A Look at Cigarette Companies in a Declining Market

Damian is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Health habits and government regulation have negatively affected the tobacco industry. At the same time, new opportunities have been created for those who adapt. Let us take a look at what Reynolds American (NYSE: RAI), Lorillard (LO), and Altria Group (NYSE: MO) have been doing to keep a declining market profitable.

Thank you for NOT smoking

Reynolds reported improved earnings per share, but a drop on sales. Government regulation had a negative impact over sales, but shareholders have benefited nonetheless. Earnings growth is the result of cost reduction and positive pricing, which helped to offset the decline on the firm’s leading brands sales.

After selling its international business, Reynolds limited operations to the US market. Demand has shifted to smokeless tobacco products, and the firm has responded in kind. Cost reduction and improved productivity have allowed the business to capture part of the growing demand helping to keep revenues stable. For those who keep on puffing, the company offers a natural brand that has been capturing a bigger market share over the past years. At the same time, R&D has put out a new vapor technology.

Financially, Reynolds is good condition. Revenue and cash flow remain stable, while free cash has been on the rise. This market performance allows the company to keep investing on new smokeless products, which have already proved to be successful. The downside is raising debt in 2012, which has reverted its downward trend after several years.

Currently, Reynolds trades slightly over industry average valuations and close to its 52-week high. However, my recommendation is a Buy because the company’s operating margin is above the industry’s average and the projected yield is around 5%. Moreover, the firm has proved to adapt to new market demands making the stock suitable for long-term investment.

Menthols will refresh and freeze revenues

A long road has been walked since Kool cigarettes arrived to the market. Today, menthol cigarettes are a worldwide fashion, and Lorillard is leading the pack. Like Reynolds, the firm has entered the e-cigarette market, has seen its debt rise considerably, and operations are limited to the US market.

Far from similarities, Lorillard depends heavily from the US market and its menthol segment. The firm will find declining smoking habits a big obstacle to maintain its market position and financial health. Growing FDA regulation is putting heavier pressure on the firm to adapt, and acquisitions towards that end have been made.

Trading at a 12% discount to industry average valuations and offering almost a 5% dividend yield, the stock is attractive. On the downside, debt has risen exponentially while cash volumes remain stagnant. Also, EBITDA for the firm is half that of Reynolds’, and insider sales have been plenty. Last, the business marketing strategy has not been successful when compared to major competitors.

In all, Lorillard is not a good option for long-term investment, and it is recommended to hold. The company has entered the smokeless business, but acquisitions alone do not guarantee future profits. It is necessary for the company to develop new products and inaugurate an R&D division with that purpose.

The cowboy will kill you

Leading the cigarettes market, Altria holds the biggest potential for losing in the future. Holding a staggering 50% of the cigarette market, future FDA regulations and taxation hold the potential to gravely hurt revenues and income. Also, the company is currently in no better position than Lorillard.

Raising prices can delay negative revenue effects, derived from government regulation and market declining volumes. Altria holds an important pricing leverage, but price marking may drive customers to switch brands, especially if the company is curtailed from communicating discounts due to tough advertisement regulation.

When looking at finances, Altria has put free cash flow back into a positive trend. However, overall cash has not recovered since 2008 and debt levels have passed historic highs. In consequence, the firm holds a comparative less potential for R&D and adaptation to new market trends.

Finally, Altria is trading at a similar premium than Reynolds, but holding a greater operating margin. It is recommended to hold because the firm continues to trust on its leading market position, and has not taken decisive steps to meet new market trends.

Adapt quickly or take your winnings

Current times are not good for freshman smokers. Government regulation and health awareness have put the focus on the downside of smoking. However, the change on market trends brought new opportunities for those willing to adapt. It is my opinion that Reynolds has done the most to adapt so far, and for that simple reason holds the best potential for future revenues. The company is in the best position to steal customers from those competitors still focused on making profits from cigarettes.

Damian Illia has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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