Pair Trade: Philip Morris Upgraded, Reynolds Downgraded At Goldman Sachs

Since the Tobacco sector valuation has a high correlation to 10-year yield, which is expected to rise, there is risk to tobacco multiples, Goldman Sachs’ Judy E. Hong said in a report. She added, however, that the global tobacco industry’s fundamentals remained strong and that solid pricing and margin expansion were expected to result in high-single-digit to double-digit EPS growth in 2017.

While maintaining a Neutral coverage view on the Tobacco sector, analyst Hong recommended a shift in preference from Reynolds American, Inc. RAI to Philip Morris International Inc. PM.

Philip Morris

Hong upgraded the rating on the company from Neutral to Buy, and added the stock to the Americas Conviction List. The price target has been raised from $106 of $114.

The analyst cited the following positives for Philip Morris:

1. The company’s EPS growth is expected to accelerate to 10 percent in 2017, from an estimated 2 percent in 2016, with the easing of currency headwinds
2. The company is expected to record an EPS CAGR of more than 11 percent from 2018-2020, with iQos heat-not burn [HNB] products contributing 5-6 percent of EPS by 2020
3. Capital allocation should improve, with a likely dividend hike in mid-September and the resumption of share buyback by mid-2017

Reynolds American

Hong downgraded the rating on the company from Buy to Neutral, while reducing the price target from $56 to $53. She commented, “We believe our bull thesis on RAI has largely played out.”

Since being added to the GS Americas Buy List on June 16, 2015, Reynolds American’s shares have appreciated 28 percent, versus a 1.5 percent gain in the SPX.

The analyst expects Reynolds American’s EPS growth momentum to slow from an expected 17 percent in 2016 to 11 percent in 2017. She cited the following reasons:

1. US cigarette industry volume declines resume to the historical rate of decline
2. Deal synergies are likely to run out by yearend 2016
3. The company is likely to record ~$250 million higher settlement costs in 2017

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