This is from the AMM Dividend Letter released March 29, 2014. If you want to see the latest “Dividend Stock in Focus” as soon as it’s released then join our mailing list here.
This is the sixth edition of the AMM Dividend letter and we hope it has been both informative and entertaining (at least in as much as an investment letter can be entertaining). Our primary goal for this letter is to provide current investors in our firm’s dividend strategy with a “closer look” at some of the investments that we have made on their behalf.
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Thank you,
Your Portfolio Management Team
Dividend Stock in Focus
Lorillard, Inc. (LO): $53.35*
*price as of the close March 28, 2014
Early History**:
Lorillard, originally known as P. Lorillard & Co., is America’s oldest tobacco company. While the company’s public shares have only been trading since 2008 when it was spun off fully from Loews Corp., it was originally founded in 1760. In fact, some of North America’s first tobacco advertisements were run by P. Lorillard & Co. in Ben Franklin’s newspaper. Below is an ad from 1789.
The early history and founding of the United States was heavily influenced by tobacco. If not for two key tobacco related moments it is quite possible the United States of America would have never been.
1. King James’ Hatred of Tobacco:
King James (I of England & VI of Scotland) despised many things: witches, burning up to 400 per year; sex with women, the nickname Queen James is self-explanatory; and especially tobacco smokers, who he viewed on par with Devil worshipers. In 1604 King James raised the duty on Tobacco by 4,000 percent.
The increased duty made the push for a New World tobacco supply even stronger. In 1607 The Virginia Company landed in the Chesapeake Bay and founded the Jamestown colony. This third English colony seemed destined to fail like the previous two, that is, until John Rolfe planted Nicotiana Tabacum seeds.
Over several seasons John Rolfe perfected his growing, harvesting, and curing to create the unique Virginia tobacco. Demand took off. Immigration rose to meet the need for labor. Sadly, most of the new labor came in the form of slavery. Life expectancy abounded. Disposable incomes grew to the point that a ship in 1619 arrived carrying “young maids to make wives priced at one hundred and twenty pounds of the best leaf tobacco”. Births finally out paced deaths.
The Jamestown experiment and the future American colonies would succeed, in part, because of tobacco.
2. War Allies:
It was the French Navy that prevented Lieutenant General Lord Cornwallis from escaping Yorktown as George Washington and his army pressed forward. Leading to the surrender of Cornwallis and prompting the British Government to negotiate an end to the Revolutionary War.
It is said that the French help, troops and a loan, was secured by the Patriots’ win at the battle of Saratoga and by the charisma of Ben Franklin, who served as Minister to France during the war. What is not often discussed was the vital role tobacco played.
Five million pounds of Virginia tobacco served as the collateral for the loan Ben Franklin negotiated that helped the patriots defeat one of Europe’s most potent nations. Securing the independence declared by the colonies on July 4, 1776 and still celebrated 238 years later.
** The information in this section is from the book: Tobacco: A Cultural History of How an Exotic Plant Seduced Civilization
by Ian Gately.
Dividend History:
Once spun off from Loews Corp., Lorillard immediately started paying a quarterly dividend of $0.30667 per share. In February of this year Lorillard increased its quarterly dividend again by 12% to $0.615. This is the sixth increase in 6 years, doubling the initial payout. This represents a 13% compound annual growth rate since August 2008.
Click to enlarge. Data from S&P Capital IQ
Lorillard’s policy is to return 70-75% of its earnings to shareholders in the form of a dividend. The company’s current payout ratio is 70%.
Catalysts for Dividend Growth and Price Appreciation
Electronic Cigarettes:
Civilization’s love affair with smoking is waning. The harm is just too great. Enter the electronic cigarette (eCig), a device focused on harm reduction and renewing man’s love affair with nicotine.
An eCig is a battery powered device that converts liquid nicotine, not tobacco, into a vapor that is inhaled by the user. There is no fire, smoke, or ash.
Image courtesy of Howstuffworks.com
In April 2012 Lorillard purchased Blu eCigs for $135 million in cash. Sales have grown from $61 Million in 2012 to $230 million in 2013 per Lorillard’s latest 10-K filing. Utilizing Lorillard’s well established distribution network Blu eCigs have already captured 50% of the U.S. electronic cigarette market. The market share gains are even more impressive when we consider that Blu eCig’s have so far only been available in approximately 1/3 of the retail locations that comprise Lorillard’s distribution network. As Lorillard fills out its distribution network, we would expect Blu eCigs’ strong sales growth to continue.
During the 4th quarter of 2013 Lorillard also purchased SKYCIG, a leading U.K. electronic cigarette maker. The acquisition gives Lorillard an entrance into the U.K. market and Western Europe. The company has announced plans to rebrand SKYCIG, unifying Lorillard’s global electronic cigarette brand under the Blu eCig banner.
While Blu eCig’s operating and profit margins are well below the margins of traditional cigarettes, there is reason to believe this situation may reverse itself in the future. Cigarette sales are subject to excise taxes and part of the revenue goes to funding legacy legal settlements while sales of e-cigarettes do not. Goldman Sach’s research department estimates that eCigs as a whole could generate profit margins in excess of 50%. Traditional cigarettes currently generate around 30% profit margins and Lorillard’s trailing twelve month profit margin is at 23%. Sales growth and margin expansion driven by expanding market share and greater adoption by the consumer should be positive for Lorillard’s stock price in the year’s to come.
Market Leader in Menthol Cigarettes:
Cigarette sales for tobacco companies are declining. Over the last 3 years the total volume of sales for domestic cigarettes has declined at a compound annual rate of -2.31%. In comparison, Lorillard’s total sales volume has declined at a much slower rate, -0.59% compounded annually over the last 3 years. This is due to Lorillard’s Newport brand of cigarettes, a menthol flavored cigarette. As seen in the chart below, Newport’s represent the bulk of Lorillard’s sales and the brand continues to gain market share.
Click to enlarge. From Lorillard’s 2013 10-K
Lorillard’s management has more than offset any volume declines with price increases. Since becoming a fully independent company in 2008, Lorillard has grown revenue at a compound annual rate of 6%.
Click to enlarge. Data from S&P Capital IQ
Potential Merger:
Lorillard and Reynolds American surged earlier this month on the rumored news that Reynolds would make a bid for Lorillard. The rumored bid is expected to be north of $20 billion. Rather than an outright buyout of Lorillard the deal would most likely be a merger and involve an equity offer from Reynolds.
There are significant hurdles for this deal to be completed. Reynolds and Lorillard are the number 2 and 3 U.S. tobacco companies. A combined entity would control about 92% of the U.S. market and 67% of the U.S. menthol market. Additionally, British American Tobacco owns 42% of Reynolds and controls five board seats. Any equity Reynolds issues that would dilute shareholders by 5% or more needs approval from British American Tobacco.
Right now the deal is a rumor along with the speculation that Imperial Tobacco or Japan Tobacco would make counter-bids for Lorillard. We were happy to hold Lorillard for the long-term when we first bought it in the $47-49 range and the failure of a bid to materialize will not change our thinking.
Capital Efficiency:
Lorillard is an extremely capital efficient company generating Return on Assets (ROA) over 30% and Return on Capital (ROC) over 90%.
Click to enlarge. Data from S&P Capital IQ
Return of Capital:
Besides rewarding shareholders with a growing dividend, Lorillard has also bought back a lot of shares. Since it’s spin-off in 2008 Lorillard has reduced total shares outstanding at a compound annual rate of -5.35%.
Click to enlarge. Data from S&P Capital IQ
Conclusion:
Cigarette sales across the U.S. are in decline, making an investment in this industry somewhat contrarian. However, due to Lorillard’s leadership in the menthol category, the company has seen below average declines in sales volumes, and management has more than offset these declines with price increases. Total revenue has grown at a compound annual rate of 6% since 2008. Assuming a fairly conservative growth rate of 3%, a discount rate of 12.5%, long-term average margins, and accounting for share buybacks we derive a fair value of $55 per share. Fair value represents the price we would be willing to pay to generate a return commensurate with a particular stock’s risk (i.e. it does not represent a “target” or static price objective). For a company like Lorillard we estimate this return objective to be 12-15% annually. Additionally, our fair value estimate gives little weight to the eCig business which we feel could provide significant upside.
Chart courtesy of Stockcharts.com
Further Reading:
For more on the history of civilization’s love/hate relationship with tobacco read
Tobacco: A Cultural History of How an Exotic Plant Seduced Civilization
Rich Man, Poor Man (Dow Theory Letters)
Choose dividend growth over highest yield (Alliance Bernstein)
How to Generate an 11% Yield on Cost in 6 Years (Dividend Growth Investor)
All previous AMM Dividend Letters are archived here.
