Why I Said Goodbye To Lorillard, Inc.

| About: Lorillard, Inc. (LO)

I recently said "goodbye" to my stock in Lorillard (NYSE:LO). I have owned a substantial number of shares in LO for years. It has been a great investment. LO has provided me with outstanding dividend income, as well as growth in its share price. I hated to see it go.

Why, you may ask, did I sell such a fabulous stock?

Well, I believe that a substantial decrease in the share price is lurking on the horizon. I can't tell you when the decrease will hit, but I feel assured it will hit. When the "trigger" is pulled, I believe that the share price will drop like a rock. I also expect that there will be virtually no chance of a recovery or bounce in the price of LO's shares, at least not to the lofty levels seen in the recent past. I fully expect LO's revenues to drastically decline. Consequently, I expect its dividend to be substantially cut or even vanish.

What, you may ask, is the "trigger" event that could possibly produce such a catastrophe? In a word, "menthol."

After much study, I believe that the FDA is on the verge of taking significant regulatory action against mentholated cigarettes, and perhaps menthol in other tobacco products that fall within its jurisdiction. If you visit the FDA's website devoted to the issue of menthol in cigarettes, it is hard to reach a different conclusion. While the regulatory action could run the gamut from restricting the amount of menthol in a cigarette to prohibition on the use of menthol in cigarettes, I think the odds favor outright prohibition.

A prohibition on the use of menthol in cigarettes would have a devastating impact on LO. This is readily apparent when one reviews LO's Form 10-K for 2012. LO sells its cigarettes primarily in the U.S. domestic market. Its flagship brand is Newport, the top-selling menthol cigarette in the U.S. and the second-largest selling brand overall in the country. As of year-end 2012, LO owned 39.3% of the menthol market. The Newport brand accounted for 87% of LO's net sales. Imagine for a moment what will happen to LO's revenues if the Newport brand is withdrawn from the market because of a prohibition on menthol.

Will the FDA be so bold as to eliminate menthol, wipe out billions in sales, and millions in net income for LO, not to mention other producers? The pressure to do so will be immense. The Family Smoking Prevention and Tobacco Control Act was signed into law on June 22, 2009. The bill passed by wide margins in both the Senate (79 to 17) and the House (298 to 112). The FDA was granted broad regulatory authority over tobacco in the Act. Moreover, the FDA was given authority to prohibit the use of menthol in cigarettes. A weapon of this magnitude has been the holy grail of the anti-smoking lobby for years.

A tour through the Family Smoking Prevention and Tobacco Control Act, and the submissions found at the FDA's website, reveal a decided tone in favor of eliminating menthol from cigarettes. The Act itself eliminated all artificial or natural flavorings and spices from tobacco products, with the exception of menthol. The issue of menthol was set aside for further study by the Tobacco Products Scientific Advisory Committee. The Committee was charged with studying "the impact of the use of menthol in cigarettes on the public health, including such use among children, African-Americans, Hispanics, and other racial and ethnic minorities," and making a recommendation to the FDA.

TPSAC submitted its report to the FDA in 2011. The report concluded that "removal of menthol cigarettes from the marketplace would benefit public health in the United States."

The FDA next undertook an independent review of the "available science" concerning menthol in cigarettes. This led to the publication of the FDA's preliminary report entitled "Preliminary Scientific Evaluation of the Possible Public Health Effects of Menthol Versus Nonmenthol Cigarettes" in July 2013. The FDA reported that mentholated cigarettes were no more toxic than nonmentholated cigarettes. Nonetheless, the summary of the FDA's findings on other issues reflects a strong bias toward the elimination of menthol:

The impact of cigarette smoking upon public health is indisputable. More than 400,000 deaths per year in the United States are caused by tobacco use. Consistent patterns have emerged as a result of FDA's evaluation of the scientific evidence relevant to the impact of menthol tobacco products on public health. While there is little evidence to suggest that menthol cigarettes are more or less toxic or contribute to more disease risk to the user than nonmenthol cigarettes, adequate data suggest that menthol use is likely associated with increased smoking initiation by youth and young adults. Further, the data indicate that menthol in cigarettes is likely associated with greater addiction. Menthol smokers show greater signs of nicotine dependence and are less likely to successfully quit smoking. These findings, combined with the evidence indicating that menthol's cooling and anesthetic properties can reduce the harshness of cigarette smoke and the evidence indicating that menthol cigarettes are marketed as a smoother alternative to nonmenthol cigarettes, make it likely that menthol cigarettes pose a public health risk above that seen with nonmenthol cigarettes. (emphasis added)

The preliminary report went on to disclaim that the FDA's findings suggested what regulatory action, if any, would be taken by the FDA or when such action, if any, might be taken. Notably, three other menthol related studies are being funded by the FDA. Presumably, no action will be taken by the FDA until the results of these studies are received. One study in particular ("Real-Time Measurement and Uptake of Carcinogens by Menthol Cigarette Smokers") should be of interest to the FDA.

I believe that the handwriting is on the wall. It is not a question of "whether" a major source of LO's revenues is going to get hammered, the question is "when." I have no clue as to when the FDA will publish its forthcoming regulation. But I believe that the day the news breaks, the stock will tank.

Banning menthol will affect not only LO, but also Altria (NYSE:MO) and Reynolds (NYSE:RAI). The major impact, however, will be on LO, whose revenues largely depend on mentholated cigarettes and whose sales are primarily domestic, as opposed to international. And while there will be a negative impact on Federal and State tax revenues, any regulation adopted will not ban regular, nonmentholated cigarettes. The Act itself prohibits the FDA from banning all cigarettes and other tobacco products under the authority granted by the Act. These products will live to fight another day.

One is tempted to believe that e-cigs will save the day for LO. It should be noted, however, that the FDA is already taking steps to "deem" that e-cigs fall under the regulatory mantel of the Family Smoking Prevention and Tobacco Control Act. Thus, flavored vapors, including menthol, can be expected to face the same kinds of regulatory control as combustible products.

Shareholders of LO are whistling past the graveyard if they think that LO and other tobacco companies will be able to dodge this bullet. In today's world of ever increasing governmental regulation, a belief that the FDA is going to pass up the chance to put another nail in big tobacco's coffin requires a leap of faith that I am unwilling to make. I do not know when the music is going to stop, but when it does, I certainly don't want to be standing there without a chair.

Disclosure: I am long MO, RAI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.