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A high dividend yield of 5%, cheaper forward P/E ratio of 12.7x in comparison to its peers (as shown below), and an impressive expected five years growth rate of 10% makes me bullish on Lorillard (NYSE:LO). Also, the company is actively working on e-cigarettes, which will be an important source of growth for the tobacco industry.

The U.S. tobacco industry has been pressurized due to intense competition and lower volumes. Health concerns and tougher regulations imposed on the tobacco industry have made business conditions difficult. The ongoing conditions have made cost saving initiatives, price increases, and allocation of cash for share repurchases important tools for the industry to achieve bottom line expansion. Volume growth is hard to achieve and this situation has prevailed for quite some time now. The following chart shows the downward volume trend for the tobacco industry from 2010 through 2012.
(click to enlarge)
Source: Quarterly Reports

Lorillard is the third largest tobacco company in the U.S. The company holds a significant market share of 14.9% in the cigarette category and 38% market share in the menthol cigarette sub category. The company's flagship brand is Newport, which makes nearly 85% of the total cigarette volume of the company.

LO was able to deliver healthy financial performance in 1Q 2013. LO reported earnings per share of $0.66, beating the analysts' consensus by 2 cents, up 14% as compared to the corresponding period last year. The company was also able to post better sales volume in the quarter, a decline of 2.6%, in comparison to the industry volume decline of 6.2%. However, top line for the company increased to $1.57 billion (including excise taxes), representing an increase of 3% on a year on year basis. LO was able to expand its market share by 0.4% to 14.9% in the most recent first quarter.
(click to enlarge)
Source: Quarterly Reports

LO is among the leading tobacco companies that are competitively working towards the e-cigarette category. LO acquired e-cigarette maker BlueCigs in April last year. E-cigarettes contributed $57 million in total revenue for LO in the recent first quarter. The solid sales for e-cigarettes during the last quarter were mainly a result of marketing efforts and expansion of retail distribution. BlueCigs distribution increased to more than 80,000 retail outlets. The company's efforts towards e-cigarettes and other alternatives to traditional tobacco remain important stock price catalysts for LO.

Last month LO and Reynolds (NYSE:RAI) announced that they will increase prices across their respective portfolios by 6 cents, following in the footprints of Altria (NYSE:MO). Prior to the recent price increases, the three companies increased prices in Dec. 2012. Recently, price increases for the premium brands and discount brands of LO were 1.4% and 2.3% respectively.

Key catalysts for LO include its continued growth in the menthol market, ability to increase prices in the future, share repurchases and increases in leverage. Aforementioned factors can significantly impact the financial performance and stock price of LO.

Share repurchase and Dividend

As stated earlier, share repurchase programs remain an important tool for tobacco companies to expand their bottom lines. LO has also been following the industry in regards to the share repurchase initiatives. The company repurchased 3.8 million shares for an amount of $149 million in 1Q'13. LO also approved another $500 million worth share repurchase program; worth 3% of the current market capitalization.

Dividend payments have been a popular tool for LO to share its successes with its shareholders. LO currently offers an impressive dividend yield of 5%, which is closely backed by its strong free cash flow yield of 7.1%. The company has increased its dividends consistently over the years; there have been five dividend increases since 2008. The ongoing quarterly dividend offered by LO is 55 cents, translating into an annualized dividend rate of $2.20 per share.

Risks

A major concern for the tobacco industry and LO is declining volumes. The decline is a result of a shift towards alternative tobacco products, tightening regulations and decreasing social acceptability for smoking. Moreover, FDA may increase menthol regulation which is now one of the important company level risks for LO. The recent appointment of Mitch Zeller as head of the Center for Tobacco Products at the FDA poses a risk to LO due to Zeller's history of being an anti-tobacco advocate. There is also uncertainty regarding the ongoing review of menthol, which can adversely affect the financial performance and growth expectation of LO. (Menthol has been a concern for the regulators as it is perceived to be popular among the young smokers and therefore prompts them to start smoking at an early age).

Conclusion

LO

Altria

Reynolds

Philip Morris (NYSE:PM)

Average

Dividend Yield

5%

5%

5.3%

3.9%

4.8%

Forward P/E

12.7x

13.5x

14x

14x

13.5x

PEG

1.5

2

2

1.5

1.75

5 Years growth est.

10%

7%

7%

11%

8.75%

Source: Yahoo Finance

LO offers a high dividend yield of 5%, in comparison to its peers' average of 4.8%. Also, LO has a cheaper forward P/E of 12.7x as compared to its peers' average of 13.5x. Moreover, LO's lower PEG of 1.5 indicates that the company offers cheaper growth in comparison to MO and RAI. Furthermore, analysts are projecting a high EPS growth rate of 10% per year for the next five years that is likely to be driven by price increases, share repurchases and an alternative tobacco segment. Due to these attractive aforementioned valuations, I remain bullish on LO.

Source: High Dividend Yield Of 5% And Attractive Valuations Make Lorillard A 'Buy'