What Reynolds American Should Pay For Lorillard

May.24.14 | About: Lorillard, Inc. (LO)

Summary

The tobacco industry is looking to consolidate.

Let's calculate what Reynolds American should pay for Lorillard.

Despite all the merger talk, we still prefer Altria due to its stake in SABMiller and hefty dividend yield.

The rumors have been swirling, and the latest buzz is that Reynolds American (NYSE:RAI) is looking to acquire Lorillard (NYSE:LO). In this article, let's establish a basis for what Lorillard is worth on a standalone basis (excluding deal synergies). We think this is a great starting point for the respective management teams during negotiations. If Reynolds American can scoop up Lorillard at our fair value estimate, the former's shareholders will reap all of the synergistic benefits as a result of the transaction. On the other hand, Lorillard's shareholders should be looking for something north of our fair value estimate and perhaps north of the fair value range.

For those that may not be familiar with our boutique research firm, we think a comprehensive analysis of a firm's discounted cash flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. We think stocks that are cheap (undervalued) and just starting to go up (momentum) are some of the best ones to evaluate for addition to the portfolios. These stocks have both strong valuation and pricing support. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best.

Most stocks that are cheap and just starting to go up are also adored by value, growth, GARP, and momentum investors, all the same and across the board. Though we are purely fundamentally-based investors, we find that the stocks we like (underpriced stocks with strong momentum) are the ones that are soon to be liked by a large variety of money managers. We think this characteristic is partly responsible for the outperformance of our ideas - as they are soon to experience heavy buying interest. Regardless of a money manager's focus, the Valuentum process covers the bases.

We liken stock selection to a modern-day beauty contest. In order to pick the winner of a beauty contest, one must know the preferences of the judges of a beauty contest. The contestant that is liked by the most judges will win, and in a similar respect, the stock that is liked by the most money managers will win. We may have our own views on which companies we like or which contestant we like, but it doesn't matter much if the money managers or judges disagree. That's why we focus on the DCF - that's why we focus on relative value - and that's why we use technical and momentum indicators. We think a comprehensive and systematic analysis applied across a coverage universe is the key to outperformance. We are tuned into what drives stocks higher and lower. Some investors know no other way to invest than the Valuentum process. They call this way of thinking common sense.

At the methodology's core, if a company is undervalued both on a discounted cash flow basis and on a relative valuation basis, and is showing improvement in technical and momentum indicators, it scores high on our scale. Lorillard posts a Valuentum Buying Index score of 7, reflecting our "fairly valued" DCF assessment of the firm, its attractive relative valuation versus peers, and bullish technical. A 7 is not a poor score - in fact, it is better than average - but we prefer higher-rated equities. In the tobacco industry, we prefer Altria (NYSE:MO) thanks to the significantly financial flexibility garnered by its stake in SABMiller as well as its hefty dividend yield. With that said, let's get back to our analysis of Lorillard's standalone intrinsic valuation.

Lorillard's Investment Considerations

Investment Highlights

• Lorillard earns a ValueCreation™ rating of EXCELLENT, the highest possible mark on our scale. The firm has been generating economic value for shareholders for the past few years, a track record we view very positively. Return on invested capital (excluding goodwill) has been excellent during the past three years.

• Lorillard is the third-largest cigarette maker in the US. Newport, Lorillard's flagship premium cigarette brand, is the top selling menthol and second-largest selling cigarette in the country. The Lorillard product line has four additional brand families: Kent, True, Maverick, and Old Gold.

• We're impressed with Lorillard's ability to continue to grow share in the mature and ultra-competitive tobacco industry. Lorillard's retail market share has advanced to nearly 15% in 2013 from 8.7% in 2002. Even more impressive is that the firm grew share in each consecutive year over that time period. We expect its share expansion to continue.

• Contingent legal liabilities will always be a concern for cigarette makers. Many have claimed or expressed concerns that mentholated cigarettes pose greater health risks than non-mentholated cigarettes. This is a bigger potential threat for Lorillard, which makes the top-selling menthol brand Newport (boasting more than 37% share of the menthol market).

• Lorillard boasts a dominant 40%+ share of the fast growing e-cigarette market in the US with its blu Ecigs (NJOY has roughly 35%-40% share), but Altria and other rivals are hot on its tail. Lorillard recently entered the UK e-cig market by buying SKYCIG.

Business Quality

Economic Profit Analysis

The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Lorillard's 3-year historical return on invested capital (without goodwill) has been significantly above the estimate of its cost of capital of 9.8% during the past several years. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. We disclose our WACC calculation below.

Cash Flow Analysis

Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Lorillard's free cash flow margin has averaged about 16.7% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At Lorillard, cash flow from operations increased modestly from levels registered two years ago, while capital expenditures expanded about 11% over the same time period.

Valuation Analysis

On a standalone basis, we think Lorillard is worth $55 per share, which represents a price-to-earnings (P/E) ratio of about 17.4 times last year's earnings and an implied EV/EBITDA multiple of about 10.8 times last year's EBITDA. Though the fair value is lower than its current market price (~$59), we think this is the value that Reynolds American should pay for Lorillard. However, a deal would never get consummated at this price (given where shares are trading).

With that said, the important concept when looking at this potential transaction is our fair value range of Lorillard's shares, which is $41-$69 per share. In this light, we think the real area of negotiation between Reynolds American and Lorillard is between about $59 and $69 per share for Lorillard - or between Lorillard's current market price and the high end of the fair value range. Reynolds is likely looking for a price near present levels, while Lorillard may be bargaining for something in the $70s. Whoever is better at the bargaining table will decide which price is ultimately final.

In full disclosure, our fair value estimate of Lorillard reflects a compound annual revenue growth rate of 4.2% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 5.4%. The fair value estimate also reflects a 5-year projected average operating margin of 32.8%, which is above Lorillard's trailing 3-year average. We make all of our fully-populated three-stage financial models available via a financial-advisor membership on our website.

Beyond year 5, we assume free cash flow will grow at an annual rate of 2.7% for the next 15 years and 3% in perpetuity. For Lorillard, we use a 9.8% weighted average cost of capital to discount future free cash flows. We think both of these assumptions are quite reasonable.

In the context of our stock-selection methodology, we understand the critical importance of assessing firms on a relative value basis, versus both their industry and peers. Many institutional money managers - those that drive stock prices - pay attention to a company's price-to-earnings ratio and price-earnings-to-growth ratio in making buy/sell decisions. With this in mind, we have included a forward-looking relative value assessment in our process to further augment our rigorous discounted cash flow process. If a company is undervalued on both a price-to-earnings ratio and a price-earnings-to-growth ratio versus industry peers, we would consider the firm to be attractive from a relative value standpoint. For relative valuation purposes, we compare Lorillard to peers Altria Group and Phillip Morris (NYSE:PM), among others. As we stated in the 'Investment Considerations' section, we think Lorillard is priced attractively on a relative valuation basis.

Click to enlarge

Margin of Safety Analysis

Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $55 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Lorillard. We think the firm is attractive below $41 per share (the green line), but quite expensive above $69 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion. We think most of the negotiation is being conducted on the right half of the yellow line.

Lorillard's Standalone Pro Forma Financial Statements

Click to enlarge

Click to enlarge

Click to enlarge

In the spirit of transparency, we show how the performance of the Valuentum Buying Index has stacked up per underlying score as it relates to firms in the Best Ideas portfolio. Past results are not a guarantee of future performance.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

Additional disclosure: MO is included in Valuentum's actively-managed portfolios.