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Recently I've been looking to shift some of my more conservative funds currently in bonds over to low volatility stable dividend stocks. My goal is to invest some relatively short-term money (2-3 year time frame) in a couple of dependable dividend payers, which I feel have a significant chance of outperforming bonds while at the same time being non-cyclical businesses with low downside risk.

With this thought in mind, I ran a simple screen on Yahoo Finance, using these inputs:

  • Market Cap >$10B
  • Beta < 0.80
  • Yield > 3%
  • Earnings Growth Past 5 years > 5%
  • Forward P/E < 15
  • ROA > 10

The theory on this screen is that it should give me relatively large companies with low volatility and above-average returns on assets (good businesses). Also these companies will have good dividend payouts and be showing continued earnings growth in recent years. Finally I want to ensure a reasonable valuation, so I've put in a P/E < 15, which would be below the market average.

The screen has given me just four names, shown below:

  • Lorillard (NYSE:LO)
  • Sysco Corporation (NYSE:SYY)
  • Rogers Communications (NYSE:RCI)
  • British American Tobacco (NYSEMKT:BTI)

While all of these could potentially be good fits to meet my goals, in this article I will highlight Lorillard from this list, and describe why I believe it is a sold dividend investment to consider adding to your portfolio.

Business Overview

Lorillard is the 3rd-largest manufacturer of cigarettes in the U.S. The company has a market cap of $15.23B and has annual revenue around $4.55B. The flagship brand is Newport, which constitutes 88% of sales and is the 2nd-largest cigarette brand in the U.S. based on units sold, according to the company's website. Besides Newports, the company also manufacturers four other brands for a total of 43 products. These brands include Kent, True, Maverick, and Old Gold. The trademarks outside the U.S. were sold in the 1970s, and the company only manufacturers and sells products in the U.S.

4 Reasons to Buy

Here are four reasons that I like Lorillard as an investment now:

1. Well Managed, Good Business -

Putting aside the obvious negative health effects of smoking and the long-term downward decline of this industry, Lorillard is currently a well managed and good business, judging by its financial fundamentals. I frequently use management effectiveness criteria such as ROA and ROI as methods for finding good businesses. In the screen above I used ROA > 10, however I always like to see it significantly higher than that. This can be a reflection on the business model and industry but also how effective management is with generating shareholder returns for invested capital and the amount of tangible assets the company requires to produce that return. With an ROA about 33% and ROI a very high 59% this is quite impressive for Lorillard. This is higher than major competitors Philip Morris (NYSE:PM), British American Tobacco , Altria (NYSE:MO), and Reynolds American (NYSE:RAI). They all have ROA and ROI figures in the teens and low 20s. The only exception being the ROI of 46% for PM. So although smaller than several of these competitors, Lorillard is for sure a very good business with higher returns.

2. Attractive Valuation

Looking at the EV/EBITDA valuation for Lorillard, it is attractively priced compared with major tobacco industry peers:

CompanyEV/EBITDADiscount to Average
Lorillard8.1121%
Philip Morris11.52-12.5%
Reynolds American9.0112.1%
British American Tobacco12.34-33%
Altria10.35-0.8%

3. Continued Steady Growth

Lorillard has seen impressive revenue and earnings growth in the past five years. Revenue is up 21% per annum and EPS over 17%. This is all the more impressive when looking at the general state of the tobacco industry and the long-term secular trends. U.S. cigarette market value sales are expected to increase at only a 2% CAGR through 2016. Actual volume sales are expected to decrease about 1% per annum over the same period.

One of the major reasons for the outperformance is likely the economy. Lorillard has many lower end, cheaper cigarette brands and some smokers were downgrading to save money in tougher economic times. With about 13% market share in the U.S., Lorillard has more room to grow than some of its larger competitors. Although growth is likely to be much slower in the coming five years, single-digit growth combined with continued high-dividend payouts and share buybacks should continue to propel strong earnings. In August 2012, the company announced a $500 million share buyback program. Since 2006 about 25% of outstanding shares have been repurchased reducing the share count from 521 to 388 million. The company has increased debt the past few years to be able to buyback more stock. Although it cannot keep doing that year after year, the dividend payout ratio is around 70% ($723m), capital expenditures are quite low ($56m in 2011), and interest payments are running around $125m, which is also quite manageable. With stable margins and some growth in revenue, the dividend seems quite secured and some further buybacks can be expected.

4. Non-Cyclical, Low Volatility

Finally I want to point out that like many consumer product companies, Lorillard has a lower volatility than the overall market. In fact the company has a beta of only 0.46 making it less than half as volatile as the overall market. This is exactly what I want in a short-term income generating investment. Although cigarettes are not a necessity, their addictive nature makes it very difficult for people to stop. Therefore economic swings will not have drastic impacts on the earnings of these companies.

Risks to Consider

The most important risk with Lorillard is the recent discussions in the U.S. government about a possible ban on menthol cigarettes. In 2011 an FDA advisory panel actually recommended a ban. This would be devastating to the company, as Newports are menthol and this would almost kill the company overnight. However I doubt that an outright ban would go into place in the near term. For one, the smoking of menthol cigarettes is heavily skewed toward poorer minority communities. Several prominent national minority organizations have lobbied against a ban for fear that it would cause an illegal underground market for these products. Even law enforcement agencies have spoken out against it. Also with many states now legalizing marijuana I think this kind of ban will go against recent trends on how to deal with "sin" substances and will cause more problems than it solves. This being said there are many angles and layers to this debate , and it is a legitimate threat and should be monitored closely by any investors in the company.

Conclusion

Overall I think Lorillard is a solid dividend pick for 2013. Although there are some regulatory risks with menthol cigarettes, I think the risk of outright ban is quite low in the near term. Still I wouldn't put all my eggs in one basket with this one, and be sure to properly diversify as you never know what might happen. However in the short term the company's strong dividend and attractive relative valuation make it a worthwhile investment candidate to seriously consider.

Source: Lorillard: A Solid Dividend Investment For Your Portfolio