Tobacco typically has been considered a more defensive industry and as such it does not lend itself to high growth rates. However Wells Fargo sees more growth in the future for this industry, according to its most recent “Tobacco Talk” survey.

Industry cigarette (cig) volume has been surprisingly strong and the pricing momentum is likely to be continued in the first quarter. Wells Fargo recently conducted a survey of its tobacco retailer and wholesaler contacts representing about 36,000 convenience stores in United States.

According to the survey, there are several dynamics contributing to moderating smokeless category growth. First of all, consumers are “up trading” to combustible cigs, and the Price/Value proposition of smokeless relative to cigs is less attractive than it used to be — or is “getting out of line with combustibles” according to one contact. There are more non-combustible options than ever before, including e-cigs and vapor competing for smokers that are seeking alternatives. Another contact said that it is difficult to keep cycling robust smokeless category growth forever, but “eventually all categories hit terminal velocity.”

However the survey results also detailed how the overall combustible cig environment remains robust:

• Strong manufacturer net price realization of around +7% in the first quarter driven by lower promotional spend and a positive mix shift to premium brands given a stronger tobacco consumer.
• A cigarette list price increase of $0.07 per pack is expected in mid-May, led by Phillip Morris USA.
• Wells Fargo expects surprisingly strong cig volume with a decline of “only” 3% despite an “easy” comp of -2.7% shipment volume in the first quarter of 2014.
• Moderating vapor category growth and high dual use.

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Separately, given the continued strong fundamentals, Wells Fargo expects manufacturers should all report low double-digit first-quarter earnings per share (EPS) growth. The firm remains very bullish on U.S. tobacco given the way the stars are aligned. Wells Fargo reiterated an Overweight rating for the sector. Reynolds American Inc. (NYSE: RAI) $75.62) remains the top sector stock pick.

One of the key takeaways from Wells Fargo’s report was that the firm recently reached out to several of its industry trade contacts to get a sense of cigarette, smokeless and other tobacco products category trends during the first quarter of 2015 as well as current brand dynamics and the state of the overall U.S. tobacco industry.

Wells Fargo believes that the industry is entering its next generation of growth as reduced risk or vapor products will accelerate combined profit pool growth over the next decade. Five key tailwinds include:

• Stronger pricing power driven by a strengthening consumer with greater disposable income, particularly lower-income consumers.
• U.S. tobacco companies are insulated from volatility driven by forex risk and emerging markets.
• Fundamentals, especially pricing, are the strongest they have been in recent history and should continue to improve.
• Multiple cost savings levers.
• Upside potential from e-cigs/vapor, esp. as they generate profitability this year. Further, the analysts believe the Reynolds-Lorillard deal will benefit the industry, ultimately driving even greater manufacturer pricing power.

Reynolds American shares were down 1.5% Wednesday, at $74.51 on a 52-week trading range of $53.17 to $76.23. The stock has a consensus analyst price target of $77.17.

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