Why Lorillard is Still a Good Bet

By Ashish Sharma - August 9, 2012 | Tickers: MO, LO, PM, RAI | 0 Comments

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After reaching 52-week high on July 18, the stock price of Lorillard (NYSE: LO) has dropped more than 12% in just a matter of 20 days. The downfall was primarily driven by mixed second quarter earnings results with sales showing an upside but profits falling short. We believe Lorillard will continue to be a great investment going forward backed by notable growth drivers and an impressive dividend despite low valuations.

Domestic Pricing Power Remains Strong

In June, Altria Group (NYSE: MO), Reynolds (NYSE: RAI), and LO all raised prices across each of their cigarette portfolios on top of two rounds of pricing taken in July and December last year. MO and RAI raised their prices by $0.06/pack while LO raised its prices by $0.08/pack. Thus we remain confident that domestic cigarette manufacturers can continue to successfully raise prices on their cigarettes despite of some recent concerns about heightened promotional environment.

Competitive Environment but Easier Accelerated Growth Likely in 2H12

Entering into the second half, the operating environment should remain challenging given the state of the economy and promotional activities in the industry. But LO is expected to benefit from wholesaler inventory restocking and the lapping of the Newport Red introduction and volume transition out of Native American reservations in NY. Thus, we believe the growth rate for LO will accelerate in 2H12.

Potential Catalyst in Roll-out of new Products

LO indicated that it has a pipeline of fully tested new products. These products are awaiting FDA approval as substantially equivalent products (S/E’s). The lack of visibility into the FDA’s review process for substantial equivalence submissions may delay the roll out. However, if LO is able to receive such approval before the end of the year, these new products could be rolled out quickly and the subsequent sales impact would result in a significant earnings upside.

Institutional Ownership Provide Stability

Most large cap cigarette companies, including Altria Group, Reynolds American and LO, enjoy significant levels of institutional ownership. The following table provides a summary of the percentage of shares held by institutions for all the above mentioned companies.

Source: Yahoo Finance

Clearly, LO has the highest level of institutional ownership. A high proportion of institutional ownership provides a support and stability to the stocks as institutional investors are long-term investors in general. 

Inexpensive Stock with Impressive Dividend Yield

The tobacco industry is known for huge dividend payouts, and Lorillard pays out one of the largest in the industry, annually yielding around 4.90% at current prices. 

Philip Morris (NYSE: PM), despite being expensive (15.88x forward PE), has the least dividend yield. The following chart summarizes valuation, dividend yield as well as expected growth for major tobacco companies.

Source: Yahoo Finance

Clearly, LO has the lowest valuation yet it offers second highest dividend yield and best-in-class expected EPS growth in FY12. Thus for investors looking for a good dividend yield, LO provides a relatively inexpensive way.

Additionally, the company returns significant cash to the shareholders with share repurchase activity. Thus, despite the EPS miss and the disappointing volume performance, we continue to prefer LO in its peer group. We believe the company has the strong fundamentals and expect a better performance going forward. Impressive dividend yield, low valuation and high levels of institutional ownership makes it a safe and inexpensive bet for defensive investors.

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