FDA Scrutiny Hits Tobacco Giant's Secret Weapon

The Food and Drug Administration is considering the health impact of dissolvable tobacco, leaving investors concerned that new regulations may hurt Reynolds American (NYSE: RAI). Shares in the tobacco giant dropped nearly 2.5% in early trading on Thursday. With experts urging regulators to consider the candy-like appeal of flavored dissolvable tobacco on children, there may be good reason to worry.

Reynolds has invested heavily in dissolvable tobacco products such as Camel Orbs, Camel Strips and Camel Sticks, as consumer demand for smokeless tobacco grows. Previously, Reynolds was able to capture 70% of the snus market with its Camel Snus product, and it hopes to repeat that success. FDA scrutiny would endanger those plans and leave Reynolds in search of other engines for revenue.

Reynolds American is heavily dependent on innovation, as cigarette smoking continues to fall and smoking in public becomes less tolerated. Indeed, Reynolds sees its smokeless tobacco products as being “more in line with societal expectations about tobacco product use today,” according to a 2010 statement. However, fears about the health risks of smokeless tobacco and concerns that products such as mint and cinnamon-flavored Camel Orbs appeal to children may make the new products less socially acceptable than Reynolds would hope.

Despite a drop in cigarette consumption in the United States, Reynolds has remained popular with investors thanks to a strong global presence and a consistent rise in dividends even during the subprime mortgage crisis of 2008, when the stock fell to nearly $18 a share. Reynolds increased dividends last quarter by 5.7% thanks in part to an increase in operating income by 2.6% from the previous year.

The company has also seen its operating margin steadily rise thanks to higher prices and greater productivity, which offset lower sales of cigarettes. There is greater room to increase prices if necessary, since a pack of Reynolds cigarettes is on average cheaper than offerings from competitors Lorillard (NYSE: LO) and Altria (NYSE: MO).

Despite lower prices, the company hasn’t been able to grow its share of the cigarette market. On the other hand, its smokeless products account for 31.4% of the market and the sector offers the company greater room for growth than cigarettes. The smokeless products didn’t keep net sales from dipping slightly, down from $6.1 billion to $6 billion for the first three quarters of 2011.

With a greater reliance on smokeless alternatives, more FDA regulation of these new tobacco products could hit Reynolds where it is most vulnerable.

Another key risk for the company is the price of commodities, which may continue to rise in 2012. Higher costs for tobacco and paper would narrow the company’s operating margin, which stayed nearly flat in the third quarter of 2011 at 31.2%, up 1.4 percentage points from the previous year.

Tobacco companies can never ignore the headache of rising state and federal excise taxes, which remains a serious concern as cash-strapped states search for sources of revenue without raising taxes. Sin taxes on tobacco remain popular in many parts of the United States for the same reason that the smokeless tobacco market is growing: smoking is less in line with societal expectations than ever before.

Read more at benzinga