Lorillard's Valuation Leaves Something to Be Desired

| About: Lorillard, Inc. (LO)

The FDA recently ruled that beginning in the fall of next year, all cigarette packaging and advertisements in the U.S. must reveal prominent and perhaps gory health warning labels. These new and larger cigarette warnings, which include an image of a man smoking through a hole in his throat and an image of a parent holding a baby as smoke drifts toward them, represent a huge step by the current administration to curb new smokers from picking up the habit, while encouraging others to quit. But should investors of Lorillard (NYSE:LO), Altria Group (NYSE:MO) and Reynolds American (NYSE:RAI) be concerned?

Regulation has long been a part of the tobacco industry and while we applaud the FDA's intentions to improve the health of Americans, we don't believe such labels will create an abrupt change in the trajectory of the already downward trend of smokers in the U.S. For starters, smokers have already felt the brunt of additional taxation on cigarettes and the health concerns caused by smoking already appear to be fairly well known by the public. As a result, cigarette smoking in the U.S. has been declining at a pretty decent clip for years.

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That said, the new labels will certainly have some impact, with the FDA estimating that it will cause over 200,000 Americans to quit by 2013. However, this appears to be merely a drop in the bucket compared to the 46 million Americans currently smoking today (that's less than one-half of one percent). As such, we don't view the new, larger warning labels as a material concern for investors of the domestic cigarette makers.

We Release Our Estimated Fair Value for Lorillard

Lorillard has been perhaps the most watched stock in the tobacco industry, given recent efforts to ban menthol-flavored cigarettes. Such a ban would be catastrophic for the cigarette maker, as its menthol-flavored Newport brand is the source of 90% of revenue for the company. Though the regulatory environment can change on a dime, the firm appears for now to have largely dodged these efforts and the stock has rocketed accordingly (it's up to current levels of $110 per share from under $80 in March). But what is Lorillard worth?

At Valuentum, we like to use a discounted cash-flow model to estimate a fair value for all of the companies within our equity coverage universe. Given the robust cash-flow characteristics of tobacco industry participants, we think the DCF approach is the best process for valuing companies in the industry. Below, we outline our forecasts and fair value estimate for Lorillard and offer up our valuation model template to investors if they are interested in using it to value any operating (non-financial) company they wish. This model template can be found at DCF Valuation Model.

Valuation Summary

Absent an abrupt regulatory shock, we think Lorillard's shares are worth about $110 each, roughly matching its current stock price. We'd grow more constructive on its valuation if it fell below $90 per share and of course, menthol-flavored cigarettes are never banned.

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Income Statement

We reveal our income-statement forecasts for Lorillard.

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Balance Sheet

We display our forecasts for Lorillard's balance sheet.

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Cash Flow Statement

We reveal our free cash flow forecasts for this cash-rich firm.

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The Bottom Line

Though we find Lorillard's cash stream and dividend yield attractive, we don't think the firm's current stock price provides a sufficient margin of safety, given future regulatory risk that's inevitably going to come back to haunt this one-trick pony at some point down the road.

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

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