Cigarette Maker Poised for Gains After FDA Decision

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

Potential government action creates bargains overnight. The latest victim of the big government regulatory regime is Lorillard (NYSE: LO), maker of Newport menthol cigarettes.

The FDA is considering a possible ban on menthol cigarettes. An outright ban would effectively bankrupt Lorillard, which receives 90% of its revenue from the Newport brand. However, the cigarette lobby, various consumer and minority lobby groups (African American smokers overwhelmingly smoke menthol cigarettes), and $10 billion in annual tax revenue make a ban unlikely. As a result, the FDA's decision on the matter will likely send Lorillard's shares higher.

Great Business

It is hard to be a major cigarette manufacturer and not have a moat -- customers are literally addicted to the product. Lorillard's Newport brand has a 36% share of the U.S. menthol market -- the largest of any brand. As a result of its market leadership and premium product mix, Lorillard commands the highest margins in the industry.

Unfortunately, Lorillard sold the rights to its international brands several decades ago, so it is unable to expand overseas. Meanwhile, Altria (NYSE: MO) and Reynolds American (NYSE: RAI) are aggressively discounting their menthol brands in an attempt to capture more of the market.

However, the company's Blu e-cig is leading the rapidly growing electronic cigarette category. This presents an enormous growth opportunity for the company over the coming decades.

Room for Everybody

Every major cigarette manufacturer earns enviable returns on capital. There is so much pricing power in the industry that there is enough pie for everyone to have a large slice.

Altria is the largest U.S. cigarette manufacturer. It owns the Marlboro brand, which is the most popular in the U.S. and has a 42% market share. However, the cigarette market is facing a long-term decline in sales due to health concerns and government regulation.

Like Altria, Reynolds American is also heavily dependent on non-menthol cigarettes. It owns five of the top ten brands in the U.S. However, unlike Lorillard, Reynolds owns other of non-premium brands that cause it to earn lower margins. However, to its credit, Reynolds American's management has focused marketing spend on only the most profitable brands.

Investment Case for Lorillard

Lorillard stands out not only because potential FDA regulation of menthol cigarettes has disproportionately hit its stock, but also because it has been growing at a decent rate despite a lackluster U.S. market overall. In addition, its Blu electronic cigarettes present a growth opportunity that can not yet be fully quantified.

More importantly, Lorillard has a record of buybacks and dividends. In fact, the stock currently yields over 5.4%.

Were it not for the ominous cloud of potential regulation, Lorillard would be trading much higher than it is today. It has enviable pricing power that allows it to earn high returns on capital and is outpacing its competitors in most aspects of the business.

The key consideration for investors is whether or not the FDA will take action that will hamper the company's future profitability. I think the threat of a ban is overblown, especially because neither big business nor consumers want the ban. If you think so too, now would be a good time to get in on this stock.

Ted Cooper has no position in any stocks mentioned. 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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