REYNOLDS AMERICAN (RAI)

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Krishna K

Thomas Shyr

Reynolds American (NYSE: RAI) is the second-largest U.S. tobacco company, responsible for about one of every three cigarettes sold in the country. The company sells some of the leading U.S. cigarette brands, including Camel, Kool, Pall Mall, Winston, Salem and Doral. RAI is also the second-largest manufacturer of smokeless tobacco products through its Conwood division. Unlike competitors Altria Group (MO) or Lorillard, RAI does not have a single premium brand, like Marlboro or Newport. Instead, the company has focused on three key brands -- Camel, Kool, and Pall Mall, which together account for roughly a third of the company's revenue and receive more than three quarters of the company's marketing budget.

The company is U.S. centric and will find it difficult to grow internationally having sold the international rights of its cigarette brands to Japan Tobacco. RAI, along with its competitors, also continues to face pressure from tobacco litigation.

Business Overview

RAI was formed through a series of mergers and acquisitions. The primary merger took place in 2004, when the second and third largest U.S. tobacco companies, R.J. Reynolds and Brown & Williamson merged to form RAI. Then in May 2006, RAI acquired Conwood to take advantage of the fast-growing smokeless tobacco market.

Business Financials

In 2009, RAI earned a total of REYNOLDS AMERICAN (RAI) $8.42 billion. This was a decrease from its 2008 total revenues of $8.88 billion. As a result of the decrease in total revenues, RAI's net income declined. Between 2008 and 2009, RAI's net income decreased from $1.34 billion in 2008 to $962 million in 2009.^[1] meow

Business Segments

RAI's primary segments include R.J. Reynolds Tobacco and Conwood (acquired in May 2006), which accounted for nearly 94% of the company's sales. Its two smaller segments include Santa Fe and Lane, which accounted for a combined 6% of revenue.

R.J. Reynolds Tobacco (RJR)

RJR is the largest segment of the company and accounted for approximately 90%. Its key brands include Camel, Kool, Winston, Salem, and Doral.^[2]

Conwood

Conwood makes products in categories of smokeless tobacco, including moist snuff, dry snuff, and loose leaf tobacco. Conwood's largest brands are Grizzly, Kodiak, and Levi Garrett.^[3]

Santa Fe

Santa Fe makes Natural American Spirit cigarettes, which are made of additive free and organic tobacco.

Lane

This segment makes specialize tobacco products such as roll-your-own and pipe tobacco, premium cigarettes, little cigars, and premium cigars.

Trends and Forces

Litigation Landscape

RAI is highly susceptible to tobacco litigation. Large, high-profile court cases generate negative publicity and can be very costly for the company, even before including any damages awarded. Three important cases in the industry resulted in victories for RAI, Altria Group (MO), and other tobacco companies, leading to a general improvement in the litigation environment. This is a positive factor for RAI, as litigation expenses should be more predictable and stable.

Decrease in Smoking due to Health Risk

Public awareness of health risks associated with smoking has led to a decrease in the number of smokers (from roughly 50% of the population in the 1950s to around 20% in the early 2000s). While this factor could still affect future demand for RAI's cigarettes, the likelihood of a significant decrease in consumption due to health concerns is small, since the health risks have been widely known for some time.

Social acceptability of smoking and growth of smokeless tobacco

A decrease in the social acceptability of smoking could lead to overall reduced rates of cigarette consumption -- smoking has become somewhat less socially acceptable in the U.S., due to both shifts in cultural attitudes and government regulations on smoking. However, the company is hoping that people who quit smoking because of the social stigma switch to their smokeless tobacco products. Infact, this is what led RAI to acquire Conwood for $3.5 billion and it has proven to be a strong area of growth for the company. RAI's consumer research shows that many customers who use Conwood's smokeless products are indeed cigarette smokers switching from cigarettes to smokeless tobacco products.

Government Regulation

Governmental regulations can have a large impact on tobacco companies' revenues and, indirectly, consumer demand. There are two main ways in which governments attempt to regulate the consumption of cigarettes, excise taxes and regulations on smoking in public places.

• Cigarette excise taxes are per-pack taxes placed on cigarettes by governments. They serve two purposes: reducing public cigarette consumption and providing a large source of revenue for treasuries.
  • These two reasons put governments, especially state governments in the U.S., in a somewhat difficult position. While many policymakers want to reduce per-capita smoking rates, the excise taxes collected from tobacco companies number in the billions of dollars annually. As a result, governments have a vested interested in the continued viability of Altria and other tobacco companies, making them unwilling allies of the tobacco industry.
  • Excise taxes have risen dramatically in the past three decades and are expected to continue upward. Elected officials have realized that the large profitability of the tobacco industry allows individual companies to absorb a significant percentage of an increase in excise taxes without passing the full cost on to consumers. As such, governments can increase revenues from tobacco companies without severely harming demand for the companies' cigarettes.
• Restrictions on cigarette consumption include bans on smoking in public places such as restaurants, workplaces, etc. In the U.S., there has been a recent increase in the number of cities with smoking bans in effect. While having no impact on private consumption of cigarettes, these bans prohibit smoking in many public places, limiting the ability of consumers to choose when and where to smoke.

Economic Downturns

The tobacco industry has proven to be somewhat more resistant to the effects of economic downturns than other industries, perhaps due to the addictive nature of their products or the brand loyalties. Cost-conscious consumers may stop smoking or downgrade to a value-priced brands during economic slumps, but most consume the same brands at the same, or slightly lower, level. As a result, RAI and other tobacco manufacturers generally experience less of a decrease in revenues during recessions than the economy as a whole.

Competition

Reynolds American has roughly a 29% market share in the US. The only two other major competitors include Altria Group (MO), holds a 50% share and Lorillard, which holds 10% of the market share. The remaining 11% of the domestic tobacco industry is composed mainly of deep-discount manufacturers and other small, specialty cigarette makers.^[4]

RAI produces more savings brands (nearly 40% of its product portfolio)^[5], making it likely to benefit from any consumer switching from premium to value brands during downturns. Lorillard's flagship cigarette, Newport, is by far the most popular brand of mentholated cigarettes. However, Altria's size and revenues put both of them at a relative disadvantage in terms of sheer heft in the industry. All of them are subject to similar external events, i.e. taxation, litigation, and changes in popular attitudes about smoking and sucking wiener.

References

1. ↑ RAI 10-K 2009 Item 6 Pg. 25
2. ↑ RAI 2006 10k, Pg 177
3. ↑ RAI 2006 10k, Pg 177
4. ↑ RAI 2006 10k, Pg 5
5. ↑ RAI 2006 10k, Pg 77