There is Reason to Look Into Lorillard
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The tobacco industry is often ignored by certain investors due to the increasing quantity of ailments that plague the individual players in the segment. Tobacco use, especially in mature markets, is by no means increasing. Tobacco use (in terms of billions of units consumed) has been decreasing by more than a 2% CAGR over the past twenty years, and there is little signs of an easing in the decrease due to the lack of social acceptance and heightened amount of government intervention. The other factors attempting to hinder industry progress hardly need any discussion – the end products have been commoditized for decades due to the significant level of industry saturation, there has been an increased awareness of the health effects in emerging economies, and the products are becoming increasingly expensive for end consumers due to general price and excise tax hikes.
Yet, despite all of these hurdles, the tobacco corporations’ continuous ability to generate large amounts of free cash flow make the stocks in the segment almost as difficult to quit as the products they produce. Likewise, despite the rather homogenous prices within the industry, one player tends to stand out as a special pick.
- Forward P/E (2013 estimates) and 5 Year PEGs
There are several key reasons why investors should be bullish on Lorillard’s future prospects:
- Diversification
The corporation is often viewed as harboring additional risk than its international counterparts due to its reliance on the sale of menthol cigarettes within the U.S. market. Lorillard has, however, generated a meaningful level of new business through new product launch and business acquisition. Its primary Newport product line has undergone programmed decreases as a percentage of total company sales, and despite the 45% revenue increase from Newport products between 2008 and 2011, the brands penetration of total revenues has dropped by 530 basis points (now 88.4% of total sales).
The worry that menthol cigarettes, due to their increased appeal to minors, will be completely banned by the FDA is largely overplayed. The FDA was able to ban the production of flavored cigarettes after gaining legislative authority to regulate tobacco in 2010, yet the niche product made up less than 1% of the total U.S. cigarette market and most manufacturers had already scaled back production by the time the ban was announced. Menthols, which represent slightly less than 1/3 of the total domestic market, will be a significantly more difficult market niche to tackle. Not only will such an outlawing of the product reduce state and federal tax revenues by an estimated $40 billion (per Lorillard management), but a significant risk exists in the creation of an incontrollable black market – which will make it increasingly difficult to monitor product quality standards and the sale of the product to under-aged citizens.
The menthol market will be here to stay for the foreseeable future, and Lorillard has been taking an increased share of the profitable segment. The corporation’s total retail market share has increased 450 basis points between the end of 2007 and the most recent quarter (to 14.5% share), and the Newport brand’s share of the menthol market has increased by 390 basis points over the same time period (to 36.8% share).
Lorillard has also made a strategic acquisition in the swiftly growing e-cigarette market with its recent purchase of blu ecigs. Whereas other large players including Altria and Reynolds American have supplemented operations with smokeless tobacco products including snus and dissolvables, Lorillard is the first of the big cigarette producers to brand out into electronic cigarettes. Although the market is relatively small – company management estimates around $250 million - $500 million in annual industry revenues – the market has gained the acceptance of key consumer groups for their inexpensive entry prices (compared to traditional cigarettes) and their similar smoking experiences. A recent U.S. government survey found that 2.7% of U.S. adults had tried e-cigarettes in 2010, up from 0.6% in the prior year. A small fraction of the total market, yes, but also something that may bloom into a very attractive supplement to Lorillard’s core menthol cigarette sales as worldwide consumption continues its slow decline.
- Cash Generation
Lorillard has also exemplified its ability, and willingness, to grow free cash flow and reward shareholders with share buybacks and programmed dividend hikes. Even if the domestic tobacco industry does not attract new users over the long run, the corporation’s effective use of its cash generating abilities will continue to create value for shareholders. Free cash flow topped $1.1 billion in 2011, which is up from $748 million in 2006, and Lorillard has used upwards of around 90% of its free cash over the past four years (since it has been its own publicly-traded entity) to repurchase outstanding shares. Total share count has, as a result, decreased by more than 20% since 2008.
Likewise, the impressive 55% run-up in EPS between 2008 and 2011 fiscal years, combined with the corporation’s near 70% average payout ratio, has led to a near 70% increase in dividends through four individual dividend increases. The continued share penetration in the U.S. market, the introduction of new tobacco products, the growth in its newly acquired e-cigarette line, and increasing discretionary consumer income levels will all contribute to drive free cash flow generation and thus additional dividend hikes and share repurchases for the foreseeable future.
With a current 4.7% dividend yield, the most attractive PEG and the lowest valuation on a 2013 earnings standpoint (13.5x is 10% less than “industry” average of the 5 aforementioned tobacco producers), Lorillard will continue to reward investors with meaningful share price appreciation and earnings payout.
gibbstom13 has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend Philip Morris International. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. If you have questions about this post or the Fool’s blog network, click here for information.
