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Reynolds American reported Q1 2014 adjusted EPS of $0.72 (flat Y/Y) that missed consensus of $0.74 and revenues of $1.94B that came in slightly above the Street at $1.91B. The stock is trading down today on mix results. Our neutral outlook on RAI remains intact.

On the positive side, RAI saw solid results from its core brands (Camel, Pall Mall, Santa Fe, and Grizzley), the company re-affirmed its FY EPS guidance of $3.30-$3.45 (or growth of 3.5% to 8.2% Y/Y), and saw strong pricing in the quarter (+4.2%) to offset RJR tobacco volume down -5.2%, which underperformed the industry cigarette volume down -4.4%.

On the negative side, RAI is boosting its e-cigarette spend on VUSE (nearly $60M over the last 6 months). Concerns on the call about just how much of a “drag” VUSE will be on the bottom line moving through the year or if the category can realize margins as high as cigarettes remained largely unanswered (more below).  Further, operating Margin dropped 220bps, and CEO Daan Delen’s decision to step down in May is a bit puzzling, however by all accounts he’s being replaced by a very capable operator in Susan Cameron who served as the company’s president and CEO from 2004-11 and rejoined the company’s board of directors in December 2013.

Our preferred tobacco stock is long Lorillard (LO). The company’s Q1 2014 earnings conference call is tomorrow at 1pm EST. (Email me if you’d like a copy of the Best Idea Long Presentation on LO)

 

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 VUSE.

As we’ve said previously, we expect 2014 to be a big year of investment for the company behind VUSE as it plans to roll-out nationally (and play catch up to LO’s blu as it competes alongside MO’s launch of MarkTen).

Today the company said that it will begin selling in Wisconsin and Indiana in early June, after its initial test state launches in CO and UT, where the company stated it has nearly 80% market share in each state. It then expects to launch by late June into 15,000 stores nationwide. 

CEO Delen brought forward a cautious tone to the VUSE rollout, suggesting that the company was “hedging its bets” by first gauging the 15,000 store rollout (and assessing the size of the overall category) before further launching into more outlets in the second half of the year. [For reference, LO’s blu has a national distribution in 85,000 retail outlets].  This cautious tone on the category’s growth and size echoes some of the slowing we’re seeing in the category, and certainly Delen’s tone does not strike the exuberance chord that we’ve become so accustomed to on the subject of e-cigs. 

RAI reinforced that its investment in VUSE is 1H weighted (heavy on factory and machine start-up costs and purchase of merchandise material to properly support the brand in the quarter and throughout the launch to 15,000 stores). We believe in RAI’s long-term strategy to grow VUSE as an add-on growth business and one to soak up declining cigarette smoking trends. That said, for RAI we’re concerned about the extent to which VUSE could cannibalize its tobacco business at a lower margin in the years out.  To this end we’ll be doing survey work to better understand these trends.  (Note: we do not see cannibalization risk for LO this year given its core smoker demographic (that differs from that of RAI and MO) smokes Newport menthol, its core business (~ 85% of total profits).

When questioned on the call about the potent for disappointment from the profitability of VUSE (being lower than cigarettes), Delen only said the company sees huge opportunity in e-cigs as a growth category. He thinks there are some technological shortcomings across the industry, but that VUSE is ahead of the curve. He added, he’s very confident that the current iteration of VUSE already meets what the industry is calling “next generation technology” and his team is diligently working on future enhancements (no discussion on what the future technology may incorporate). He reaffirmed he’s confident that VUSE can get cigarette-like margins over the long term.


Finally, on deeming regulation, the company reiterated that it has no knowledge of what they may include or when they might be announced. We continue to wait with bated breath, as the FDA will soon have to step in with a pronouncement to regulate e-cigs closer to traditional tobacco. Tick tock. 

Call or email with questions,

Matt

Howard Penney

Managing Director

Matt Hedrick

Associate

Fred Masotta

Analyst