Lorillard (LO)

Lorillard participates in an economically independent industry and returns over the long term are not predicated on the overall economic conditions of the US. The cigarette industry is protected by regulatory moats, as well as scale economies and brand loyalty. Brand power is an empty CEO speak if it does not translate into pricing power, and historically, tobacco manufacturers have been able to raise prices faster than volumes have fallen. A pack of cigarettes costs 25 cents to make the fact that it can be sold for 20x that amount is a testament to the robust business fundamentals underlying the industry. 5.5 trillion cigarettes were consumed last year, of which 27-28% belonged to the menthol category. LO, which boosted its market share for the seventeenth straight year in 2007, is the de facto play on menthol, which has enjoyed less detrimental volume trends than the rest of the tobacco group: Newport leads the category in terms of customer retention and margins. According to Merrill Lynch, 1000 sticks of Newport is generating a profit of more than $36 dollars vs. $28 per 1000 sticks at Altria/PMUSA.

Spin offs are created when a large company decides that one of its divisions would do better on its own or when tax laws/regulations make cutting the division sensible. Management realizes it’s hard to keep all the pieces together, and orphans away one or more divisions into the marketplace, which in turn unlocks value the general market may have been missing when the spun off division was hidden under the parent’s umbrella. Historically speaking, spin offs have been immense shareholder wealth creating vehicles, as several academic studies have proven. A well know study from Penn State found that spin offs beat the SP500 by 10% per year in the first three years; a McKinsey & Co. study published in 1999 proved similar: during the 1988-1998 decade, spin offs outperformed the broad market and their ex parents by 10%. Although spin offs facilitate a wider understanding of the orphan’s business and valuation, it never happens overnight – the typical spin out belongs to a boring industry and not widely disseminated via loud press coverage; furthermore, institutions take time to warm up the story, which subsequently creates a nice opportunity for retail investors, who can pick up shares before the large mutual funds have kicked the tires, modeled everything, and gotten acquainted with the story. As a spin out, LO offers investors tangible ownership in the company, whereas before, a holder of Lorillard/Carolina Group was limited to an economic interest (dividends only). Besides wider investor appeal, management walks away with better decision control after the spin & will likely allocate more capital towards dividend payouts than its former parent, Loews, was allocating.

LO is a takeover target. As a #3 player dominating the menthol category, LO would make a good strategic fit for an international player, we think. The cigarette industry is rapidly consolidating as players move to cut costs and enter new markets, and although the action has been on the emerging market frontier, a firm like Imperial tobacco (ITY) strikes us as a likely suitor for Lorillard: ITY is already the market leader in the UK, as well as in Spain. Its market cap of $27B is more than twice that of Lorillard’s and a ITY/LO deal would overnight give the former a leading menthol brand, as well as a better chance to deal head on with Altria here in the US or Phillip Morris International (PM) abroad. ITY management is still digesting the Altadis and Commonwealth acquisitions, but the company’s focus on steam-lining costs should not be overlooked. A deal with weakest link RAI is also possible, assuming no anti trust issues get in the way and the two management teams decide a combo between the two is the only way PMUSA will ever concede share. In any event, investors should note that any deal is unlikely before 2010 given the tax-treatment afforded by the spin-off (see IRS Code Section 355e).