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Why I Sold Lorillard Inc. (LO)

May 26, 2014 | About:

I don’t sell stocks often, so it’s always a bit tough for me to write these articles. I look at each position in my portfolio as essential branches to my dividend tree, where every branch produces fruitful dividends which will eventually provide the income I need to pay my bills. And I eventually want at least 50 such branches on my tree so that if one branch becomes unhealthy the tree continues to thrive. So selling is something I try to avoid unless absolutely necessary, because it means my tree is becoming smaller. However, if the occasional pruning makes the tree stronger over the long haul then I consider it a wise chore to perform.

This is the eighth such article I’ve written since I went live with this blog in early 2011. They don’t come up often, but I always try to provide a reasonable and sound case for my actions, and will attempt to do so once again here.

I sold 50 shares of Lorillard Inc. (LO) on 5/7/14 for $58.74 per share, for a total net sale of$2,929.94 after commissions.

Lorillard, Inc. is a tobacco and cigarette manufacturer, which markets and sells its products in the U.S. Its brands include: Newport, Kent, True, Maverick, and Old Gold. It is the third largest cigarette manufacturer in the U.S., and also has significant exposure to e-cigarettes through its subsidiary blu.

This is a reduction of a position rather than the outright elimination, as I still own 50 shares of Lorillard. So I reduced my exposure to Lorillard by selling off half of my position here.

I wrote an article a few years ago in regards to my view as to when to sell a dividend growth stock. Basically, I view only three circumstances which would warrant a sale: changing fundamentals, a static or reduced dividend, or a gross overvaluation. Looking back on this article, and applying what I’ve learned as an investor over the past four years, I would probably add another reason to that list: risk reduction. Managing risk is an important part of ongoing portfolio management, and my strategy here has usually been to build other lower-risk positions around my higher-risk plays in order to accelerate around risk and keep positions weighted appropriately according to my risk profile. However, LO’s recent stock price run, coupled with what I believe to be a more aggressive stance by regulators, forced me to look at reducing risk directly here by selling off part of my position.

While Lorillard’s dividend growth has been positively impressive since I initiated a position back in October 2012, I’ve become concerned about the possibility of increasing regulation around its core product, which would obviously affect the fundamentals negatively. In addition, the share price performance over the last few months has given me the opportunity to reduce my risk by realizing significant capital gains and investing that capital elsewhere.

My main concern with Lorillard here is the possibility of greater regulation in regards to the manufacture and sale of menthol cigarettes in the U.S. And since Lorillard receives approximately 90% of its revenue from its blockbuster Newport Menthol offerings, this would be a major blow to the company. The FDA has the authority to regulate menthol cigarettes including harsher restrictions and/or an outright ban. While I think an outright ban is unlikely due to the backlash, lost of tax receipts, and potential for black market products and illicit trade, the language the FDA uses regarding menthol cigarettes appears aggressive to me.

Specifically, the FDA initiated an independent scientific evaluation regarding the impact of menthol cigarettes on society and concluded:

…adequate data suggest that menthol use is likely associated with increased smoking initiation by youth and young adults. Further, the data indicate that menthol in cigarettes is likely associated with greater addiction.

Now, I’m no expert on the FDA or broader government regulation. However, this language does seem to suggest that there is at least a chance that some type of increased regulation could be coming down the pipeline at some point. It’s impossible to say exactly when/if the FDA might take action, but because the risk is simply there, and my dividend income is going to fund my lifestyle in the future, I felt it appropriate here to take action of my own.

However, it wasn’t just the possibility of regulation that forced me to take a look at selling off part of my stake in this tobacco company. After all, the risk of increased regulation is nothing new in the tobacco industry, and certainly not for Lorillard as they’ve been dancing with the FDA for years now.

Rather, shares have had quite a run-up over the last few months as rumors of a potential merger with Reyonlds American Inc. (RAI) have continued to persist. It’s hard to say what’s going to happen here as there is a ton of moving parts - British American Tobacco Plc (BTI) is the largest shareholder in RAI – but I felt it appropriate to take a fresh look at the valuation of shares after this kind of pop.

LO shares are trading hands for a P/E ratio of 19.22 right now, which is well over the five-year average of 14. The yield on shares, at 4.22% based on my sales price, is also much lower than the average over the last five years of 4.8%. However, I also performed a Dividend Discount Model on shares, using a 10% discount rate and a 6% growth rate. This gave me a fair value on shares of $65.19, which is well over the price at which I sold. I think the growth rate is fair because it’s well under the projected three-year growth rate in EPS – at 9%, according to S&P Capital IQ. It’s also well under the 10-year growth rate in EPS (13.1%) and five-year growth rate in dividends (29.1%). However, I also feel that one would want a very large margin of safety on shares here due to the potential of increasing regulation on menthol cigarettes and shrinking demand for cigarettes in general here in the U.S. Basically, shares in LO are usually undervalued by a large margin due to uncertainty in the industry and a shrinking customer base, but that discount is slowly disappearing as the share price advances.

Overall, I still feel Lorillard is an attractive investment at today’s prices, which makes it probably appear odd I sold. However, I didn’t completely eliminate my position. I rather just cut it in half, which reduces my risk significantly. In addition, I wanted to reduce my exposure to the tobacco industry as a whole, as before this sale I had an ~11% allocation to cigarette manufacturers through my investments in LO, as well as Altria Group Inc. (MO) and Philip Morris International Inc. (PM). Tobacco manufacturers are historically wonderful investments due to a combination of chronic undervaluation, high yields, and addictive products. However, as shipment volumes continue to decrease across the world, and more specifically developed markets like the U.S., I felt it made sense to reduce my exposure a bit here.

My cost basis on these shares was $1,940.65, as part of a lot of shares I purchased in October 2012. In addition, I’ve received $177.25 from these 50 shares during my time of ownership in the company. That means my total return on these shares is 60.1%, which is obviously quite attractive over a period of just 19 months.

I would have preferred just to leave the entire position be, but I honestly felt a little uneasy about both my exposure to tobacco in general, and my exposure to a company that receives such a large percentage of its revenue from a product that could face unfavorable attention from the FDA. My view is that the less one sells and handles a portfolio the better, but I also feel that one should be prudent when faced with changing environments.

I’m keeping the other 50 shares because the valuation still seems relatively attractive, and the company is still growing at a robust clip. Earnings, revenue, and dividends are all growing appreciably, and they still have a 45% dollar market share on the fast growing e-cigarette market through its investment in blu. Furthermore, they continue to gain market share in traditional cigarettes, recently reaching a 15% market share of the entire U.S. cigarette market for the first time ever, with a 13% market share for Newport. And if menthol cigarettes are indeed more addictive, and the FDA continues to stay passive, this gives Lorillard a significant economic moat around its product. Furthermore, they have seven consecutive years of dividend growth under their belt after being spun off from Loews Corporation (L) in 2008. And their dividend growth has been most impressive, as I discussed earlier. I think high-single-digit dividend growth is very likely for the foreseeable future.

I’ve already reinvested this capital into another company, so be sure to stop by over the coming days to read about that! I’m excited about these transactions, and feel that I’m able to sleep just a tick better at night, which is priceless.

This transaction reduces my dividend income by $123.00, based on the current quarterly payout of $0.615 per share.

My portfolio still holds 46 positions after this sale, as this was a reduction of a position rather than an outright elimination.

And just like I do when I announce purchases, I’m going to include some analyst valuation opinions on this stock.

*Morningstar rates LO as a 2/5 star value, with a fair value estimate of $45.00.
*S&P Capital IQ rates LO as a 3/5 star hold, with a fair value calculation of $53.40

I’ll update my Freedom Fund in early June to reflect my recent sale.

Full Disclosure: Long LO, MO, PM

What do you think? Was it prudent to reduce my LO holdings here? Should I have done nothing instead?

Thanks for reading.

About the author:

Dividend Mantra
Trying to retire by 40 by investing in dividend growth stocks and living frugally, valuing time over money.

Visit Dividend Mantra's Website


Rating: 3.5/5 (4 votes)

Voters:

Comments

klausbella
Klausbella premium member - 2 months ago

One never knows what's around the corner, but at this stage LO is still in a beautiful uptrend

Belarophon
Belarophon - 2 months ago

Just for your info: In Europe menthol cigarettes will be forbidden by 2020 as far as I know. In the end I would say congratulations on your 60% and also nice to see that you stick to your rules.

broview
Broview - 2 months ago

If menthol cigarettes will be forbidden, then how about menthol candy? menthol gum?

Another similar case: MNST's caffeine got challenged.

Should we ban all coffee shops? and Starbucks as well?

SeaBud
SeaBud premium member - 2 months ago

I too struggle with selling stocks, but I believe trimming branches when valuations rise is prudent. I trimmed some JNJ as I think a company that size will find it hard to justify growth implied by their P/E. My guess is this is a good call.

Broview - Yea, lets say "what do we do if they ban menthol cigarrettes, will they ban menthol gum??? What about caffeine?" We can't let them outlaw keeping a nuclear weapon, because if they do they might outlaw an assault rifle. And if they outlaw an assault rifle, they will outlaw sling shots.

Menthol candy has never been argued to kill. There may be plenty of reasons not to forbid menthol cigarrettes, but the risk of it leading to outlawing menthol candy is absurd. You have advanced the slippery slope argument from the Grand Canyon to Florida!

zacsanborn09
Zacsanborn09 - 1 month ago

I really enjoy your insights. One point worth making (truly the ONLY meaningful point I could find that you didn't effectively make) is the fact that although Blu and Skycig are growing E-cig brands, they have yet to show a profit... indeed so far a 0-7 million loss between the two, and a slightly shrinking profit margin on blu (per 2012-2013 data). This is small, and likely insignificant in the long run, but troubling due to the increased profit potential on these brands due to (currently) decresed regulation.

I'm going to start following your articles, as your goals (early retirement via growth dividend stocks) closely mirrior my own.

Thanks again for writing this magnificent article!

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