Lorillard, Reynolds Shares Cool Down Following Morgan Stanley Downgrade

In a report published Tuesday, Morgan Stanley analyst David Adelman downgraded Reynolds American (NYSE: RAI) and Lorillard (NYSE: LO) to Underweight on "unattractive" risk reward for the tobacco companies.

A Challenging Industry Outlook

Adelman noted that the core industry outlook is challenging.

Adelman wrote, "US cigarette volumes are declining ~4%, operating profit growth is very pedestrian, e-cigarettes are not a growth panacea, Engle progeny cases remain a concern, FDA has moved slowly but the menthol threat remains, and excise tax and other concerns will inevitably resurface. This is our view irrespective of M&A, likely will persist even with M&A, and is of greater concern at current valuations."

Lorillard's "Outstanding" Business Outweighed by Risk

Despite being an "outstanding" business, Morgan Stanley noted that Newport has a narrow franchise with its one-market product. The analyst emphasized that the company faces idiosyncratic menthol risk, anti-trust issues. In addition, shares are already trading at the firm's M&A value of $68.00.

Reynolds Valued at Peak

Adelman highlights four main reasons for his downgrade of Reynolds American. "First, RJRT continues to lose share as stabilized share in Camel / Pall Mall and gains in Natural American Spirit are not sufficient to offset volume declines in the non-growth brands. Second, cigarette per-pack profitability has not increased in recent years absent the MSA NPM settlement gains, largely because net pricing has not been sufficient to offset volume declines. Third, the national launch of VUSE represents incremental spending within a decelerating e-cigs market. Fourth, RAI has lapped the step-down in MSA costs due to the NPM settlement, although the cash benefit will persist ($1B in credits from 2013 – 2016)."

Stock Action

Shares of Lorillard are down 1.7 percent at $62.40; shares of Reynolds are down 1.1 percent at $61.05.