Hasn’t it been interesting to see how much insider selling has happened at Reynolds American since the announcement of the Lorillard merger?
Martin Holton III, General Counsel, has sold shares. Murray Kessler, a director, has sold hundreds of thousands of shares. Thomas Wajnert, a director, has sold tens of thousands of shares. Daniel Herko, whose official title is unclear, has sold tens of thousands of shares. Richard Thornburgh, a director, has sold tens of thousands of shares. Jeffery Gentry, an executive manager, has sold tens of thousands of shares. Debra Ann Crew has sold tens of thousands of shares. Andrew Gilchrist, the CFO, has sold tens of thousands of shares.
Is this rush to prune shares of the combined tobacco giant merely coincidental estate planning, or is it a signal that the stock has gotten a bit overvalued?
From 1989 through through 2011, Reynolds American traded at a valuation range between 7x earnings and 14x earnings. Most of the time, it traded in the 11x earnings to 13x earnings range and offered a dividend yield somewhere around 5% or 6%. That’s not the case right now–it is trading at $47 per share compared to $1.80 in annual profits for a P/E ratio of 26.
Some of that is misleading because the “E” in the P/E equation is about the climb faster than usual for two reasons–reduced merger-related costs and improved operating efficiencies once the combined company becomes settled, and the expiration of a ten-year $10 billion payout to tobacco farmers that Reynolds, Lorillard, and Altria had been paying since 2005. The expiration of this farmer payment program will add $0.20 per share to earnings, and the integration of the company will add about $0.10 in 2016. In addition to growth, and Reynolds American ought to earn $2.20 per share in 2016.
That is still a P/E ratio of 21, which is higher than is merited, but the company is not quite as expensive as a basic screen of the firm would suggest. Even though the Reynolds is positioning itself to still give shareholders dividend hikes in the high single digits, the valuation is something to be concerned about in light of declining sales and a now enormous debt burden following the merger.
Consider this: In 2007, Reynolds sold $9 billion worth of tobacco and related products. By 2014, the sales at Reynolds were $8.4 billion. Seven years passed, and the prices of cigarettes climbed, and the volume declines so substantial that revenues declined. The earnings grew from $1.14 in 2007 to $1.35 in 2014 due to higher profit margins that were the result of price hikes and cost cuts. The lack of revenue growth at Reynolds was tolerable when the dividend was 6% and the P/E ratio was 11 because the value of the firm compensated you well for dealing in an industry that has inherent volume declines.
But this isn’t IBM at $131. If Reynolds reverts to the high end of its mean at 14x earnings five years from now, and earns $2.75 per share at that time, the stock will trade at $38.50. The current price is $47–it is entirely possible that the shareholders of today will not see any capital appreciation over the next five years and will only collect the dividend. If earnings are higher than expected at $3.20 in 2020, you would still need a valuation of 14.68x earnings to break even with the current price right now.
I also think the debt burden is something that may prove bothersome as interest rates rise if Reynolds refinances some of its debt at higher rates. Back in 2011, Reynolds had $3.2 billion in debt while it was earning $1.6 billion in annual profits. The leverage was only twice annual profits. It had the strongest balance sheet among large tobacco firms, and had the flexibility to do something like acquire Lorillard.
Now that the Newport brand is part of the Reynolds fold–and really, that’s all Lorillard was, as over 88% of sales came from the Newport brand though it had a faster growing e-cigarette option compared to what Reynolds was growing in house–Reynolds no longer has such flexibility. It is making $2.5 billion while owing $18 billion in debt. It is going to have to pay off almost $7 billion of that in the next five years, and that is going to eat up a good chunk of the estimated $18 billion cash flow that the combined Reynolds and Lorillard brand will be generating over that time frame.
Counterpoint: Reynolds has increased its cash position from $1.5 billion to $4 billion, and is expected to generate $3.5 billion in total profits by 2018. This may make the required debt payments more of an annoyance than a burden.
I think it’s clear that now is not a good time to buy Reynolds stock. The P/E ratio is much higher than it’s ever been, even adjusting for the factors that make it slightly less expensive than meets the eye. The 3% dividend yield is far and away the lowest it’s been in thirty years. There’s no reason to purchase stocks at a generational high, especially when things like Exxon, Hershey, Tiffany, Diageo, Royal Dutch Shell, and Berkshire Hathaway are out there.
The harder question: At what point should a buy-and-hold investor sell a large tobacco stock that raises its dividend every year and has satisfactory prospects for earnings growth, but is overvalued? If it were me, I wouldn’t see until I thought I was guaranteed to lose half my valuation over the long term due to P/E compression. I would beg that figure somewhere around 25x normalized earnings. If Reynolds earns $2.25 in 2016, that would imply a sell price of $56. If it makes $2.50 the year after, that would imply a sale price of $62. I would be reluctant to sell any money machine that has an extraordinary history of creating shareholder wealth, but I would do it once I felt there was a high probability that P/E compression would cut the valuation of the stock in half.