Wednesday, June 15, 2011

Should You Add Lorillard Stock To Your Portfolio?

Lorillard (NYSE: LO) popped nearly 12% Tuesday on hopes that federal regulators may back off demands to require it to pull menthol from its cigarettes. Is this a signal that you should add it to your portfolio?

What's all the fuss about? The Food and Drug Administration (FDA) is holding a July meeting at which it will discuss the future of menthol cigarettes. The FDA concluded that taking out menthol would benefit public health. The unexpected surprise was that the FDA said that changes are not imminent and could not happen until rule making, requiring public comment, had occurred.

This matters to Lorillard because 90% of its sales come from Newport, a menthol flavored premium cigarette. This delay means that Lorillard can keep selling its menthol-flavored cancer sticks. And selling Newports is a big business. In the last 12 months, for example, the $16.4 billion market capitalization company (up 54% in the last year), generated $6.1 billion in revenue and $1 billion in net income, up at five year average growth rates of 10.7% and 7.8% respectively.

Lorillard's recent financial performance has been solid. In the first quarter, its net income rose 6.9% to $248 million ($1.71/share) -- 9% above analysts' estimates of $1.57 -- from $232 million ($1.50/share) in 2010's first quarter. And its revenues rose 12.9% to $1.53 billion.

And Lorillard's ability to boost cash flow above its cost of capital is strong. In the last year, Lorillard has been creating so-called Economic Value Added (EVA) Momentum, a sign that the company is generating cash flows that exceeds the capital required to finance its operations. Bennett Stewart coined the term -- it's a number calculated by dividing the change in EVA [Net Operating Profit After Tax - (Total Assets - Current Liabilities) x the Weighted Average Cost of Capital)]/Beginning Period's Revenues.

The best companies create value in excess of their cost of capital -- generating a positive EVA momentum. The higher the EVA momentum, the faster management is creating value. And Lorillard's EVA Momentum is a solid 2%. This figure comes from subtracting Lorillard's 2009 EVA of $881 million from its 2010 EVA of $973 million and dividing the difference by its 2009 revenues of $5.2 billion.

Does the market fully recognize Lorillard's ability to create value -- making it too expensive to be worth adding to your portfolio? To think about that, we can look at their price-to-earnings-to-growth (PEG) ratio — a way to determine whether the value that the market assigns a stock is justified by the rate at which it expects the company’s earnings to grow. I think a PEG of 1.0 is a fair price, and anything below that is a bargain.

Lorillard stock is fairly expensive, trading at a PEG of 1.63. Its P/E is 16.3 and its earnings are forecast to grow 10% to $8.50 in 2012. Even though its reported earnings have been beating expectations for the last five quarters, the extent of that upside surprise is fairly modest.

It looks like yesterday's pop priced in the value of the FDA's stay of Newport's execution. Too bad the same can't be said for Newport smokers. If that doesn't bother you, wait for a market dip to inhale this stock.


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