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Investment Thesis for Lorillard, Inc. (NYSE: LO)

July 13, 2010 | About:
It is certainly taking us longer to find great investments than in previous years, even after the recent decline in the market. Additionally, a lot more bargains seem to be appearing in the large cap sector, one of them being Lorillard, Inc (LO). We are adding Lorillard, Inc. to the ValueHuntr Portfolio. Lorillard, Inc., through its subsidiaries, engages in the manufacture and sale of cigarettes in the United States.

Profile

The company offers 41 different product offerings under the Newport, Kent, True, Maverick, Old Gold, and Max brand names. It sells its products primarily to wholesale distributors, who in turn service retail outlets, chain store organizations, and government agencies, including the United States Armed Forces.

Lorillard’s Newport brand is the leader in the menthol category, with a 35% share. With an 11% share in the total domestic cigarette industry, 94% of Lorillard’s sales come from Newport. This product is also the second-strongest cigarette brand behind Altria’s MO Marlboro. The company is currently trading for $74.67 per share.

Thesis

Despite Lorillard’s wide economic moat, potential restrictions on menthol tobacco products by the FDA present a significant threat to its medium-term future. Although the FDA is currently reviewing menthol-based products, I do not expect the FDA to implement an outright ban on menthol cigarettes. More likely scenarios include additional marketing restrictions, and larger warning labels on packs. Given the likely scenarios, I believe LO shares are attractive at this level.

Valuation

Lorillard is currently trading at an 8.3% earnings yield with a 5.6% dividend. With $1 billion of net cash on its balance sheet, its EV/EBITDA multiple stands at 5.94 versus multiples of 6.5 and 8 for Reynolds American and Altria, respectively.

Earning Power Value (no growth) = Normalized EPS/WACC ~ $69/share

Earning Power Value (2.5% growth) = Normalized EPS/(WACC-G) ~ $92/share

The growth-case EPV implies a price/earnings of 15 times, and EV/EBITDA of 7 times.

Competitive Advantage

Scale is critical to Lorillard’s wide operating margins and high returns on capital, but tobacco marketing restrictions make it very difficult for new entrants to steal market share at the expense of well-known brands. Even powerful incumbents such as Altria with its Marlboro brand and Reynolds with Camel have found it very difficult to take share from Newport. The recent decision by Reynolds American to withdraw promotional support for Kool is an admission that their attempts to do so had failed. The addictive nature of cigarettes and the loyalty to the Newport brand in particular give Lorillard a wide moat.

Risks

With almost all of its revenue generated from sales of menthol cigarettes, Lorillard’s medium-term performance will depend heavily on the upcoming FDA review of the menthol category. We expect the FDA to impose greater restrictions on the marketing and perhaps the availability of menthol cigarettes, but we think an outright ban is highly unlikely.

Possible Catalyst: Acquisition Target

Given the current valuation levels, dominant market share position, and strong balance sheet, I believe Lorillard is a viable acquisition target. Regarding this possibility, Morningstar writes the following in a recent report:

We think the firm’s strong brand appeal and relatively clean balance sheet could make Lorillard an acquisition target, with Reynolds, Imperial Tobacco ITYBY, and Japan Tobacco as potential suitors. However, we think there are several reasons no bids will appear in the short term. First, we think that potential buyers will wish to have more visibility into the long-term future of the menthol category before making a move. Second, Reynolds may face resistance from antitrust authorities, although its recent relaxation of promotional support is likely to lower its menthol market share. Third, having acquired Altadis in 2008, we doubt that Imperial has sufficient capital to close a deal at present. These hurdles are all temporary, however, and Lorillard could be in play in 2011

Regarding this possibility, I believe Morningstar’s assessment has merit.


Disclosure: I own shares of Lorillard (LO)

Valuehuntr

http://valuehuntr.com/


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Comments

harison
Harison - 4 years ago


I was long LO last year, and I understand your long thesis, in fact I think my IV estimate was around $92 as well. The reason why I sold was because of the huge deficits, and the government's need to fund them with tax hikes. They will look immediately to cigarette makers, and last year was the first time that we saw consumer and channel pushback in the face of price increases.

Finally, I don't think an acquisition is likely. A leveraged buyback is more likely, and I think would do shareholders well. Let me say I don't think there is tons of risk here, but I'm not sure if there is great upside either.
ValueHuntr
ValueHuntr - 4 years ago


Thanks Harison, those are great points.
augustabound
Augustabound - 4 years ago
Just a question about EPV. Doesn't using a growth scenario defeat the purpose of EPV?

It's a valuation model that I know the least about (maybe I should re-read Greenwald :) ), but I'm somewhat intrigued by it because I thought if put little value in the unknown of any future growth.
ValueHuntr
ValueHuntr - 4 years ago
Augustabound, the point is to be conservative. I do both cases (growth and no growth) just to see the range of possible outcomes.
ValueHuntr
ValueHuntr - 3 years ago
The LO play is done, just reached $108 per share yesterday.
gurufocus
Gurufocus premium member - 3 years ago
Well Done.

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