Identifying The Gem Of The Tobacco Industry

Mar. 8.13 | About: Lorillard, Inc. (LO)

The tobacco industry is a great investment opportunity. The addictive nature of cigarettes and the outstanding brand loyalty has provided tobacco companies a strong foot - hold in the economy. The tobacco industry posted $35 billion as revenue in 2012 and this figure is expected to grow at an annual rate of 5%. The "Master Settlement Agreement" has turned the American tobacco industry into a cartel. This opportunity will provide a boost to the sales and revenues of the tobacco companies.

Stock Selection

To identify good investment opportunities in the tobacco industry, I short-listed stocks with the highest five-year average annual dividend growth rate. The two stocks that made it to my list are analyzed later in this article to assess their financial position and growth potential. A valuation is also carried out to calculate potential price appreciation.

The five-year average annual dividend growth data is collected for Philip Morris (NYSE:PM), British American Tobacco (NYSEMKT:BTI), Altria (NYSE:MO), Reynolds (NYSE:RAI) and Lorillard (LO).PM and LO have experienced the highest average annual growth rate of 14.6% and 13.8%, respectively. We will make further analysis to unlock their hidden return potential.

5-Year Average Annual Dividend Growth

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Overview of the giants

Though the tobacco industry is facing ever-increasing regulations, smoking bans and high tobacco prices, the tobacco industry is destined to grow. According to the Euromonitor International, the cigarette market was estimated to be worth around $22 billion in 2011. The industry has attracted competition due to the lucrative profits it presents. As Warren Buffett says:

"I'll tell you why I like the cigarette business. It costs a penny to make. Sell it for a dollar. It's addictive. And there's fantastic brand loyalty."

In this competitive landscape, British American , Philip Morris International , Imperial Tobacco (OTCQX:ITYBF) and Japan Tobacco, together, reign over more than 90% of the Russian tobacco sale. At the global level, Philip Morris has claimed the largest market share of 15% and Lorillard is the third-largest manufacturer of cigarettes in U.S. Newport, Lorillard's premium cigarette brand, is the top-selling menthol and the second-largest selling cigarette in the country.

Philip Morris

Philip Morris International is the global tobacco giant that has spread its sales throughout the world, while manufacturing and marketing 'Marlboro.' From 2008 - 2012, PM's dividend increased at a cumulative average growth rate (OTCPK:CAGR) of 33.32%. The market leader built a loyalty for its stock as it left investors with a return of 120% since 2008 whereas its peers provided a return of 65% to its investors over the same time period.

Comparing this giant with the industry, some analysts estimate PM to grow at a rate of 11.6% per annum whereas the industry is forecast to grow at 5%. Philip Morris has a consistent and progressive dividend history with a dividend yield of 3.71%. The ratio comparison of Philip Morris is presented below in a tabular form.

Key Stats

Philip Morris

Industry Average

Price/Earnings TTM

17.9

17

Price/Book

-43.9

58.5

Price/Sales TTM

2

2.2

Rev Growth (3 Yr Avg)

7.6

-1.9

EPS Growth (3 Yr Avg)

16.9

-

Operating Margin % TTM

17.9

23.4

Net Margin % TTM

11.4

21.3

ROE TTM

0

108.8

Debt/Equity

0

1.8

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Source: Morningstar

Lorillard Inc. (LO)

Lorillard is the third-largest manufacturer of cigarettes in United States. Over the last five years Lorillard grew its dividend at a CAGR of 35.486%. It has the dividend yield of 5.8%, the highest among the U.S. tobacco market players. The payout ratio of this giant stands at 74% and a return on assets is calculated at 40%.

The year 2012 was full of significant events for Lorillard. In 2012, Lorillard acquired blu Ecigs for $135 million and announced a $500 million share repurchase. These strategic decisions can have a positive effect on the stock price and can improve investor sentiments.

Financial Results - 2012

Lorillard

Adjusted Non - GAAP figures

USD mm

2012

2011

% change

Net Sales

6,623

6,466

2.4%

Operating Income

1,883

1,867

0.9%

Net Income

1,103

1,101

0.2%

Diluted EPS

Reported US GAAP

2.81

2.66

5.6%

Adjusted Non GAAP

2.82

2.63

7.2%

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Lorillard recently announced its 4Q12 and annual results (Table above). The net sales of the company grew 2.4% from 2011 to 2012 resulting in 5.6% increase in the reported U.S. GAAP, diluted EPS.

Analysts estimate LO to grow at a rate of 10.5% compared with the industry growth rate of 5%. Lorillard has a constant dividend history with the trailing dividend yield of 5.5% and a forward dividend yield of 5.8%.

Key Stats

Lorillard

Ind Avg

Price/Earnings TTM

13.6

17.1

Price/Book

-8.2

58.5

Price/Sales TTM

2.3

2.3

Rev Growth (3 Yr Avg)

8.2

-1.9

EPS Growth (3 Yr Avg)

13.5

-

Operating Margin % TTM

28.4

23.4

Net Margin % TTM

16.6

21.3

ROE TTM

0

108.8

Debt/Equity

0

1.8

Click to enlarge

Source: Morningstar

Putting a call on the gem

A multiple - based approach is used to value Philip Morris and Lorillard. Multiples are collected for the major tobacco manufacturers to calculate average multiples for the industry and the valuation for Philip Morris and Lorillard. (Tables below)

Company Financials, Reuters, CapIQ

PM

LO

RAI

BTI

Average

P/E TTM

17.76

13.61

19.25

16.77

16.85

P/S TTM

4.82

3.13

2.87

4.19

3.75

EV / Sales TTM

5.44

3.42

3.20

4.77

4.21

EV / EBITDA TTM

11.52

7.62

10.13

11.94

10.30

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Valuation Matrix

Average Multiples

PM

LO

Cash (Per Share) PM

Cash(Per Share) LO

P/E

16.85

5.17

6.34

P/S

3.75

18.54

11.91

EV / Sales

4.21

18.54

11.91

1.81

4.55

EV / EBITDA

10.30

8.76

5.34

1.81

4.55

Click to enlarge

Equity Value Per Share

PM

LO

P/E

87.10

106.81

P/S

69.57

44.69

EV / Sales

79.82

54.66

EV / EBITDA

92.08

59.55

Weighted Average Value

82.14

66.43

Current Price

91.6

38.24

Expected Return

-10%

74%

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Using the multiples - based analysis the target price for Lorillard is calculated at $66.43, which is 74% higher than its current price in the market. Philip Morris, on the other hand, is over - priced as its calculated fair value is lying 10% below its current market price.

Conclusion

Due to the debt the company has piled on in its balance sheet Lorillard is currently trading close to its 52-week low. The investors are not realizing the potential price appreciation that is locked in it at the current time. The company has an exceptional payout ratio of 74%, a low beta (0.43) and a forward annual dividend yield of 5.8%. The exceptional return potential, large dividend yield, high dividend growth rate and strategic decisions to expand and pace growth have placed Lorillard at the top of my "stocks - to - buy" list. With its suppressed market value and growing earnings per share, Lorillard is the gem of the tobacco industry. I am not hesitating in claiming it a "long-term buy."

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.