Lorillard and the Tobacco Industry

The tobacco industry continues to be under pressure, with most companies posting not-so-satisfactory results. However, Lorillard (NYSE: LO  )  reported exceedingly healthy results in its recent quarter.

Whether Lorillard will prove to be the dark horse of the tobacco industry or will succumb to the pressure surrounding the industry remains to be seen. Let us have a look at the company before placing our bets.

Third-quarter analysis
Lorillard had an admirable third quarter. The company posted healthy earnings per share of $0.83, beating the Zacks consensus estimate of $0.81. The earnings showed an increase of 15.3% from the comparable period of last year. The company also reported a 10% year-over-year increase in net sales which stood at $1.8 billion. Analysts at Zacks expected the company to post revenue of $1.3 billion. The increase in the company's revenue was attributed to higher sales volume and higher average selling prices.

Segment analysis
Cigarettes
Cigarette revenue grew by 7.1% to a total of $1.76 billion compared with $1.67 billion in the year-ago quarter. On aggregate, the year-over-year increase in wholesale cigarette volume was 3.5%, which is striking as there is a lot of regulatory and consumer pressure on the cigarette industry. The retail market share of the company also improved by 0.5 percentage points from last year to 14.9%. This was due to strong gains in the company's main brands: Newport and Newport Menthol. Newport's market share increased by 0.5 percentage points to 12.6%, while Newport Menthol's share jumped 0.8 percentage points to 40.4%.

E-cigarettes
The company undertook strong brand-building initiatives for its Blu eCigs, which included advertisement campaigns on national television, the launch of low-priced rechargeable kits, and expanding the retail distribution network to over 127,000 outlets. These activities had a favorable impact on the segment as e-cigarette net sales increased 10% from the previous quarter to $63 million in the third quarter. Blu eCigs already have 49% share of the electronic cigarette market in the United States, which shows potential for future growth.

Acquisitions & stock buyback
Recently, Lorillard acquired British based e-cigarette company SKYCIG for approximately $49 million. This acquisition is of vital importance as it provides Lorillard with a leading e-cigarette brand in the United Kingdom. The newly acquired company will be able to benefit from Lorillard's marketing and R&D expertise to strengthen its grip in the U.K's e-cigarette market.

Earlier this year, the management of Lorillard announced a $1 billion share repurchase program. During this quarter, the company repurchased 5.7 million shares, which cost $249 million. In the future, the company will further repurchase shares worth $542 million under this program. This indicates that management believes that the company's stock is undervalued right now.

Valuation
I believe Lorillard is a good bargain at this point in time as it currently has one of the lowest forward price-to-earnings ratios in the industry. Lorillard's forward price-to-earnings ratio stands at 14.1, while Phillip Morris  (NYSE: PM  ) and Reynolds  (NYSE: RAI  ) have forward price-to-earnings ratios of 15.2 and 14.7, respectively.

My belief is further strengthened by the five-year price/earnings-to-growth, or PEG, ratio of the company, which is 2.69. Phillip Morris and Reynolds have five-year PEG ratios of 2.1 and 2.2, respectively. Also, Lorillard has the lowest price-to-sales ratio of the group at 2.69. Phillip Morris and Reynolds have price-to-sales ratios of 4.37 and 3.30, respectively.

The tobacco industry
Philip Morris International has been engulfed by several problems varying from higher taxes to decreasing sales volumes throughout the world.

In the most recent quarter, Philip Morris International's year-over-year earnings per share increased by 4.3% to $1.44. However, Philip Morris' sales volume continued to decline, which indicates that the company's higher earnings came from higher pricing policies rather than the expansion of its business activities. This raises serious concerns for investors as the practice of higher pricing is not sustainable in the long term. Furthermore, due to higher taxes and stringent government polices, the company's sales are expected to decrease by 7%-8% in the European Union and 9%-11% in Russia.

Unlike Philip Morris, Lorillard's core business is in the U.S., where the e-cigarette market is growing faster than the other markets. Philip Morris has given a rosy outlook for its e-cigarette segment, but as the e-cigarette market is still in the initial phase in regions outside the U.S., the company will have to wait before its e-cigarettes drive high sales volumes.

Reynolds American, the second largest tobacco company in the United States, posted earnings per share of $0.86 which represented an 8.9% year-over-year increase in its EPS. The company's net sales increased marginally by 0.9% as core brands performed well. The company is trying to target the e-cigarette category and plans on a nationwide launch of its e-cigarette Vuse next year. The financial position of Reynolds American is not very strong as it has the lowest free cash flow of the group and it has a lot of debt in its capital structure.

Final words
Even though the tobacco industry is facing a lot of pressure, Lorillard continues to perform well. More importantly, strong revenue growth isn't merely backed by increased prices but also by higher sales volume. With 49% market share in the U.S. e-cigarette market, Lorillard has already made a strong base which will propel it to further growth. Moreover, the SKYCIG acquisition allows the company to capitalize on the developing e-cigarette market in the U.K.

Lorillard is actively repurchasing its shares, which is yet another positive sign for investors. By looking at the financials, I feel that the company's stock is undervalued right now and further appreciation is highly likely. Taking all this into account, I believe that Lorillard will prove to be a superior investment opportunity in the tobacco industry.

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