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Lorillard, Inc. Diagonal Call Spread

|Includes: Lorillard, Inc. (LO)

On 12/9 I entered into a diagonal call spread on tobacco company Lorillard, Inc. (ticker symbol: LO), manufacturer of the Newport menthol cigarettes, which consisted of selling 10 March 80s for $3,200, and purchasing 10 Jan 2011 75s for 8,000, or a net debit of $4,800, less commissions.

While I've failed to discuss the position on the blog for more than a month, its pricing has stayed largely flat so its ultimate success or failure is largely yet to be determined. Lorillard, like most major tobacco companies, is a terrific business - it operates with very high gross and operating margins and generates enviable (and sustainable) returns on assets and equity, due to the scale and pricing power of a successful cigarette operation and its loyal customer following. While LO doesn't have a growing international operation like several of its competitors, and the US domestic cigarette market faces significant headwinds, LO's current price more than reflects these weaknesses. With excess cash on its balance sheet, LO trades at an enterprise value of roughly 7x trailing EBITDA. In short, I consider LO at its current price to be a compelling long-term investment.

Similar to the rationale for my LMT diagonal call discussed yesterday, because of the headwinds facing US tobacco sales and the general lack of excitement regarding the tobacco business I don't believe LO has the potential for short term pops in price, but will likely increase gradually over a long period of time due to stock buybacks and dividend increases. This position will allow me to profit from time decay if the stock stays relatively flat towards expiration, at which point I will roll over the March calls to a later month. In the event LO does increase substantially, the position won't make much money if any, but will not lose money. In the event LO decreases substantially, and the business fundamentals remain intact, I will look to increase exposure.


Disclosure: Long LO