Comparing Two Magic Formula Tobacco Stocks
Tobacco stocks have been a staple of Magic Formula Investing® (MFI) since the formula was invented by Joel Greenblatt over 7 years ago. Over that time, all of the major, publicly traded domestic tobacco firms - Altria (MO),Reynolds American (RAI), and Lorrilard (LO)- have entered the formula at one time or another. And other, foreign focused firms such as Philip Morris International (PM) have had the statistical profile of a "Magic Formula" stock.
Today, there are two - Lorillard and Vector Group (VGR). Are either worth looking into as a potential investment? And if so, which of the two is better?
The Domestic Tobacco Industry
The manufacture and sale of cigarettes has historically been a great business, all else aside. Cigarettes are consumables, purchased over and over again, and their habit-forming properties have generated reliable sales and cash flows for producers, through good times and bad. Although volume growth in the U.S. died out over 30 years ago, "big tobacco" has been able to generate very good shareholder returns via price increases, product line extensions (particularly smokeless tobacco), and most importantly, voluptuous dividend payments and share buyback programs. In fact, from the 1950's through 2003, the single best-returning S&P 500 stock was that of Philip Morris, now Altria.
As in most consumer products, brand is the strongest competitive advantage here. Smokers are usually loyal to their brand, and it is difficult for non-established brands to get off the ground given the choking restrictions on marketing of smokes. This leads to another important factor - barriers to entry are immense. With a declining volume outlook, heavy regulation, and a very consolidated market (Altria, Reynolds, and Lorillard control 85% of the market), no new company in their right mind is going to enter the cigarette game.
All this said, the industry continues to face a lot of challenges. Volume declines have averaged about 3% a year, and fell 2.2% in 2012. This will likely continue, as more people become conscious of the health risks of smoking, increasing laws banning smoking in public places, much higher cigarette prices (due to both dramatically higher excise taxes and manufacturer pricing), and diminishing social acceptance of the habit.
Two other regulatory challenges remain over the industry. The Master Settlement Agreement (MSA) of 1998 was the final agreement from the litigation wars of the 1990's, requiring the 3 largest cigarette makers to make settlement payments to the states totaling over $9 billion a year. And in 2009, the Food and Drug Administration (FDA) was given the power to regulate the industry, and immediately raised concerns with its proposed "graphic image" warnings(since shelved) and threat to ban menthols.
Lorillard and Vector
Lorillard and Vector have quite different profiles, despite both being in the same business. Lorillard sits squarely in the "premium" segment of the market, with its flagship Newport brand the most popular menthol cigarette in the U.S. (almost 40% of the category, and 12% of overall cig sales). The company is the third largest cig maker, at just under 13% market share, and has actually been gaining market share as menthols became more popular - it held under 8% of the market 10 years ago. Lorillard is the only big tobacco firm to increase volume over the past 6 years, in the face of U.S. stick volumes declining over 20%. Finally, Lorillard is also forward looking, acquiring electronic cigarette maker Blu in 2012 and quickly ramping it up to a nearly $300 million run rate for 2013. While this would represent only 5% of sales, this is an important forward-looking market that is growing at 40% sequential (not year-over-year) rates, and one that Lorillard is establishing impressive 40% market share in.
Vector Group is a different story. The firm is strictly active in the value segment of the category, selling down-market brands such as USA, Pyramid, Grand Prix, Liggett, and Eve. Vector is the 4th largest cigarette maker, although with a tiny market share of 3.5%. The one thing the firm has is substantially lower payments under the MSA, which gives Vector an important cost advantage over the "big 3" who also compete on the discount shelf.
Let's make this simple - operationally, there is no question that Lorillard is a far better pick. Newport smokers are extremely loyal, menthol continues to grow as a percentage of the market, and the eCig business is a foothold to the future. Vector, on the other hand, has little brand loyalty and is getting squeezed on costs by excise taxes and on pricing by competition. In the most recent quarter, Lorillard's volumes fell just 2.3% while Vector suffered a 7.7% decline.
Checking the Numbers
A quick examination of the financials paints a similar story. Lorillard's debt-to-cash ratio at about 3:2 ($3.1 billion to $2 billion) is far better than Vector's stretched 2:1 ($880 million to $440 million). Lorillard's operating margins are 31% - Vector's, 15.4%. Free cash flow margins, maybe the most important number of all, are striking. Lorillard generates a very solid 17.5% of revenues as free cash flows, while Vector's figure is just over 5%. However you look at it, Lorillard runs a far better business.
Surprisingly, this even extends to valuation. When accounting for cash and debt, and backing out non-operating items (of which VGR has a ton), Lorillard is actually cheaper at an earnings yield of 11.1%, vs. 8.9%.
Vector Group does win one comparison that a lot of investors care deeply about - dividend yield. At a nearly 10% yield, VGR nearly doubles LO's 5%. However, for many years now that firm has paid out far more in dividends than it has generated in free cash flow. The dividend has been fueled by new debt - long-term debt has more than doubled over the past 5 years. On the other hand, Lorillard funds its dividend purely with free cash flow, although payout ratio is pretty high at over 70%.
Packing It Up
Clearly, Lorillard is easily the better pick of the two. But is it a good pick, period?
Assuming Lorillard continues its historical norms of 4-6% share buybacks, modest dividend increases, and generally steady revenues (from price hikes, share gains, and eCigs), I see Lorillard as worth about $47 per share. With the current share price in the low $43's, that's only about 15% margin-of-safety, not enough for me given the poor industry outlook and still-hairy regulatory environment. It is not a candidate for our Top Buys list at this time. I'd like to see Lorillard get into the mid-$30's before getting interested.
Disclosure: Steve owns no stocks referenced here.