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MagicDiligence (< 20)

Will Scrutiny over Menthol Cigarettes Snuff Lorillard?

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November 18, 2010 – Comments (1) | RELATED TICKERS: LO , MO , RAI

Lorillard is the third largest cigarette producer in the United States. The company was spun off from conglomerate Loews (L) in June 2008. 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 an 11% total market share, behind only Altria (MO) and Reynolds American (RAI) in the U.S. Newport accounts for almost 95% 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.

Newport is one fantastic asset. It is the second most popular cigarette brand in the U.S. behind Marlboro. The brand has been steadily taking market share from competitors like Altria's Marlboro Menthol, and Reynolds' Kool and Camel Menthol/Crush brands. In fact, Reynolds has recently scaled back its promotional support behind Kool, presenting even less of a barrier to continued market share gains. Newport has taken market share for an amazing 19 straight years. Lorillard can charge a premium for its product (Newport is one of the most expensive brands), earning higher margins than competitors and protecting those margins through brand loyalty. The company's operating margin is a very high 29%. 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 advantages here.

Lorillard's most intriguing financial quality is its enormous free cash flow generation (over $1 billion in the past 12 months). The firm has largely returned it to shareholders in the form of dividends and share repurchases. The dividend yield of 5.2% is over double the average 2.4% yield of dividend paying S&P 500 stocks. The dividend was increased by 12.5% back in August. At only about 60% of free cash flow, the dividend payment looks both safe and has room for further raises.

Share buybacks are the other avenue for delivering shareholder value. Lorillard has reduced share count by 13% since going public in 2008. In 2009, the firm repurchased over $900 million in stock, and so far in 2010, over $430 million has been bought back. A new $1 billion repurchase authorization was announced in August.

While cigarette volumes in the U.S. have been declining at about 3% annually for the last decade, Lorillard can still grow. In fact, market share gains and price increases have allowed the company to expand revenues at a 10.3% compound annual growth rate (CAGR) since 2005, while largely maintaining operating margins. In the near term, price increases should be able to outweigh volume decreases. Competition is of little concern. There are only 3 major cigarette makers in the U.S., where huge brand loyalty and government restrictions almost eliminate new competition from the picture. One thing Lorillard can't rely on for growth is expansion overseas. The firm sold its international rights to sell Newport in 1977.

The single biggest risk to Lorillard is the FDA. Given wide power to regulate the cigarette industry last year, the FDA wasted no time, enacting a huge 158% increase in the excise tax and now plans to require pictures of corpses on the side of packs. The excise forced the cigarette makers to drastically hike product prices, which has been surprisingly well tolerated so far.

Undeterred, the FDA is pushing forward, this time launching a direct attack on Lorillard with a focus on menthol cigarettes. Last year, cigarettes with fruit or herbal flavors were outlawed (for the kids, of course). Now, they are focused on whether the same arguments can apply to menthol. Studies ostensibly show that menthol is preferred by young smokers, and especially by young African-Americans. A decision on menthol is set to be announced by next March. The worst case would be an outright ban , which would no doubt be aggressively fought, but ultimately a very significant adverse event for Lorillard. A better case scenario would be further restrictions on marketing of menthol, which cigarette companies have proven to be quite adroit at working around.

Nevertheless, assuming slowing growth from volume decreases and increased restrictions, Lorillard looks to be worth about $95 a share, which would give the firm about a 2.4 price/sales ratio. That would place its valuation below Altria (2.7) but well above Reynolds (1.9), which seems fair given the relative merits of those two companies against Lorillard. Adding in the dividend, the implied one-year return would be 14.5%. That is a decent return, but with the very serious threat of government intervention into menthol, I don't believe it is enough of a margin of safety to invest in Lorillard at this time.

Steve owns no position in any stocks discussed in this article.

1 Comments – Post Your Own

#1) On November 19, 2010 at 1:57 AM, walt373 (99.83) wrote:

Nice writeup, thanks.

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