Lorillard Inc: a Smoking Opportunity? (LO)

ticker loFrank Voisin is a value investor and independent analyst whose site, Frankly Speaking, contains Frank’s investment theses as well as educational material to help investors avoid value traps. Subscribe to Frank’s feed here.

Lorillard Inc. (NYSE:LO) manufactures cigarettes in the United States, including Newport, the leading menthol-flavoured brand. The company trades in the mid $70s (at the time of writing), but my conservative estimate of its earnings power puts its value at $100. More impressive, however, is the fact that my EPV is based on a no-growth scenario which would normally be applicable for a big player in a mature industry. But LO has been able to achieve impressive revenue growth despite this context, with a CAGR of 10.5% since 2007 – not bad for a premium brand in the midst of a recession!

The company has extremely low capex demands, and given its high net profit margin (averaging 20% for the last 7 years) and growing sales, has contributed to a high and growing level of free cash flow, which averaged $955 million for the last three years (representing an FCFF yield ex-cash of 10.6%).

LO is shareholder friendly. Rather than using its free cash flows to expand its empire, management has chosen to retun capital to shareholders, with share repurchases of $2 billion (~15.5%) over the last four years and dividends of another $3.25 billion.

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So why is LO so cheap? It appears the market is worried that its major source of revenues (menthol cigarettes, which account for >90% of its revenue) will soon be banned. The FDA has created a committee, the Tobacco Products Scientific Advisory Committee (TPSAC) to create a non-binding report on the effects of the use of menthol in cigarettes.

The FDA won the authority to regulate tobacco in June 2009. The law doesn’t let the FDA ban nicotine or tobacco, just regulate what goes into tobacco products, require the ingredients be publicized and limit how tobacco is marketed, especially to young people. The agency’s panels advise it on scientific issues. It doesn’t have to follow their recommendations, but usually does.

This report is due March 23, and LO (and the other major cigarette manufacturers) believe this report will be negative andhave sued to block its release. The cigarette manufacturers believe that members of the committee are biased:

The suit specifically alleges that three members of the committee, Drs. Neil Benowitz, Jack E. Henningfield and Jonathan M. Samet are conflicted because they have made tens of thousands of dollars as paid expert witnesses in litigation against tobacco products manufacturers and due to their continuing financial relationships with pharmaceutical companies that make smoking-cessation products.

Beginning last year, the two companies and others urged the FDA to ensure that members of the panel were free of conflicts. Those concerns, however, were either summarily rejected or entirely ignored.

Draft chapters from the report were made public earlier in March, and seemed to indicate that the company has little to worry about. According to the NYTimes,

Menthol tobacco products may not increase smokers’ risk of disease more than other cigarettes, according to a draft report from a Food and Drug Administration advisory panel. …

According to the report, released late Monday, there is insufficient evidence to show that menthol increases smoke inhalation, exposure to nicotine or disease risk. Analysts say the results are in line with expectations and echo what panel members had said in prior public meetings.

It is important to keep in mind also that the report is non-binding, and that LO (along with the other manufacturers) will certainly work their legal magic to delay or otherwise minimize any negative effects. Given the uncertainty stemming from the report (and the FDA’s reaction to it), I have not bought yet, but I’ll be keeping an eye on LO as this company has some of the best economics I have ever seen.

Author Disclosure: Long LO


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