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How many times in the last three years have we, as an investing community, heard the familiar tune to trade up in quality and buy companies that are large cap names with strong balance sheets and good international exposure?

Guess what? The worst performing stocks over the last five months have been in the industrial sector. Tobacco stocks, while higher than they were several years ago, still offer the unique combination of earnings growth and consistently increasing dividends that few sectors in the S&P 500 can boast. Better yet, these stocks have been consistent performers no matter what the mood of the market.

The key? Find the names that have strong balance sheets and consistent revenue growth so that they generate increasing greater revenue streams that lead to greater earnings and higher dividends in a low growth economy.

I have maintained for several quarters now that, despite popular fanfare, Lorillard (NYSE:LO) is a significantly better buy than its two competitors Reynolds (NYSE:RAI) and Altria Group (NYSE:MO). This past earnings report, while a little under the radar since everyone has been watching the industrials so closely, separated LO from its underperforming, overdebted tobacco peers in a way that has not been seen in years. MO was a core holding of mine for several years between 2008-2011; I recently sold MO at around 25 and bought LO in the 70s only after doing a good deal of research. I would like to share my research as I see continued upside in LO's share price and dividend while MO and RAI seem to be topping out at these prices.

A couple facts: Valuation-wise these stocks look similar even though LO is seeing earnings revisions modestly higher while RAI and MO are seeing lower revisions due to higher costs and lower sequential cigarette shipments than in recent earnings reports. LO is valued at approximately 13x the average estimate for next year's earnings while RAI is also valued at approximately 12.5-13x next years earnings estimates. MO is valued slightly lower at around 12-12.5x next year's average earnings estimate.

The difference is simple. LO has 2 billion in cash, 1.7 billion in debt, and 1-1.2 billion in annual free cash flow. LO pays its dividend out of cash that it generates through its core cigarette business, which is shipping 5 million more cigarettes per year and increasingly taking market share from the only two significant industry peers, Reynolds (RAI) and Altria (MO).

These trends are powerful and likely to be sustained if not accelerated given that LO is only 10% of a market where MO is approximately 50% and RAI is nearly 30%. Altria has 12 billion in debt, approximately 4 billion in free cash flow, and about 2 billion in cash on its balance sheet. Reynolds has around 5 billion in debt and about 1-1.3 billion in free cash flow. Reynolds and Altria both pay around 80% of their free cash flow in dividends while LO only pays about 65%, despite having the stronger balance sheet, better revenue growth, and superior debt profile.

Do the math or, better yet, look at the companies' respective history of returning cash to shareholders via buybacks and dividends over the last several years. LO has increased its dividend by 30% for three straight years and increased its share buybacks, while RAI and MO have increased their respective dividends by less than half that rate during the same time span; MO has even had to suspend its share buyback program and take out an additional 3 billion line of credit (a free cash flow machine?). MO and RAI have had no market share gains of more than .5-.7% over the last couple years and have relied on price increases and cost cutting to accomplish the revenue gains that their with new products could not.

Additionally, Reynolds and Altria are still trying to grow their revenue to sustain and grow their dividends despite their stagnating-to-declining core cigarette businesses which boast margins in the 40-50% range. Their answer? Borrow at 6-8% to buy lower margin, slower growth businesses in the smokeless and chewing tobacco industries. LO's business plan is to keep growing its high margin cigarette business and ignore the possibility of using cash for any primary use other than the two best ways tobacco companies can return money to shareholders: Through dividends and buybacks.

Lorillard just increased its share buyback program in the last year to around half a billion after increasing its dividend by 30%. LO is a high growth cash cow in a market that is a regular monopoly and it is the only company at a 15 billion dollar market cap who can continue to grow and take market share without having to borrow or compromise its 35-45% operating margins which come in at 3-4x that of the average S&P 500 company. LO also relies on youth and blue collar smokers more than RAI and MO, whose primary consumers consist of older smokers. Youth and blue collar smokers are two groups of individuals that are seen as likely to smoke at similar or higher rates in the near future.

This is one of several reasons (in addition to LO being a smaller company) that the LO management team has put greater emphasis on the innovation of new and better products, like the recently successful maverick cigarette, while RAI and MO are trying to minimize losses with price increases.

The catch? While the supposed Achilles heel here is that since the FDA has been mandated to conduct a review of menthol flavored cigarettes per the 2008 bill called the Tobacco Regulation and Control Act, a possible menthol ban could be looming. To be fair, a menthol ban would essentially crush LO overnight as nearly 95% of the companies revenue comes from its flagship Newport brand.

But let's look at this issue reasonably. I manage money and trade, but I also have a law degree and follow politics very closely. LO is a 15 billion dollar company that is employing thousands of workers and making payment under the tobacco settlement agreement between the big three (prorated to market share). Translation: The more money that LO makes, the more money municipal, state, and federal authorities will see (100 billion in tobacco bonds have been issued at the state level already).

Also, the original 2008 legislation banned coconut, chocolate, and other flavors which companies could use to entice kids to smoke tobacco, but did not ban menthol. Why? Because the co-sponsors of the bill knew that a bill banning menthol was dead on arrival given how popular the cigarette is in minority communities and that is a cash cow for every broke state and local government imaginable.

Additionally, the most misunderstood part of the 2008 legislation - besides the way it side-stepped menthol - is the mandate that it passed to the FDA by requiring further studies on the effect that menthol cigarettes can have on addiction and health. The FDA panel, which was commissioned to study the effects of menthol, is obligated to give a recommendation to regulatory authorities, but the authorities have no timetable whatsoever on which they must act on the recommendation, and no obligation to follow the recommendation whatsoever.

By they way, the FDA panel, which did not even recommend banning menthol, has said that none of their core conclusions will be changed in subsequent revisions that may or may not be done. Also, the only studies that have been commissioned so far show that menthol poses no greater health risks than other forms of tobacco, and there is similarly no evidence in any existing studies showing that menthol is more likely to lead to addiction either.

Conclusion

I don't think conventional valuation models work here. It's easy to say that LO has a 4.5-5% dividend and 10-12% growth, so a valuation of 12.5-13x next year's average earnings estimates is rich, but remember, this company is growing in an industry that is a regulated monopoly, since no market or advertising of tobacco products is allowed anymore. LO is also generating free cash remains at 75-80% of its growing annual revenues. I'd bet this company continues to be rewarded with a premium valuation.

Given that the company is steadily increasing market share, has a pristine balance sheet, a great management team, and a relatively small market cap, this should be a safe and lucrative bet.

Source: Lorillard: The Only U.S. Tobacco Stock Worth Owning