Recently, I argued that shares of Philip Morris (PM) were overvalued just a bit. Philip Morris was my top value pick for both 2012 and 2013 given its decent dividend and sizable stock buyback. However, my list of value names for 2013 included another cigarette name, Lorillard (LO). While Lorillard and Philip Morris have varying businesses and countries of operations, they have always been on my list of names to compare in this space. Part of my reasoning that Philip Morris was overvalued had to do with Lorillard. Despite the larger stock buyback from Philip Morris, Lorillard had a much higher dividend and traded at a significantly lower valuation with a similar growth profile. Last week, Lorillard announced a new $500 million share repurchase program. This makes Lorillard an even more attractive investment, and today I will describe why (using most of the arguments from my PM article).
Dividends versus buybacks:
Investors love companies that pay dividends and buy back stock. Cigarette names, including Altria (MO) and Reynolds American (RAI), pay very nice dividends, and these stocks are buying back stock as well. As of Friday's close, the dividend yields on an annual basis were as follows: Philip Morris 3.73%, Altria 5.18%, Reynolds 5.47%, and Lorillard 5.70%. Lorillard had a slightly higher yield earlier Friday and late Thursday, approaching 5.80%, but the stock popped during Friday's session on the buyback announcement.
As for buybacks, Philip Morris stated that they would be buying back about $6 billion worth of stock this year. At the end of last year, Philip Morris had a market cap of roughly $138 billion, so their plan would be for about 4.35% of shares this year. Lorillard's $500 million buyback would represent about 3.39% of the $14.75 billion market cap at the start of 2013. However, if you add in the $109 million left on the outstanding plan at the end of 2012, you are at about 4.13% of outstanding shares. Given these numbers, we can probably assume that Philip Morris will buy back more stock in 2013. However, Lorillard's dividend yield is roughly 2 full percentage points higher. That higher yield more than makes up for a smaller buyback, even if you exclude the $109 million.
When it comes to revenue growth, Lorillard leads in projected growth (by analysts) for 2013 and 2014. Lorillard is projected to show 6.2% revenue growth in 2013, compared to just 3.8% for Philip Morris, 0.9% for Altria, and 0.1% for Reynolds. For 2014 projected revenue growth, Philip Morris maintains a slight edge over Lorillard (6.1% to 5.8%), with Altria and Reynolds a bit behind again. Over the two year period, Lorillard is expected to show total revenue growth of 12.3%, while Philip Morris trails at 10.1%.
In terms of earnings per share growth, I've pasted part of the table from my Philip Morris article since the numbers have not changed.
Philip Morris leads in terms of projected earnings per share growth, although the two-year margin isn't as great as Lorillard's two year revenue growth margin. The other item to consider is that analysts might not have taken into account any buybacks from Lorillard just yet. Now that Lorillard has announced the new buyback, it is possible that analysts could raise their estimates by a few pennies, which could put Lorillard's earnings growth on par with that of Philip Morris. For most of these names, a significant amount of earnings per share growth is coming from the buybacks. It's not all coming just from growth in net income.
Lorillard has the lowest valuation among the group when it comes to both price to sales and price to earnings, based on current expectations for 2013 and 2014. The following table shows this.
Some may argue that Lorillard deserves to trade at a discount because of the menthol issue. Newport, Lorillard's flagship premium cigarette brand, is the top selling menthol and second largest selling cigarette in the U.S. The US Food and Drug Administration is deciding on whether to ban menthol, which would obviously be a huge negative for Lorillard. As you might expect, Lorillard Chief Executive Officer Murray Kessler has said menthol cigarettes don't warrant greater regulation than regular cigarettes.
I can understand that some are fearful of owning Lorillard, however, shares trade at a huge discount, especially against Philip Morris. Is that huge discount warranted? When Lorillard shares were in the $42 to $43 range, I would have been a little more worried, but in the $38 to $39 range, concerns are a little less. If you were to take out the menthol issue, and focus solely on the growth prospects, dividend, and buyback, Lorillard is definitely undervalued compared to the others.
I recently argued that Philip Morris was a bit overvalued, and that probably means that by the numbers, Lorillard was a bit undervalued. Lorillard's announcement of a new $500 million buyback plan strikes home that point a little more. With a 5.70% dividend yield and solid growth estimates, Lorillard remains a top play in the cigarette space. Those that are uneasy about a potential menthol ban believe the company should trade at a huge discount, and it does. If a ban doesn't occur, Lorillard should trade more in line with other names in the space, which would represent significant upside. Also, ask yourself this question. If the company thought that a menthol ban may be coming, would they really announce a new buyback plan?
Additional disclosure: Investors are always reminded that before making any investment, you should do your own proper due diligence on any name directly or indirectly mentioned in this article. Investors should also consider seeking advice from a broker or financial adviser before making any investment decisions. Any material in this article should be considered general information, and not relied on as a formal investment recommendation.