RAI—Balancing Profitability and Market Share On Weak Cig Volume

Neutral Outlook on RAI


Reynolds American reported Q4 EPS of $0.77 that missed consensus of $0.81 and revenues of $2.04B that came in slightly below the Street at $2.07B. It announced a dividend increase of 6.3% and FY 2014 EPS guidance $3.30-$3.45. The stock is trading down over -2% intraday.

 

In the quarter sales were down -1.9% versus the previous-year quarter and EPS up +1.3%. The company was able to take pricing across cigarettes and moist-snuff to make up for cigarette volume declines that outpaced the industry average.  

 

Cigarette volume was down a full -7.0% in the quarter (versus the industry average of -4.0%) and fell -6.2% for the full year (vs the industry average of -4.2%); the company cited the decline was due to a slow macro environment and migration to non-combustible tobacco. This volume result compares to the company’s guidance last quarter that its FY volumes would track closer to -4%.

 

Strong brand results came from Camel that grew Q4 market share by 0.4 pp to 9.0%; Camel SNUS that continues to hold about 80% of the category; and Pall Mall that grew market share 0.2 pp to 9.1%. American Snuff’s Grizzly brand also continued to show strong performance, increasing operating income 17.0% on the quarter and 12.1% on the year and boosting its Q4 operating margin 2.5% to 58.9%; and Santa Fe’s performance grew operating income 12.3% in the quarter and 17.9% on the year.

 

The company expects cigarette volume to moderate in 2014 to around -3.5%, and it’s unclear if e-cigs will be driving the improvement in cigarette volume loss.  We expect 2014 to be a big year of investment for the company behind its e-cig VUSE as it plans to roll-out nationally (more below) and for it to heavily discount and promote the product to compete with MO’s e-cig offering and play catch-up to LO’s Blu, among the Big Tobacco players.  Recent category weakness remains a concern, which was partially confirmed by a much more cautious outlook on the category from CEO Daan Delen today.

 

We’re currently neutral on the stock. Our preferred play is long Lorillard (LO) and short Philip Morris (PM).

 

 

On E-Cigs


E-cigs were once again a focal point of the call: the company began the call discussing its e-cig business under the brand VUSE and the majority of analysts’ questions in the Q&A were about e-cigs.

 

RAI launched its made-in-America e-cig in its first test market of Colorado in July 2013 and recently expanded to its second market in Utah. The company maintained its plan to have national distribution by mid-year, however took a more critical and cautious tone on the e-cig category, suggesting that expansion will depend on growth in the category. CEO Delen said that for now while trialing is high for the category, repeat purchasing and adopting is very lower, and had no concrete answer for why the e-cig category has recently slowed.  He said consumer trends were based on current products that did not meet smokers’ expectations, and that VUSE is poised to buck that trend.

 

VUSE’s results in CO: Category volume has tripled since its launch with mix driven by 80% cartridges (razorblade) vs 20% disposables. The company believes that higher long-term margins can be achieved by cartridges.

 

On a national rollout: The company is confident with its strategy citing its industry-leading trademark and distribution network, the self-imposed restrictions it has in place (including no self service with its products placed on the back bar so it can assure age verified sales).

  • As we look to a national rollout, we’d expect heavy discounting and promotion to encourage trialing (similar story with Altria’s e-cig MarkTen under a similar timeline) to suggest selling at a loss or at best breakeven for this year (alongside the potential for heavy price competition). 

On the recent growth pick-up in the tank or open-ended system: Delen confirmed the growth pick-up and said it will be interesting to see what happens from a regulatory point of view, noting that in an open-ended system people can put any types of liquids in, whereas VUSE is a closed system that shuts down if the consumer tries to tamper with it/add liquid.

 

On M&A to expand its e-cig business: CEO Delen deflected the question and suggested that he is confident VUSE is a differentiated and experienced brand that can compete in the marketplace. [Note: the recent M&A activity has included MO’s acquisition of Green smoke for $110M on February 3, 2014; LO’s acquisition of SKYCIG for £30M in October 2013; and LO’s original purchase of Blu in April 2012 for $135M].

 

Call or email with questions,

 

Matt Hedrick


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