Is This Tobacco Investment's Risk Worth the Reward?

The tobacco sector is well known for its impressive shareholder returns, and Lorillard (NYSE: LO  ) offers some of the best. Indeed, according to my research, through both share buybacks and dividends Lorillard returned 8.9% of its share price to investors during 2012.

The only company that returned more was Reynolds American (NYSE: RAI  ) , which returned 10.1% of its share price. In comparison, Philip Morris returned 8.8% and Altria Group  (NYSE: MO  ) 7.6%. But is the risk of investing in Lorillard worth the reward?

A burning but minty issue
Of course, the risk here is the impending regulation of menthol-cigarette products. I recently covered the key facts of the menthol argument here. However, let's not get caught up in the "will they or won't they" argument, as more than three- quarters of Lorillard's revenue comes from the sale of menthol cigarettes.

That being said, if we think about things logically, it is not unrealistic to suggest that if the U.S. Food and Drug Administration moves against menthol cigarettes, Lorillard will not lose all of its sales overnight. The company is likely to lose some of its sales, but it is more than likely that smokers will switch from menthol to regular cigarettes and stay with Lorillard's Newport brand. In addition, Murray Kessler, the chairman and chief executive of Lorillard, has gone on record to say

"The science does not support differential regulation between menthol cigarettes and non-menthol cigarettes. They're both bad for you. There is not a higher risk of disease...It would be a shame if they went down a path and proposed regulations that weren't based on science and we ended up spending the next 10 years in court. I think it's a very low likelihood."

So it would appear that if the FDA were to move against menthol, Lorillard would fight to the death in court to appeal the decision.

That being said, the company is still likely to report lower sales immediately off the back of any regulation.

It not all bad
Still, Lorillard and its Blu brand have the "first-mover" advantage in the rapidly growing electronic-cigarette market. Blu already has a 40% share of the e-cig market within the U.S., and sales during the second quarter alone totaled $57 million. For the first half of the fiscal year, the gross margin stood at 33% although the net margin was only 8%. However, this did include the cost of rolling out the product across the country; margins should expand into the third quarter and second half of the year.

Not just Lorillard
These menthol threats are not just limited to Lorillard. Altria's Philip Morris USA unit sells menthol versions of Marlboro, and Reynolds makes menthol versions of its Camel brand, as well as Kool and Salem--all menthol-flavored products.

Still, both Reynolds and Altria are less reliant on their menthol sales than Lorillard. Specifically, Altria's menthol Marlboro's only account for around 20% of total sales, and Reynolds' menthol brands only account for 30% of the company's overall sales.

Summing up
All in all, this does push me toward the conclusion that Lorillard is not really worth the risk. Yes, it is unlikely that a menthol ban will come into force, but on the other hand, tobacco stocks are famous for their defensive nature and buy-and-forget qualities. If any regulations were to be introduced, Lorillard would lose this status as investors would have to keep a close eye on the company's progress fighting the regulation.

Meanwhile, Lorillard's peers, Reynolds American and Altria, look safer as their exposure to menthol is more limited. Furthermore, in the case of Altria, investors have more diversification in the form of the company's wine estates and 30% share of SABMiller. Reynolds American also offers a 5% dividend yield at present, more than Lorillard's current offering of 4.3%.

So overall, Lorillard is not worth the risk. 

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