One of the more liberating ideas that I have come across, courtesy of Berkshire Hathaway's (BRK.B) Vice Chairman Charlie Munger, is that we do not have to reach a conclusion about every stock. He points out that it is perfectly fine to have an "I Don't Know" reaction to the long-term future of a particular investment. More specifically, Munger points out that he puts all his investment considerations into one of three categories: "yes," "no," or "too damn hard." As a general rule, I have put tobacco industry investments into my own "too hard" pile because I have not been able to reconcile the increasing government regulations and taxation against the fact that the cash flow generated by Lorillard (LO), Altria (MO), Reynolds (RAI) and Philip Morris International (PM) remains enormous.
That is why I cannot make 15+ year predictions about tobacco companies. But what I can do is take a look at the decisions of management and make a determination as to whether they are allocating capital efficiently over the medium term. In particular, I would like to talk about Lorillard's intelligent stock buyback program that has been ongoing since becoming an independent publicly held company after Loews (L) spun it off in June 2008.
First off, let's keep in mind the big picture with Lorillard:
For a mature company in a declining industry, Lorillard generates a meaningful amount of cash flow that is not committed to the dividend. The current quarterly payout of $0.55 works out to $2.20 in annual payouts. Lorillard is expected to earn $3.05 this year, making the dividend payout represent 72% of earnings. The company is expected to generate $3.20 in cash flow this year, making the dividend represent 69% of cash flow per share.
The company's ability to effectively use that 30% not committed to the dividend will have a large impact on determining whether Lorillard will be able to crank out earnings and dividend growth going forward. The company has a good handle on its debt - Lorillard has $3.1 billion in debt as of 2012, and over $2 billion of that has been refinanced in the past three years, indicating that the company has locked in lower rates. The company only has $700 million due by 2017-2018, ensuring that the present debt will have a minimal effect on the company's overall cash flow.
The debt and free cash flow (not dedicated to the dividend) has been dedicated to stock buybacks. In my opinion, the continuation of this aggressive buyback program may be the saving grace for Lorillard shareholders over the long term. In 2007, the company had 504 million shares outstanding. The share count is estimated to be 372 million shares outstanding by the end of 2013 (it was 384 million at the end of 2012). Lorillard's commitment to steadily reducing the share count by tens of millions of shares each year possibly signals that the dividend and earnings can continue to grow indefinitely even if the core tobacco business stagnates or declines modestly.
While these continual stock repurchases that steadily reduce the share count have the potential to make Lorillard a relentless cash generator for years to come, the long-term viability of a business is only as strong as its core underlying business. In the case of Lorillard, everything is concentrated. Not only is the company in a declining industry, but it only sells products in the United States. It manufactures all of its products from a single facility in Greensboro, North Carolina. The Newport brand accounts for 88.4% of net sales (although the acquisition of Blu Ecigs should bring that figure down a bit). This kind of heavy concentration may bother some investors.
If I were a Lorillard shareholder, I would keep my eye on the stock buyback program. That is the company's saving grace because steady 5-10% annual reductions in the share count can manufacture long-term earnings and dividend growth even if the core business stagnates. If overall cigarette volumes are going to decline 3-4% annually in the United States (and price increases are not an available option to offset this), then Lorillard's strong buyback program can serve as a decent coping mechanism against this long-term trend.
As a hedge, I would take the proceeds from the 5.42% annual dividend and reinvest the funds elsewhere. I personally could not bring myself to escalate my commitment to a business in a declining industry by reinvesting the dividends back into the same company. But that is just me. Monitoring is the name of the game with tobacco companies, and I would perform my due diligence by watching for significant declines in the Newport brand and maintaining awareness of how many shares are retired each year by the buyback program. The continuation of a well-executed buyback may be the primary driver of Lorillard's earnings and dividend growth over the next 5+ years.