Book Gains in Lorillard Now

Rupert is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

It has finally happened. The FDA has finally started to seriously raise the issue of a full-on ban on menthol tobacco products. However, before it takes action, the administration has decided to purse more research and public comment on the issue. On July 23, the FDA issued what it called '"an advanced notice of proposed rule making," which typically indicates that the administration is considering regulation. In this case, it's considering establishing or amending tobacco-product standards.

The latest FDA evaluation on menthol-tobacco products appeared to show that there are no significant risks to smokers from smoking menthol cigarettes compared to normal tobacco products. However, the FDA noted that due to the minty flavor and smoother taste of the menthol products, consumers are more likely to start smoking and less likely to give up than with regular cigarettes and tobacco products. The FDA also noted that due to the minty flavor, younger smokers were more likely to start smoking menthol than if they were only offered regular products.

Major problem

This is a major problem for tobacco company Lorillard (NYSE: LO), which depends on menthol cigarette sales for 90% of its revenue. Indeed, Lorillard's Newport menthol brand accounts for 35% of the market.

Although these findings are damming, especially to Lorillard, there is still a significant amount of uncertainty ahead. The FDA is not proposing any changes to the law until further study is completed, especially public comment, which can be submitted for 60 days. On the other hand, four months ago in a different study, the FDA found that menthol smokers are at a lower risk of dying from lung cancer compared to non-menthol smokers at the age of 50 or over - another conflicting and confusing opinion.

Will this just affect Lorillard?

Any restriction will significantly affect Lorillard. As I have already mentioned, the company gets 90% of its revenue from the sales of menthol and comprises 35% market. Furthermore, it remains to been seen if this negativity from the FDA concerning menthol cigarettes will dampen sales of its key Newport menthol brand, which has seen both its sales volume and market share rise rapidly over the past five years despite the general decline in cigarette sales overall.

Reynolds American (NYSE: RAI) also holds 3% of the US menthol market through its Camel menthol, Camel crush and Pall Mall brands. Some 30% of Reynolds' sales are in menthol products, so it can be assumed that Reynolds will lose between $1 billion and $2 billion in sales per year. In addition, Reynolds' menthol products are its fastest-growing range.

Currently, on a valuation basis, Reynolds is trading at a premium to its peers in the sector, so it could be time to avoid the company for now. Reynolds trades at the highest trailing-12 month P/E in the tobacco sector at 18.8 compared to the sector average of 16.7. This is also true on a forward valuation. Reynolds trades at a forward P/E of 14.8 compared to the sector average of 14. 

What about Altria?

On the other hand, Altria (NYSE: MO) is well placed to benefit from a menthol ban. You see, while Altria does have some menthol and any ban would lead to an immediate fall in revenue, the company could possibly see a trend toward its menthol-snuff products that it has available to customers. Over the longer term, Altria could see a rise in revenue thanks to the ban. In addition, Atria is better placed than both of its domestic peers to outlast any tobacco bans within the country as Altria is well diversified into beer through SABMiller, wine and smokeless-tobacco products such as snuff and eCigs.

Foolish summary

All in all, whatever happens with regard to the menthol ban, Lorillard is faced with uncertainty and uncertainty is not good for investors. It could be time to consider selling Lorillard in favor of larger peer Altria, which appears to have a much more stable outlook.

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Fool contributor Rupert Hargreaves owns shares of Altria Group. The Motley Fool has no position in any of the stocks mentioned. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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