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12 Sep 2016 16:03:46 ET │ 68 pages Tobacco North America

MO and RAI – Lighting Up We initiate with a Buy on both but we prefer RAI

 Demand for cigarettes in the U.S. is stronger than it has been for decades, and we think it is likely to remain robust — We are now in the surprising position where U.S. cigarettes sales are growing faster than sales of food, HPC or CSDs, according to Nielsen. We think sales growth will remain robust in the next couple of years, as the migration into dip and e-vapor – which was a major drag in the years to 2014 – is likely to remain subdued, in part because of FDA regulation of e-vapor products. We don’t think gas prices have as much impact as some say.

 Domestic tobacco is a more attractive asset class than international in our view — We therefore believe that MO and RAI can rerate relative to PM. We think domestic deserves a higher multiple because (1) it is more predictable, as it doesn’t suffer from FX-driven volatility; (2) sales growth is stronger when adjusted for inflation; (3) taxation and regulation is much more benign; (4) outside the U.S. there is more risk from next generation nicotine products now; and (5) because we think the litigation could well be a negative surprise in Canada.

 Why buy the stocks now? — For us the solid outlook justifies the rerating relative to the S&P. Changes to expectations on Treasury yields can buffet tobacco in the short term, but Citi economists expect Treasury yields to remain low relative to the 4% dvd yields on tobacco stocks. In addition we expect 8-9% EPS growth.

 Where are we different? — We believe we are more bullish on the mid-term volumes, and on the relative attractiveness of domestic vs international.

 Reynolds is our preferred name — The investment cases (and valuations) are similar, but we expect better sales and earnings growth at RAI, driven by faster market share growth and better mix, both within cigarettes and dip. We have RAI growing sales at 4% mid-term and EPS at 9%, both a point better than MO.

 We also have a Buy on Altria — We like the fundamentals on MO too. As the dominant player it leads industry prices in a way to suit itself. We expect ABI to increase quarterly EPS volatility, as its EPS has moved ±60% in 3 of the last 9 quarters, although the number should be known in advance (give or take different accounting standards), as ABI’s contribution will be reported in arrears.

 Valuation — If these companies hold their multiple, and they deliver EPS in-line with history and consensus, the shares will rise about 8-9% a year. However we think the market will come to see that fundamentals have improved, and therefore small rerating is justified on top. Both stocks trade at about 19x 2017 P/E, vs 20x for PM. Our price targets assume that MO can move to about 20x and RAI to 20.5x, but in 12 months’ this will be applied to 2018 EPS, not 2017.

Adam Spielman AC +44-20-7986-4211 [email protected]

Jemima Benstead +44-20-7986-4125 [email protected]

Ravi Sharma +44-20-7986-6196 [email protected]

Citi Research

Deep Dive | Equities

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Current Fiscal Year Next Fiscal Year Price Rating Target Price EPS EPS Company Ticker Currency 09 Sep Old New Old New Div Yld (%) ETR (%) Last Rpt Year Old New Old New Altria Grp MO US$ 63.56 - 1 - 72.00 3.8 17.1 Dec-15 - 3.00 - 3.35 Reynolds Amricn RAI US$ 47.15 - 1 - 57.00 4.0 24.9 Dec-15 - 2.32 - 2.52 1 = Buy, 2 = Neutral, 3 = Sell, H = High Risk Source: Citi Research

Data Summary

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We are bulls on the domestic tobacco stocks 4 We prefer to Reynolds to Altria 7 What about macro factors? What happens if interest rates go up? 9 Valuation – there should be further to go 11 We are different because we appear more optimistic than consensus on a 2-3 year view 14 Altria – Bull Bear Analysis 15 Reynolds – Bull Bear Analysis 16 Strong trends likely to remain in place 17 It seems the total nicotine market has been falling at less than 2% since 2011 21 There was migration to non-cigarette products, but that has slowed now 23 Tax has been favorable in the U.S. since 2011 25 FDA regulation also helps the majors 27 Very long-term trends remain negative 28 Domestic tobacco is more attractive than international 29 1. Domestic stocks don’t suffer from FX-related volatility 31 2. Underlying demand trends are currently better domestically 32 3. Domestic industry is structurally more attractive 34 4. Litigation risk is arguably lower in the U.S. 37 5. We see more risks from new technologies outside the U.S. 38 The differences between MO and RAI 39 We prefer RAI (Buy) to MO (Buy) 40 1. Reynolds brands should grow market share faster 41 2. Mix is positive for Reynolds 43 3. Increasing volatility for MO from ABI 45 4. Litigation risk is higher at RAI 47 5. M&A risk at Reynolds 48 Altria (MO) 49 Altria - The Key Charts 50 Financial Summary 51 Reynolds American (RAI) 53 Reynolds – The Key Charts 54 Financial Summary 55 Appendix 57 Appendix A-1 62

Contents

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We are initiating coverage of the U.S. tobacco sector, with Buys on Reynolds American (RAI) and Altria (MO), and a Neutral on Philip Morris International (PM). For RAI, our share price target is $57 (about +25%, including the 4% dividend yield) and for MO it is $72 (about +17%, including the dividend).

We believe RAI and MO have further to go RAI and MO have performed strongly since 2014, as Figure 3 shows. We believe this outperformance is fully justified, and indeed can go further, for two reasons:

1. Demand for cigarettes in the U.S. is stronger than it has been for decades, and we think it is likely to remain robust We are now in the surprising position where U.S. cigarettes sales are growing faster than sales of food, HPC or CSDs, according to Nielsen.

Total “nicotine” volumes – which is the combination of cigarettes, smokeless, and e- vapor – have been declining at less than -2% since 2011, when State Excise Tax increases slowed noticeably. However cigarette volumes remained weaker than this up to 2014, due to the growth of other types of nicotine product (e-vapor, MST, pipe tobacco.) In 2015, however, none of these grew significantly, which explains why cigarettes performed well.

Looking forward we expect cigarette industry sales to remain robust, as we expect tax rises to remain low and the migration into e-vapor to remain subdued, because FDA regulation of next generation products will slow innovation1.

State Excise Tax did increase in Pennsylvania this August and California is holding a ballot initiative on SET this November. But these tax increases are not big enough to change our view that the tax situation in the U.S. remains fundamentally favorable, unless these states start a new trend, and we don’t think they will.

In the five years 2010-2015, MO and RAI reported 8-9% compound EPS growth, even though U.S. cigarette volumes fell at 3%. We believe that MO can at least maintain that earnings growth, and RAI can improve on it, in part because for 2016 and 2017 we expect cigarette volumes to fall by only about 1.5%, significantly better than the long-term trend of -3% to -4%.

2. We think that domestic tobacco is a more attractive asset class than international We believe that MO and RAI can rerate further relative to PM because:

 Domestic tobacco earnings are more predictable, as they don’t suffer from FX- related volatility

 Underlying trends are currently better domestically

 Taxation and regulation (the main medium-term drivers) are also more benign domestically

1 It doesn’t make that much difference to MO and RAI whether a tobacco user chooses to dip or to smoke, as they are very roughly as profitable, and each company has broadly similar market shares in the two categories. However, it does make a big difference if a user switches out to e-vapor, as all the players are loss-making in this area, and anyway there is a much greater chance of the smoker ending up with another company’s product

We are bulls on the domestic tobacco stocks

This report looks at the two domestic stocks – MO and RAI – in detail. [Philip Morris International (PM) - Lighting Up] is our re-initiation on PM.

This coverage of the U.S. listed names builds on our long-established coverage of the European tobacco sector. See

BATS: Brazil squeezes margins but EPS beats

IMB: Just as much change to come again

SWMA: FDA risk affects almost the entire cigar business

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 We think growth in e-vapor (which is loss-making) will be subdued in the U.S., thanks to FDA regulation, but there is a risk it won’t be in Europe. It is quite possible that PM’s iQos does make a profit-enhancing breakthrough in Europe, but if it does it is likely to be equally successful in the U.S. (where MO will market it), albeit with a multi-year delay while it obtains FDA authorization.

 We think the litigation could well be a negative surprise for international, specifically from Canada.

Figure 1. Cigarettes vs Total Nicotine Growth Rates Figure 2. PM trades at a premium to other tobacco companies

Cigarettes

Total Nicotine Market

2011

-3.5%

-1.5%

2012 -2.3% -1.2% 2013 -4.6% -1.9% 2014 -3.2% -0.9% 2015 -0.1% -0.7%

P/E Price 2016 2017 2018

PM $97.5 21.6 19.8 18.3 MO $63.6 21.2 19.0 17.6 RAI $47.2 20.3 18.7 17.0 BATS £47.0 19.3 17.3 15.8 IMB £39.3 15.5 14.1 13.3 JT ¥3,950 17.6 16.2 15.0

Source: RAI Company Reports, except for Citi Ests for 2011 & 2012 Nicotine Mkt. Source: DataCentral

Figure 3. RAI and MO have outperformed since 2014 Figure 4. All the tobacco P/Es have risen; PM remains at a premium

MO, 306 RAI, 324

PMI, 184

S&P500, 205

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March 3, 2014. FT reports RAI may buy LO

May 2013 Start of Taper Tantrums

MO, 19.6 RAI, 18.9

PM, 20.5

S&P 17.2

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12 Month Forward P/E – Last 5 Years

March 3, 2014. FT reports RAI may buy LO

May 2013 Start of Taper Tantrums

March 3, 2014. FT reports RAI may buy LO

May 2013 Start of Taper Tantrums

Source: DataStream Source: DataStream

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Tobacco has been a consistently good investment It is also worth noting that all the tobacco stocks have performed extremely strongly, both on a multi-decade basis (Figure 6) and in more recent years (Figure 5 and Figure 7). Investors could have said at any point “we’ve missed the run” and they would have been wrong.

Figure 5. Tobacco Stocks’ TSR has been consistently strong since 2009

2009 2010 2011 2012 2013 2014 2015 2016 YTD MO 40% 33% 28% 12% 29% 35% 23% 11% RAI 43% 32% 34% 6% 27% 35% 49% 5% PMI 17% 28% 39% 11% 8% -2% 13% 13% BAT 32% 23% 31% 11% 10% 6% 6% 16% IMB 23% 0% 30% 6% 5% 20% 27% 1% JT 6% 11% 31% 23% 18% -11% 37% 6% S&P500 26% 16% 1% 16% 32% 14% 1% 6% S&P500 Cons.Staples 15% 14% 14% 11% 26% 16% 7% 6%

Shows US$ TSR for all names for each year.Source: Datastream

Figure 6. Since 1999 domestic tobacco has performed extraordinarily well

Figure 7. Even over the last decade the outperformance is outstanding

MO,CAGR 18%

RAI,CAGR 23%

BAT,CAGR 17%

S&P500,CAGR 5%

US Cons. Staples,CAGR 8%

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Note: We start at 1999 as this is the further we can trace RAI back. PM’s performance has been roughly similar to BAT’s since the spin. Source: Datastream

PM’s performance has been roughly similar to BAT’s since the spin. Source: Datastream

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The economic drivers of these two companies are similar, and they are on similar valuations, so it is hard to imagine one proving a good investment while the other underperforms. This is why we write about them in one report.

However we prefer Reynolds mainly because we expect it to generate better earnings growth – about 9% in the mid-term vs about 8% for Altria – following the acquisition of Newport and the disposal of some tail brands. This means that RAI is now gaining share faster, and seeing uptrading, unlike MO, which is suffering from downtrading within cigarettes.

Financials compared Figure 8 summarizes the difference in financials, both between MO and RAI, and between the recent past and our projections for the future.

Figure 8. MO and RAI’s compound growth rates – We expect improved growth in future years due to benign conditions, with RAI posting slightly better numbers than MO

Compound Growth Rates 2009-14 2016-20E MO Cigarette Volume -2.9% -1.5%

Net Sales1 1.3% 3.0% "Price mix"2 4.3% 4.5% Adj EBIT 4.0% 5.0% Margin Expansion (bps) 90 90 EPS 7.9% 8.3%

RAI Cigarette Volume -5.3% -0.9% Net Sales1 0.1% 4.2% "Price mix"2 5.4% 5.2% Adj EBIT 5.4% 7.3% Margin Expansion (bps) 135 135 EPS 8.1% 9.3%

Note: 2015 excluded due to distortions with RAI.1 Sales excluding excise tax. 2 “Price mix” in this table is the difference between cigarette volume and total net sales growth, so it includes some effects from the both of the companies’ non-cigarette divisions. Source: Company Reports and Citi Estimates.

 For MO, we expect volume growth in 2016-20E to be about 150bps better than it was in 2009-14 because of the improvement in U.S. market volumes. We are assuming price-mix and margin expansion remain pretty much unchanged. As a consequence we expect 3% sales growth (which is 170bps better than the past) and 5% growth in EBIT (which is “only” a 100bp acceleration, because the impact of the 90bps margin change is lower on the higher base). Total EPS growth remains at a bit over 8%, as the higher share price means we forecast less of a kicker from buybacks. However it is important to note that we expect MO to receive about $1.7B aftertax from the ABI transaction, which is likely to be used for buybacks, or possibly a special dividend, and this isn’t in our model.

 For RAI, our volume forecasts step up quite sharply, from -5% to -1%, due mainly to the change in brand portfolio following the Lorillard transaction, as well as our hopes for the market as a whole. As we explain below, we expect more uptrading at RAI, and this means we expect “Price mix” to remain 1 point higher at RAI than at MO, which leads to faster sales growth, and faster margin expansion. All this means we expect about 7% compound EBIT growth at RAI which is about 2 points better than at MO. Our EPS forecast at RAI is only 2 points faster than at MO (and only 1 point better than it was in 2000-14) but it could be that our estimates are conservative.

We prefer to Reynolds to Altria

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Operating differences RAI is now gaining share faster than MO (due to its portfolio of up-and-coming brands and greater exposure to young smokers) and is obtaining much better mix as its fastest growing brands are also its most profitable. By contrast MO is seeing the best growth with Marlboro Special Blend and Blend 72, which generates lower profit per pack than Red and Gold. As a result we have about +1 percentage point more price-mix in for Reynolds for most years than for MO, as well as more margin expansion.

Figure 9. Retail Prices of Key Altria and Reynolds Brands

AltriaBrands Reynolds Brands Avretail price price

Marlboro Red/ Gold $6.62 Natural American Spirit $7.42 Marlboro Menthol $6.55 Newport (menthol) $6.79 Marlboro Special Blend / 72 $5.81 Camel $6.34 L & M $5.35 Pall Mall $5.30

Note: Nationwide Av Retail Price. Source: Company Reports

In addition, we believe MO will suffer greater volatility in quarter-to-quarter EPS following the transition from holding a stake in SAB to holding a stake in ABI.

There are some arguments that go against this preference for RAI, however: MO has less litigation risk (due to historically lower market shares), and it also benefits from the growth of dip more, as its profit per can of dip is considerably higher than RAI’s. Furthermore it has a much smaller percentage of its volumes coming from menthol, and therefore if the FDA ever acted against menthol, it would be the relative winner. Finally, however, there is some chance of RAI being taken over by BAT in due course2, whereas we think there is close to zero chance of a take-over of MO.

Earnings quirks Both companies offer very predictable earnings, but each has a quirk that means we are below consensus for a single period:

 For MO, 4Q16 EPS won’t include a contribution from ABI (assuming ABI completes its takeover of SAB), as the ABI contribution will be reported a quarter in arrears. This has no impact on cash, but it means we our EPS estimate for 4Q ($0.67) is well below consensus ($0.73). MO announced (another) savings program earlier this year, but we view the $300MM savings as safeguarding the EPS outlook as opposed to increasing it.

 For RAI, 2017 will see an increase MSA expense of $250MM. We expect this will be largely offset by increased savings, notably the end of special merger related bonuses (roughly $100 MM we estimate), and the full year impact of the merger cost saves. Nonetheless we think the consensus for 2017 EPS growth (11%) is about 2 ppts too high. However for 2018 and beyond we believe RAI can do at least 9% EPS, vs consensus at around 8%.

2 BAT has owned 42% of RAI since 2004. Both sets of management have said a takeover is possible, but unlikely in the short term.

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We have always argued that macro factors are the biggest single driver of tobacco shares – which means if the market wants to rotate out of, or into, high yield defensives, then the shares will either fall or rise.

That said, we think that interest rates will have less impact on the shares in the next couple of years than some might assume, even if the shares fell on Sept. 9 in response to concerns that the Fed might raise rates faster than previously expected:

 To the extent that increasing interest rates will drive MO and RAI, more risk is now priced in.

 The statistical correlation between MO and RAI, and 10-year Treasury yields has fallen. (Figure 10)

 Even if Treasury yields rise, they are likely to remain way below the dividend yields on these names. One of the reasons we (and our global strategists) like high yielding stocks is precisely that their yield hasn’t fallen in the same way as fixed income yields have – which is why we often show charts like Figure 11. The implication is that if Treasury yields were to rise, the dividend yield on tobacco wouldn’t necessarily rise either. Figure 11 also shows that in Oct 2010 and April 2013, when Treasury yields started to rise, this had little effect on MO.

Figure 12 shows MO’s price vs 10-year Treasury yields (on an inverted scale), and Figure 13 is identical, except it zooms in on the past couple of years. At first glance Figure 13 appears to show a good correlation, but in fact MO rose strongly until October 2015, when yields were roughly flat, and since early July MO has fallen (from almost $70 to $63.5) even though yields have barely moved.

 Citi economists are forecasting only a very modest increase in rates, with 10-year Treasuries’ yield increasing by about 10bps by the end of 2017, to 1.65%. By contrast we are forecasting about 8-9% EPS growth for Altria and Reynolds, and dividend yields of about 4%.

Figure 10. MO’s correlation with 10-Yr Treasury yields has fallen Figure 11. MO’s dvd yield has fallen more than U.S. Treasury yield

US 10Y Treasury Yield, 1.6%

MO dvd yield, 3.7%

MO earnings yield, 4.9%

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Rolling 3-year correlation of daily movements in MO and U.S. 10-yr Treasury yields. RAI’s chart looks almost identical. Source: DataStream

Earnings yield = reciprocal of P/E. Source: DataStream

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What about macro factors? What happens if interest rates go up?

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But as we have said, if the market decides to rotate significantly either into, or away from, defensives, or the dollar moves sharply, this will have a much bigger effect on the stock prices than any tobacco-specific issue. Therefore if an investor has a strong view on rotation, or expects interest rates to rise much faster than Citi does, this will have clear implications for tobacco shares.

Figure 12. MO shares vs 10-Yr Treasuries Yield (Inverted Scale) Figure 13. MO vs 10-Yr Treasuries (since 2014)

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Currently both MO and RAI trade at about 19x 2017 P/E, while PM trades at about 20x.

Consistent increases in multiples These are considerably higher multiples than tobacco stocks have traded at in the past, as Figure 14 and Figure 15 show. Domestic tobacco has benefited from many of the strongest trends in the market in recent years.

 Defensive growth at a time when many cycle and financial sectors are struggling

 High dividend yields (and growing dividends) at a time of low interest rates

 Little or no overseas exposure at a time of dollar strength.

In addition the sector has benefited from consolidation, following the Lorillard takeover.

Figure 14. MO – P/E vs NTM Consensus Figure 15. RAI – P/E vs NTM Consensus

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Source: DataStream Source: DataStream

But we think there may be further to go Despite all this, we believe that the multiples can increase further.

 We have a more-positive-than-consensus view on U.S. tobacco volumes and on the value of U.S. tobacco vs. international, and therefore we believe the multiples on U.S. names should be higher than PM’s

 More generally, tobacco has traded at a discount to other staples historically because of its volume declines and regulatory and litigation risk. However

– Volumes declines have gotten less bad in tobacco, but have not improved in any other sector.

– FDA regulation has turned out to be very favorable for the industry

– Litigation is well understood, and shows absolutely no sign of getting worse in the U.S.

Valuation – there should be further to go

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 The multiples have increased about in line with the more domestically focused HPC names, Church & Dwight and Clorox3.

 Tobacco stocks still look very good value vs. fixed income, and are likely to continue to seeing buying from “bond refugees”.

Figure 16. The increase in MO’s P/E is similar to CHD’s and CLX’s Figure 17. MO’s yield remains attractive relative to fixed income

MO, 20.5

Clorox, 22.9

SJM, 17.8

CHD, 26.0

10 12 14 16 18 20 22 24 26 28 30 MO, SJM, CLX, CHD-- 12M FWD P/E (5 Years)

US 10Y Treasury Yield, 1.6%

MO dvd yield, 3.7%

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Figure 18. Summary P/E multiple for Tobacco stocks Expected Returns P/E based on Latest Price P/E at TargetPrice EPS Price Price Target NTM Dvd Share Price Dvd yield ETR 2016 2017 2018 2017 2018 2016 2017 2018 PM $97.5 $106 4.16 8.7% 4.3% 12.9% 21.6 19.8 18.3 21.6 19.9 4.52 4.92 5.32 MO $63.6 $72 2.44 13.3% 3.8% 17.1% 21.2 19.0 17.6 21.5 20.0 3.00 3.35 3.60 RAI $47.2 $57 1.90 20.9% 4.0% 24.9% 20.3 18.7 17.0 22.6 20.6 2.32 2.52 2.77 BATS £47.0 £54 1.60 15.0% 3.4% 18.4% 19.3 17.3 15.8 19.9 18.2 243.6 270.8 297.1 IMT £39.3 £47 1.55 19.7% 3.9% 23.7% 15.9 14.3 13.5 17.1 16.2 246.9 274.8 290.8

*Fiscal Years to Sept. Share prices as at September 9th close. Source: datacentral, Citi Research

In short, because we believe the U.S. tobacco industry is stronger than it has been for years, and that it has become inherently more attractive than international, we believe that the multiples can rise further, at least as high as PM’s current multiple. We therefore set price targets as follows:

 For MO we set a price target of $72. This assumes that in 12 months’ time, its forward P/E increases slightly, to the level of PM’s. PM is currently trading at about 20x 2017 earnings, and therefore we assume that MO will trade at 20x forward EPS, but in 12 months’ this will apply to 2018 EPS. 20x our 2018 EPS gives a fair value of $72.

 For RAI, we set a price target of $57. This also assumes that its P/E increases, but because we expect both the fastest EPS growth in tobacco (albeit by a small margin), and the least volatile, we believe it should trade at a small premium. We therefore assume that it 12 months’ time it will trade at 20.5x 2018 EPS, which based on our estimates, gives a fair value of $56.8, which we have rounded to $57.

3 At least until CLX’s recent derating.

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Figure 19. MO – P/E Relative Figure 20. RAI – P/E Relative

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We believe that we are more optimistic than consensus on domestic stocks, in a number of areas:

 We believe that U.S. cigarette volumes will hold up quite well. We believe that the main driver of the growth in 2015 was reduced substitution of cigarettes by other products, and that this will continue. By contrast most industry executives are more bearish as they have said 2015 growth was driven in large part by lower gas prices, and these are now rising again. They say they expect volumes to return to -2% to -4% declines this year. We would expect volumes to return to trend in 4-5 years.

 We believe that domestic multiples should be higher than international (in part this is because we are more concerned about litigation outside the U.S. than most). In addition, we think that outside the U.S., next generation nicotine products4are more likely to be a negative than a positive for the industry. In particular we think it is too early to conclude that iQos will be transformative for PM.

 We believe ABI will add volatility to MO’s quarterly earnings.

 On a 20-year view, we are pessimistic about the industry, both inside and outside the U.S.

4 “Next generation nicotine products” includes e-cigarettes and other e-vapor products, and technologies like heat-not-burn. PM’s iQos product is growing rapidly in Japan currently, and showing positive signs in European test markets. To be fair, some e-vapor products don’t contain nicotine, but we would still bundle them up in this category.

We are different because we appear more optimistic than consensus on a 2-3 year view

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Figure 21. MO - Bull Bear Analysis

Source: Citi Research

Altria – Bull Bear Analysis

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Figure 22. RAI - Bull Bear Analysis

Source: Citi Research

Reynolds – Bull Bear Analysis

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Strong trends likely to remain in place

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We are bullish on domestic tobacco We are bullish on the domestic tobacco shares. Partly this is because, in the past 18 months, the U.S. cigarette business has seen extraordinarily strong sales growth, both relative to history, and relative to other sectors. More importantly, we expect demand to stay above historic levels during the rest of the 2016 and in 2017/18, even if it slows down a bit:

 The “total nicotine market” – which combines cigarettes, other tobacco products, smokeless and e-vapor – has been falling only modestly since 2011, we believe, as a result of the very low tax increases.

 Between 2010 and 2014, however, the migration into roll-your-own tobacco (in 2011-12), dip, and more recently e-vapor, have meant that cigarette volumes were falling at 2.3%-4.6% between 2010 and 2014.

 In 2015 the migration has slowed: The recent improvement in demand for cigarettes seems to us to have been driven more by lower substitution of cigarettes by dip and e-vapor than by macro trends and lower gas prices (as the companies say), and we expect the rate of substitution to stay subdued, in part due to FDA regulation of e-vapor.

 Tax and regulation are likely to remain very favorable, and these are the main drivers of demand in the medium term.

– On tax, we see no reason to expect the current benign environment to change, even when the federal Administration changes. Pennsylvania raised SET by $1.00/pack in August and there is a Californian proposal to increase state taxes there dramatically, but even if it passes, we estimate it would reduce national volumes by about 0.6% only. We don’t think the changes to SET herald a change in the tax environment.

– On regulation, it remains extremely hard for rival companies to offer new tobacco products domestically, and the new FDA regulations reduce the threat from next generation nicotine products like e-vapor.

Figure 23. Cigarettes vs Total Nicotine Volume Growth Rates

Cigarette Total Nicotine Market 2011 -3.5% -1.5% 2012 -2.3% -1.2% 2013 -4.6% -1.9% 2014 -3.2% -0.9% 2015 -0.1% -0.7%

Source: RAI Company Reports, except for Citi Ests for 2011-12 Nicotine Market

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Domestic cigarette trends are currently strong Strong relative to history Currently trends in U.S. cigarettes look stronger than they have done for decades, with national volumes falling by less than 1% in both 2015 and 1H16. Pricing also remains solid as Figure 25 shows.

Figure 24. U.S. Cigarette volume growth was almost flat in 2015 Figure 25. Marlboro – Increase in Average Retail Price YoY

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Source: Company Reports (RAI), Note: 1H16 growth rate adjusted for destocking Note: Shows 12 month change from end of period. 2009 distorted by FET increase Source: Company Reports (MO)

Stronger than most other consumer categories currently What is most important for investors is that this improvement in cigarette volumes comes at a time when other categories are seeing no acceleration in demand. Figure 26 shows (again) how domestic volumes of cigarettes have improved since 2007, but it compares this with total beer volumes, where trends remain roughly flat. Figure 27 has the latest Nielsen data and it shows the extraordinary situation whereby cigarette sales trends are now actually better than the trends in food, HPC and CSDs.

Figure 26. Annual Volume Growth in % -- Beer vs Cigarettes Figure 27. Nielsen Growth Rates for Domestic U.S. Demand

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Source: Citi Research, ABI Press release, Euromonitor Note: No aggregate volume and price measure for HPC.

Source: Nielsen, periods to Aug 13, 2016. AOC+C channel.

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All this means that the domestic tobacco companies’ organic sales growth is now outperforming organic sales trends for other categories. This is illustrated in Figure 28, which compares MO’s organic growth in net sales (which is entirely domestic) with the organic sales growth of ABI’s U.S. sales.

Figure 28. MO vs ABI – Organic Sales Growth in U.S. Domestic Sales, 2008-2016E

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Note: ABI: Net sales; MO: Core sales.Source: Company Reports and Citi Research Estimates

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In our view the key explanation of why cigarette sales have improved so much in the past 18 months is that

 The underlying market that cigarettes compete in – the total nicotine market – has been fairly strong since about 2011, thanks to low tax increases; but

 This was hidden by the migration within that market from cigarettes to dip and e- vapor;

 Now the migration away from cigarettes has slowed significantly.

The companies, by contrast, attribute the improvement mainly to better disposable income for blue collar workers. We don’t believe this can be the main explanation, although it surely must have helped, because it can’t explain why tobacco has improved so much more than other sectors.

The market that cigarettes compete in It is extremely difficult to create accurate volume figures for the total market in which cigarettes compete in – which in our view includes roll-your-own, smokeless, and e- vapor, as well as cigarette. Figure 29 shows MO’s estimates of the consumer spending on the market, and we have added our estimate for Pipe and RYO, which is surprisingly important, as it contributes about 6% of the total tobacco volumes.

Figure 29. U.S. Consumer Expenditures, 2014, ($B) Figure 30. Volumes of tobacco products, 2015 (Excludes e-vapor)

Source: Company Reports (MO) and Citi Estimates (for Pipe) Note: Excludes e-vapor. Source: Company reports, TTB and Citi

The declines in volumes in this total nicotine market have been surprisingly modest since 2011 as far as we can tell. This is shown in Figure 31, which combines data from RAI’s latest investor seminar (for 2013 onwards), with our own calculations for 2011 and 2012.

Cigarettes, $73 bn, 87%

Smokeless, $6 bn, 7%

Pipe/RYO, $3 bn, 4%

e-Vapor, $2 bn, 2%

Cigarettes 84%

Little Cigars 0%

Pipe & RYO 6%

MST 9%

Chew 1%

Combustible

Non Combustible

It seems the total nicotine market has been falling at less than 2% since 2011

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Figure 31. The Total Nicotine Market has been falling at less than 2% since 2011, but until 2015, cigarette volumes were worse.

Cigarettes Total Nicotine Market 2011 -3.5% -1.5% 2012 -2.3 -1.2 2013 -4.6 -1.9 2014 -3.2 -0.9 2015 -0.1% -0.7%

Source: RAI Company Reports except for 2011-12 Nicotine Growth Rates which is Figure 33.

Figure 32 shows all the packs in the tobacco categories (but not e-vapor) that are most easily substituted for cigarettes, and Figure 33 shows the implied growth rates. There was a sharp decline in 2009 due to the increase in Federal Excise Tax on all types of tobacco. This tax rise was particularly harsh on little cigars5, which have virtually disappeared, but they favored the growth of pipe tobacco.

Figure 32. U.S. Tobacco Market – Packs of Combustible and Non-Combustible Tobacco Products

Cigarettes Little Cigars Pipe & RYO tob Total Combust MST Chew Non-combust Total Absolute Packs of 20 Packs of 20 Equivalent Cans 3oz Packs Packs “Packs” 2005 19,090 189 490 19,769 924 207 1,131 20,900 2006 18,800 210 494 19,504 993 207 1,200 20,704 2007 17,860 238 515 18,614 1,068 187 1,255 19,869 2008 17,265 274 592 18,131 1,147 177 1,324 19,454 2009 15,787 108 562 16,456 1,170 161 1,331 17,788 2010 15,184 49 711 15,944 1,266 146 1,412 17,356 2011 14,655 40 952 15,647 1,314 131 1,445 17,092 2012 14,323 38 1,026 15,387 1,374 127 1,501 16,888 2013 13,663 31 1,076 14,770 1,430 117 1,547 16,317 2014 13,230 27 1,030 14,287 1,454 114 1,568 15,855 2015 13,215 27 994 14,236 1,483 103 1,586 15,822 Proportion 84% 0% 6% 90% 9% 1% 10% 100%

Source: Company reports (RAI, SWMA) and TTB

Figure 33. Growth in the U.S. tobacco market

% Growth Cigarettes Little Cigars Pipe & RYO Combust MST Chew Non-combust Total 2006 -1.5% 11.1% 0.8% -1.3% 7.5% -0.1% 6.1% -0.9% 2007 -5.0 14 4 -4.6 7.6 -10 4.6 -4.0 2008 -3.3 15 15 -2.6 7.4 -6 5.5 -2.1 2009 -8.6 -61 -5 -9.2 2.0 -9 0.6 -8.6 2010 -3.8 -55 27 -3.1 8.2 -9 6.1 -2.4 2011 -3.5 -18 34 -1.9 3.8 -10 2.3 -1.5 2012 -2.3 -6 8 -1.7 4.6 -3 3.8 -1.2 2013 -4.6 -19 5 -4.0 4.1 -8 3.1 -3.4 2014 -3.2 -11 -4 -3.3 1.7 -3 1.3 -2.8 2015 -0.1% -1% -3.5% -0.4% 2.0% -9% 1.2% -0.2%

Source: Citi Research calculations based on company reports (RAI, SWMA) and TTB

5 Little cigars grew very strongly up until 2008, as they had minimal tax on them. In 2009 however their tax treatment changed and they were treated the same as cigarettes, and these large tax hikes drove sharp volume declines.

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Figure 34 shows how the migration away from cigarettes has fallen. It shows that MST6 used to be growing at about 8% a year, except in 2009 when the increase in federal excise tax caused all tobacco products to slow. However since 2011 the growth in dip has slowed, most recently to about 2-3%. Then in 2013 and 2014 spending on e-vapor products took off, which reduced conventional cigarette volumes materially. More recently, e-vapor growth has slowed again and dip has stayed subdued. This all means that in 2015, cigarette volumes benefited from (1) the weak decline in total nicotine and (2) relatively weak migration into both dip and into e-vapor.

Figure 34. U.S. cigarette volumes have got less bad in 2015/16 as the growth of MST and e- vapor have both slowed

Note: 2009 distorted by the 160% increase in federal excise tax. E-vapor products were negligible before 2010. E- vapor spend increase measured in $ billions. Source: Company Reports and Citi Research Estimates

Why has dip slowed?

We believe the slowdown in dip reflects a number of factors, including (1) the better macro environment (because it is more expensive to smoke than to dip); (2) the growth of e-vapor (because smokers looking for a healthier alternative now have a better solution than dip); and (3) dip may simply be less fashionable that it once was.

6 MST: Moist smokeless tobacco, commonly called “dip”

2006 -1.5% +7% 2007 -5 8 2008 -3 7 2009 -9 2 2010 -4 8 2011 -3 4 $0.2 2012 -2 5 0.2 2013 -5 4 0.8 2014 -3 2 0.7 2015 -0.1% 2 $0.5 1H16 -0.9% +3%

E-Vap Spend Incr.Cigarette Vol Decline MST Vol Increase

n/a

There was migration to non-cigarette products, but that has slowed now

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Macro factors may help explain the improvement in cigarettes vs history, but not vs other categories As we have said, tobacco industry executives attribute the strong cigarette trends to improved disposable income among blue collar workers, partly due to improved macro indications and in particular lower gas prices. They say gas prices are particularly relevant because about 70% of cigarettes are bought at c-stores, and 80% of U.S. c-stores (by numbers) are gas stations.

Figure 35. Cigarette volumes vs average gas prices (absolute) Figure 36. Cigarette volumes vs average gas prices (yoy Change)

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Gas prices in $/gallon, left had side. Quarterly cigarette volumes in billions, right side Source: U.S. Energy Information Administration and RAI company reports.

Change in gas prices left had side; change in cigarette volumes right side. Source: U.S. Energy Information Administration and RAI company reports.

Presumably the macro factors have helped, but even so it is important to note:

1. The better macro situation can’t explain why cigarette trends have improved to a greater extent than other categories, including those that are also biased to blue-collar consumers, like beer

2. We can’t see any real correlation between cigarette volumes and gas prices, in either Figure 35 (which shows the absolute level of cigarette sales and gas prices since 2006) or in Figure 36, which shows the year on year change7.

Of course it is true that the macro environment has improved for cigarettes – with better employment trends, better hourly wages, and low utility and gas bills – and so we assume this has been helpful. But the point we are making is that this can’t explain the difference between tobacco and other sectors.

7 Industry executives we have spoken to argue the oscillation in gas prices around 2008/09 are irrelevant because this is around the time of the financial crisis and the 2009 FET increase. However even if this is right, it seems to us the correlation since 2013 has been weak.

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In tobacco the most important single driver of tobacco volumes is tax, followed by regulation. Both are (and have been) very favorable in the U.S. On tax specifically there has been little change since 2011, and we think this explains why the total nicotine market has declined so little since then. It means the tobacco companies are operating in a benign context, and we expect this to continue.

In the U.S., there has been no increase in Federal Excise Tax (FET) since 2009, and Figure 37 shows that since 2011, State Excise Tax (SET) increases have been very moderate, reflecting the anti-tax mood in the U.S. (particularly in states where smoking rates are highest.)

During calendar 2015, the combined FET and average SET increased by only 2%. In 2016, it will be a little higher than this due to Pennsylvania (which alone increases the average SET by about 3%). However, we don’t think this increase (even combined with California) heralds a change in attitudes to tax in the U.S., so we continue to think the outlook is favorable for the industry.

Figure 37. Average state Excise Taxes have been increased only modestly since 2011

Source: TMA and Company reports

Pennsylvania Pennsylvania increased its SET by $1.00/pack in August. We calculate this will increase the nationwide average SET by about 5¢, and increase the average retail price of Marlboro by 0.8%, which is hardly material.

California In California there is a proposition to increase the state tax by $2.00/pack (from $0.87), to be voted on in November. This alone would add about 13¢ to the average SET, increasing the nationwide average sales price by about 2%. Clearly if the tax increase does pass, it would be unhelpful for the industry, but nonetheless it would not be big enough to alter our thesis on domestic tobacco, because we would expect it to reduce total volumes by only about 0.6% for a single year.

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Tax has been favorable in the U.S. since 2011

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In 2012 there was a similar proposition, and the tobacco industry spent $60 MM on fighting it. Initially the polls showed a larger majority in favor of the tax rise, but in the end the proposal was defeated, by a small margin. This year, up to Sept. 7, the industry has spent $37 MM.

We are not concerned about FET There will be a new Administration (and Congress) in Washington soon, and in theory this could change the tax rate. Nonetheless we are not especially concerned about the outlook on FET:

 Unless the Democrats take control of Congress, there is little reason to suppose the next Administration will be able to raise tobacco taxes because the Obama Administration failed to do so, despite his efforts

 In 2009, the industry was able to grow profits, without significant impact from the one-off, 160% increase in FET.

We would be worried by several years of large increases in FET, but we don’t think this at all likely.

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We think the way the FDA is regulating tobacco is very helpful for the established tobacco companies in the U.S. because it is acting so slowly and cautiously that:

 It is blocking innovation, effectively limiting competition

 It seems unlikely to take any effective action on menthol, which has the potential to threaten the industry, especially Reynolds.

We say the FDA is acting slowly and cautiously because:

 Since 2009, the FDA has resolved about 560 applications for new tobacco products (including components of cigarettes, like new papers), but there are still over 3,000 unresolved applications

 It took 7 years to issue regulations on cigars and e-cigarettes, despite the importance of addressing the health issues of e-cigarettes. Furthermore the approach it adopted is based on a legal reading of an Act of Congress as opposed to a health-led approach

 It frequently misses its own deadlines, usually by many quarters

 On menthol, it has kicked the can down the road, possibly by decades. The FDA has initiated several long-term studies on smoker behavior and menthol, which will take years to complete. In the long-run it is possible that the FDA attempts to ban menthol, but as the evidence will be on the association between menthol and smoking behavior – not on the association between menthol and health – we believe it is more likely that any rules will be on dosage control (but again these could take years to justify).

New regulations on e-vapor likely to be a further boost The newest thing in tobacco is that the FDA has started regulating e-vapor products, as well as cigars, from early August this year.

The FDA has said that existing e-vapor products, despite their health advantages, must apply for retrospective authorization to remain on the market. This may result in many products being removed from the market in a few years.

Companies wanting to launch new products now must apply for permission before they are launched, using the same bureaucratic procedure that is applied to cigarettes.

We think the overall effect of the new rules will be to slow and possibly reverse the growth of e-vapor products in the U.S. Not only is innovation now much, much harder, but because there is now a threat that many existing products may be removed from the market in a few years, this may give manufacturers an incentive to try to boost cash flows (by raising prices and reducing marketing spend) rather than chasing after volumes.

Overall we think the regulations hand a big advantage to RAI and MO. Mainly this is because they are likely to slow and possibly reverse the growth of e-vapor products, thereby helping volumes of conventional cigarettes. Furthermore MO’s and RAI’s greater resources put them at a significant advantage when dealing with the FDA as they develop their own e-vapor products.

FDA regulation also helps the majors

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Although we are relatively bullish on a 2- to 4-year view, we do think that eventually the industry will return to seeing accelerating volume declines. We take this view because the demographics remain unfavorable, with a decreasing number of young people taking up smoking, as is shown clearly in Figure 38.

Figure 38. Percentage of young adults and teenagers who smoke continues to fall

Daily smoking rates. Source: CDC

In the very long-term, the industry relies on extracting cash from that section of the population who consume nicotine. And if that group is a shrinking proportion of the total (and becoming poorer relative to the average), then it is hard to see how profit and cash in the tobacco industry can continue to grow as fast as GDP.

Figure 39. Adult Smoking Rates in the U.S., 1999-1Q15

By Age Group 1999 2001 2003 2005 2007 2009 2011 2013 2014 1Q15 18-24 27.9 26.9 23.9 24.4 22.2 21.8 18.9 18.7 16.7 17.0 25-44 27.3 25.8 25.6 24.1 22.8 24.0 22.1 20.1 20.0 45-64 23.3 23.8 22.2 21.9 21.0 21.9 21.4 19.9 18.0 16.9 65+ 10.6 10.1 9.1 8.6 8.3 9.5 7.9 8.8 8.5 7.5 All Adult (18+) 23.5 22.8 21.6 20.9 19.7 20.6 19 17.8 16.8 15.2

Source: CDC

Figure 40. Smoking Rates by Highest Educational Level.

Decline 2005 2014 Points Percentage

9-11 Grade 32.6% 29.5% 3.1 10% 12 Grade (no diploma) 26.0 25.7 0.3 1% High School Graduate 24.6 21.7 2.9 12% Some College 23.5 19.7 3.8 16% Undergraduate Degree 10.7 7.9 2.8 26% Graduate Degree 7.1 5.4 1.7 24%

Adults, Aged 25+. Source: CDC

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Domestic tobacco is more attractive than international

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Domestic tobacco is a more attractive investment In the previous section we said why we are bullish about domestic tobacco and think the current strong trends will remain for several years.

Beyond this however, we believe that domestic tobacco is a more attractive investment class than international tobacco. At the moment both RAI and MO trade at a discount to PM, whereas we think that over time they should and could trade at a premium to PM, for five reasons:

1. Domestic stocks don’t suffer from FX-related volatility

2. Underlying trends are currently better domestically

3. Taxation and regulation – the main medium-term drivers – are also more favorable domestically

4. Litigation risk is, if anything, lower domestically

5. We see more risks from new technologies outside the U.S.

In addition, we are yet to be convinced that iQos will transform PM’s prospects.

It is certainly true that domestic names have outperformed PM since 2014, howeverour point is that both MO and RAI still trade at a discount as can be seen in Figure 42, and we think that could well change in time, especially if the dollar remains volatile.

Figure 41. Domestic tobacco has outperformed PM since 2014 Figure 42. P/Es of MO, RAI, PM, BATS and S&P, Last 5 Years

MO, 466 RAI, 502

PMI, 284

S&P500, 201

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Investors own tobacco stocks for cash, predictability and some growth. The lack of FX headwinds means that only RAI and MO offer predictability, whereas PM (and BAT, Imperial and JT) will always have FX volatility.

For MO and RAI, EPS growth has been remarkably consistent during the last 7 years unlike PM’s, as Figure 43 shows. PM also reports EPS excluding FX, and on this basis it would have actually outperformed MO and RAI over the period but investors should remember (1) that PM faces higher inflation, and so ongoing FX downgrades are likely, and (2) without the FX downgrades PM would have taken less pricing.

Figure 44 is similar to Figure 43, but it shows EPS as a rolling average, and it shows how all three U.S.-listed tobacco companies have outperformed the S&P.

Figure 43. MO and RAI have reported steady EPS growth, unlike PM Figure 44. PM’s total EPS since the spin has underperformed MO, RAI

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10% 15% 20% 25% 30%

2008 2009 2010 2011 2012 2013 2014 2015

EPS Growth % (2008-15) MO CAGR 8% RAI CAGR 7% PMI CAGR 4% PMI ex FX CAGR 9%

1. Domestic stocks don’t suffer from FX- related volatility

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It may be surprising, but we think tobacco demand is better domestically.

In terms of volumes, Figure 46 shows the international market as a whole continues to fall at a steady 2½%, and shows none of the improvement seen recently in the U.S. (In fact there has been a similar improvement in Europe, but this has been offset by worsening volumes in EMs).

Figure 45. U.S. cigarette volume growth has improved Figure 46. Global cigarette volumes continue to fall at a steady 2½%

-1.5%

-5.0%

-3.3%

-8.6%

-3.8%-3.5% -2.3%

-4.6%

-3.2%

-0.1% -0.9%

-12%

-10%

-8%

-6%

-4%

-2%

0%

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 1H16

US Cigarette Market Volume Growth (yoy)

-0.1%

-1.7% -2.4%

-1.1% -0.7%

-3.3% -2.5% -2.4% -2.5%

-12%

-10%

-8%

-6%

-4%

-2%

0%

Global Cigarette Market Volume Growth (yoy) --excl China and Duty Free

Source: Company Reports (RAI), Note: 1H16 growth rate adjusted for destocking Source: Company Reports (PMI), Note: Volume growth excluding China, U.S., and Duty Free, 2016 estimated by PMI

In terms of pricing the picture is a little more complicated but the conclusion is the domestic companies are obtaining better prices relative to local inflation.

Figure 47. PM’s price-mix vs MO’s Figure 48. Sales weighted CPI inflation for PM

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

2010 2011 2012 2013 2014 2015 1H16

PM MO ( Increase in Core Selling Price) MO (Increase in net selling price)

Source: Pricing data for Smokeable division for MO, Company Reports Source: Company Reports and Haver Analytics

Figure 47 shows the increase in price-mix PM has achieved over time, and compares it to the increase MO has achieved for net and core prices8. In 2011 and

8 The net price excludes excise tax, but includes tax-like government charges like the MSA and FDA payments. The core price excludes both excise tax and similar tax-like charges. See Figure 91.

3.6% 3.9%

4.2%

5.1%

4.4% 4.6% 4.7%

1.5% 2.4% 2.6%

5.0% 3.7%

2.1% 2.5%

0%

1%

2%

3%

4%

5%

6%

2012 2013 2014 2015 2016E 2017E 2018E

CPI inflation -- PM weigthed av. vs U.S. (%) PM US

2. Underlying demand trends are currently better domestically

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2012 PM price-mix that was about 3-4% better than MO’s, but recently MO has been getting more-or-less the same increase in average selling price. However this is before taking into account that PM faces consistently higher inflation (on a weighted basis) than the domestic players, which is what Figure 48 shows.

This higher inflation has the clear implications that

1. PM should be obtaining more price mix than MO and RAI, simply to keep up with inflation, and that

2. Investors should expect this to be offset each year with ongoing (small) FX downgrades

In short, MO is obtaining similar increases in ASP, but suffering from less inflation. We therefore conclude that in real terms MO (and RAI) are obtaining better price increases than PM, as well as decent volumes.

Mix

In the U.S., tobacco is (still) showing positive mix (Figure 50) whereas PM’s mix has been mostly negative in the past few years, (Figure 49), albeit with some improvement in 1H16.This is due to both negative geographic and brand mix.

Figure 49. PM Mix Impact on Organic Sales Growth Figure 50. U.S. Cigarette Market – Premium Mix is improving over time

0.0%

-0.6% -0.3%

1.9%

-0.5%

0.7%

-2.3%

-0.4% -0.5%

0.2% 0.4%

-3%

-1%

1%

3%

72.7%

70.5% 70.2%

70.5% 70.7% 71.2% 71.5%

72.0% 72.2% 71.7%

72.7%

67%

69%

71%

73%

Source: Company reports (Philip Morris) Source: Company reports (Reynolds)

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Not only do we believe that current demand is stronger domestically, we also believe the structure of the market is more attractive, both in terms of tax (which is low and increasing comparatively slowly) and in terms of regulation (which in effect favors incumbents).

Tax – Lower domestically, and shrinking as a % of sales  Figure 51 shows that PM’s total excise tax has risen by $9bn to $47bn since

2008, in a period when net sales rose by only $1bn to $27bn.More importantly, Figure 52 shows that PM’s tax burden has risen from 148% to 176% of net sales.

 Figure 53 shows MO’s Federal Excise Tax burden. It increased from $0.39/pack to $1.01/pack in 2009, but since then hasn’t increased. As a result FET has fallen as a percentage of MO’s net sales since 2010.

 Our preferred measure is core sales however. However even on this measure the trend is the same for MO, with all tax-like charges falling as a percentage of core sales, from 183% in 2010 to 148% in 2015 (Figure 56).This is because, along with stable FET, SET increases have been very moderate since 2011, and MSA and FDA payments increase only at roughly the rate of inflation, not more.

Figure 51. PM total excise tax has risen to $47B vs net sales of $27B

Figure 52. PM’s excise tax burden rose from 146% of sales in 2011 to 176% in 2015

26 25 27 31 31 31 30 27

38 37 41

45 46 49 50 47

0

10

20

30

40

50

60

70

80

90

2008 2009 2010 2011 2012 2013 2014 2015

PMI Excise Tax vs Net Sales (US$ bn) Tax Net Sales

100 100 100 100 100 100 100 100

148 148 149 146 147 156 169 176

0

50

100

150

200

250

300

2008 2009 2010 2011 2012 2013 2014 2015

PM Excise Tax vs Net Sales (net =100)Tax Net Sales

Source: Company Reports Source: Company Reports

3. Domestic industry is structurally more attractive

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Figure 53. MO – Gross Sales vs Net Sales (USD bln) Figure 54. MO - FET as % of Net Sales

16 17 17 17 18 18 18 19

3.4 6.7 7.5 7.2 7.1 6.8 6.6

6.6

0

5

10

15

20

25

30

2008 2009 2010 2011 2012 2013 2014 2015

Federal Excise Tax Net Sales

100 100 100 100 100 100 100 100

22 40 44 43 41 39 37 35

0

20

40

60

80

100

120

140

160

180

2008 2009 2010 2011 2012 2013 2014 2015

Federal Excise Tax Net Sales

Source: Company Reports, Calculated at Group level including Wine and Other Division

Source: Company Reports, Calculated at Group level including Wine and other division

Figure 55. MO – Split of all Tax-like Charges vs Core Sales (USD bln) Figure 56. MO – All Tax-like Charges as % of Core Sales

12 12 12 12 13 13 14

5.0 4.8 4.8 4.9 4.2 4.6 4.5

6.7 7.5 7.2 7.1 6.8 6.6 6.6

8.9 9.4 9.2 9.4 9.4 9.3 9.5

0

5

10

15

20

25

30

35

40

2009 2010 2011 2012 2013 2014 2015

SET FET FDA MSA Core Sales

100 100 100 100 100 100 100

42 41 41 40 33 36 32

57 63 62 58 54 50 47

75 79 79 76 75 71 68

175 183 184 175 163 159 148

0

50

100

150

200

250

300

2009 2010 2011 2012 2013 2014 2015

Core Sales MSA FDA FET SET

Source: Company Reports, Calculated at Group level including Wine and Other Division

Source: Company Reports, Calculated at Group level including Wine and Other Division

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Regulation – More benign in the U.S. than international As we have said earlier in this report, while less important than tax policy, we think the way the FDA is regulating tobacco is helpful for the established U.S. domestic companies, whereas it is generally quite negative overseas.

 In the U.S., tobacco is now entirely regulated by the FDA, a slow and cautious regulator, which thus far has seemed mainly concerned with avoiding litigation. It took 7 years to start to regulate cigars and e-cigarettes.

 The FDA’s rules effectively prevent all innovation, which limits competition and is supportive for the incumbent operators.

This contrasts to international regulation, which is very often much more activist around the health agenda, and takes a different approach to the evidence required for action. As a result, there are increasing rules outside the U.S., such as

 Packaging restrictions: Most major markets outside the U.S. now mandate large, gruesome pictorial health warnings. Beyond this, plain packaging is spreading. It started in Australia, and is due to be implemented in the UK, France, Canada and beyond. Over-time this is all likely to reduce brand equity and accelerate downtrading to low-margin packs

 Bans on flavors in several markets, including on menthol and capsules in the EU (from 2020)

 Bans on smaller pack sizes in the EU, which will increase the minimum purchase price and push up the out-of-pocket expense for poorer smokers. The most notable impact is in the UK, where currently 25% of cigarettes are sold in packs of less than 20, and 70% of RYO is sold in packs of less than 30g, the new minimum sizes. These new minimum sizes, and the new minimum tax from March 2017, mean we expect further pressure on UK volumes and profits.

 Bans on all advertising and displays in stores and price-led promotions.

One quite extreme example of this, which may never be implemented but nonetheless illustrates the issue, is the French health minister’s recent proposal to ban all names that have any positive or non-abstract quality9. This would ban the word “Gold”, in Marlboro Gold,” Lucky” in Lucky Strike, and Imperial’s brands Fortuna, (= luck) and Gitanes (= bohemian in local slang).

However international regulators do not stop innovation in the way the FDA does, and as a result we think next generation products could be a considerable negative for the established industry in the Europe and Japan, whereas we think it poses little risk to the established players in the U.S.

9 The proposal stems from a strict interpretation of an EU directive.

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The fourth reason why we prefer the U.S. domestic names is that we see less risk from litigation. We are well aware this is likely to be quite a controversial view.

In the U.S., litigation occurs but it is well understood. The industry has fought many cases over decades, and the outcomes are reasonably predictable. The Engle progeny cases rumble on, and the industry loses many of the cases, but the awards are small in the context of the profits.

In Canada, by contrast the situation is not well understood. It seems to us that most observers feel the industry will win its cases simply because it has won all the big cases in the U.S. We think this is wrong. There are important cultural differences, but in addition each Canadian province has passed a law that allows the provincial governments (and any Quebec class action) to sue the tobacco companies using much, much lower levels of evidence. In particular:

 The laws make it vastly easier for the courts to blame the companies for smoking, as opposed to holding the smokers responsible for their actions. Under the provincial laws, if a tobacco company ever broke a law, the trial court must assume that smokers can only obtain cigarettes in relevant province because of the companies’ actions. In other words, if a tobacco company has ever broken a law it is no longer the individual’s responsibility that he or she smokes, rather it is the company’s.

 Class action cases do not have to show that any individual member of the class was individually hurt – they can rely on statistical evidence.

We think these laws are quite unfair, but that is beside the point. The Supreme Court of Canada has ruled these laws are constitutional and so they form the basis of the litigation.

Very large damages, but the final decision is several years away

Currently there is a C$16B ruling against the tobacco companies in Canada in the Blais-Le Tourneau case, with the appeal starting in November this year. The outcome will probably not be known for a couple of years, at least.

The industry faces other cases in Canada, most notably the provinces suing the industry for hundreds of billions. The industry is fighting them all the way, but so far it has lost many more battles in Canada than it has won. That said none of these cases will come to court before late next year at the earliest.

Conclusion on Canada litigation

Of course we don’t know if the outcome in Canada will be bad, or when it will come, or whether any other jurisdiction (?New South Wales ?Norway ?Singapore) could copy the underlying legislation. Furthermore it may well be possible to isolate the damages in Canada, so that the parents don’t have to pay the huge damages, if they are awarded. But our point is that the litigation risks outside the U.S. are not well understood – and potentially more burdensome – than the risks within the U.S.

4. Litigation risk is arguably lower in the U.S.

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Tobacco is an attractive industry for investors, despite the declining volumes, because of the exceptionally high, and growing, margins. However, it could well be disrupted by e-vapor, which until now has been a zero (or negative) margin industry. We discuss this at much greater length in the Philip Morris note (Lighting Up), but the key point is that FDA regulation means that innovation in e-vapor will be much harder, slower and more expensive in the U.S. than in Europe, and therefore we see a much greater chance of disruption outside the U.S.

5. We see more risks from new technologies outside the U.S.

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The differences between MO and RAI

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In the last section we explained why we think the two domestic tobacco stocks are more interesting to U.S. investors than the international tobacco stocks, including PM.

In truth the investment cases for the domestic pair – Reynolds and Altria – are very similar, and we would be surprised to see them move in opposite directions. However, of the two we prefer Reynolds because valuations are similar but we believe Reynolds is in a better position to grow earnings and sales faster, because (1) its brands should gain market share faster and (2) it should enjoy positive mix. In addition the conversion of MO’s beer holding from SAB to ABI is likely to increase MO’s EPS volatility, and we think many shareholders will see this as a negative.

That said, RAI has more litigation and menthol risk, and MO benefits from the growth of dip more. Finally, it is worth pointing that BAT has the option to buy the remaining 58% of RAI it doesn’t currently own – although any deal could be a decade away or more.

Figure 57. MO and RAI’s compound growth rates – We expect improved growth in future years due to benign conditions, with RAI posting slightly better numbers than MO

Compound Growth Rates 2009-14 2016-20E MO Cigarette Volume -2.9% -1.5%

Net Sales1 1.3% 3.0% "Price mix"2 4.3% 4.5% Adj EBIT 4.0% 5.0% Margin Expansion (bps) 90 90 EPS 7.9% 8.3%

RAI Cigarette Volume -5.3% -0.9% Net Sales1 0.1% 4.2% "Price mix"2 5.4% 5.2% Adj EBIT 5.4% 7.3% Margin Expansion (bps) 135 135 EPS 8.1% 9.3%

Note: 2015 excluded due to distortions with RAI.1 Sales excluding excise tax. 2 “Price mix” in this table is the difference between cigarette volume and total net sales growth, so it includes the companies’ non-cigarette divisions. Source: Company Reports and Citi Estimates.

Figure 58. MO Tobacco Operating Income 2016E Figure 59. RAI Tobacco Operating Income 2016E

Source: Citi Research Source: Citi Research

Marlboro 73%

Other Cigs 10%

Cigars 2%

Wine 2%

Combustible 90%

Combustible 90%

Combustible 90%

Combustible 90%

Note: Excluding "Other" division

Copenhagen 8%

Skoal & Other 5%

MST 13%

Smokeable 85%

Newport 40%

Camel 21%

Pall Mall 15%

Other 6%

NAS 9%

Grizzly 8%

Other MST 1%

Note: Excluding "All Other" division (negative contribution) and Corporate expenses

Santa Fe 9% Non-

Combustible 9%

Combustible 91%

We prefer RAI (Buy) to MO (Buy)

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One of the key differences between Reynolds and Altria is the market share growth of their core brands. We think that following the change in Reynolds’ brands as a result of the Lorillard transaction, it should grow market share faster than Altria’s.

Cigarettes Over the last 10 years, the brands Reynolds currently own have taken almost 10 ppts of market share10, whereas Altria’s total market share has grown only very modestly. For Reynolds, the key market share drivers have been the recently acquired Newport and Natural American Spirit. Camel has made modest share increases over the 10 years and Pall Mall grew share strongly to 2011, before plateauing. MO on the other hand, has had broadly flat market share, despite modest gains from Marlboro.From here, we see no reason why the share trajectories should materially alter, and would expect Newport and Natural American Spirit continue to take share.

Figure 60. MO’s brands have had relatively stable market share Figure 61. Whereas RAI’s core brands are all growing market share

41.3% 41.8%

42.3% 42.9%

42.8% 43.6%

43.0% 43.6%

43.7% 43.8%

44.0% 44.1%

0%

10%

20%

30%

40%

50%

60% Marlboro Other Premium Discount 50.6% 51.1% 51.4% 51.5%50.4% 50.3

% 49.5%50.3% 50.7% 50.9% 51.3% 51.4%

6% 7% 7% 7% 7%

7% 8% 8% 8% 8% 8%

8%

9% 9% 10% 10% 10% 11% 12%

12% 13% 13% 13% 14% 1% 1%

1% 2% 4%

7% 8% 8% 8% 8% 8% 8%

0% 5%

10% 15% 20% 25% 30% 35% 40%

Newport Camel Pall Mall NAS* Other

23.7% 24.5% 25.1% 25.5%

27.1% 30%

31.9% 31.8%32.9% 33.6% 33.8

% 34.5%

Source: Company Reports Source: Company Reports & Citi Research Estimates

* No NAS share data pre 2010

Menthol Menthol has been growing strongly in the U.S., taking increasing market share of the U.S. cigarette market (Figure 62). Reynolds has been a major beneficiary of this trend, with Newport and Camel taking share within menthol, 7ppts and 10ppts over the last 10 years respectively (Figure 63). Menthol now accounts for 55% of Reynolds’ volumes (FY15), demonstrating how much it benefits from the growth in this category. Menthol makes up a higher proportion of the ASU30 market (49% in FY15) and Reynolds has a higher share of this market (42% vs its 35% total U.S. market share), which should also be supportive for long-term growth. Clearly it would be at risk if the category slows, or if indeed regulation came in, but we aren’t too concerned by the former and think the latter is very unlikely near-term.

10 RAI’s old portfolio – before it acquired Newport -- was very different. See Figure 72.

1. Reynolds brands should grow market share faster

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Figure 62. Menthol Share of U.S. Market Figure 63. Menthol Brands that are driving growth

26% 27% 27% 27%

28% 28% 29%

29% 30%

31% 31% 31%

33% 34%

23%

25%

27%

29%

31%

33%

35%

30.3% 32.5% 33.7% 35.1%

36.2% 37.1% 39.4%

11.4% 14.2% 16.4%

19.4% 20.3% 21.3% 20.9%

1.3% 1.0% 2.9% 4.8%

7.5% 10.8% 11.2%

0%

10%

20%

30%

40%

50%

Newport

Marlboro Menthol

Camel Menthol

Source: Company Reports Source: Company Reports

MST In MST, the broad trends are very similar – MO has had overall flat market share in the last 6 years, whilst RAI has gained about 5ppts. The market share growth for RAI has been driven by a robust performance by Grizzly, increasing its range of product offerings and taking advantage of the fast growth in pouch styles. For MO, Copenhagen has seen strong market share growth, benefitting (like Grizzly) from new product introductions, including Wintergreen Pouches and different Blends. However the overall MST portfolio was flat due to declines in Other and a flat to negative performance in Skoal.

It is important to note, however, in the last three quarters, MO’s Copenhagen brand has gained more market share than Grizzly has, thanks to the national expansion of Copenhagen Mint at retail.

Figure 64. MO’s Copenhagen has been taking share, but overall MST share has been flat

Figure 65. Grizzly has boosted RAI’s market share in MST

22.2% 24.2% 25.7% 27.9%

29.3% 30.7% 31.6% 33.2%

24.8% 23.6% 23.1% 22.5% 21.4% 20.3% 19.7% 18.8%

0%

10%

20%

30%

40%

50%

60%

2009 2010 2011 2012 2013 2014 2015 1H16

Copenhagen Skoal Other

54.3% 55% 54.9% 55.2% 55% 55% 54.9% 55.5%

25.1% 25.1% 26.7%

28.3% 29.5% 30.0%

30.7% 30.7%

0%

5%

10%

15%

20%

25%

30%

35%

2009 2010 2011 2012 2013 2014 2015 1H16

Grizzly Other MST

29.4% 29.2% 30.4% 31.7% 32.6% 32.9%

33.5% 33.3%

Source: Company Reports & Citi Research Estimates Source: Company Reports & Citi Research Estimates

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Another key difference between the two companies is mix. We think Reynolds will enjoy better mix than Altria, and this will show up (over time) with better sales growth and better margin growth.

Mix within cigarettes We think the outlook for RAI’s mix looks much better.

 Altria is seeing trading down, because Marlboro Special Blend and 72 is growing at the expense of full price Marlboro – and Special Blend retails at about an 80¢ discount to Red and Gold.

 By contrast Reynolds is seeing trading up. This is partly because Sante Fe (net sales: $3.58/pack) is growing much faster than RJRT (net sales: $2.58/pack). However within RJRT, there is uptrading, because Newport (retail price: $6.79) is growing, Camel (which is 45¢ cheaper) is stable, and Pall Mall (which is about $1.00 cheaper than Camel) is shrinking.

Figure 66. Retail Prices of Key Altria and Reynolds Brands

AltriaBrands Reynolds Brands Avretail price price

Marlboro Red/ Gold $6.62 Natural American Spirit $7.42 Marlboro Menthol $6.55 Newport (menthol) $6.79 Marlboro Special Blend / 72 $5.81 Camel $6.34 L & M $5.35 Pall Mall $5.30

Note: Nationwide Av Retail Price. Source: Company Reports

Because Reynolds has fundamentally changed since acquiring Newport in June 2015, there is no long time-series to prove that mix has been better over the past few years. However Figure 67 shows the sequential quarterly price points since the acquisition – both in terms of net sales per pack, and in terms of core sales -- and it does support our view that Reynolds is seeing better price-mix

Figure 67. Revenue per Pack shows better progression of the RAI’s than MO’s

3Q15 4Q15 1Q16 2Q16 Total Change Net Price MO smokeable 2.60 2.60 2.63 2.66 +0.06 RJRT 2.49 2.52 2.56 2.58 +0.09 Santa Fe 3.35 3.52 3.63 3.53 +0.17 Core Price MO smokeable 1.92 1.82 1.81 1.88 -0.04 RJRT 1.77 1.83 1.88 1.88 +0.11 Santa Fe 2.72 2.87 3.02 2.87 +0.15

Note: Net sales excludes FET. Core sales excludes FET and also tax-like government charges such as the MSA and FDA expenses. Source: Company Reports and Citi Research Estimates

Mix within MST MST is only about 15% of the companies’ profits. However RAI has seen better price growth since 2013, and this can be seen in Figure 68. It has one core brand – Grizzly – which is sold at a discount to MO’s premium brands. As a result MO has been offering cheaper variants, in particular on Copenhagen, to improve its market share trends.

2. Mix is positive for Reynolds

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Figure 68. In MST, MO’s average net price has grown more slowly than RAI’s

2013 2014 2015 2016E Altria – Net Sales per Can 2.09 2.11 2.15 2.22 Change (yoy %) 1.2% 0.7% 1.9% 3.4% Reynolds– Net Sales per Can 1.60 1.64 1.71 1.80 Change(yoy %) 2.7% 2.3% 4.7% 5.0%

Note: In MST, net price and core price are very close. Source: Company Reports and Citi Research Estimates

Cigarettes vs MST As we have said, we expect RAI to continue obtaining better mix both within cigarettes and within MST. However this is partially offset by the fact that MO benefits more from the growth of MST.

In the past this factor was much more important because MO made so much more EBIT from each pack of dip it sold than each pack of cigarettes, and also because MO’s dip is so much more profitable than RAI’s dip.(In 2013, for example MO made about 30% more from each can of MST than for each pack of cigarettes, whereas RAI made only 18% more.)

However times have changed for both companies because (1) margins have moved up faster in cigarettes especially for RAI, and (2) MST is now growing at only about 2-3% a year, whereas it used to growth at around 8%.

All this means that MO is still advantaged by growth of dip relative to cigarettes, but the advantage is much smaller than previously.

Figure 69. For MO, a can of dip is still more profitable than a pack of cigarettes, but this is no longer true of RAI

2013 2014 2015 1H16 MO EBIT per pack of cigarettes $0.98 $1.08 $1.19 $1.30 EBIT per can of MST 1.30 1.34 1.37 1.49 RAI EBIT per pack of cigarettes 0.77 0.88 1.07 1.21 EBIT per can of MST 0.91 0.92 1.01 1.09

Source: Company Reports and Citi Research Estimates

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Another reason why we prefer RAI is that we believe the transition of MO’s associate from SAB to ABI will increase quarterly EPS volatility, making MO less attractive to those investors who value tobacco’s predictability.

ABI’s proposed takeover of SABMiller means Altria expects to exchange its 430 million shares of SAB (≈27% stake) into 208MM Restricted Shares in the ABI (≈ 10.5% stake) + about $1.7B (after tax), with the transaction expected to close on October 10, 2016. As a result of the transaction (and the synergies it should provide), we expect beer to return to about 11-12% of MO’s overall EBIT, up from 8% in 2015.

There are two (small) risks around the deal:

1. Will it actually close? and

2. Will MO get as much equity as it would like?

On both risks, MO is very likely to get what it wants, according to Andrea Pistacchi, our European Beverages analyst.

 On the first risk, he thinks few investors will vote against the deal, apart from Aberdeen and Vontobel, because it is still attractive in this time of uncertainty (and because many SAB shareholders also own ABI).

 On the second risk he has said he expects few large shareholders will accept the 5-year lockup implied in the Partial Share Alternative, and therefore MO will be able to convert its entire stake into the PSA11

Figure 70. EPS growth for ABI has been much more volatile than SAB’s Figure 71. Proportion of MO’s EBIT from SAB/ABI

-70%

-50%

-30%

-10%

10%

30%

50%

70% ABI EPS Growth SAB EPS Growth

0%

2%

4%

6%

8%

10%

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Source: Company Reports, Citi Research Estimates Not adjusted for 1Q delay in reporting MO’s EPS. Source: Company Reports, Citi

Research Estimates

11 MO (and BevCo) have both said they will elect the PSA, which was designed for them. Under the PSA, each SAB share will swap in £4.6588 in cash and 0.483969 Restricted Shares in ABI. The Restricted Shares will be 1) subject to a 5 year lock-up; 2) be convertible into ABI ordinary shares on a one-for-one basis at the end of the 5 years; and 3) rank equally with ordinary shares with regards to dividends and voting rights. However only a limited number of PSA elections will be allowed, and if substantially more shareholders than the MO and BevCo elect to receive the PSA, their allotment will be scaled back.

3. Increasing volatility for MO from ABI

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However for us the more important point is that ABI’s quarterly EPS is much more volatile than SAB’s was. This can be seen in Figure 70, which compares the historic EPS growth of the two companies. ABI’s EPS has moved ±60% in three of the last nine quarters. Because MO will report ABI’s earnings a quarter in arrears, consensus shouldn’t be blindsided by these moves, unless the earnings that MO incorporates (which is reported under U.S. GAAP) differs materially than the total that ABI reports (under IFRS). Nonetheless, we regard the additional volatility as mildly unhelpful.

So why is ABI’s EPS so volatile? The answer is because it records very large swings in its financial charges line, which mainly reflect marks-to-market for its options.

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As we have said, we believe Reynolds has the best growth outlook and it will offer less volatile earnings. However we have to acknowledge that litigation risk is also higher at Reynolds. This is because litigation risk depends on historic volumes/ market, and in the past the brands for which Reynolds is now responsible had a much larger share.

 The brands which came together to form RAI’s current portfolio (plus the ones it sold to Imperial but for which it remains responsible12) had almost 60% market share in 1985, whereas its total is now down to about 34.5% share.

 By contrast, PM USA’s (Altria’s cigarette subsidiary) share has grown from about 35.9% in 1985 to 51% now.

Figure 72. RAI is now responsible for brands that used to have much higher market shares

Source: Company Reports and Citi Research Estimates

12 Reynolds has given indemnities to both BAT and Imperial, which means Reynolds is responsible for any legal bills generated from historic claims by the brands BAT used to own, but also for the brands that Imperial bought, including Winston, Kool, Salem, Maverick and others. These brands represent a bit under 7% market share.

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Lorillard NAS RJRT American Brands Brown & Williamson RJR

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4. Litigation risk is higher at RAI

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BAT owns 42% of Reynolds, and has done so since RJR merged with BAT’s U.S. subsidiary (Brown and Williamson) in 2004. BAT is an acquisitive company, and eventually we think it is quite likely that it will buy the remaining free float in RAI rewarding shareholders with a takeover premium. (The managements of both companies have said this is an option on several occasions.) However, we think this is unlikely for several years, in part because the dollar is strong. Had BAT wanted to buy RAI, we think it would have made more sense to do it before RAI bought Lorillard.

5. M&A risk at Reynolds

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Altria (MO) Dominant Force in U.S. Tobacco  We initiate with a Buy rating and a $72 price target —We’re bullish on MO

because we’re bullish on U.S. tobacco. The critical driver of earnings in tobacco is pricing. Because MO has over 50% market shares in both cigarettes and smokeless, it can control industry prices in way to suit itself.

 Trends in the U.S. tobacco market are very positive now — We are now in the surprising position where U.S. cigarettes sales are growing faster than sales of food, HPC or CSDs, according to Nielsen. We think cigarette sales growth will remain robust for the next couple of years, as the migration into dip and e-vapor – which was a major drag on volumes in the years to 2014 – is likely to remain subdued. The taxation and litigation environment appears benign. Furthermore, we think the regulatory environment is supportive – the FDA’s rules effectively prevent innovation, which limits competition and is helpful for the tobacco majors.

 The stock has performed well but we think it has further to go — MO has performed extremely strongly since 2014, as MO offers many of the qualities the market is valuing most currently: steady, predictable EPS growth averaging about 8%; a 3½% dividend yield (with growing dividends); and little FX exposure. We think it will rise further, both as it continues to grow earnings over time, and because we the multiple can expand. MO still trades at 0.5-1pt P/E discount to PM, but we think the market will come to see that domestic tobacco is a more attractive investment than international. We are mindful that sector rotation or accelerating interest rate hikes could derail our view, however.

 ABI’s takeover of SAB means 4Q16 EPS will probably miss current consensus although this is not a substantive issue— Assuming ABI does buy SAB, as expected, MO will start reporting the equity income one quarter in arrears, which means for 4Q16 we are expecting just 10 days’ worth of income from beer (about $22MM), not the normal $200MM. Consensus doesn’t appear to have factored this non-cash item in yet, so we forecast $0.67 vs cons at $0.73.

 We expect MO to receive $1.7B cash from ABI (post tax), which may result in an extra buyback or a one off dividend — We expect ABI to end up with about 208MM Restricted Shares in ABI as well. If MO uses the cash to increase its buyback beyond our existing forecast ($1.4B), we would expect a further increase in EPS of about 1%.

Company Focus

Buy Price (09 Sep 16) US$63.56 Target price US$72.00 Market Cap US$124,187M Expected share price return 13.3% Expected dividend yield 3.8% Expected total return 17.1%

EPS (US$) Q1 Q2 Q3 Q4 FY FC Cons 2015A 0.63A 0.74A 0.75A 0.68A 2.81A 2.80A 2016E 0.72A 0.81A 0.80E 0.67E 3.00E 3.07E Previous na na na na na na

2017E 0.76E 0.87E 0.89E 0.83E 3.35E 3.34E Previous na na na na na na

2018E na na na na 3.60E 3.60E Previous na na na na na na

Source: Company Reports and dataCentral, Citi Research. FC Cons: First Call Consensus.

 Initiation of Coverage

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Figure 73. Altria vs PM vs RAI, Last 5 Years (USD) Figure 74. Altria – Consensus EPS

MO, 306 RAI, 324

PMI, 184

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Figure 75. Altria – 12 Month Forward P/E Multiple Figure 76. Altria – P/E Relative to S&P 500

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Figure 77. Altria – Split of Sales, FY16E Figure 78. Altria – Split of Operating Income, FY16E

Source: Company Reports and Citi Research Estimates Source: Company Reports and Citi Research Estimates

Marlboro 70%

Other Cigs 9%

Cigars 3%

Wine 5%

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Wine 2%

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Altria - The Key Charts

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Figure 79. Altria - Financial Summary, FY10-FY20E (US$ in Millions) Profit and Loss 2010 2011 2012 2013 2014 2015 2016E 2017E 2018E 2019E 2020E 5-yr CAGR Sales Excl. Excise Tax 16,892 16,619 17,500 17,663 17,945 18,854 19,428 20,155 20,807 21,382 21,888 3.0% EBITDA 6,842 7,127 7,494 7,684 7,835 8,668 9,337 9,805 10,357 10,867 11,341 5.5% Operating Company Income (Underlying) 6,802 7,150 7,517 7,727 7,888 8,701 9,370 9,852 10,397 10,901 11,368 5.5% Central Costs and Amortization (236) (276) (248) (255) (261) (258) (240) (260) (260) (260) (260) Interest Expense (1,133) (1,216) (1,126) (1,049) (808) (817) (740) (627) (706) (652) (593) SABMiller 628 730 882 991 1,006 757 487 1,089 1,192 1,327 1,464 14.1% Pretax Profit (Underlying) 6,061 6,388 7,025 7,434 7,842 8,470 9,025 10,055 10,623 11,317 11,978 7.2% One-offs (163) (812) (67) 634 (5) (41) (211) (100) (75) (50) (50) Tax (Underlying) (2,088) (2,148) (2,542) (2,671) (2,755) (2,966) (3,156) (3,569) (3,718) (3,961) (4,192) 7.2% Underlying Tax Rate 34.5% 33.6% 36.2% 35.9% 35.1% 35.0% 35.0% 35.5% 35.0% 35.0% 35.0% 0% Net Profit (Underlying) 3,973 4,240 4,483 4,763 5,087 5,504 5,865 6,481 6,901 7,352 7,782 7.2%

Per-Share Data 2010 2011 2012 2013 2014 2015 2016E 2017E 2018E 2019E 2020E 5-yr CAGR EPS (Underlying) 1.91 2.05 2.21 2.38 2.57 2.81 3.00 3.35 3.60 3.87 4.14 8.1% DPS 1.43 1.58 1.70 1.84 2.00 2.18 2.35 2.64 2.86 3.08 3.30 8.6% Av No. Dil. Shares Out 2,079 2,064 2,024 1,999 1,978 1,961 1,952 1,934 1,915 1,897 1,881 -0.8%

Growth Rates (%) 2010 2011 2012 2013 2014 2015 2016E 2017E 2018E 2019E 2020E 5-yr CAGR Sales Excl. Excise Tax 0.4% -1.6% 5.3% 0.9% 1.6% 5.1% 3.0% 3.7% 3.2% 2.8% 2.4% 3.0% Op Cos Income (Underlying) 4.8% 5.1% 5.1% 2.8% 2.1% 10.3% 7.7% 5.1% 5.5% 4.8% 4.3% 5.5% Pretax Profit (Underlying) 6.7% 5.4% 10.0% 5.8% 5.5% 8.0% 6.6% 11.4% 5.6% 6.5% 5.8% 7.2% Net Profit 9.1% 6.7% 5.7% 6.2% 6.8% 8.2% 6.6% 10.5% 6.5% 6.5% 5.8% 7.2% EPS (Underlying) 8.7% 7.5% 7.8% 7.6% 7.9% 9.1% 7.0% 11.5% 7.5% 7.5% 6.8% 8.1%

Margins (vs Sales Excl. Tax) 2010 2011 2012 2013 2014 2015 2016E 2017E 2018E 2019E 2020E 5-yr CAGR Operating Income Margin 40.3% 43.0% 43.0% 43.7% 44.0% 46.1% 48.2% 48.9% 50.0% 51.0% 51.9%

Cash Flow 2010 2011 2012 2013 2014 2015 2016E 2017E 2018E 2019E 2020E 5-yr CAGR Operating Cash Flow 2,767 3,614 3,663 4,375 4,663 5,810 5,313 7,448 7,195 7,593 7,949 6.5% Investing Cash Flow 259 387 920 602 177 (15) 1,622 (100) (100) (100) (100) ~ Capex (168) (105) (124) (131) (163) (229) (177) (180) (180) (180) (180) -4.7% ~ M&A 115.00 0 0 0 (102) 0 1,745 0 0 0 0 Financing Cash Flow (2,583) (3,044) (5,175) (4,702) (4,694) (6,747) (5,528) (6,507) (6,877) (7,244) (7,607) 2.4% ~Dividends (2,958) (3,222) (3,400) (3,612) (3,892) (4,179) (4,574) (5,107) (5,477) (5,844) (6,207) 8.2% ~Buybacks 0 (1,327) (1,082) (634) (939) (554) (965) (1,400) (1,400) (1,400) (1,400) 20.4% Change in Cash 443 957 (592) 275 146 (952) 1,408 841 218 249 242 Free Cash Flow (ex M&A) 2,911 4,001 4,583 4,977 4,942 5,795 5,190 7,348 7,095 7,493 7,849 6.3% Cash and Investments (Yr End) 2,314 3,270 2,900 3,175 3,321 2,369 3,777 4,619 4,836 5,085 5,326 Debt (Yr End) 12,194 13,689 13,878 14,517 14,693 12,919 12,837 12,837 12,837 12,837 12,837 Net Cash/(Debt) (End of Year) (9,880) (10,419) (10,978) (11,342) (11,372) (10,550) (9,060) (8,218) (8,001) (7,752) (7,511) -6.6%

Ratios 2010 2011 2012 2013 2014 2015 2016E 2017E 2018E 2019E 2020E Interest Cover 6.00 5.88 6.68 7.37 9.76 10.65 12.66 15.72 14.72 16.73 19.17 Dividend Payout Ratio 75% 77% 77% 77% 78% 78% 78% 79% 79% 79% 80% Net Debt/EBITDA (x) 1.4 1.5 1.5 1.5 1.5 1.2 1.0 0.8 0.8 0.7 0.7

Historical Multiples 2010 2011 2012 2013 2014 2015 2016E 2017E 2018E 2019E 2020E 5-yr CAGR Historical Average Share Price 22.06 26.50 32.29 35.48 42.09 53.84 63.66 63.56 63.56 63.56 63.56 P/E 11.5 12.9 14.6 14.9 16.4 19.2 21.2 19.0 17.6 16.4 15.4 FCF Yield 6.3% 7.3% 7.0% 7.0% 5.9% 5.5% 4.2% 6.0% 5.8% 6.2% 6.6% Historic EV 48,620 54,828 63,865 65,660 75,224 96,740 113,121 110,081 108,594 107,211 105,918 EV/EBITDA 7.1 7.7 8.5 8.5 9.5 11.1 12.1 11.2 10.4 9.8 9.3

Source: Company Reports and Citi Research Estimates

Financial Summary

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Figure 80. Altria - Divisional Summary, FY10-FY20E (US$ in Millions) Volumes 2010 2011 2012 2013 2014 2015 2016E 2017E 2018E 2019E 2020E 5-yr CAGR Smokeable Products (mn sticks) 1,246 1,246 1,237 1,198 1,271 1,325 1,410 1,480 1,525 1,449 1,376 3.7% Growth Rate -1.0% 0.0% -0.7% -3.2% 6.1% 4.2% 6.4% 5.0% 3.0% -5.0% -5.0% Smokeless Products (Cans and packs) 724 735 763 788 793 814 856 879 901 927 955 2.6% Growth Rate 12.2% 1.4% 3.9% 3.2% 0.7% 2.5% 5.3% 2.6% 2.6% 2.9% 3.0% Wine (Cases 000) 6,681 7,321 7,589 7,972 8,351 8,866 9,360 9,828 10,319 10,835 11,377 4.3% Growth Rate 11.3% 9.6% 3.7% 5.0% 4.8% 6.2% 5.6% 5.0% 5.0% 5.0% 5.0%

Pricing ($) 2010 2011 2012 2013 2014 2015 2016E 2017E 2018E 2019E 2020E 5-yr CAGR Smokeable (Core sales per pack) 1.39 1.46 1.49 1.56 1.68 1.83 1.88 1.98 2.08 2.18 2.29 4.3% Smokeless (Core sales per can) 1.98 2.05 2.05 2.07 2.09 2.13 2.20 2.26 2.31 2.37 2.43 2.1% Wine(Core sales per case) 66.01 67.75 71.16 73.63 74.24 75.34 76.73 77.88 79.05 80.24 81.52 1.3%

Sales Excl. Tax 2010 2011 2012 2013 2014 2015 2016E 2017E 2018E 2019E 2020E 5-yr CAGR Smokeable 14,843 14,917 15,232 15,217 15,523 16,369 16,795 17,380 17,880 18,287 18,612 2.9% Smokeless 1,447 1,519 1,578 1,648 1,671 1,746 1,901 1,996 2,098 2,212 2,335 4.7% Wine 441 496 540 587 620 668 718 765 816 869 927 5.6% Other 161 -313 150 211 131 71 14 14 14 14 14 -36.1% Total Altria 16,892 16,619 17,500 17,663 17,945 18,854 19,428 20,155 20,807 21,382 21,888 3.0%

Op. Cos Income (OCI) 2010 2011 2012 2013 2014 2015 2016E 2017E 2018E 2019E 2020E 5-yr CAGR Smokeable 5,730 6,018 6,271 6,421 6,851 7,599 8,050 8,446 8,894 9,295 9,650 5.4% Smokeless 832 896 959 1,026 1,060 1,112 1,256 1,329 1,411 1,499 1,594 5.9% Wine 83 95 104 118 134 152 163 176 190 206 222 7.3% Other 157 141 183 162 (157) (162) (99) (99) (99) (99) (99) -8.8% Total OCI 6,802 7,150 7,517 7,727 7,888 8,701 9,370 9,852 10,397 10,901 11,368 5.7%

OCI Margin (vs Sales Ex. Tax) 2010 2011 2012 2013 2014 2015 2016E 2017E 2018E 2019E 2020E Smokeable 38.6% 40.3% 41.2% 42.2% 44.1% 46.4% 47.9% 48.6% 49.7% 50.8% 51.8% Smokeless 57.5% 59.0% 60.8% 62.3% 63.4% 63.7% 66.1% 66.6% 67.3% 67.8% 68.3% Wine 18.8% 19.2% 19.3% 20.1% 21.6% 22.8% 22.7% 23.0% 23.3% 23.6% 23.9% Wine 97.5% -45.0% 122.0% 76.8% -119.8% -228.2% -707.1% -707.1% -707.1% -707.1% -707.1% Total OCI Margin 40.3% 43.0% 43.0% 43.7% 44.0% 46.1% 48.2% 48.9% 50.0% 51.0% 51.9%

Source: Company Reports and Citi Research Estimates

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Reynolds American (RAI) Fastest Growth in U.S. Tobacco  We initiate with a Buy recommendation on RAI — We are Buyers of Reynolds

and it is our preferred name among the U.S.-listed tobacco stocks. The backdrop for U.S. domestic tobacco is supportive, and we prefer it to MO mainly because we expect it to generate better EPS and sales growth in the medium term.

 Trends in the U.S. tobacco market are very positive now — We are now in the surprising position where U.S. cigarettes sales are growing faster than sales of food, HPC or CSDs, according to Nielsen. We think cigarette sales growth will remain robust for the next couple of years, as the migration into dip and e-vapor – which was a major drag on volumes in the years to 2014 – is likely to remain subdued. The taxation and litigation environment appears benign. Furthermore, we think the regulatory environment is supportive – the FDA’s rules effectively prevent innovation, which limits competition and is helpful for the tobacco majors.

 RAI is our preferred name — We prefer RAI to MO, because we expect it to grow earnings about 1 ppt faster. Since it bought Newport, and sold many tail brands, it is in a better position to grow volumes as it over-indexes to young adults. In addition, its fastest growing brands (NAS and Newport) are also its most profitable, which should drive better mix and margin growth.

 The stock faces a $250MM increase in MSA costs in 2017, but we expect this to be offset by cost saves — The one short-term headwind is the increased MSA costs next year. We believe the substantial offsets are (1) the end of the special merger-related bonuses (roughly $100MM), and (2) the full-year impact of the cost saves. Nonetheless we think the consensus 11% EPS for 2017 is a little racy. We have 9% in, 2ppts below consensus, but our growth estimates are above consensus for 2018 and beyond.

 Valuation — RAI trades at just under 19x 2017 P/E, vs ~20x for PM. Our price targets assume that RAI can move to about 20.5x, as we think the market will come to see that the U.S. fundamentals have improved, and that domestic tobacco is more attractive than international, in part because it is inherently less volatile. However in 12 months’ this multiple will be applied to 2018 EPS, not 2017.

Company Focus

Buy Price (09 Sep 16) US$47.15 Target price US$57.00 Market Cap US$67,299M Expected share price return 20.9% Expected dividend yield 4.0% Expected total return 24.9%

EPS (US$) Q1 Q2 Q3 Q4 FY FC Cons 2015A 0.43A 0.51A 0.55A 0.48A 1.98A 1.98A 2016E 0.50A 0.61A 0.64E 0.57E 2.32E 2.32E Previous na na na na na na

2017E 0.57E 0.66E 0.69E 0.61E 2.52E 2.58E Previous na na na na na na

2018E na na na na 2.77E 2.79E Previous na na na na na na

Source: Company Reports and dataCentral, Citi Research. FC Cons: First Call Consensus.

 Initiation of Coverage

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Figure 81. Reynolds vs MO vs PM, Last 5 Years (USD) Figure 82. Reynolds – Consensus EPS

MO, 306 RAI, 324

PMI, 184

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Figure 83. Reynolds – 12 Month Forward P/E Multiple Figure 84. Reynolds – P/E Relative to S&P 500

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Figure 85. Reynolds – Split of Sales, FY16E Figure 86. Reynolds – Split of Operating Income, FY16E

Source: Company Reports and Citi Research Estimates Source: Company Reports and Citi Research Estimates

Newport 38%

Camel 20%

Pall Mall 16%

Other 6%

NAS 8%

Grizzly 8%

All Other 3%

Other MST 1%

Santa Fe 8%

Combustible 88%

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Camel 21%

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Grizzly 8%

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Santa Fe 9% Non-

Combustible 9%

Combustible 91%

Reynolds – The Key Charts

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Figure 87. Reynolds - Financial Summary, FY10-FY20E (US$ in Millions)

Profit and Loss 2010 2011 2012 2013 2014 2015 2016E 2017E 2018E 2019E 2020E 5-yr CAGR

Sales Excl. Excise Tax 8,551 8,541 8,304 8,236 8,471 10,675 12,621 13,166 13,783 14,338 14,905 6.9% EBITDA 2,823 2,956 2,994 3,124 3,211 4,560 5,850 6,169 6,682 7,194 7,720 11.1% Operating Income (Underlying) 2,672 2,818 2,863 3,021 3,105 4,438 5,725 6,041 6,551 7,059 7,581 11.3% Net Interest Expense (227) (213) (261) (391) (269) (569) (849) (534) (568) (568) (568) Pretax Profit (Underlying) 2,445 2,605 2,602 2,630 2,836 3,869 4,876 5,507 5,982 6,490 7,012 12.6% One-offs 24 419 649 (111) 574 (2,515) (4,692) 160 160 160 160 Tax (Underlying) (912) (958) (916) (886) (1,005) (1,360) (1,558) (1,928) (2,094) (2,272) (2,454) 12.5% Underlying Tax Rate 37.3% 36.8% 35.2% 33.7% 35.4% 35.2% 32.0% 35.0% 35.0% 35.0% 35.0% Net Profit (Underlying) 1,533 1,647 1,686 1,744 1,831 2,509 3,318 3,580 3,889 4,219 4,558 12.7%

Per-Share Data 2010 2011 2012 2013 2014 2015 2016E 2017E 2018E 2019E 2020E 2015 EPS (Underlying) 1.31 1.41 1.48 1.59 1.71 1.98 2.32 2.52 2.77 3.04 3.32 10.9% DPS 0.92 1.08 1.17 1.24 1.34 1.39 1.80 2.02 1.99 2.18 2.39 11.4% Av No. Dil. Shares Out 1,170 1,171 1,136 1,094 1,070 1,268 1,429 1,418 1,404 1,389 1,375 1.6%

Growth Rates (%) 2010 2011 2012 2013 2014 2015 2016E 2017E 2018E 2019E 2020E 5-yr

CAGR Sales 1.6% -0.1% -2.8% -0.8% 2.9% 26.0% 18.2% 4.3% 4.7% 4.0% 4.0% 6.9% Operating Income (Underlying) 11.4% 5.5% 1.6% 5.5% 2.8% 42.9% 29.0% 5.5% 8.4% 7.8% 7.4% 11.3% Pretax Profit (Underlying) 13.4% 6.5% -0.1% 1.1% 7.8% 36.4% 26.0% 13.0% 8.6% 8.5% 8.0% 12.6% Net Profit (Underlying) 13.3% 7.4% 2.4% 3.4% 5.0% 37.0% 32.2% 7.9% 8.6% 8.5% 8.0% 12.7% EPS (Underlying) 13.1% 7.3% 5.5% 7.4% 7.3% 15.7% 17.3% 8.7% 9.8% 9.6% 9.2% 10.9%

Margins (vs Sales Excl. Tax) 2010 2011 2012 2013 2014 2015 2016E 2017E 2018E 2019E 2020E 5-yr

CAGR Operating Income Margin 31.2% 33.0% 34.5% 36.7% 36.7% 41.6% 45.4% 45.9% 47.5% 49.2% 50.9% RJR Op. Income/1,000 Cigarettes 28.89 32.16 33.34 38.50 43.89 53.73 61.18 63.80 69.59 75.86 82.89

Cash Flow 2010 2011 2012 2013 2014 2015 2016E 2017E 2018E 2019E 2020E 5-yr

CAGR Operating Cash Flow 1,265 1,420 1,568 1,308 1,648 196 517 3,373 3,873 4,213 4,553 Investing Cash Flow (126) 60 (54) (113) (205) (10,005) 5,018 (184) (188) (191) (195) ~ Capex (174) (190) (88) (153) (204) (174) (179) (184) (188) (191) (195) 2.3% ~ M&A - - - - - (10,164) 5,015 - - - - Financing Cash Flow (1,349) (1,714) (971) (2,207) (1,918) 11,438 (7,195) (3,189) (3,569) (4,027) (4,273) ~Dividends (1,049) (1,212) (1,307) (1,335) (1,411) (1,583) (2,423) (2,859) (2,789) (3,027) (3,273) 15.6% ~Buybacks (5) (282) (1,101) (775) (440) (124) (499) (850) (800) (1,000) (1,000) Change in Cash (528) (239) 546 (1,002) (509) 1,601 (1,653) (0) 116 (5) 85 Free Cash Flow (ex M&A) 1,091 1,230 1,480 1,155 1,444 22 338 3,189 3,685 4,021 4,358 Cash and Investments (Yr End) 2,195 1,956 2,502 1,500 966 2,716 4,455 965 1,081 1,076 1,161 (Debt + Settlement Liability) (Yr End) (4,101) (3,663) (5,095) (5,099) (5,083) (17,447) (13,716) (13,692) (14,193) (13,692) (13,692) Net Cash/(Debt) (inc MSA) (Yr End) (1,906) (1,707) (2,593) (3,599) (4,117) (14,731) (9,261) (12,727) (13,112) (12,616) (12,531)

Ratios 2010 2011 2012 2013 2014 2015 2016E 2017E 2018E 2019E 2020E 5-yr

CAGR Interest Cover 11.8 13.2 11.0 7.7 11.5 7.8 6.7 11.3 11.5 12.4 13.3 Dividend Payout Ratio 70% 76% 78% 78% 78% 70% 78% 80% 72% 72% 72% Net Debt/EBITDA (x) 0.7 0.6 0.9 1.2 1.3 3.3 1.6 2.1 2.0 1.8 1.7

Historical Multiples 2010 2011 2012 2013 2014 2015 2016E 2017E 2018E 2019E 2020E 5-yr

CAGR Historical Average Share Price 21.3 23.9 28.7 40.1 49.1 47.1 47.1 47.1 47.1 P/E 10.8 13.1 14.3 15.0 16.8 20.3 21.1 18.7 17.0 15.5 14.2 FCF Yield 6.6% 5.7% 6.1% 4.4% 4.7% 0.0% 0.5% 4.8% 5.6% 6.1% 6.7% Historic EV 18,505 23,245 26,754 29,712 34,805 65,562 79,428 79,603 79,300 78,127 77,355 EV/EBITDA 6.6 7.9 8.9 9.5 10.8 14.4 13.6 12.9 11.9 10.9 10.0

Source: Company Reports and Citi Research Estimates

Financial Summary

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Figure 88. Reynolds - Divisional Summary, FY10-FY20E (US$ in Millions) Volumes (Blns) 2010 2011 2012 2013 2014 2015 2016E 2017E 2018E 2019E 2020E 5-yr CAGR RJR Cigarette Volumes 77.5 73.0 68.9 64.2 61.0 71.3 80.4 79.5 78.2 76.8 75.1 1.0% Growth Rate -5.1% -5.8% -5.6% -6.8% -5.0% 16.9% 12.7% -1.1% -1.6% -1.8% -2.2% Smokeless Volumes 377 405 437 466 479 499 506 514 527 543 560 2.3% Growth Rate 5.7% 7.3% 8.0% 6.5% 2.8% 4.3% 1.4% 1.6% 2.6% 3.0% 3.1% RJR Price per 20 pack 1.90 2.00 2.02 2.10 2.22 2.42 2.60 2.72 2.86 3.02 3.19 5.6% Change in Price 5.6% 5.7% 0.8% 3.7% 5.9% 9.2% 7.5% 4.3% 5.4% 5.5% 5.5%

Sales Excl. Tax 2010 2011 2012 2013 2014 2015 2016E 2017E 2018E 2019E 2020E 5-yr CAGR RJ Reynolds Tobacco 7,350 7,317 6,960 6,728 6,767 8,634 10,466 10,798 11,200 11,603 11,969 6.8% Santa Fe - 416 486 572 658 818 961 1,107 1,243 1,383 1,525 13.3% American Snuff 719 648 681 745 783 855 907 945 1,008 1,069 1,130 Other 482 160 177 191 263 368 287 316 331 282 282 -5.2% Total RAI Sales 8,551 8,541 8,304 8,236 8,471 10,675 12,621 13,166 13,783 14,338 14,905 6.9%

Operating Income 2010 2011 2012 2013 2014 2015 2016E 2017E 2018E 2019E 2020E 5-yr CAGR RJ Reynolds Tobacco 2,239 2,348 2,297 2,472 2,677 3,831 4,917 5,072 5,442 5,828 6,226 10.2% Santa Fe 0 187 237 280 337 448 523 599 678 759 842 13.5% American Snuff 374 346 379 424 442 503 543 570 611 652 692 6.6% Other 140 29 11 (70) (234) (265) (157) (100) (80) (80) (80) Corporate Expenses (95) (92) (61) (85) (117) (79) (102) (100) (100) (100) (100) 4.8% Total RAI Adj EBIT 2,672 2,818 2,863 3,021 3,105 4,438 5,725 6,041 6,551 7,059 7,581 11.3%

Operating Margins 2010 2011 2012 2013 2014 2015 2016E 2017E 2018E 2019E 2020E RJ Reynolds Tobacco 30.5% 32.1% 33.0% 36.7% 39.6% 44.4% 47.0% 47.0% 48.6% 50.2% 52.0% Santa Fe - 45.0% 48.8% 49.0% 51.2% 54.8% 54.5% 54.1% 54.5% 54.9% 55.2% American Snuff 52.0% 53.4% 55.7% 56.9% 56.4% 58.8% 59.9% 60.3% 60.7% 61.0% 61.3% Other 29.0% 18.1% 6.2% -36.6% -89.0% -72.0% -54.7% -31.7% -24.1% -28.4% -28.4% Total RAI Margin 31.2% 33.0% 34.5% 36.7% 36.7% 41.6% 45.4% 45.9% 47.5% 49.2% 50.9%

Source: Company Reports and Citi Research Estimates

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1. U.S. market share data

Figure 89. Reynolds Market Share RAI 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 1H16 Newport 8.8% 9.2% 9.6% 9.9% 10.3% 10.9% 11.9% 12.0% 12.6% 12.9% 13.4% 13.9% Camel 5.9% 6.6% 7.0% 7.3% 7.2% 7.4% 7.5% 7.5% 7.8% 8.2% 8.2% 8.2% Pall Mall 0.6% 0.9% 1.2% 1.7% 3.8% 6.5% 7.6% 7.7% 8.1% 8.1% 7.8% 7.8% NAS* 0.7% 0.9% 1.1% 1.3% 1.5% 1.9% 2.1% Other 8.4% 7.8% 7.3% 6.6% 5.8% 4.5% 4.0% 3.5% 3.1% 2.9% 2.6% 2.4% Total Cigarettes 23.7% 24.5% 25.1% 25.5% 27.1% 30.0% 31.9% 31.8% 32.9% 33.6% 33.8% 34.5%

Grizzly 15.8% 19.2% 20.9% 23.1% 25.1% 25.1% 26.7% 28.3% 29.5% 30.0% 30.7% 30.7% Other MST 5.7% 4.9% 4.2% 4.6% 4.3% 4.1% 3.7% 3.4% 3.1% 2.9% 2.8% 2.6% Total MST 21.5% 24.1% 25.1% 27.7% 29.4% 29.2% 30.4% 31.7% 32.6% 32.9% 33.5% 33.3%

Source: Citi Research Estimates, Company Reports * NAS data not available pre-2010

Figure 90. Altria Market Share MO 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 1H16 Marlboro 41.3% 41.8% 42.3% 42.9% 42.8% 43.6% 43.0% 43.6% 43.7% 43.8% 44.0% 44.1% Other Premium 4.9% 5.0% 5.0% 4.7% 4.2% 3.7% 3.5% 3.2% 3.1% 2.9% 2.8% 2.7% Discount 4.4% 4.3% 4.1% 3.9% 3.4% 3.0% 3.0% 3.5% 3.9% 4.2% 4.5% 4.6% Total Cigarettes 50.6% 51.1% 51.4% 51.5% 50.4% 50.3% 49.5% 50.3% 50.7% 50.9% 51.3% 51.4%

Copenhagen 22.2% 24.2% 25.7% 27.9% 29.3% 30.7% 31.6% 33.2% Skoal 24.8% 23.6% 23.1% 22.5% 21.4% 20.3% 19.7% 18.8% Other 7.3% 7.2% 6.1% 4.8% 4.3% 4.0% 3.6% 3.5% Total MST 54.3% 55.0% 54.9% 55.2% 55.0% 55.0% 54.9% 55.5%

Source: Citi Research Estimates, Company Reports

Appendix

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Figure 91. Price Breakdown of U.S. Cigarette (1H16)

Operating Profit, 1.26

SG&A, 0.26 COGS, 0.28

FDA Fees, 0.05 Settlement Payments, 0.77

Federal Excise Tax, 1.01

State Taxes, 1.55

Wholesaler Margin, 0.18

Retailer Margin, 0.85

0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

Core Sales

$1.81

Net Sales

$2.63

Reported Sales

$3.63

Retail Price

$6.21

Source: Company Reports and Citi Research Estimates

Other companies mentioned: (BATS.L; £46.96; 1); (IMB.L; £39.25; 1); (PM.N; US$97.54; 2); (SJM.N; US$135.93; 1); SABMiller (SAB.L; £43.84; 2); (ABI.BR; €111.05; 1)

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Altria Company description Altria dominates the US tobacco industry, with about a 51% share on the cigarette market and a 55% share of the MST sector. About 73% of profit comes from Marlboro, which has a 44% market share in cigarettes, and about 13% of profit comes from smokeless tobacco, via the brands Copenhagen and Skoal. About 10- 12% of profit has historically come from beer, via MO’s 27% stake in SABMiller. ABI is taking over SAB, and assuming the takeover goes ahead, beer will still generate a similar proportion of MO’s earnings, but it will end up with a roughly 10.5% stake in ABI. Altria has no tobacco operations outside the US, as Philip Morris International was spun off in 2008. Investment strategy We have a Buy rating on MO as we think the fundamentals for the US domestic tobacco sector are supportive. Demand is stronger than it has been for decades, and there is a relatively benign taxation, regulation and litigation environment. The business is more diversified than its nearest peer, (due to MO’s exposure to beer and wine), however we expect the contribution to earnings from ABI will increase MO’s overall earnings volatility. Valuation Our target price of $72 assumes that in 12 months’ time the stock trades at 20x forward P/E, but at that point it will be applied to 2018 EPS. Our target multiple is fractionally higher than MO currently trades at, but it is roughly in line with PM’s multiple. PM has historically traded at a premium, but we believe MO should close the gap because the very strong fundamentals in the US are likely to mean that investors come to see domestic tobacco as being a fundamentally a more attractive investment proposition than international. Risks The following risks could affect Altria’s share price:

 Market Risk – Tobacco stocks move up or down in large part due to sector rotation. This means the stock may rise above our target price, or fall below it, depending on whether the market rotates into or away from defensives.

 Taxation – While we think this is unlikely, several years of large increases in FET would be a negative. In California there is a proposition to increase the state tax by $2.00/pack (from $0.87), to be voted on in November.

 Regulation – At present the way the FDA regulates is relatively supportive for the tobacco majors, however this could change.

 Litigation – Although we are quite relaxed at present about US litigation, the threat could worsen, or get less bad.

 SAB acquisition – We expect ABI to buy SAB. However it is possible that the deal doesn’t complete. Furthermore, if the acquisition does go ahead, the proportion of ABI’s stock could be lower than we expect.

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 ABI – Assuming the deal goes ahead as we expect, about 10% of earnings will come from ABI. MO could also suffer from large volatility in quarter-to-quarter EPS due to this stake.

If the impact of these risk factors is more negative or more positive than we currently expect, the share price may not reach our target price, or it may exceed it.

Reynolds American Company description Reynolds American is the second-largest tobacco company in the US, with about a 35% share of the cigarette market and 33% share of smokeless. It was formed from a number of mergers and acquisitions over the years and has three main divisions: 1) R.J. Reynolds Tobacco, which contributes about 82% of group operating profit and comprises of Newport, Camel and Pall Mall, plus a series of small cigarette brands. 2) Santa Fe Natural Tobacco (9% of operating profit) which sells Natural American Spirit cigarettes. 3) American Snuff (9% of profit) which sells smokeless tobacco (Its main brand is Grizzly). It also owns Vuse, the No1 brand in e- cigarettes. British American Tobacco, the no.2 international tobacco company, holds a 42% stake in Reynolds. Investment strategy We have a Buy rating on Reynolds. The backdrop for US domestic tobacco is supportive, with demand stronger than it has been for decades, and a relatively benign taxation, regulation and litigation environment. We expect it to generate the best sales and earnings growth of any major US tobacco company, due to market share gains and (driven by its portfolio of up-and-coming brands) and because it is obtaining much better mix as its fastest growing brands are also its most profitable. Valuation Our price target for Reynolds is $57, based on P/Es. Its tobacco peers currently trade at about 19-20x forward earnings. We expect Reynolds to generate both the fastest EPS growth within the U.S. tobacco sector (albeit by a small margin), and the least volatile, so we believe it should trade at a small premium. We therefore assume that it will trade at 20.5x, slightly higher than where it is now, and a lsight premium to its peers, but in 12 months’ time this will be based on 2018 EPS. Given our fractionally-above consensus estimates, this implies fair value of $57. Risks The following risks could affect RAI’s share price:

 Market Risk – Tobacco stocks move up or down in large part due to sector rotation. This means the stock may rise above our target price, or fall below it, depending on whether the market rotates into or away from defensives.

 Taxation – While we think this is unlikely, several years of large increases in FET would be a negative. In California there is a proposition to increase the state tax by $2.00/pack (from $0.87), to be voted on in November.

 Regulation – At present the way the FDA regulates is relatively supportive for the tobacco majors, however this could change. If it decides to take more action

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on menthol for example, this would be particularly negative for Reynolds, as very roughly half its cigarette volumes are mentholated.

 Litigation – Although we are quite relaxed at present about US litigation, the threat could worsen, or get less bad. Reynolds has the greatest litigation risk among all tobacco stocks because the potential liability depends on historic volumes, and in the past the brands for which Reynolds is now responsible had a much larger share than they do now. Reynolds has also given indemnities for the brands it has sold to Imperial Brands.

 M&A – Currently BAT owns 42% of Reynolds. It is possible that BAT could bid for the rest of the company, potentially helping the shares materially, or even sell down the stake, hurting the shares.

If the impact of these risk factors is more negative or more positive than we currently expect, the share price may not reach our target price, or it may exceed it.

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Appendix A-1 Analyst Certification The research analysts primarily responsible for the preparation and content of this research report are either (i) designated by “AC” in the author block or (ii) listed in bold alongside content which is attributable to that analyst. If multiple AC analysts are designated in the author block, each analyst is certifying with respect to the entire research report other than (a) content attributable to another AC certifying analyst listed in bold alongside the content and (b) views expressed solely with respect to a specific issuer which are attributable to another AC certifying analyst identified in the price charts or rating history tables for that issuer shown below. Each of these analysts certify, with respect to the sections of the report for which they are responsible: (1) that the views expressed therein accurately reflect their personal views about each issuer and security referenced and were prepared in an independent manner, including with respect to Citigroup Global Markets Inc. and its affiliates; and (2) no part of the research analyst's compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by that research analyst in this report.

IMPORTANT DISCLOSURES

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Due to Citi's involvement in the acquisition of Lorillard Inc by Reynolds American Inc also involving British American Tobacco Plc (the "Company") and Imperial Tobacco Plc, Citi Research restricted publication of new research reports, and suspended its rating and target price on 15th July 2014 (the "Suspension Date”). Please note that the Company price chart that appears in this report and available on Citi Research's disclosure website does not reflect that Citi Research did not have a rating or target price between the Suspension Date and 20 July 2015 when Citi Research resumed full coverage. Due to Citi's involvement in the acquisition of Lorillard Inc by Reynolds American Inc also involving British American Tobacco Plc and Imperial Tobacco Plc (the Companies”), Citi Research restricted publication of new research reports, and suspended its rating and target price on 15th July 2014 (the Suspension Date”). While Citi Research may continue to publish research on the British American Tobacco Plc and Imperial Tobacco Plc, it will not express a view about the proposed transaction, nor will its financial model(s) take into account the transaction. Additionally, British American Tobacco Plc and Imperial Tobacco Plcs’ price charts available on Citi Research's disclosure website are current only through the Suspension Date and, accordingly, does not reflect that Citi Research suspended its rating and target price on the Suspension Date. Due to Citigroup Global Markets Limited's involvement as advisor to Affinity Equity Partners and KKR in relation to the sale of Oriental Brewery Co Ltd to AbInbev, Citi Research restricted publication of new research reports and suspended its rating and target price on ABInbev on 20th January 2014 (‘the Suspension Date’). Please note that the Company price chart that appears in this report and available on Citi Research's disclosure website does not reflect that Citi Research did not have a rating or target price between the Suspension Date and the 11th February 2014,when Citi Research resumed full coverage. A director of Citi serves on the board of Reynolds American Inc. Citigroup Global Markets Inc. owns a position of 1 million USD or more in the debt securities of Reynolds American Inc Citigroup Global Markets Inc. owns a position of 1 million USD or more in the debt securities of Philip Morris International Inc Citigroup Global Markets Inc. owns a position of 1 million USD or more in the debt securities of Altria Group Inc Citigroup Global Markets Inc. or its affiliates beneficially owns 1% or more of any class of common equity securities of SABMiller. This position reflects information available as of the prior business day. Citigroup Global Markets Inc. or its affiliates has a net long position of 0.5% or more of any class of common equity securities of SABMiller. Citigroup Global Markets Inc. or its affiliates beneficially owns 2.0% or more of any class of common equity securities of SABMiller. Within the past 12 months, Citigroup Global Markets Inc. or its affiliates has acted as manager or co-manager of an offering of securities of British American Tobacco PLC, AB-InBev, Philip Morris International. Citigroup Global Markets Inc. or its affiliates has received compensation for investment banking services provided within the past 12 months from British American Tobacco PLC, SABMiller, Imperial Brands PLC, AB-InBev, Reynolds American, Philip Morris International, Altria. Citigroup Global Markets Inc. or its affiliates expects to receive or intends to seek, within the next three months, compensation for investment banking services from AB-InBev. Citigroup Global Markets Inc. or an affiliate received compensation for products and services other than investment banking services from British American Tobacco PLC, SABMiller, Imperial Brands PLC, AB-InBev, Reynolds American, Philip Morris International, Altria in the past 12 months. Citigroup Global Markets Inc. currently has, or had within the past 12 months, the following as investment banking client(s): British American Tobacco PLC, SABMiller, Imperial Brands PLC, AB-InBev, Reynolds American, Philip Morris International, Altria. Citigroup Global Markets Inc. currently has, or had within the past 12 months, the following as clients, and the services provided were non-investment- banking, securities-related: British American Tobacco PLC, SABMiller, Imperial Brands PLC, The J.M. Smucker Company, AB-InBev, Reynolds American, Philip Morris International, Altria. Citigroup Global Markets Inc. currently has, or had within the past 12 months, the following as clients, and the services provided were non-investment- banking, non-securities-related: British American Tobacco PLC, SABMiller, Imperial Brands PLC, AB-InBev, Reynolds American, Philip Morris International, Altria.

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Citigroup Global Markets Ltd Adam Spielman; Jemima Benstead; Andrea Pistacchi Citigroup Global Markets India Private Limited Ravi Sharma Citigroup Global Markets Inc David Driscoll, CFA

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