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Magic Formula Stock of the Week: Lorillard Inc. (LO)
Posted by: Paul Andrews (IP Logged)
Date: November 22, 2011 10:53AM

Lorillard (LO) is a cigarette company formed by spin-off from Loews (L) in 2008. Most people know them for their flagship Newport brand, which, behind Marlboro, is the second-most popular brand in the country. This brand is an absolutely incredible asset; it’s gained market share for almost 20 consecutive years and has demonstrated tremendous pricing power and loyalty from its smokers. But it’s not just the brand that makes LO so valuable. The cigarette business has incredibly attractive economics. There’s huge brand loyalty from smokers, the product is incredibly addictive (resulting in hugely stable cash flows), and government regulation and economies of scale almost completely rule out new competitors and allows the three largest players (Altria (MO), Reynolds America (RAI), and LO) to form a practical tri-opoly.

Of course, the cigarette business faces significant headwinds too. Namely, the percentage of smokers is going down as older smokers die and high tax rates price prospective new smokers out. The number of cigarettes shipped has declined by 3.5% per year for the past 10 years. While the decreased volume has been mainly offset by increases in prices, the decrease shows no signs of abating and the price increases are showing signs of hitting their limits. Finally, politicians are raising taxes or regulations on the smoking business with increased frequency, so the future looks murkier still.

Add it all up and you get a perfect magic formula stock — a business with incredible returns and great economics in an entrenched strategic position trading at a low multiple because of regulatory uncertainty. It’s exactly the type of formula we look for when putting together GuruFocus’ own Micro-Cap Magic Formula newsletter.

Let’s start by taking a look at LO’s historical results. From 2006-2010, LO managed to increase revenues (excluding excise taxes) at 6% CAGR and operating income at 7% CAGR. They did this by increasing market share from under 9% to over 12.3%, so that their volume actually increased despite a significant decrease in industry volume.

This increase in volumes has generated massive cash flows for LO. Operating cash flow has shot up from $778M to over $1.1B with no signs of slowing down. Now, recent experience has taught us that generating massive cash flows is only half of the equation. Companies like Microsoft (MSFT) and HP (HPQ) have made their way onto the magic formula screen because of incredible economics and compelling valuations but squandered their cash flows on mind-numbing acquisitions at nose bleed prices.

Fortunately, LO investors don’t have to worry about that. The company returns all of its cash flows to its shareholders through dividends and share buybacks. As a matter of fact, in recent years the company has actually leveraged its balance sheet to return additional cash to shareholders. Normally, this would be a cause for concern, but given LO’s steady cash flows it’s not too alarming.

Normally, a business this well run with such a commitment to returning cash to shareholders would trade for a huge premium. However, in LO’s case, it’s still trading at a very reasonable valuation. At today’s prices, it trades for under 13x trailing earnings and around 8x EV / EBIT, or about the same level as the rest of the market.

That seems too cheap. LO returns between $1.5 billion-$2 billion per year in cash flows to its shareholders, depending on how aggressive they are with share repurchases. In other words, today’s buyer could reasonably expect to have his entire investment returned to him through share repurchases and dividends within the next seven years.

Of course, there’s a reason LO is cheap. Many investors prefer to avoid the “sin stock” space, and there’s always the risk of further regulatory reform or increased taxes. Let’s address each of these concerns individually.

The avoiding sin stock argument is understandable. Who wants to supply capital to companies whose products kill people? Of course, investors could also look at it as an edge — if most investors won’t look at the space, that means the investors who are willing to look at the company could have an edge.

It’s true there is a risk of increased taxes. But after nearly tripling the taxes on cigarettes over the past five years, politicians may be tired of fighting of the tobacco lobbyists to raise taxes.

Finally, further regulatory reform or legal troubles is certainly possible. That was the knock on the stock at the beginning of the year, when the FDA gained regulatory power over the cigarette industry and seemed intent on shutting it down. However, the FDA report has come and gone, and the cigarette industry was barely affected by it. In other words, it’s tough to see any short to medium-term regulatory reform coming that would harm the industry.

Add it all up, and you get a stock that is gaining market share in an incredibly attractive (albeit declining) industry that offers investors an attractive price in a stock that they might be able to pick up an edge in.

Stocks Discussed: LO, L, MSFT, HPQ, MO, RAI,
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