Lorillard Fights off Industry Headwinds

With Lorillard (NYSE: LO  ) showing consistent growth on its top and bottom lines while delivering a generous yield, it might be difficult to imagine the stock being an unsafe investment. For now, all remains fine and well. However, massive long-term headwinds exist. Lorillard's top competitors, Altria Group's (NYSE: MO  ) Philip Morris USA and Reynolds American's (NYSE: RAI  ) RJR Tobacco, are likely to see similar patterns. This is somewhat predictable based on strikingly similar trends for these three companies over the past five years. Let's take a look at the current, and likely future, situation for Lorillard and its peers.

Current situation
Let's start by taking a look at top-line performances for Lorillard, Altria, and Reynolds American over the past five years: 

RAI Revenue (TTM) Chart

Reynolds American revenue (trailing-12 months) data by YCharts

Lorillard, best known for its Newport and blue Cig brands, is seeing much higher top line growth than its peers. The consistently improving revenue can be attributed to higher volumes (demand) and price increases.

In Lorillard's most recent quarter (third quarter), its retail market share increased to 14.9% from 14.4% in the year-ago quarter. Its premium market share increased to 17.3% from 16.7% in the year-ago quarter. And its menthol market share increased to 40.4% from 39.6% in the year-ago quarter.

Furthermore, Lorillard has expanded its eCig category leadership, now with a whopping 49% share. It should also be noted that Lorillard acquired the British eCig company, SKYCIG.

That said, Lorillard noted in its most recent 10-Q filing that its ability to compete in some markets is restrained due to retail merchandising contracts for Altria's Philip Morris USA and Reynolds American's RJR Tobacco. This limits retail shelf space, which then limits sales potential.

However, Lorillard has consistently found a way to outperform its peers over the past several years. This isn't just the case on the top line but on the bottom line as well, which indicates superior cost management:

LO EPS Diluted (TTM) Chart

Lorillard EPS diluted (trailing-12 months) data by YCharts

This might make you think that Lorillard has greatly outperformed its peers in total return price (stock appreciation + dividend payments), but that's not the case. You would be hard pressed to find an industry that moves as in sync as this one. Consider total return price performances for these three companies over the past five years:

LO Total Return Price Chart

Lorillard total return price data by YCharts

At the moment, Lorillard yields 4.2%. Impressive, but not as high as Altria at 5.2% or Reynolds American at 5%. None of these companies sport positive balance sheets, but they all generate enough cash flow that the dividends appear to be safe at this point in time.

Additionally, all three of these companies are trading at fair valuations. Lorillard, Altria, and Reynolds American are trading at 16, 14, and 18 times earnings, respectively.

That's the good news. Now let's take a look down the road.

Long-term concerns
Have you seen the poster of James Dean sitting on a motorcycle smoking a cigarette? That was the epitome of cool at the time. Females wanted to get to know him; men wished they could be him. If Hollywood were to make a similar attempt with one of today's popular actors, it would more likely be met with criticism throughout the media due to the marketing of an unhealthy product.

If you don't believe me, that's understandable, but you might want to read Lorillard's most recent 10-Q filing. The company lists the following headwinds, many of which are likely to get worse ... not better: restricted advertising, excise taxes, less availability of public smoking areas, litigation, the rise of the health-conscious consumer, decline in social acceptance, pressure from anti-smoking groups.

These are all major negatives, but most people tend to overlook the most important factor of all. In order for our economy to grow, our government needs consumers -- healthy ones. Much of economics comes down to demographics. Without population growth, we go nowhere. As far as the tobacco industry goes, it has a tough long-term fight on its hands. This likely wouldn't be the case if cigarettes were healthier and more socially acceptable, but that's not the current situation.

If you're thinking that e-cigarettes are a potential avenue for future success, you're correct. At the same time, Lorillard has already warned that the FDA will likely regulate the e-cigarette market in the future.

Speaking of the FDA, also consider one of the comments it made in March 2011: "[The] removal of menthol cigarettes from the marketplace would benefit public health."

Not good for Lorillard and friends.

The bottom line
As long as the Lorillard's top line continues to grow and cash flow remains strong, near- to mid-term shareholder rewards are likely. However, over the long haul, Lorillard, and the industry as a whole, will have a difficult time sustaining growth due to a multitude of headwinds. If you choose to initiate a position in Lorillard, Altria, or Reynolds American, you're likely to see some near- to mid-term success, but initiating that position and throwing away the key isn't recommended. 

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