits year-over-year, as noted by the company’s chief operating officer, Debra Ann Crew.

Premium marketing

Reynolds American (RAI) plans to provide marketing support for the launch of Newport Smooth Select. Along with premium positioning, distinctive packaging, and multicultural appeal, new point-of-sale materials could benefit Newport Smooth Select. The new point-of-sale materials will include brand-specific direct mail, e-mail, and print advertising, highlighting brand relevance and smooth flavor profile into selected markets.

On May 16, 2016, RAI constituted 1.9% of the iShares US Consumer Goods ETF (IYK).

Reynolds American’s Camel Brand Ranked Number 3 in the US

Pall Mall moves to number 4

Reynolds American’s (RAI) combustible brands include Pall Mall and Camel. Pall Mall has been a solid success for Reynolds over the past decade. According to the company’s chief operating officer, Debra Ann Crew, Pall Mall brand’s value proposition of premium quality at an attractive price has helped the brand rank number four among other cigarette brands in the US.

Camels-market-share

British American Tobacco (BTI) produces Pall Mall cigarettes internationally at multiple sites. Similarly, Philip Morris International (PM) is licensed with Altria Group (MO) for Marlboro’s international business. Reynolds continues to increase awareness of Pall Mall through brand building, balance profitability, and market share of the brand.

Camel brand architecture

According to Crew, Reynolds American’s (RAI) Camel brand is positioned to thrive and is the number three brand in the US. Camel’s portfolio of offerings across premium, non-menthol, menthol, and premium value segments makes it difficult for the brand to fend off its significant competition.

However, Reynolds plans to strengthen Camel’s brand architecture by reevaluating, revamping, and upgrading popular and profitable product families in order to build brand equity.

For example, Camel launched its Hump promotion in March, which offered digital content and gifts for adult tobacco consumers. The promotion spotlights unique content on unexpected topics, people, places, and events, reflecting Camel’s image.

Website redesign and Since Now campaign

Reynolds American (RAI) redesigned Camel’s website in January 2016. The website features a bold, simple design optimized for mobile devices. Also, Camel’s entire product family—including Classics, Crush, Wides, No. 9, Red Camel, and Camel Snus—is linked together on the new website.

In its move to celebrate Camel’s heritage, Reynolds is introducing Camel’s Since Now visual campaign, which will be visible in retail (XRT) locations later in 2016. Crew noted that the campaign will be utilizing various one-to-one marketing channels.

Reynolds American (RAI) constitutes 1.9% of the Vanguard Dividend Appreciation ETF (VIG).

RAI’s Awareness Campaign for Its Natural American Spirit Brand

Santa Fe’s volume growth

Reynolds American’s (RAI) Santa Fe Natural Tobacco Company’s Natural American Spirit brand aligns with consumers seeking authentic products. The company notes that Natural American Spirit brand is made of natural, additive-free tobacco. Natural American Spirit is a super-premium, undiscounted brand, which helped Santa Fe’s volume growth in 1Q16 rise above 20%.

NAS-brand

Among the other tobacco companies, Vector Group (VGR) and Altria Group (MO) do not produce additive-free tobacco cigarettes. Despite consumers being aware of the Natural American Spirit brand, less than 30% of adult consumers understand the brand’s proposition of environment-friendly products.

According to the company’s chief operating officer, Debra Ann Crew, Natural American Spirit ranks as the number seven cigarette brand in the US.

Initiatives for awareness

Reynolds American (RAI) continues to focus on the expansion of Natural American Spirit increasing its retail distribution in the US, as well as outside the US. As a result, RAI successfully completed the sale of the Natural American Spirit brand’s international rights to Japan Tobacco (JAPAY) (JAPAF) for $5 billion.

RAI also started a direct mail campaign focused on direct communications with adult smokers, addressing the distinctive taste of Natural American Spirit. This increased communications by 30% in 1Q16, resulting in improving the brand education of its adult smokers.

In addition, the brand acknowledges Earth Day and participates in cigarette litter prevention activities to communicate its earth-friendly business practices. This helped the double-digit organic growth of the brand.

Moist snuff

According to Crew, American Snuff’s Grizzly brand is the top moist snuff brand in the US. The brand’s four-week Pack a Better Pouch, Pick a Better Prize promotion held on Grizzly.com doubled its number of adult consumers in February 2016, which was up by 50% from 2015. Grizzly experiences 10 million website page views from digital interactions.

RAI’s Innovation Transformation, No Ban on Flavors from FDA

Vapor innovation

Reynolds American’s (RAI) key to transformation is robust results and an active innovation pipeline. The company formed RAI Innovation Company to seek alternatives to traditional cigarettes.

With increasing health consciousness, vapor products have been the most important industry innovation. In 2015, over 60% of adult smokers have tried these alternatives. However, only 7% choose vapor products over traditional cigarettes exclusively.

VUSE

Innovative products versus peers

In January, national price increases of Reynolds American’s innovative vapor product VUSE increased its VUSE Solo units by 10% and its VUSE cartridges by more than 15%. Another significant innovation is Zonnic nicotine gum, which is carried in 33,000 convenience stores. From a ten-count package, Zonnic launched a 40-count gum package in two flavors and two strengths in April 2016, which helped its significant growth.

In addition, Reynolds also expanded distribution of its heat-not-burn products like REVO and CORE. However, the company continues to assess the long-term potential of these products and improve technology to increase acceptance.

British American Tobacco (BTI) and Vector Group (VGR) also produce innovative e-cigarettes to meet consumer expectations: Vype (BTI) and Zoom (VGR), respectively. Philip Morris International (PM) is exclusively licensed to commercialize Altria Group’s (MO) MarkTen e-vapor internationally.

Deeming regulation

On May 10, 2016, the FDA published Deeming regulations covering newly regulated products like electronic cigarettes or electronic nicotine delivery systems. The FDA banned the sale of these products to minors and prohibits providing free samples of these products.

No ban was put on flavors for vapor, realizing the benefits of transitioning away from traditional cigarettes and associated health risks. In addition, the FDA’s premarket authorization for products will be required through premarket tobacco product application, substantial equivalence, or exemption to substantial equivalence avenues.

Reynolds American (RAI) comprises 0.5% of the SPDR S&P 500 Growth ETF (SPYG).

Reynolds American’s Stock Price Has Risen by 9.8% Year-to-Date

Consistent upward movement

On May 12, 2016, Reynolds American (RAI) was trading at $51.51. The stock price rose by 0.6% after the investors meeting in London. RAI’s stock has risen by 9.8% year-to-date and by 58.6% since January 2015. However, the stock price fell by 0.2% to $48.31 on April 26, 2016, after its results were announced.

Reynolds American’s stock has consistently seen an upward movement since the beginning of 2015. On March 10, Reynolds was trading at its two-year peak of $51.89.

1Q16-Stock-Price-overview5

Stock price versus peers

In comparison, the benchmark S&P 500 Index (SPY) (IVV) (VOO) has also fallen by 0.5% since January 2015 and has risen by 1.7% year-to-date. Among the other tobacco companies, the stock prices of Vector Group Limited (VGR), British American Tobacco (BTI), and Philip Morris (PM) increased by 2.4%, 14.1%, and 22.1%, respectively, since January 2015.

Reynolds American’s (RAI) stock gained momentum due to its recent announcement of the asset sale to Japan Tobacco (JAPAF) (JAPAY) for $5 billion on September 29, 2015. RAI has risen by 14.1% since then. To learn more about this deal, please read Japan Tobacco Buys Natural American Spirit’s International Assets.

Shareholder return and debt repayment

During 1Q16, Reynolds American’s board approved an increase of 16.7% in its quarterly cash dividend to $0.42 per share, or an annualized $1.68. This is consistent with RAI’s 75% target payout ratio. Since 2004, RAI’s total shareholder return until April 2016 was 942%, significantly outpacing the S&P 500 Index.

The company aims to repay debt and remains focused on deleveraging as quickly and efficiently as possible while continuing to return excellent value to shareholders. RAI’s long-term debt at the end of 1Q16 was $13.3 billion with a 4.9% average interest rate and an average maturity of 12.6 years. On April 15, Reynolds made its MSA payment of $2.3 billion, including $597 million paid into the NPM disputed payments account.

Reynolds American (RAI) comprises 0.5% of the SPDR S&P 500 Growth ETF (SPYG).

Reynolds American: Reported Earnings Up by 591.7% in 1Q16

Reynolds American’s 1Q16 earnings highlights

Reynolds American (RAI) released its 1Q16 earnings on April 26, 2016. The quarter ended on March 31, 2016. The company’s adjusted diluted EPS (or earnings per share) rose by 16.3% to $0.50 per share in 1Q16. Revenue increased by 41.8% to $2.9 billion in 1Q16.

However, after missing expectations last quarter, Reynolds American’s 1Q16 earnings came in line with consensus Wall Street analyst estimates. The consensus had also projected diluted earnings of $0.50.

1Q16-EPS-overview

Increase in adjusted EPS

Reynolds American’s adjusted earnings benefited from higher volumes and pricing across the board. Adjusted EPS excludes a charge of $0.11 per share for debt and financing costs, a charge of $0.01 per share primarily related to implementation costs following the Lorillard acquisition and related divestitures to Imperial Tobacco (ITYBY), as well as a gain of $2.11 for the divestiture of Natural American Spirit’s business to Japan Tobacco (JAPAY) (JAPAF).

Due to gains on the sale of Natural American Spirit’s business outside the US, its reported EPS increased by 591.7% from $0.36 in 1Q15 to $2.49 in 1Q16.

Earnings versus peers

Similarly, adjusted diluted earnings grew by 14.3% to $0.72 per share for Altria Group (MO) in 1Q16. Vector Group’s (VGR) diluted EPS came in at $0.16 in 1Q16. However, Philip Morris’s (PM) 1Q16 adjusted diluted earnings per share fell by 15.5% to $0.98 per share in 1Q16. However, excluding unfavorable currency of $0.19, the adjusted EPS rose by 0.9%.

EPS guidance

With the addition of the Newport brand in June 2015, the company expects Newport’s manufacturing integration to be completed by mid-2016. The company expects adjusted EPS guidance to be in the range of $2.25–$2.35 for the rest of the year. This represents an increase of 13.6% to 18.7% compared to last year’s adjusted EPS.

In the next part of this series, we will discuss Reynolds American’s 1Q16 revenue growth.

Reynolds American (RAI) makes up ~5.0% of the PowerShares DWA Consumer Staples Momentum Portfolio ETF (PSL).

Why Did Reynolds American’s 1Q16 Revenue Increase?

Reynolds American’s 1Q16 revenue highlights

Reynolds American’s (RAI) reported revenue increased by 41.8% to $2.9 billion in 1Q16 compared to $2.1 billion in 1Q15. The increase was primarily due to Reynolds American’s increased cigarette volume of 34.2% in 1Q16, largely driven by the addition of the Newport brand.

However, after beating the consensus estimates last quarter, Reynolds American’s revenue missed Wall Street expectations in 1Q16. The consensus has projected revenue of slightly over $2.9 billion.

1Q16-Sales-overview

Volume and market share

The total industry cigarette volume increased by 0.4% during the quarter. This was partly driven by improved economic factors and lower gas prices, which benefited the disposable income of adult tobacco consumers. After adjusting the wholesale inventory changes, industry shipments fell flat in 1Q16. However, total RAI’s domestic retail (XRT) market share increased by 0.3% to 34.6% in 1Q16.

Similarly, Altria Group’s (MO) 1Q16 net revenue of excise taxes increased by 6.0% to $4.5 billion. However, Philip Morris’s (PM) 1Q16 revenue excluding excise taxes fell by 8.1% to $6.1 billion. Excluding the adverse impact of foreign currency, net revenue increased by 2.4% in 1Q16. Vector Group’s (VGR) 1Q16 pro forma adjusted revenue also fell by 11.7% to $0.3 billion.

RAI’s peers British American Tobacco (BTI) and Japan Tobacco (JAPAF) (JAPAY) release their results on a yearly basis.

Revenue growth opportunities

Reynolds American’s (RAI) completion of Lorillard’s acquisition and related divestitures to Imperial Tobacco (ITYBY) and the integration of the Newport brand has helped RJR Tobacco to identify new revenue opportunities and expanded presence to drive further growth.

In addition, the vapor collaboration between RJR Tobacco and British American Tobacco (BTI) will facilitate RAI’s efforts to efficiently meet the preferences of adult tobacco consumers in a rapidly evolving marketplace.

In the coming parts of this series, we will focus on Reynolds American’s four operating segments’ 1Q16 revenue and income.

RAI comprises 0.9% of the WisdomTree High Dividend Fund ETF (DHS).

Reynolds American in 1Q16: How Did Newport Help?

Segment overview

Reynolds American (RAI) operates in four business segments:

  • RJR Tobacco
  • Santa Fe
  • American Snuff Co. (Conwood)
  • Others

1Q16-RJR-Tobacco-Overview

Revenue and operating income

To begin with, RJR Tobacco’s net revenue increased by 49.9% to $2.4 billion in 1Q16 compared to $1.6 billion in 1Q15. The increase was primarily due to a strong performance by its powerful key brands benefiting from the Newport brand’s incorporation into the company’s cigarette portfolio.

RJR Tobacco’s operating income increased by 88.3% to $1.1 billion in 1Q16 compared to $0.6 billion in 1Q15. The increase was primarily due higher cigarette pricing and the addition of Newport brand. Adjusted operating income increased by 73.8% to $1.1 billion. The adjusted results exclude charges for the Engle progeny lawsuits and implementation costs.

Retail market share

The Newport Menthol brand delivered strong 1Q16 results. The brand’s retail market share increased by 0.6% to 14% in 1Q16 compared to 1Q15. The increase was primarily due to improved presence in retail stores and increased engagement with adult tobacco consumers. RJR Tobacco’s total retail (XRT) market share was in line with the prior year’s quarter at 32.5% in 1Q16.

RJR Tobacco’s 4Q15 retail market share was reflected on a pro forma basis for the company’s new brand portfolio following the Lorillard acquisition and the divestiture to Imperial Tobacco (ITYBY). Camel and Pall Mall brands’ retail market share decreased in 1Q16 from 1Q15. However, the combined retail market share of Newport, Camel, and Pall Mall increased to 30.0%. These brands comprise up to 93% of RJR’s total cigarette retail market share.

International rights

RJR Tobacco primarily conducts business in the United States. However, in 1999, the international rights to RJR’s Tobacco’s brands were sold to Japan Tobacco (JAPAF) (JAPAY). RJR Tobacco also manages super-premium cigarette brands Dunhill and State Express 555, which are licensed from British American Tobacco (BTI).

In the highly competitive tobacco industry, like Philip Morris (PM), Reynolds American is also producing innovative products and expanding into smoke-free tobacco.

Reynolds American (RAI) makes 0.4% of the iShares Core US Growth ETF (IUSG).

Reynolds American in 1Q16: Natural American Spirit Helped

Santa Fe’s revenue and operating income

Reynolds American’s (RAI) Santa Fe subsidiary’s 1Q16 revenue increased by 27.5% to $0.22 billion compared to ~$0.20 billion in 1Q15. The increase was primarily due to higher pricing and strong volume growth. Santa Fe’s operating income increased by 33.7% to $0.12 billion in 1Q16.

1Q16-Santa-Fe-Overview

The increase was driven by higher pricing and volume growth of its premium brand, Natural American Spirit. The brand offers natural additive-free tobacco, including styles made with organic tobacco. As a result, Santa Fe’s products are priced higher than other cigarette brands like Lucky Strike, which is an additive-free tobacco cigarette by British American Tobacco (BTI).

Peers in additive-free tobacco

Other tobacco companies like Vector Group (VGR) and Altria Group (MO) do not produce additive-free tobacco cigarettes. Philip Morris International (PM), in an attempt to meet demand for innovative products, produces reduced-risk tobacco products (or RRPs). To learn more about Philip Morris’s reduced-risk products, please read Philip Morris’s New Innovative Products in the Reduced-Risk Tobacco Market.

Natural American Spirit’s retail market share increased by 0.3% to 2% in 1Q16 in the US, on a volume growth of 22.1%. Natural American Spirit’s volume grew by double digits, increasing by 22% in 1Q16.

Completion of acquisition

Apart from expanding in the US, RAI is focused to expand internationally with Natural American Spirit brand. As a result, RAI successfully completed the sale of Natural American Spirit brand’s international rights to Japan Tobacco (JAPAY) (JAPAF) for $5 billion on September 29, 2015.

This collaboration should accelerate RAI’s growth trajectory. It can also benefit JAPAF to continue its overseas growth and help in offsetting shrinking cigarette demand in Japan.

To learn more about this deal, please read Japan Tobacco Confirms Acquisition of Santa Fe Assets.

Reynolds American (RAI) constitutes 1.1% of the WisdomTree Dividend ex-Financials Fund ETF (DTN).

Reynolds American’s American Snuff: Higher Pricing for 1Q16

American Snuff’s revenue and operating income

Reynolds American’s (RAI) 1Q16 revenue for the American Snuff Co. increased by 7.5% to $0.22 billion compared to $0.20 billion in 1Q15. The increase was primarily due to higher pricing. The reported operating income increased by 12.7% to $0.1 billion in 1Q16.

1Q16-American-Snuff-Overview

Market share and volume growth

The increase in operating income came about due to higher pricing and volume. American Snuff’s 1Q16 moist-snuff retail (XRT) market share rose by 0.2% to 33.4%, on volume growth of 3.3%, compared to industry growth of ~5%. The industry growth was impacted by the national expansion of competitive line extensions in the moist-snuff category in 1Q16.

The increased retail market share was driven by American Snuff’s flagship brand Grizzly. Grizzly’s market share increased to 30.8% on volume growth of 3.9% in 1Q16.

Peers in smokeless tobacco products

Other companies like Altria Group (MO), Japan Tobacco (JAPAF), and Imperial Tobacco Group (ITYBY) have a presence in the smokeless tobacco products. Marlboro Snus (MO), Skurf Snus (JAPAF), and Zerostyle Mint (ITYBY) are some of their smokeless tobacco product brands. To learn more about Altria Group’s smokeless product segment, please read A Glimpse at Altria’s Smokeless Tobacco Products Segment.

However, British American Tobacco (BTI) and Philip Morris International (PM) do not have a presence in smokeless tobacco products.

Continued innovation

American Snuff Co. is planning to focus on market share and profits from its Grizzly branded products through innovation, branding, and promotions. For example, Grizzly’s continued strong leadership position in the growing pouch style which provides pre-measured portions and is convenient than traditional moist snuff. Additionally, the popular Wintergreen flavor was being supported by its recently expanded Dark Wintergreen product.

Reynolds American (RAI) makes up 0.4% of the iShares Russell Top 200 Growth ETF (IWF).

Reynolds American’s Vuse E-Vapor: 1Q16 Performance

Revenue and operating income of the All Other segment

Reynolds American’s (RAI) 1Q16 revenue for its All Other operating segment decreased by 6.5% to ~$0.1 billion. RAI’s All Other operating segment includes:

  1. RJR Vapor, which manufactures and markets Vuse Digital Vapor Cigarette
  2. Niconovum USA and Niconovum AB, which manufacture and market nicotine replacement therapy gums under the Zonnic brand name
  3. SFR Tobacco International GmbH (or SFRTI), which distributes Natural American Spirit brand outside the US

1Q16-All-Other-Segment-Overview

Operating income for the All Other segment decreased by 44.3% to $30 million in 1Q16. Despite a weak top line, Vuse Digital Vapor Cigarette continued to deliver robust results in 1Q16.

According to the company’s CEO, Susan Cameron, Vuse is about three times the size of its competitor. Additionally, Vuse has been ranked at the top of 2015’s most successful new products in convenience stores.

Peers in e-cigarettes

In an attempt to meet the growing demand of e-vapor cigarettes, many tobacco competitors also have a presence in the e-cigarette market. As a result, Philip Morris International (PM) is exclusively licensed to commercialize Altria Group’s (MO) MarkTen e-vapor internationally. To learn more, please read Altria’s Nu Mark Subsidiary: Innovation in Tobacco Products.

Other companies like British American Tobacco (BTI) and Vector Group Ltd. (VGR) produce innovate e-cigs to meet consumer expectations. Vype (BTI) and Zoom (VGR) are the e-cigs produced by these companies.

Expansion of Vuse

The company plans to expand distribution of Vuse by making it available in almost 115,000 stores. Also, Reynolds rolled out two more variants of Vuse online, VUSE Connect and VUSE FOB. In addition, the Niconovum subsidiary remains focused on the national expansion of the Zonnic nicotine replacement therapy gum. Earlier this quarter, Zonnic launched four styles in a 40-count pack and plans to roll out a ten-count mini lozenge by 2Q16.

RAI comprises 0.6% of the WisdomTree LargeCap Dividend ETF (DLN).

In the coming parts, we will discuss RAI’s 1Q16 margins and valuation multiple.

Strong Segment Growth Helps RAI’s 1Q16 Operating Margin

Operating income

Reynolds American’s (RAI) reported operating income increased by 786.3% to ~$6.1 billion in 1Q16 versus $0.7 billion in 1Q15. This includes charges for implementation costs, asset impairment, and exit costs. It also includes transaction-related and financing costs for the Lorillard acquisition and related divestitures to Imperial Tobacco Group (ITYBY), as well as other litigation charges.

1Q16-Margin-Overview

Adjusted operating income

Excluding the above charges, RAI’s adjusted operating income increased by 72.4% to $0.72 billion in 1Q16 compared to $0.46 billion in 1Q15. The operating income increased primarily due to strong results delivered by RJR Tobacco’s new addition of Newport brand, RJR Vapor’s Vuse Digital Vapor Cigarette, and American Snuff’s Grizzly brand.

Operating margin versus peers

As a result, RJR Tobacco’s adjusted operating margin increased by 6.4% to 46.5% in 1Q16. Santa Fe’s operating margin increased to 56.4% while American Snuff’s operating margin increased to 61.3% in 4Q15.

RAI’s 1Q16 adjusted operating margin increased by 8% to more than 45%, while its reported operating margin increased to 211.6% in 1Q16.

However, Altria Group’s (MO) 1Q16 operating margin fell by 2 basis points to ~43.6% in 1Q16. The impact on the operating margin was due to higher pricing, volume, and the benefit of the federal tobacco quota buyout expiration, offset by lower volumes. Similarly, Philip Morris International’s (PM) 1Q16 operating margin fell by 2.8% to 41.9% due to lower adjusted operating income mainly due to EEMA and Asia.

Cash tender and higher profit margins

RAI completed a cash tender offer and redemption of $3.6 billion for its outstanding notes. This reduced the company’s level of outstanding debt. RAI expects to reach the top end of its target leverage of 2.5x debt-to-EBITDA by the end of this year. In 1Q16, the company had a cash balance of $4.4 billion.

RAI plans to strengthen American Snuff’s moist snuff products, as profit margins on moist snuff products are higher than on cigarette products.

RAI makes 0.2% of the iShares Russell 3000 ETF (IWV).

Reynolds American’s Valuation Higher after 3 Weeks of Results

Relative valuation

Reynolds American (RAI) and Philip Morris International (PM) are trading at a higher valuation relative to the S&P 500 Index (SPY) (IVV) (VOO) and the Dow Jones Industrial Average (DIA). Reynolds American is trading at 20.4x forward earnings.

Philip Morris is trading at 21.3x forward earnings. In comparison, the S&P 500 Index and the Dow Jones Industrial Average are trading at forward PE multiples of 17.4x and 16.3x, respectively. All valuations are dated May 18, 2016.

1Q16-Valuation-Overview

Valuation of peers

Competitors like Altria Group (MO), Japan Tobacco (JAPAY) (JAPAF), and British American Tobacco (BTI) are trading at lower PE multiples of 20.3x, 18.3x, and 17.8x, respectively, compared to Reynolds American. However, these companies are trading at pricier valuations compared to the S&P 500 Index.

Reynolds American is trading at a higher valuation multiple since it completed the acquisition of Lorillard and related divestitures to Imperial Tobacco (ITYBY).

Sales growth

Markets generally value companies at higher multiples if growth expectations are higher. Reynolds American’s sales growth for the trailing 12 months came in at 26%, the highest among its peers. Respectively, Japan Tobacco’s and British American Tobacco’s sales growth came in at -6.1% and -8.5%, respectively, for the trailing 12 months.

Focus on innovation and distribution

Reynolds American’s focus is to strengthen the dynamics of the new product portfolio with the addition of Newport. The company also created the RAI’s Innovation Company, which is focused on product development and commercialization of leading-edge vapor and nicotine products.

In addition, the company continues to focus on distribution. For example, Reynolds has increased retail contracts by 50,000, growing its contract coverage to approximately 90% of the total cigarette industry volume

Also, RAI’s recent sale completion of Natural American Spirit’s international rights to JAPAY will help the company to grow its geographic diversification.

To learn more about Reynolds American’s business, please read An Essential Guide to Leading Tobacco Giant Reynolds American: Investor Must-Knows. For more industry updates and analysis, please visit the Market Realist Consumer Products page.

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