Is Lorillard the Best Tobacco Buy?

Will blu e-cigarettes prove to be Lorillard’s savior?

Jun 6, 2014 at 12:55PM

Ever since consumers became more health conscious, investors have lost their faith in most of the tobacco companies. With people abandoning their smoking habits, sales volumes for traditional cigarettes have been constantly dropping. As a result, Lorillard Tobacco (NYSE:LO), Philip Morris International (NYSE:PM), and Reynolds American (NYSE:RAI) are increasing their prices to make up for the volume declines.

Quarterly earnings
In the first quarter, Lorillard's earnings grew 4.5% year-over-year to $0.69 per share on the back of strong revenue in the traditional cigarettes segment and the impact of share buybacks. During the quarter, the company repurchased 3.2 million shares at a cost of $158 million.

Traditional cigarettes:
Traditional cigarettes' net sales increased 1.4% to $1.541 billion as higher prices offset lower sales volume. Adjusted gross profit rose 4.2%, which in turn increased adjusted operating income by 4.9%.

Electronic cigarettes:
As the company reduced its prices for rechargeable kits, net sales for e-cigarettes declined 4% to $49 million. Adjusted operating loss for the segment was $5 million due to the impact of advertising costs in the U.S. and rebranding expenses in the U.K.

What's in store for the future?
As health-conscious people continue to quit smoking, most of the cigarette companies are increasing their prices to offset the volume declines. Though this strategy is paying off in the short term, it isn't a long-term solution for the declining tobacco industry. In other words, the catalyst for Lorillard's growth in the coming years will be its e-cigarettes.

Lorillard's e-cigarette brand for the U.S. market, blu, is doing a great job; its share in the country rose to 45% in the recent quarter, according to Nielsen. Moreover, the company's acquisition of SKYCIG will ensure that it makes further inroads in the UK's e-cigarette market as well. On the whole, Lorillard's long-term future in e-cigarettes looks quite secure.

Lorillard expects its blu category in the U.S. to keep operating at a break-even level in the short-term. The reason behind this is its decision to lower prices on rechargeable kits to attract more customers. As the company is rebranding its product from SKYCIG to blu in the U.K., it expects to incur more marketing and launch costs this year. The net operating impact of these investments over the next six to nine months could be around $10 to $20 million. In short, the company won't be making any substantial profit from the e-cigarettes category in the next few quarters.

Valuation

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Of all these tobacco giants, Philip Morris is the only company which hasn't provided any return in the last year. When we compare Lorillard to Reynolds, we see that Lorillard's share price has appreciated a lot more than that of Reynolds. It's also cheaper than Reynolds, which is evident from its lower forward price to earnings (one-year) ratio. Lorillard's high cash per share shows that the company can keep yielding healthy dividends in the future, plus, it can easily repurchase shares to boost its share price.

Philip Morris and Reynolds American
Philip Morris once again posted disappointing results as its earnings dropped by 8% in the recent quarter. Revenue in the European region improved slightly due to higher pricing; however, sales for Asia and Canada declined significantly.

Growing health concerns about cigarettes aren't going anywhere, which is a worrying sign for the company. The National Health Insurance Service, or NHIS, South Korea's state health insurer, has recently said that it will be suing Philip Morris, British American Tobacco, and local market leader KT&G in a South Korean court. NHIS is seeking $51.9 million from these three tobacco giants to offset treatment costs for smoking-linked diseases. NHIS says it spends around $1.6 billion every year to treat smoking-related diseases.

Compared to the last year, Reynolds American's first quarter adjusted earnings remained flat at $0.72 per share. Just like its peers, its sales volume declined, though its Camel and Pall Mall brands did a better job.

In order to meet the changing preferences of consumers, the company plans to invest heavily in smokeless and moist snuff products. Apart from this, it expects a lot from its e-cigarette brand, VUSE, which will begin nationwide distribution in fiscal 2014.

Bottom line
Like all tobacco companies, Lorillard's sales volume has taken a hit as a result of growing numbers of health-conscious consumers. This is why the company is raising its prices to offset the volume decline. However, this strategy isn't sustainable over the long run because it can't hike prices on a regular basis.

On the other hand, Lorillard's e-cigarette brand, blu, has been doing a great job over the last few months, which is why the company is investing a lot in it. Once the company gets a hold in the U.K. e-cigarette market, its e-cigarettes will become the major driving force behind its revenue. This in turn means that it won't to have to raise prices for traditional cigarettes in the future. On the whole, Lorillard's future looks brighter than those of most of the tobacco companies, which makes it a good long-term buy.

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Waqar Saif 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.

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