An old saying goes, “where there’s smoke there’s fire”. This is certainly true of the second largest tobacco company in America, Reynolds American (RAI). At the current stock price of $53.50, the company yields an impressive 6.54% in dividends and trades at a PE ratio of 12.83 times.
Reynolds American (RAI) is a holding company. The Company's wholly owned subsidiaries include R. J. Reynolds Tobacco Company, Santa Fe Natural Tobacco Company, Lane, Conwood Holdings, and American Snuff Company. The Company operates through two business segments. The RJR Tobacco segment consists of the primary operations of R. J. Reynolds Tobacco Company. Two of RAI's wholly owned subsidiaries, Santa Fe, and Niconovum AB, among others, are included in the All Other segment. RAI's largest operating segment, RJR Tobacco, is a cigarette manufacturer in the United States. Conwood is a smokeless tobacco products manufacturer in the United States.
Reynolds American's subsidiaries manufacture and market a variety of tobacco products, including cigarettes (Camel, Pall Mall, Kool, Winston, Salem, Doral, Misty, Capri and Natural American Spirit brands); moist snuff (Grizzly and Kodiak brands); little cigars (Winchester and Captain Black brands); pipe tobacco; roll-your-own cigarette tobacco (Bugler and Kite brands); and other tobacco products. Reynolds American’s operating companies sell about 28% of all cigarettes sold in the U.S.
The cigarette business is of course a wonderful industry: cigarettes cost a penny to make and can be sold for a dollar each. There’s also tremendous brand loyalty and hard-dying consumer habits. The majority of people who smoke do so on a regular basis and have strong brand preferences. As such cigarette companies can collect a royalty on people’s smoking habits without having to incur continuously large capital expenditures. That in effect is scalable business and what value investors look for.
With a market capitalization of $15 billion, Reynolds is an established player. The company is 42% owned by British American Tobacco (BTI), which itself pays a dividend exceeding 6%.
The reason Reynolds is attractive is because of the relatively conservative valuation currently being afforded the company. The price to book ratio is 2.5 times, which is much lower than the industry average, and price to cash flow comes in at 11 times. Price to sales at 1.89 times is a quarter below the industry average. Reynolds also manages to generate gross, operating and net profit margins above the industry mean and produces a return on equity and return in investment of 20% and 10%, respectively. The company is also more conservatively geared than peers.
The cigarette business is largely mature in a global sense and thus large earnings growth at the company is highly unlikely. What is certain, however, is that the company will continue to produce strong cash flows ($1.4 billion from operations last year) to pay continued strong dividends. As Reynolds is currently arguably the “cheapest” on a fundamental basis, it makes the most sense to obtain the juicy cigarette yield from the company. The dividends are not going to go away so long as people are going to smoke – and there are likely to be people around for some time yet.
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