Lorillard - Great Value Going Long Or Using A Covered Call

| About: Lorillard, Inc. (LO)

Today I would like to take a look at Lorillard (NYSE:LO) and assess both its value as a long investment and also as a long investment accompanied by covered call(s). First of all, I understand that some people are morally against investing in tobacco companies and this article is not intended to offend anyone who feels that way.

However, I personally think tobacco stocks offer great value and potential returns. Also, they have been some of the best performers in the past few years out of many large-cap stocks.

There are some great articles out there right now focusing on Lorillard's business and the future trends for their industry. One of those articles is one that questions if electronic cigarettes are a threat to big tobacco. The mention of Lorillard buying blu Cigs is the key point I took from that article as it shows me Lorillard is positioning itself to benefit from this market if it takes market share away from the traditional cigarette business. Here is another great article that neatly summarizes this e-cigarette opportunity and recaps Lorillard's business performance along with discussing their future opportunities.

Here are some of the reasons I think this stock offers great value. First is the dividend. In a Feb. 17, 2011, press release from Lorillard's website, it announced the 2011 dividend increase. In that press release, the company stated that they have a "targeted dividend payout ratio of 70%-75% of earnings." This targeted dividend payout ratio transparency is something that is done by other tobacco companies as well. I believe that management should be commended for this transparency. In my opinion, this shows a firm commitment to acting in the best interest of shareholders, and I like to know that a company I am investing in will always act in this regard for me.

In 2012, this dividend payout ratio meshes nicely with the consensus analyst estimate for EPS. That estimate is for $8.39 per share of earnings (all numbers per Yahoo Finance), and the 2012 dividend total was $6.20 ($1.55 per quarter). This is a 73.9% dividend payout ratio. For 2013, the analyst consensus estimate is for EPS of $9.11. If they pay out 73.9% of that, we should see the dividend increase to $6.73 per share, or $1.68 per quarter. This would be an 8.4% dividend increase from 2012. At Lorillard's current share price as of the Dec. 7, 2012, close ($121.48), the yield would be 5.54%. This is important because the stock went ex-dividend in late November and the next dividend should be an increased amount, which will be announced in February.

Second, let's take a look at the 52-week range in price of the stock. It is $106.83-$141.07. In taking a further look at this, a Yahoo Finance chart of one-year price performance shows that the low was established before the 2012 dividend increase in February 2012 that accompanied earnings. After that, the stock went up considerably. I'd argue that the higher dividend supports the stock price to a certain extent. The $111.70 close on Oct. 24, 2012, is the lowest the stock price has gone to since that dividend increase. We are currently only 8.76% above that level. With a dividend increase likely coming, this should provide yet another floor for the stock price in my opinion. Unless there are any unforeseen upcoming negative circumstances for Lorillard, I see a good possibility here of returning to the 52-week high. The 52-week high provides an incredible one-year return, plus dividends, if we can reach it in 2013 -- let alone if the stock price pushes past that.

All of this comes into play when deciding whether I would want to be long on the stock, or buy a covered call for it against a long position. I like covered calls. Let's take one example. Let's look at the June 21, 2013, $130 call for Lorillard. The current bid price for it is $3.40, so this example assumes that those are the proceeds you would receive for opening a covered call position. Buying 100 shares of Lorillard would cost you $12,148 (these examples do not consider commissions and fees). The covered call would get you $340, plus you would get two quarterly dividends before June 21, 2013, at (estimated) $1.68 per share. That would be $340 plus $336 = $676. That is a 5.56% total return for only about six months (11.12% annualized, roughly).

If it gets called, your total gain will be $676 plus ($130-121.48 times 100 shares) $852 for a total of $1,528. That would give you a return on investment of 12.58% in only about six months, or about 25% annualized. If it does not get to $130 by then, you keep the shares and the dividends and covered call money. With the 52-week low of the stock being $106.83, as you can see, we are further away from the high than we are the low. In my opinion, this makes this stock look even more attractive at this price point than it would look if it were closer to the 52-week high. Remember, if you invest in options like this for Lorillard, the upcoming 3-for-1 stock split needs to be kept in mind for the number of shares you are responsible for in your covered call.

In order to have covered calls work for you, my philosophy is that you have to believe in the stock and be happy to own it if even if it goes down a bit. If it gets called away, you will have a nice return and you can surely find another great opportunity in this stock, or in another one. In this particular case, I believe that establishing a long position and opening a covered call position in Lorillard at this point is a very low-risk play.

For my investment purposes, however, I am currently not choosing to have a covered call against my long position. The forward projected yield I have presented here is enough for me to hold the stock. Since I see limited downside possible to the extent of the 52-week low ($106.83), and potential upside to around $140 or so, the upside seems to be more likely to me. I see the upcoming 3-for-1 stock split as a potential catalyst and the company buyback helping, not to mention the numerous potential opportunities that seem to be on the horizon for tobacco companies.

Disclosure: I am long LO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Disclaimer: This article is not an attempt to solicit investors. Additionally, this article is only for informational and educational purposes.