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RAI – Strong Pricing Offsets Volume Declines

We’re encouraged by the performance of RAI in the quarter, driven on strong price realization.  The company reported Q2 revenue of $2.16B (or -0.6% Y/Y) that came in lighter than consensus expectations of $2.19B, yet it beat consensus EPS by 2 cents at $0.89 (or +6.0% Y/Y). The quarter was marked by share gains from its core brands (Camel, Pall Mall, Grizzly, and American Spirits), and pricing to offset massive cigarette volume declines of -8.3% in the quarter (versus est. industry average volume of -5.5%), and impacted by one less shipping day in the quarter. Total cigarette market share was down 0.1pp to 26.5% in the quarter.

From a quantitative perspective RAI is broken across its immediate term TRADE and intermediate term TREND durations, follow the leg-down after the announcement of its announcement to acquire LO two weeks ago (see chart below).  

RAI – Strong Pricing Offsets Volume Declines - z. rai

From a fundamental perspective, we remain constructive on a proposed RAI + LO. The combined entity would make it the 2nd largest U.S. tobacco company to compete with #1 MO (~51% share).  We remain extremely bullish on menthol’s superior fundamentals to traditional tobacco, and Newport Menthol is the #1 U.S. menthol brand (37.4%). RAI+LO would reap $800M in cost savings over two years (according to the company) and we think the strong sales and brand equity of LO’s portfolio is complemented well by the strength in RAI’s non-menthol brands like Camel, and its more western U.S. geographic exposure.  The combined company’s ability to leverage a larger sales force, attain more shelf space and compete for higher margin (premium and above premium cigarettes and smokeless) should prove very profitable.  

If the stock can overcome our resistance levels, we expect it to grind higher in the back half of the year as the regulatory process plays out. As a reminder the closing is not expected until 1H 2015, and there may be hiccups along the way due to the brands it intends to divest to Imperial to reduce its menthol portfolio.

In the quarter, there was no updated information on the proposed acquisition of Lorillard.  A key question that remained unanswered from management is whether going forward we can expect non-combustible products like its e-cigarette VUSE to make up for declining cigarette volume and whether RAI can get VUSE to a margin at or above cigarettes. Clearly, investors have concerns on how cannibalization of cigarettes is playing out alongside the adoption of e-cigarettes, and the company was undefined, citing “early days” in the category.

What’s clear is that VUSE is creating an investment drag on the company. In the quarter operating income for the “All Other” segment, which includes VUSE, was a -$49M loss (versus -$39M last quarter).  This loss is expected as the company supports the launch of VUSE, yet it begs the question on when RAI expects VUSE to be profitable.  The company stated that it will continue to invest behind VUSE for the balance of 2014 and into 2015, and expects VUSE to be profitable sometime in the middle of 2015.  For reference, if we look at blu, which LO acquired in Q1 2012, LO’s operating profit was a mere $6M on $231M for FY 2013 (7 quarters later), signaling just how capital intense supporting the new category was for them.   

CEO Susan Cameron said the national roll-out of VUSE (underway in the western states of America since June with plans to move eastward in early September) is progressing smoothly, currently in ~ 21,000 retail outlets. She’s confident that the technology sharing agreement with BAT offers both enhanced innovation and the ability to take the brand VUSE global.

The company tightened its FY 2014 guidance to $3.35 to $3.45 (or 5% to 8%) versus prior guidance of $3.30 to $3.45 and repurchased 4.8M (worth $267M) in the second quarter to complete its $2.5B share repurchase program started in November 2011. 

Howard Penney

Managing Director

Matt Hedrick

Associate

Fred Masotta

Analyst