Some investors shy away from tobacco companies in their portfolios, arguing that it's not right to profit from products that most people see as addictive and unhealthy. Yet those who have been willing to invest in tobacco companies have come away with impressive long-term returns, and Lorillard (NYSE:LO) is no exception. With its popular Newport brand, Lorillard is a major player in tobacco and has a commanding position in the menthol-cigarette segment. Yet because of the company's pending deal with former rival Reynolds American (NYSE:RAI), those who are willing to use so-called sin stocks to generate portfolio profits should look beyond Lorillard to find the best possible exposure available. Let's take a closer look at Lorillard to explain why it's not the right sin stock to add to your portfolio right now.
A no-win situation for Lorillard
It's indisputable that Lorillard shareholders have seen huge rewards from their investment in the tobacco company. Since late 2009, Lorillard has produced total returns of almost 25% annually, with strong income in the form of dividends accompanying impressive capital gains as well.
What makes those results so surprising is that they've come with much more modest growth in revenue and earnings. Total revenue has climbed by just 36% over the past five years, and total earnings growth has weighed in just above 20% during the entire period. It's clear that Lorillard stock took the financial crisis too hard, and since then, much of the recovery in the share price has been because of its continued survival rather than fundamental improvement in the tobacco company's financial strength.
But the real problem facing would-be Lorillard investors right now is that the current merger deal with Reynolds American gives them relatively little upside against substantial downside risk. The way the merger is structured, Lorillard investors will receive $50.50 per share in cash for their Lorillard stock, as well as 29.09 Reynolds American shares for every 100 Lorillard shares they own. At current prices, that amounts to about $18 in Reynolds stock for every Lorillard share, meaning Lorillard investors will end up getting about a quarter of their payment in the merger in the form of an ongoing ownership interest in the combined entity.
That minimal equity interest gives Lorillard shareholders limited exposure to the ongoing success of the combined Reynolds-Lorillard tobacco business. Yet investors bear the full risk of any potential problems in consummating the deal. Even though Lorillard stock trades significantly below the implied value of the cash and shares Reynolds American has offered, anything that definitively terminates the deal would likely send Lorillard shares plunging.
Lorillard: Facing increased competition from other tobacco companies
Even if you discount the impact of the merger, Lorillard faces an increasingly uncertain future. In the company's third-quarter earnings report, Lorillard saw a minimal rise in revenue as cigarette volumes continued to decline. Price increases helped keep Lorillard's profits up, but the introduction of competing electronic-cigarette products from Reynolds American and Altria (NYSE:MO) put Lorillard's blu eCigs brand to the test, and a substantial drop in market share showed how vulnerable Lorillard's key growth initiative might be if its larger peers gang up on blu and promote their own products instead.
Lorillard also has to deal with the ever-present threat of greater regulation and other countermeasures from government entities and consumer advocates. The Puerto Rican government imposed a $1 per pack excise tax to try to improve its own financial picture, hurting Lorillard's sales in the region. Even the usually popular Newport menthol brand saw volume decline 1.4% from the year-ago quarter, and some believe the company faces regulatory threats that could eventually lead to the outright ban of menthol and other flavorings for cigarettes.
Under different circumstances, Lorillard would be a no-brainer for investors looking for lucrative sin stocks with a history of successful financial performance. With the Reynolds American merger hanging over its head, though, Lorillard isn't the best sin stock you can buy right now, especially if you believe in the prospects for the tobacco industry's future.
Dan Caplinger 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.