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Reynolds American, Inc. (RAI): Four Reasons To Buy, But There Is Still One Problem

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Reynolds American, Inc. (NYSE:RAI)Sometimes doing well in the stock market is less about finding a good company, and more about realizing that there might be someone better. A great example of this at work, is Reynolds American, Inc. (NYSE:RAI) seems like a great opportunity until you realize this is not the only option in the tobacco industry. In fact, looking at the company’s recent earnings, investors could logically assume that Reynolds American, Inc. (NYSE:RAI)’s performance is good enough to warrant purchasing the shares, but there is one overriding problem that those same investors need to understand.

Even If You Don’t like the Industry…
Even if you have misgivings about the tobacco industry, it’s hard to ignore the significant yield and value available in many of these companies. It’s rare when you can find multiple stocks that each carry a high-yield, as well as positive earnings growth.

For instance, investors could choose domestic tobacco companies such as Reynolds American, Inc. (NYSE:RAI), Lorillard Inc. (NYSE:LO), and Altria Group Inc (NYSE:MO), or they could choose the internationally focused Philip Morris International Inc. (NYSE:PM) for their investment dollars. In each of these cases investors can expect a yield of between 3.7% and over 5%, combined with a growth rate of between 7% and 11%. If the stocks were overvalued, these numbers might not mean a lot, but with forward P/E ratios of between 14 and 16, each of these companies look reasonably priced.

In fact, one of the main attractions to Reynolds American is their class leading yield of 5.22%. While Lorillard Inc. (NYSE:LO) comes close at 5.08%, and Altria Group Inc (NYSE:MO) pays 4.8%, investors looking for the best yield would likely pick Reynolds American, Inc. (NYSE:RAI).

More Than Just Marginally Better
A second reason investors might select Reynolds American over their competition would be the company’s class leading gross margin. In the last three months, Reynolds American reported a gross margin of over 63%. By comparison, both Lorillard Inc. (NYSE:LO) and Altria generated margins of better than 45%, whereas Philip Morris International Inc. (NYSE:PM) reported a gross margin of just 27.5%.

In addition, Reynolds American has the lowest debt-to-equity ratio of their peers. In fact, the company’s debt to equity ratio of 0.98 is significantly better than Altria Group Inc (NYSE:MO) at 3.33. The fact is, both Lorillard and Philip Morris International Inc. (NYSE:PM) both have negative debt-to-equity ratios at the present time, and can’t compete in this way with Reynolds American, Inc. (NYSE:RAI).

Another positive aspect of Reynolds American’s recent performance was the company’s commitment to retiring shares over the last year. The company repurchased 4.17% of its diluted shares, which was just slightly behind Philip Morris’ retirement of 4.25% of their shares. Lorillard turned in a respectable performance in this area by retiring 3.3% of their diluted shares, but Altria fell somewhat behind the pack with a decline of just 1.5%.

There Is Just One Problem
If Reynolds American were the only selection available in the tobacco industry, this would be a very short post and investors could simply purchase the stock. However, given the company’s competitive position, it seems only fair to point out that there appears to be one superior option to Reynolds American, Inc. (NYSE:RAI) at the present time.

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