Lorillard: The Risk And Opportunity Of Pending Regulations

May.24.13 | About: Lorillard, Inc. (LO)

Lorillard Basics

Lorillard (NYSE:LO), along with Altria (NYSE:MO) and Reynolds America (NYSE:RAI), is one of the three major domestic cigarette companies in the United States. Of the three, it stands out for the following key characteristics:

  • 87% of sales come from Newport, a menthol cigarette, which is the second most popular cigarette in the United States, after Marlboro.
  • LO is the most concentrated on cigarette sales. Both MO and RAI are still primarily cigarette plays too, but each has diversified slightly into smokeless tobacco and, in Altria's case, wine and beer. LO is almost all cigarettes.
  • LO was the first major cigarette company to branch into the e-cigarette business, and its blue eCig brand is the market leader.

On Seeking Alpha, I have seen a lot of good commentary from other writers regarding LO's historical returns, managing LO as part of a dividend income portfolio and other analysis focusing on the overall decline in domestic cigarette use. Indeed, Lorillard's incredibly high returns on capital and 5% dividend yield make it attractive for many. However, I have seen too few mentions of a very important factor at play with Lorillard, which potential investors absolutely need to consider.

The Number One Risk Factor for Lorillard

For Altria and Reynolds, litigation is the number one risk factor mentioned in their annual reports. For Lorillard, it is another issue that is a major risk particularly for them - the potential of an FDA ban on menthol. Because Lorillard's sales are almost entirely from the top-selling menthol cigarette, any decision by the FDA to ban or regulate menthol would affect them adversely.

The 2009 Family Smoking Prevention and Tobacco Control Act established a special committee to evaluate, among other things, the relationship between menthol in cigarettes and teenage smoking and the overall impact of menthol cigarettes on human health. Most importantly, the FDA was given the authority to restrict or outright ban menthol in cigarettes.

Since this act, the FDA has made slow, steady progress towards a conclusion on how to treat menthol. In 2011 they issued their first report, which stated menthol causes:

  1. More Experimentation: Menthol increased smoking "experimentation" which could lead to regular smoking among young people
  2. Less Successful Cessation: African-American menthol smokers are less likely to quit and do not respond as well to cessation options
  3. Increases youth addiction rates: Menthol likely increases the likelihood of addiction for youth smokers
  4. Has image of being less harmful: Many consumers think menthol cigarettes are less harmful than normal cigarettes, and
  5. The cooling effect reduces harshness: Menthol's anesthetic properties help new smokers get accustomed to smoking

There are other conclusions, but these are some of the main ones. All indicate the potential conclusion, when the FDA comes to its final decision, that menthol will be regulated in some way or even banned.

The 2011 report above was a preliminary report. Since then, the FDA has been conducting studies and gradually putting together a final report to recommend what to do about menthol in cigarettes. Other than a minor update in January 2012, there has been no new information about the contents of that report--just updates on timing.

Mitch Zeller's Influence

The current director of the FDA's Center for Tobacco Products is Mitch Zeller, a former lawyer who joined the FDA this March (2013). When he was announced, industry experts widely saw him as a negative influence. For an idea why, see this interview here. He also said at his appointment that the FDA should

"come up with a comprehensive nicotine regulatory policy aimed at shifting tobacco users down the continuum from the most harmful to the least harmful."

From these comments it is fairly clear what Mr. Zeller would prefer regarding menthol - if not an outright ban, at least a gradual reduction in amount or percent of the market. We will soon find out what the FDA decides: at recent speeches, Zeller has emphasized clarifying the FDA's policy on menthol is a priority, and hinted that the final report will be out soon.

The market is unprepared for harsh action on menthol

Nearly every Wall Street analyst I have read or talked with doubts the FDA will do anything significant on menthol, which makes the risk profile of the decision higher, in my view. While I cannot reprint them here due to copyrights, Morgan Stanley, Goldman Sachs and other Wall Street analysts have all played down the potential FDA actions on LO. An attitude I think shared by most Street analysts was publicly stated by Wells Fargo:

Wells Fargo: "We continue to believe that an outright ban on menthol is unlikely...a more realistic, worst-case scenario is if the FDA recommends that menthol levels in all cigarettes be reduced over a number of years."

I have no inside scoop to what the FDA will announce. All of you likely have your own opinions. But I suspect that the reason the FDA is taking its time, dotting each i and crossing each t, is that they will announce significant regulation of menthol in cigarettes, and they want to ensure the evidence and regulation is legally sound.

The market will likely react to this negatively. There are signs LO is undervalued compared to its peers (dividend yield being an obvious metric), and some of this is likely priced in. But analyst reports and my readings through SA indicate, to me, that the market will likely be surprised by the FDA's actions when they are announced. As Mr. Zeller notes, the FDA "has an unprecedented opportunity" to regulate smoking. I do not think he or the FDA will let that go by.

This will create a buying opportunity. Don't let this scare you from LO entirely. The cigarette industry as a whole has peerless returns, but LO is astounding: Pre-tax Pre-interest earnings (EBIT) were $1.8B last year off assets booked at $3.8B - a return on assets of nearly 50%. Equity and debt investors have a total of $19.6B invested in the company, valued at market, meaning the company generates returns of nearly 10%. Coke (NYSE:KO), on a similar calculation, returns 5%. Heinz (HNZ), Buffett's recent investment, returns 6%. At these returns LO is an absolute no-brainer. Even if a menthol ban causes some smokers to suddenly stop smoking, or switch to Marlboro, or otherwise cause LO's earnings to be cut in half, LO would still return the same percent as these core Buffett holdings.

But wait for the FDA's decision. Warren Buffett has famously advised investors to chose their investments as though you were given a punch card with 20 slots for your entire life - each time you invest, punch a slot. I believe the FDA menthol decision may offer this type of opportunity. There will be a reaction, and I think a smart bet is that this reaction is down as the FDA promulgates regulations harsher than people expect. If that happens, pull the trigger.

Disclosure: I am long MO. 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.