Reynolds American: A First Look After the Lorillard Merger

The old Reynolds lineup will look different, with Newport joining the company's stable of brands. Source: Reynolds American.

In June, Reynolds American finally closed on its long-awaited merger with former competitor Lorillard, creating an even bigger tobacco giant to go up against just a single remaining major rival in the cigarette space. In the aftermath of the merger, Reynolds stock has gone on to soar to new all-time record heights, and late last month, Reynolds American gave investors their first glance at the post-merger company's ability to produce revenue and net income.

Given the positive reaction from shareholders, it appears that the tobacco company has generated plenty of enthusiasm about its future prospects. Let's take a closer look at what Reynolds American told investors in its second-quarter financial result and what's ahead for the cigarette maker.

How Lorillard is enhancing Reynolds American's numbers Reynolds American's second-quarter report reflected the changes the company has gone through recently. In particular, it included results from Lorillard's Newport brand during the roughly three-week period following the merger, but it excluded the acquired company's Kool, Winston, and Salem brands, which Reynolds divested as part of the merger.

Overall, sales climbed 11% to $2.4 billion, accelerating from the growth Reynolds saw in the first quarter. GAAP net income included a number of one-time items related to the merger, but after allowing for those impacts, adjusted net income climbed 22% to $579 million, producing adjusted earnings of $1.02 per share. That was 15% higher than 2014's second-quarter figure, and it topped the consensus forecast by a nickel.

The RJR Tobacco unit continued to show healthy growth, with adjusted operating income rising more than 19%. Reynolds cited higher cigarette pricing for the gains, as well as the completion of the federal tobacco-quota buyout program. Better pricing also helped boost operating margins, which improved by more than four percentage points.

Reynolds pointed to the direct impact of Lorillard's Newport to its cigarette lineup. In particular, Newport's market share improved to 13.2%, with its status as the No. 1 menthol brand in the U.S. helping it to keep traction in the competitive cigarette industry. Newport now plays a larger role in Reynolds' portfolio than Camel or Pall Mall, and the three brands combined are responsible for 92% of RJR Tobacco's overall business. Shipment volume at Reynolds also jumped by 4.4%, with Newport helping to produce much of those gains.

Yet not all of Reynolds' success is connected to the Lorillard merger. The company saw continuing success in its Santa Fe super-premium brand, which helped to boost operating income almost by half. In addition, despite some adverse conditions in the smokeless tobacco arena, Reynolds' American Snuff division also produced attractive results, with operating income rising 18% on higher pricing and volume gains.

Can Reynolds American keep climbing?With the merger now behind it, Reynolds American's attention turns toward integrating Lorillard's operations into its own and taking advantage of the potential efficiency gains from the deal in order to justify the cost of buying Lorillard. As CFO Andrew Gilchrist said, "Following RAI's successful bond offering related to the Lorillard acquisition, the company's initial focus will be on deleveraging," with the goal of improving its balance sheet and making sure it doesn't overextend itself on the debt front.

Yet even with those challenges ahead of it, Reynolds American is optimistic. The company announced a 2-for-1 stock split and boosted its guidance, now expecting between $1.90 and $2 per share on a split-adjusted basis. Still, that guidance is subject to future revision, as Gilchrist said it hoped to narrow the range "after further assessing our new business dynamics following the acquisition."

Lorillard's Newport will play a vital role in further expansion for Reynolds. The company said earlier this month that it would offer new styles of the key brand's cigarettes, as well as hire former Lorillard sales representatives to try to bolster market share further. Newport has a much smaller market share in the Western U.S. than on the East Coast, and Reynolds hopes to alleviate that disparity with the help of sales reps with experience selling Newport in key areas.

At the same time, Reynolds hopes that linking Newport and legacy Reynolds brands Camel and Pall Mall will help bring in more sales for all three combined in areas where Newport has historically been strongest. Furthermore, Reynolds is bringing the machines and equipment that produced Newport at Lorillard into its own production facilities in order to ensure continuity.

With the second quarter only including a few weeks of Lorillard's influence, Reynolds American shareholders haven't seen everything about what the combined company will look like going forward. Nevertheless, with a sneak peek at early strategy, what's evident is that Reynolds has every expectation for the Lorillard merger to have been a key move in its corporate history.

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