Magic Formula Stock Review: Lorillard (LO)
Lorillard is the third largest cigarette producer in the United States. The company was spun off from conglomerate Loews (L) back in June of this year. Lorillard's golden asset is the Newport menthol cigarette brand. Newport has a market share of close to 35% in the menthol cigarette category, which is good enough to earn Lorillard a 10% total market share, behind only Altria (MO) and Reynolds American (RAI) in the U.S. Newport accounts for over 90% of sales, but the company also produces other, non-menthol branded cigarettes under the names Kent, Satin, True, and Max. Old Gold and Maverick brands round out the portfolio on the discount rack.
Lorillard reminds me a lot of a similar company I reviewed earlier this year: UST. UST has a lot of parallels to Lorillard. That company dominated the smokeless tobacco category with premium brand Copenhagen, similar to Newport. UST was in good financial shape and paid a generous dividend, like Lorillard (over 6.8% currently). However, I though UST had too few growth opportunities and that the price was not low enough given that fact. My final opinion of Lorillard falls almost exactly along those lines. Of course, a few months later UST was purchased by Altria at a 35% premium, so take that for what it's worth!
Newport is one fantastic asset. The brand has been steadily taking market share from competitors like Altria's Marlboro Menthol, and Reynold's Kool brand. In fact, Reynolds has recently scaled back it's promotional support behind Kool, presenting even less of a barrier to continued market share gains. Because of this brand strength, Lorillard can charge a premium for it's product, earning higher margins than competitors and protecting those margins through brand loyalty. The company's operating margin is a sky high 32%. The fact that Lorillard has been able to maintain those attractive margins against competitors hungry for a piece of that profit pie is a testament to the durability of competitive advantage here.
Two other things make Lorillard an attractive investment. MagicDiligence, of course, is an adherent to Joel Greenblatt's Magic Formula strategy, but Mr. Greenblatt wrote an earlier book (You Can Be a Stock Market Genius) that espoused the historical outperformance of recent spin-off companies due to several factors, including institutional indifference and unfamiliarity. Well, Lorillard is a very recent spin-off that very well may follow this historical pattern.
Second, the company is exceptionally strong financially. As I mentioned before, operating margins are north of 30%, and free cash flow margin is a juicy 21%. MFI return on capital is off the charts, averaging 264% since 2003. Even more impressively, Lorillard has accomplished that figure with absolutely no goodwill or intangible assets that sometimes make MFI ROC look better than it should be (the strategy subtracts these out of invested capital). The balance sheet shows $1.2 billion dollars of cash and zero debt. The dividend yield is high and the company has already begun buying back shares.
So those are the positives, and they are substantial. You can do much worse as an MFI investor - Lorillard is a fine Magic Formula pick. The thing holding me back from recommending it as a MagicDiligence Top Buy is the growth outlook and the price relative to that. Revenue growth will be difficult for a number of reasons. One is that domestic cigarette shipment volumes have been declining at a mid-single digit rate for most of this decade, and has been accelerating downward as more states enact public smoking bans and "sin taxes". Also, Lorillard cannot do what some competitors have done and focus overseas for growth; a disastrous decision to sell Newport's international rights was made over 30 years ago. Lastly, it's pretty hard to improve a 30% operating margin by cutting costs - Lorillard is already a lean machine, so significantly expanded margins are unlikely.
This leaves market share gains and higher prices as the only avenues of growth, outside of an outright acquisition (which is unlikely in the near-term due to the spin-off). Higher prices will be difficult to enact in a tough economic environment, and market share gains are a slow process. Lorillard's value is in dividends, share buybacks, and multiple expansion. Almost 100% of free cash flow is paid back in dividends. The earnings multiple of 10x is low, but not excessively so given the weak growth picture. A discounted free cash flow valuation, assuming a 3-4% annual growth, gives a fair value slightly above $60. At the current price of $54, it's just not cheap enough to wholeheartedly recommend, especially with so many other screaming bargains out there.