Tough for Reynolds to Catch Fire

We keep our Hold recommendation on cigarette maker Reynolds American, Inc. (RAI), as even though cost savings measures and the new brand portfolio strategy contribute to earnings, continued volume declines, additional debt from the Conwood acquisition, and the class-action status of the Light cigarette suit warrant caution. The company posted weaker-than-expected first-quarter profit and cut its 2008 outlook, citing the challenging economic environment.

While Reynolds American continues to generate solid net cash flow, it is engaged in numerous tobacco-related legal proceedings. The potential for mega-awards against tobacco companies has been increased by two rulings by appellate courts. Moreover, significant increases in excise taxes by state and local governments will exacerbate the declining volume trend in cigarette sales thereby slowing or reversing the earnings progression for all domestic tobacco companies, including Reynolds American.

Reynolds American has traded in a P/E multiple range of 6 to 17 over the last five years. The stock maintains a low P/E primarily due to tobacco-related litigation issues. The stock has been even pressured down to a single digit P/E during times of losses related to lawsuits. We expect Reynolds American to trade in a P/E multiple range of 11 to 17.

For 2008, management now expects earnings to be in-line with 2007 levels. Therefore, the stock is not expected to reach 15 times 12 month trailing earnings. The target price is $60, which is based on 13.5 P/E multiple on 12 month trailing earnings.

Read the full analyst report on RAI