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On Jun 28, we retained our Neutral recommendation on Reynolds American Inc. (RAI - Analyst Report) as the company reported softer sales but higher earnings in the first quarter of fiscal 2013. Governmental actions that prohibit the use of tobacco products along with the diminishing social acceptance of smoking are adversely affecting Reynolds’ cigarette volumes.

Why the Reiteration?

On Apr 23, Reynolds delivered adjusted earnings of 72 cents per share for the first quarter of fiscal year 2013, ahead of the Zacks Consensus Estimate of 69 cents by 4.3%. Earnings were up 14.3% from the prior-year quarter due to positive pricing and tight cost control.

However, net sales in the reported quarter slipped 2.6% year over year to $1.8 billion due to declining cigarette volumes. Quarterly net sales also missed the Zacks Consensus Estimate of $1.9 billion.

Following the release of the first-quarter results, the Zacks Consensus Estimate for fiscal 2013 remained flat at $3.22. For fiscal 2014, the Zacks Consensus Estimate also remained the same at $3.41.

Reynolds has a strong brand portfolio of cigarettes, which helps it to command a leading market share in the tobacco industry. Moreover, it adapts to changing consumer demand and develops its products through continuous innovations.

There has been a general shift among consumers toward low-risk and smokeless tobacco products. Therefore, Reynolds is developing innovative, smoke-free tobacco products. It has also increased its focus on the e-cigarette category like its peers Altria Group Inc. (MO - Analyst Report), Lorillard Inc. (LO - Analyst Report) and Philip Morris International (PM - Analyst Report). The company has formed a new subsidiary, R.J. Reynolds Vapor Company, and is developing its patented vapor technology and a brand called Vuse.

Moreover, management is keen on product innovation through cost savings. It plans to save about $70 million annually by 2015 to be used for product innovation and strengthen its key brands. However, strict anti-smoking regulations imposed by the governments across the world, higher manufacturing as well as marketing costs are matters of concern.

Higher taxes imposed by the governments are forcing companies to increase prices. Moreover, price increases and an unfavorable excise tax environment have led to a decline in cigarette shipments in the U.S. by 3.8%, 3.5% and 2.3% in 2010, 2011 and 2012, respectively. Hence, we prefer to remain on the sidelines for this stock.

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