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Menthol flavored cigarettes account for nearly 30% of cigarette sales. The smoother taste of menthol has allowed menthol flavored cigarette sales to outgrow the boarder industry. Much of menthol's growth has come from new smokers who are turned on to the flavor.

Lorillard (NYSE:LO), the maker of the menthol-flavored Newports, has enjoyed this growth in the form of 6% revenue growth between fiscal year 2007 and 2008 and another 6% between 2008 and 2009. Catching this kind of revenue growth in this mature industry is impressive, to say the least. It also lead to a 12% increase in earnings per share between 2008 and 2009 fiscal years. Lorillard also enjoys the highest profit margin in the industry at 25.7% for fiscal year 2009.

Despite all of this, you can own this superior operator for less than its peers on relative valuation. Lorillard shares are down over 9% year to date, yet it is clearly the best company in the sector. What is the deal?

The stock has taken a hit because of fears of a menthol ban or faze out over time. An FDA panel entitled the “The Tabacco Products Scientific Advisory Committee” is scheduled to make recommendations on menthol cigarettes to the FDA in March. On September 21st 2009, the FDA banned flavored cigarettes, which are not that different from menthols. So a ban or faze out is not impossible.

However, the chances of such an action have been greatly diminished as of late. On January 5th 2011, a key member of the advisory committee resigned. Gregory N. Connolly was one of the strongest opponents of the industry on the committee and his resignation came at a significant time. I feel his departure is a signal that things were not progressing the way he wanted. This is great news for smokers of menthol and investors alike.

Nearly 90% of Lorillard’s revenue is derived from the sale of menthols and a ban or faze out would have been a fatal blow to the company. This risk has been substantially reduced and the stock now has major room to the upside for those who wish to read between the lines. The FDA is not going to ban a product that has such a large following, and I encourage you to check out Lorillard. You can pick it up at a discount to its peers for a low price to earnings multiple of around 11 off of trailing twelve-month earnings.

Company

LO

MO

PM

RAI

P/E TTM Multiple

11.4

13.8

15.2

18.51

The management of a tobacco company knows how to get you addicted to their product and they sure know how to get you addicted to their stock with a juicy dividend. Lorillard’s current yield is around 6% and growing.

Lorillard

Actual 2009

Estimate 2010

Estimate 2011

Estimate 2012

EPS

$5.76

$6.69*

$7.34*

$8.1*

Payout Ratio

0.63

0.63

0.63

0.63

Dividend Estimate

$3.62

$4.21

$4.62

$5.10

Dividend Actual

$3.84

$4.25

Difference

6%

1%

*Mean analyst esitmate used

Although not quite as relaxing as nicotine, the sweet yield of menthol is sure to put a growing dividend in your portfolio.

The stock is currently trading around $74 and I have a price target on it of $89.16. That is over 20% upside and you can enjoy a 6% dividend yield while you wait for a total return of nearly 26%. Now that is what I call a smooth yield and a smoking return. A reasonable position in Lorillard in your diversified portfolio is a great way to light up your returns for the New Year.

Source: Lorillard to Benefit From Reduced Risk of a Menthol Ban: Smooth Yield, Smoking Return