The thesis of this article is to review the investment potential of Altria Group (MO) and Lorillard, Inc (LO). Both are predominantly domestic companies that derive the bulk of their revenues from tobacco sales.
MO is the dominant tobacco company in America with a 49.4% market share. The company's flagship brand is Marlboro, which has a 42.3% market share. Mo ability to dominate the tobacco market with such a large share makes it a wide moat company. MO is a cash flow machine that has handsomely rewarded shareholders in the past with consistently rising dividends and spin-offs.
What concerns me about MO going forward is its growth prospects. In 2008, MO spun-off to shareholders its international arm known as Philip Morris International (PM) in what has to be viewed as a very friendly shareholder move. With the spinoff, MO won't be able to access the much higher growth international tobacco markets.
During the most recent quarterly conference call Mike Szymanczyk, Altria's Chairman and CEO reported the following results.
"In the first quarter, PM USA made investments in Marlboro Black, which builds on Marlboro's rich heritage of adventure and ruggedness. Marlboro's cigarette retail share benefited from the investment in this new architecture. Marlboro delivered strong 2012 first quarter sequential share growth of 0.7 of a share point versus the fourth quarter of 2011 and grew its year-over-year share by 0.1 of a share point."
"PM USA's reported cigarette shipments decreased 2.6% for the first quarter, primarily due to trade inventory dynamics. Trade inventories were lower in the first quarter of 2012 compared to the fourth and first quarters of 2011. The impact of lower trade inventories was partially offset by retail share gains on L&M and Marlboro and one additional shipping day.
When adjusted for trade inventories and one extra shipping day, PM USA estimates that its cigarette volume was essentially flat for the first quarter of 2012 compared to the prior year period. PM USA estimates that the total cigarette categories adjusted volume declined approximately 2.5% in the first quarter, which is consistent with historical price elasticity and the secular rate of decline."
To demonstrate the wide and defendable moat the company enjoys the following quote from the CEO sums up MO dominance. "On a sequential basis, PM USA had strong 2012 first quarter retail share results, increasing 0.6 of a share point versus the fourth quarter of 2011 to 49.4%. This sequential share gain was driven by Marlboro, which grew 0.7 of a share point, partially offset by a 0.1 of a share point loss on other premium brands. Our discount portfolio was unchanged on a sequential basis versus the fourth quarter of 2011." (Source Seeking Alpha conference call transcript)
The numbers that MO reported are satisfactory however the flat adjusted volume concerns me. Going forward the tobacco market is expected to continue "its secular rate of decline". I would like to examine if a domestic company that is growing share would be more attractive invest going forward. That is the case that is presented to us now with LO.
LO is also a domestic tobacco company with no overseas exposure. LO is considered a "pure-play" that derives 100% or revenue from domestic tobacco sales. LO main brand is Newport which controls 12.2% of the overall tobacco market.
What distinguishes LO in my view is its ability to gain share in a market that is in "secular decline". The following excerpts are taken from the most recent LO earnings report and will illustrate the case.
The following excerpts are attributed to Murray Kessler, Lorillard's Chairman, President and Chief Executive Officer. "If you look at total Lorillard domestic wholesale volume, we reported a 2.5% decline versus year ago. Adjusting for the negative inventory comparison, total Lorillard domestic wholesale volume increased 1.8% versus year ago. Underneath that, the trends were also very consistent with what we had seen. Newport Menthol adjusted shipment volume was up slightly, plus 0.5%, just as before and just as we had expected. Maverick adjusted shipment volume was up double digits, plus 12.5%, just as before and just as we expected. And Newport Red volume was up slightly, just as we expected, now that we have fully lapped the introduction, and we are selling at a higher price.
As retail shipments are unaffected by wholesale inventory reductions, Lorillard's outperformance versus an industry that is estimated to have declined at retail by 2.3% versus year ago in the first quarter once again resulted in significant share gains on all segments of our business."
To demonstrate the wide and defendable moat the company enjoys the following quote from the CEO sums up LO dominance. "Lorillard's total market share reached an all-time high of 14.5%, up 40 basis points versus year ago and up 50 basis points sequentially. Total Newport share increased to 12.2%, up 20 basis points versus year ago and up 50 basis points sequentially. Newport Red share was basically stable, up just a little bit. Newport share of total menthol was 36.8%, up 50 basis points versus year ago and up 120 basis points sequentially. And Lorillard's share of total menthol was 40%, up 100 basis points versus year ago and 130 basis points sequentially.
Lorillard had no unusual or incremental trade promotions nor any new products during the quarter to drive these additional share gains." (Source Seeking Alpha Q1 earnings call transcripts)
LO ability to dominate the menthol market and its large and growing share of the domestic tobacco market give it a wide and defensible moat. LO does carry some additional risk in that the FDA has been making some overtures about the use of menthol in cigarettes. Investing in any tobacco company carries the risk of litigation and further government regulation due to the inherent dangers of the product. If an investor is comfortable that further regulation will be managed, tobacco companies offer some of the best yields available in the market.
In conclusion, investing in tobacco companies offer an excellent combination of high yield and some potential for capital gains. MO and LO are two dominant wide moat companies that offer above average yield and stability. I find LO's ability to gain market share a more compelling value than MO currently and will be looking to initiate a position in LO on any pullback into the mid 120's.
Additional disclosure: Thank you for reading. This article is for informational purposes only. I look forward to your comments.