RJR: Seeing Through the Smoke

The Brown & Williamson merger lit a fire under the stock. Now it's looking more like a dividend -- not growth -- play

By Michael Eidam

The tobacco industry has been under siege for some time, what with lawsuits, sin taxes, smoking bans, new regulations, and competition from deep-discount brands. No company has been burned more than R.J. Reynolds (RJR ). In 2003, the stock looked to have been smoked down to the filter as those challenges, coupled with fears of a reduced dividend, sent shares plunging 50%. But when the Winston-Salem (N.C.) outfit announced on Oct. 27, 2003, that it would merge with Brown & Williamson Tobacco (a subsidiary of British American Tobacco), the stock caught fire. It reached $70 a share -- the 52-week low was $31 -- after the Federal Trade Commission approved the merger in June.

Now it's shareholders' turn to vote on the deal at a special meeting on July 28, and they're expected to ratify it. If all goes as expected, over the next 18 to 24 months, a new company, Reynolds American, will begin to take shape, trading under the ticker symbol RAI. But until that happens and with RJR's stock hovering in the mid-$60s, investors might want to ask themselves if it's really time to light up.


  Some analysts see a fat dividend as reason to strike the match. Smith Barney analyst Bonnie Herzog wrote in a June 22 note to investors: "We believe Reynolds American's dividend will be even more attractive, given that it is expected to pay out 75% of its net income." Herzog estimates that 2005's earning per share (EPS) will be $7.50, translating into a $5.62 annual dividend with an 8.5% yield.

"We find [the] merger of RJR and B&W a slam dunk that will generate value for shareholders," concluded Herzog. Based on her $77 price target, investors could realize a 15% gain on the current price of around $67 -- 23.5% if one includes the dividend yield.

Why is Herzog so optimistic? Economies of scale should allow the merged company to cost-cut its way to higher earnings. Herzog, who has a buy/high-risk rating on RJR, wrote: "This merger creates a financially stronger and more rational No. 2 competitor in the U.S. and should generate more free-cash flow due to substantial cost savings of at least $500 million, which is on top of restructuring savings of at least $1 billion."

Herzog also points to RJR's history of creating shareholder value. In 2003, when Wall Street feared the dividend was in trouble and bid down the stock, RJR sucked it up and continued to dole out 95 cents per quarter -- most of its profits for 2003. Also, the stock hasn't risen merely on merger hype. In September, 2003, RJR announced a restructuring plan that, among other things, called for an emphasis on premium brands Camel and Salem.


  The first quarter of 2004 showed signs that the new strategy was paying off. While sales of RJR's low-cost or "savings" brands dropped 19% and premium brands were up only 2.1%, overall revenues were on par with 2003. So, although RJR is selling fewer cigarettes, the increase in premium-brand sales offset the volume decrease in the discount lines.

What's more, in a given year, lower sales volume decreases the Master Settlement Agreement payments -- money paid to 46 states as part of a legal deal reached with the states' attorneys general in 1998 -- thus lowering RJR's costs. Add to this the cost-cutting initiatives of $400 million in 2003 and an additional $450 million expected in 2004, and it means that while sales were even year-over-year, first-quarter EPS was up 70.2%.

Investors shouldn't start counting their money yet, however. While results for the first quarter were impressive, Prudential Equity Group analyst Robert Campagnino sees challenges ahead, including a tough promotional environment and weak pricing power. Campagnino, who has a target of $64 and an underweight/moderate risk rating, wrote in a June 23 note: "We certainly see the business combination as accretive, and substantially so, but we would need to make heroic assumptions to get to some of the earnings estimates that we have seen bandied about by the sell-side and investors."


  Wall Street's doubts about the merger focus on two uncertainties. The first is the prospect of continuing litigation. Despite some favorable recent rulings, the tobacco industry is still wrangling with some fierce lawsuits, and as part of the merger, Reynolds American will indemnify Brown & Williamson for all existing and future litigation to its U.S. business. Writes Herzog: "Although the litigation environment has improved substantially, we believe this is somewhat risky."

Perhaps weighing even heavier on investors' minds are questions about what the new company will look like and what its strategy will be. RJR's stock is now trading at more than 12 times analysts' highest earnings estimates. That's lofty for a tobacco stock, given that the industry average is 10.21 times earnings.

Considering that after the merger has been finalized, a new board and new management will be reviewing strategy and dividend policy, investors are paying a premium for a company that hasn't taken shape yet.


  Campagnino doubts that the new board will approve a dividend payment representing 75% of the profits. He argues 65% is more likely. Campagnino estimates 2005 EPS of $6.99 and a 65% of earnings dividend policy. That translates into a dividend of $4.54 and a yield of 6.8%, just shy of the 7%-8% dividend yield he says would compensate for RJR's lack of growth. Also, U.S. consumption is dwindling, and Reynolds American's ability to attain growth by entering foreign markets like China will be restricted for five years because of a noncompete agreement with British American Tobacco.

As it stands now, RJR is a stock for dividend lovers happy with modest gains (the dividend yield is now about 5.7%) rather than exciting growth. That may not be such a bad strategy with the market currently see-sawing.

Still, investors might want to hold off until Aug. 2, when the company announces its second-quarter earnings. And according to company spokesman Seth Moskowitz, "As part of the call they are going to be providing information about Reynolds American's initial plans." You might want to listen in to make sure that where there's smoke, there'll be fire, too.

Eidam is a correspondent in BusinessWeek's Atlanta bureau

Edited by Patricia O'Connell

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