Where Profits Don't Go Up in Smoke

12/21/2009 1:00 pm EST


Bryan Perry

Editor, Cash Machine, Premium Income, Quick Income Trader, Instant Income Trader

Bryan Perry, editor of Cash Machine, says tobacco is a dirty business, but someone has to do it—and profit from it.

Despite all the antismoking legislation and tax burden heaped upon the tobacco industry, when I drive down Route 95 in Virginia—better known as Tobacco Road—the one factory cooking 24/7 right by the highway is [that of] R.J. Reynolds—now called by its kinder and gentler name, Reynolds American (NYSE: RAI).

So, just how coveted is the tobacco business? Well, insiders own 42% of RAI stock! Why? Because quarterly year-over-year earnings are up 71% while top-line revenues are down by 5%.

Overall, RAI is a very closely held stock. Aside from insiders owning 42%, Invesco owns 11.88% and Franklin Resources, Capital Research Global Investors, Allianz Global Investors, Barclays Global Investors, State Street, Capital World, Bank of New York, BlackRock Investment, and Vanguard own another 18.2%. That means 72% of the stock is in what Wall Street likes to call "strong hands."

Also, consider that Reynolds American is the second largest tobacco company in the US and makes many of the nation's best-selling cigarette brands, including Camel, Pall Mall, Doral, Kool, Winston, and Salem. Ironically, tobacco companies are cornering the market on alternative cigarette products that help the chain smoker from puffing their way into oblivion.

And the strength in menthol cigarettes, combined with RAI's improving market share, pricing, and global expansion led Citigroup to upgrade RAI shares to Buy from Hold on December 4th. It also raised its price target to $59 from $52 as RAI agreed to buy Sweden's Niconovum for about $44 million, gaining a foothold in the market for smoking-cessation products.

RAI management is fearless about raising prices. Last time I was in [New York City,] a pack of smokes cost about eight bucks. Today, it might be $10. Do you think that is going to stop anyone from lighting up in the Big Apple? Fat chance.

Now, I'm not saying RAI is some golden child. Hardly: The company spent $760,000 in lobbying efforts during the third quarter to keep the chimney open. But as long as the president is firing up a smoke on Air Force One, don't expect any landmark legislation anytime soon against the tobacco industry.

Plus, smokes aren't going out of business any time soon, and the world's population is only getting bigger—way bigger—by the day. And that's going to continue to drive business to companies like RAI.

Toss in the outsized 6.8% dividend yield, and you have a strong candidate for up side. As a premier maker of some of the most widely distributed lines of tobacco in the world, RAI is a buy under $54. (It closed just above $53 Friday—Editor.)

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