(LO-NYSE) SUMMARY. Risk Level *

Transcription

1 February 12, 2015 Lorillard Inc. (LO-NYSE) Current Recommendation SUMMARY DATA NEUTRAL Prior Recommendation Outperform Date of Last Change 05/22/2012 Current Price (02/11/15) $67.55 Target Price $ Week High $ Week Low $47.31 One-Year Return (%) Beta 0.36 Average Daily Volume (sh) 2,179,247 Shares Outstanding (mil) 360 Market Capitalization ($mil) $24,318 Short Interest Ratio (days) 2.71 Institutional Ownership (%) 89 Insider Ownership (%) 0 SUMMARY Lorillard beat the Zacks Consensus Estimate on both earnings and revenues in the fourth quarter Earnings of $0.93 per share exceeded the prior-year earnings by 13.4% driven by higher cigarette sales and lower share count owing to share buyback activity. Sales increased 1.4% from the prior year quarter, driven by an increase in net sales of cigarettes owing to higher pricing, strong brands and growing market share, despite decline in cigarette shipment volumes. We also remain concerned about the recent decline in net sales of electronic cigarettes as a result of lower unit volume. Greater competition from rivals such as Altria Group and Reynolds American is also impacting sales of blu ecigs. Nevertheless, the recent news of shareholders approval for the company s merger with Reynolds American is encouraging. The companies expect the merger to complete in the first half of Risk Level * Low, Type of Stock N/A Industry Tobacco Zacks Industry Rank * 171 out of 267 ZACKS CONSENSUS ESTIMATES Revenue Estimates (In millions of $) Q1 Q2 Q3 Q4 Year (Mar) (Jun) (Sep) (Dec) (Dec) Annual Cash Dividend $2.46 Dividend Yield (%) Yr. Historical Growth Rates Sales (%) 6.0 Earnings Per Share (%) 11.5 Dividend (%) 14.0 using TTM EPS 20.1 using 2015 Estimate 18.3 using 2016 Estimate ,122 A 1,288 A 1,827 A 1,253 A 6,950 A ,147 A 1,297 A 1,324 A 1,283 A 6,990 A ,170 E 1,340 E 1,366 E 1,309 E 5,185 E ,380 E Earnings Per Share Estimates (EPS is operating earnings before non-recurring items, but including employee stock options expenses) Q1 Q2 Q3 Q4 Year (Mar) (Jun) (Sep) (Dec) (Dec) 2013 $0.66 A $0.81 A $0.83 A $0.82 A $3.12 A 2014 $0.69 A $0.84 A $0.90 A $0.93 A $3.36 A 2015 $0.76 E $0.94 E $1.01 E $0.98 E $3.69 E 2016 $4.00 E Zacks Rank *: Short Term 1 3 months outlook 3 - Hold Projected EPS Growth - Next 5 Years % 9.0 * Definition / Disclosure on last page 2015 Zacks Investment Research, All Rights reserved North Canal Street, Chicago IL 60606

2 RECENT NEWS Lorillard's Fourth Quarter Earnings Beat Estimates on Cigarette Pricing Feb 11, 2015 Lorillard reported adjusted earnings of $0.93 per share in the fourth quarter of 2014, up 13.4% from the prior-year quarter. Higher cigarette sales and the impact of share repurchases in prior quarters led to earnings growth in the reported quarter. Earnings beat the Zacks Consensus Estimate of $0.92 by 1.1%. Net sales in the reported quarter grew 1.4% year over year to $1.768 billion due to an increase in net sales of cigarettes, partially offset by a decline in net sales of electronic cigarettes. Revenues comprehensively beat the Zacks Consensus Estimate of $1.285 billion by 37.6%. Gross profit improved 10.3% to $727 million in the quarter driven by higher margins in the cigarette segment. Adjusted operating income grew 12.8% to $590 million, driven by operating efficiencies at the cigarette segment. Full-Year Results In 2014, adjusted earnings of $3.36 per share lagged the Zacks Consensus Estimate by a cent, but increased 7.7% year over year. Net sales grew 0.6% year over year to $6.990 billion. Revenues comprehensively beat the Zacks Consensus Estimate of $5.051 billion by 38.4%. Segment Details Cigarettes: Despite lower cigarette unit sales volumes, the company managed to increase its cigarette sales by 2.4% year over year to $1.7 billion. The increase was driven by a 4.7% increase in average net cigarette selling prices. Total wholesale cigarette volumes declined 0.9% to 9.76 billion units in the fourth quarter including Puerto Rico and U.S. shipments. Excluding Puerto Rico and U.S. shipments, total wholesale cigarette volumes declined 1% to 9.65 billion in the quarter. We note that the cigarette volume decline rate was narrower than the sequential quarter, owing to an improving economy and lower fuel prices. In the reported quarter, Lorillard's domestic retail market share climbed 0.3 share point to 15.2%, backed by strong gains in the company's flagship brand Newport. Its domestic retail market share also increased 0.3 share point to 13.0%. Newport s market share was driven by continued strengthening of Newport Menthol in its core geographies, continued success in expansion markets and improved volumes after the launch of Newport Non-Menthol. Lorillard's domestic retail share of the menthol market increased 0.1 share point to 40.2% in the reported quarter. Adjusted gross profit increased 11% to $714 million, driven by higher cigarette sales. Adjusted operating profit increased 16% to $610 million, owing to higher gross profit and lower selling, general and administrative expenses. Electronic Cigarettes: Segment net sales during the fourth quarter declined 27.8% to $39 million. The decline was due to lower sales of blu ecigs in the U.S., reflecting a decrease in unit volume. Sales also declined due to greater competition from rivals Altria Group and Reynolds American, who recently rolled out their respective e-cigarettes brands MarkTen and Vuse nationwide, supported by aggressive introductory "free trial" and other promotional programs. Thankfully, the decline in segment sales was narrower than the prior quarter due to the launch of the new blu PLUS+ rechargeable kit nationwide during the fourth quarter. Equity Research LO Page 2

3 The company s brand blu (formerly known as Skycig, a leading premium brand of electronic cigarettes in the UK which was acquired in Oct 2013) generated only $2 million in sales in the fourth quarter. However, net sales are expected to increase significantly during 2015 as a result of continued marketing of blu and expanded retail distribution. During the fourth quarter, blu (U.K) entered into an agreement with Fontem Ventures B.V. ("Fontem"), Imperial Tobacco Group's electronic cigarette operating subsidiary. Per the deal, Fontem will act as the exclusive distributor of blu electronic cigarette products, including blu starter kits, disposable e-cigarettes, personal vaporizers and e-liquids in the United Kingdom. Adjusted gross profit declined significantly by 87.5% to $2 million in the fourth quarter due to lower segment sales. Adjusted operating loss was $20 million in the reported quarter compared with a loss of $3 million in the fourth quarter of This was due to higher selling, general and administrative costs and a decline in gross profit. Merger Update On Jul 15, Lorillard and peer Reynolds American entered into an agreement per which Reynolds agreed to take over Lorillard for $27.4 billion, including assumption of net debt. In connection with the transaction, Reynolds also announced that it has reached an agreement with Imperial Tobacco Group PLC, the fourth-largest international tobacco company. Per the agreement, Imperial agreed to purchase the Kool, Salem, Winston, Maverick and blu ecigs brands and other assets and liabilities from Reynolds and Lorillard for $7.1 billion in cash. The shareholders of both the companies approved the merger in Jan The companies now await the approval of the Federal Trade Commission. Lorillard is tethered to menthol cigarettes. It would be able to diversify with Reynolds American's traditional tobacco brands such as Camel and American Spirit, if the $27.4 billion Reynolds-Lorillard deal materializes. In addition, both companies are likely to see significant cost synergies and should be able to shed a great deal of overlapping costs. However, the combined entity might pose a threat to its peer Altria Group, which manufactures Marlboro cigarettes and commands more than 40% market share in the U.S. The companies expect the transactions to close in the first half of VALUATION Lorillard s current trailing 12-month earnings multiple is 20.1x, representing a premium of 6.3% to the industry average of 18.9x. Over the last five years, Lorillard s shares have traded in the range of 11.1x to 19.7x trailing 12-month earnings. Based on 2015 earnings estimate of $3.69, the stock is trading at 18.3x, a 28.2% discount to the industry average of 25.5x. Our target price of $71.00 is based on approximately 19.2x our 2015 earnings estimate. Lorillard holds a Zacks Rank #3 (Hold). Equity Research LO Page 3

4 Key Indicators F1 F2 Est. 5-Yr EPS Gr% P/CF 5-Yr High 5-Yr Low LORILLARD CO (LO) Industry Average S&P REYNOLDS AMER (RAI) ALTRIA GROUP (MO) UNIVL CORP -VA (UVV) ALLIANCE ONE (AOI) TTM is trailing 12 months; F1 is 2014 and F2 is 2015, CF is operating cash flow P/B Last Qtr. P/B 5-Yr High P/B 5-Yr Low ROE D/E Last Qtr. Div Yield Last Qtr. EV/EBITDA LORILLARD CO (LO) NA NA NA NA Industry Average S&P Equity Research LO Page 4

5 Earnings Surprise and Estimate Revision History NOTE THIS IS A NEWS-ONLY UPDATE; THE REST OF THIS REPORT HAS NOT BEEN UPDATED YET. Equity Research LO Page 5

6 OVERVIEW Founded in 1760, North Carolina-based Lorillard operates through two operating segments Cigarettes segment and the Electronic Cigarettes segment. the The Cigarettes segment consists principally of the operations of Lorillard, Inc., Lorillard Tobacco (a subsidiary of Lorillard, Inc.) and related subsidiaries. Lorillard Tobacco is the third largest manufacturer of cigarettes in the United States and produces cigarettes for both the premium and discount segments of the domestic cigarette market. Newport, its flagship menthol flavored premium cigarette brand, is the top selling menthol flavored cigarette and the second largest cigarette brand in the U.S, based on gross units sold in In addition to the Newport brand, the company s product line includes four other brands namely Kent, True, Maverick, and Old Gold. These five brands include 43 different product offerings, which vary in price, taste, flavor, length and packaging. The Electronic Cigarettes segment consists principally of the operations of LOEC, Inc. (a subsidiary of Lorillard, Inc), Cygnet U.K. Trading Ltd and related entities. LOEC, Inc. is a leading electronic cigarette company in the United States and markets its brand under blu ecig, which was acquired in Apr Cygnet, based in United Kingdom is also a subsidiary of Lorillard, Inc. and markets its e-cigarette under SKYCIG brand, which was acquired in Oct 2013 and is currently named as blu. All of the company s products are manufactured at its Greensboro, N.C. facility. On Jul 15, Lorillard and peer Reynolds American entered into an agreement per which Reynolds agreed to take over Lorillard for $27.4 billion, including assumption of net debt. In connection with the transaction, Reynolds also announced that it has reached an agreement with Imperial Tobacco Group to purchase the Kool, Salem, Winston, Maverick and blu e-cigs brands and other assets and liabilities from Reynolds and Lorillard for $7.1 billion in cash. The companies expect the transactions to close in the first half of REASONS TO BUY Growing Cigarette Market Share Owing to Strong Brands: Lorillard is the third largest manufacturer of cigarettes in the United States, focused on building brands and brand power. Newport, its flagship premium cigarette brand, is the top selling menthol and second largest selling cigarette brand overall in the U.S. based on gross units sold in Despite the slowdown in the tobacco industry, Lorillard has managed to consistently gain market share over the last 10 years. In the first half of 2014, its market share grew 30 basis points year over year to 15.1%, driven by continued strengthening of Newport Menthol in its core geographies, continued success in new markets and improved volumes after the launch of Newport Smooth Select and Newport Non-Menthol Gold in Newport has a strong domestic retail market share, which has been escalating since 2009, despite higher pricing. The company expects the brand to continue to gain market share in the coming quarters. Product Innovation Adding to Growth: Lorillard has launched many new products amid the declining tobacco industry in order to boost sales. In the cigarettes category, the company launched Newport Non-Menthol Gold cigarette in the fourth quarter of 2013 and then re-launched it in two test markets during the third quarter of Newport Smooth Select Menthol cigarettes, which were launched in the second quarter of 2013, have also been doing well. Equity Research LO Page 6

7 In the e-cigarette category, the company launched blu ecigs cherry disposable products in the third quarter of 2014, which led to a sequential increase in U.S. net sales for the brand. The momentum is expected to continue. Recently, the company also introduced enhanced rechargeable kits called blu PLUS+ Tanks nationwide for adult smokers. These kits are better than the original cartridges and come in variety of flavors. blu ecigs plans to roll out more flavors in The SKYCIG brand was named as blu (U.K.) and then re-branded as blu and launched at retail stores in UK and online during the second quarter of The retail exposure has been good so far and is expected to increase significantly during the fourth quarter of 2014 and 2015, which, along with continued marketing of blu, is expected to drive an increase in net sales. Potential Benefits from Merger with Reynolds: Lorillard is tethered to menthol cigarettes and would be given valuable diversification with Reynolds American's traditional tobacco brands, such as Camel and American Spirit, if the Reynolds-Lorillard deal materializes. In addition, both companies are likely to see significant cost synergies. Since they share virtually identical manufacturing and distribution processes, the combined entity should be able to shed a great deal of overlapping costs. This should boost earnings soon after the merger closes. Strong Pricing Actions: Lorillard has always remained afloat amid declining volumes in the cigarette industry with the help of increased pricing. Cigarette prices have been increasing since 1998 and these have been driven by increases in federal, state and local excise taxes and manufacturer costs. It is impressive that the company has been able to maintain stable market share despite repeated price increases in several markets. This shows that the company has a strong business model and brands. Moreover, the price hikes help Lorillard maintain margins at the desired level. Growing Demand for Cigarette Alternative: Increasing health consciousness among the youth has reduced the demand for tobacco over time, thus forcing the company to look for other alternatives like e-cigarettes. E-cigarettes look like traditional cigarettes but do not produce smoke, ash or smell. With the acquisition of the e-cigarette brand blu e-cigs in Apr 2012, the company expanded its footprint in the electronic cigarettes market. Lorillard took a step further to strengthen its e-cigarette business with the acquisition of SKYCIG (now branded as blu) in Oct, Though e-cigarette sales are facing a slowdown recently due to lower price of rechargeable kits as well as a decline in unit volume, the company still expects to make a series of technical advances in the blu brand in Returning Value to Shareholders: Lorillard is one of the most efficient and aggressive companies in the tobacco industry that regularly increases shareholder return in the form of dividends and share repurchases. In Jun 2014, the company completed its $1 billion share repurchase program that was announced in Mar 2013 and amended in May However, in connection with the merger agreement, Lorillard suspended its future share repurchases. The company has increased dividend payment every year since In Feb 2014, Lorillard's board approved a 12% increase in its quarterly dividend, significantly up from the last hike of 6.5%. The company has grown its quarterly dividends at an average annual growth rate of about 16% since Equity Research LO Page 7

8 REASONS TO SELL Slipping E-Cigarette Sales Due to Increased Competition: Lorillard has reported significant declines in its electronic cigarettes sales in the last two quarters, raising concerns and questions about the strength of the nascent market. blu ecig, when initially launched, had 47% share of the U.S. market. Sales of the e-cigarette segment declined 35% to $37 million in the second quarter. Its retail share fell 1.1 percentage point to 40.9%. The significant decline came from greater competition from rivals Altria Group Inc. and Reynolds American Inc., who rolled out their own e-cigarettes brands - Vuse and MarkTen nationwide. These were earlier available in only two states. Also, the shift in consumer preference from smaller e-cigarettes to tank devices, which are typically larger and have longer-lasting batteries and a puff that is more similar to a combustible cigarette are also harming e-cigarette sales. Declining Cigarette Volumes: Lorillard has witnessed a decline in cigarette volumes since the past many quarters. The slowdown in the tobacco industry, increasing health consciousness among consumers and significantly higher prices of cigarettes have hurt volumes. Increases in federal, state and local excise taxes and manufacturer price have increased cigarette prices, which have significantly impacted the consumption of cigarettes. In addition, a rise in the number of people who quit smoking has also impacted sales. The company has been making constant efforts to revive volumes and is also keen on new product launches and offering discounts. However, these are yet to contribute to volume growth. We believe that volumes are expected to decline further as regulations on traditional cigarettes tighten and consumers shift to alternate tobacco products. Prohibition on Advertisements of Tobacco Products: Tobacco companies cannot market their products through advertising. Advertising of tobacco products through television and radio has been prohibited since Under the State Settlement Agreements, Lorillard cannot use billboard advertising, cartoon characters, sponsorship of concerts, non-tobacco merchandise bearing Lorillard s brand names and various other advertising and marketing techniques. Further, Lorillard s Newport brand can advertise in a limited number of magazines that meet certain requirements regarding the age and composition of their readership. In fact, Newport is the company s only brand that receives magazine advertising support. Also, Lorillard does not sell cigarettes directly to its customers and does not ship products directly to retail stores. This gives a chance to its competitors Philip Morris USA Inc. and R.J. Reynolds Tobacco Company to capture the retail shelf space available for the tobacco brands. Regulatory Restrictions: The global cigarette-making industry continues to be in a flux as it deals with increased regulation on packaging (graphic warning labels) in some international markets, heightened FDA concerns about public health issues of menthol cigarettes, and the advent of the electronic cigarette. In Mar 2011, the FDA intervened and wanted to remove menthol cigarettes from the markets but did not take an immediate action. In Jul 2013, the FDA noted through a report that menthol cigarette smokers were less successful in quitting the habit than non-menthol smokers. The European Parliament has introduced a law banning the sale of menthol cigarettes from 2022, which has also increased pressure on the United States to act. New restrictions on menthol cigarette sales would be a negative for Lorillard as the company has significant exposure in the menthol market. Equity Research LO Page 8

9 After regular cigarettes, e-cigarettes have also come under FDA review. In Mar 2014, the European Parliament imposed stronger rules on e-cigarettes, per which e-cigarettes, with nicotine strength of more than 20 milligrams per milliliter would need authorization as a medicine. Later in Apr 2014, the FDA proposed to regulate e-cigarettes, cigars, pipe tobacco, hookahs (water pipes) and dissolvable tobacco products, owing to the growing popularity of e-cigarettes among youngsters. The proposed rules, if finalized, will limit sales to minors, ban free samples, and require companies to give detailing of ingredients and warning labels as well as seek federal approval to sell e- cigarettes. However, the FDA does not recommend a restriction on flavored products or online sales and advertising of e-cigarettes. DISCLOSURES & DEFINITIONS The analysts contributing to this report do not hold any shares of LO. The EPS and revenue forecasts are the Zacks Consensus estimates. Additionally, the analysts contributing to this report certify that the views expressed herein accurately reflect the analysts personal views as to the subject securities and issuers. Zacks certifies that no part of the analysts compensation was, is, or will be, directly or indirectly, related to the specific recommendation or views expressed by the analyst in the report. Additional information on the securities mentioned in this report is available upon request. This report is based on data obtained from sources we believe to be reliable, but is not guaranteed as to accuracy and does not purport to be complete. Because of individual objectives, the report should not be construed as advice designed to meet the particular investment needs of any investor. Any opinions expressed herein are subject to change. This report is not to be construed as an offer or the solicitation of an offer to buy or sell the securities herein mentioned. Zacks or its officers, employees or customers may have a position long or short in the securities mentioned and buy or sell the securities from time to time. Zacks uses the following rating system for the securities it covers. Outperform- Zacks expects that the subject company will outperform the broader U.S. equity market over the next six to twelve months. Neutral- Zacks expects that the company will perform in line with the broader U.S. equity market over the next six to twelve months. Underperform- Zacks expects the company will under perform the broader U.S. Equity market over the next six to twelve months. The current distribution of Zacks Ratings is as follows on the 1019 companies covered: Outperform %, Neutral %, Underperform 6.3%. Data is as of midnight on the business day immediately prior to this publication. Our recommendation for each stock is closely linked to the Zacks Rank, which results from a proprietary quantitative model using trends in earnings estimate revisions. This model is proven most effective for judging the timeliness of a stock over the next 1 to 3 months. The model assigns each stock a rank from 1 through 5. Zacks Rank 1 = Strong Buy. Zacks Rank 2 = Buy. Zacks Rank 3 = Hold. Zacks Rank 4 = Sell. Zacks Rank 5 = Strong Sell. We also provide a Zacks Industry Rank for each company which provides an idea of the near-term attractiveness of a company s industry group. We have 264 industry groups in total. Thus, the Zacks Industry Rank is a number between 1 and 264. In terms of investment attractiveness, the higher the rank the better. Historically, the top half of the industries has outperformed the general market. In determining Risk Level, we rely on a proprietary quantitative model that divides the entire universe of stocks into five groups, based on each stock s historical price volatility. The first group has stocks with the lowest values and are deemed Low Risk, while the 5 th group has the highest values and are designated High Risk. Designations of Below-Average Risk, Average Risk, and Above-Average Risk correspond to the second, third, and fourth groups of stocks, respectively. Research Analyst Copy Editor Content Ed. QCA Lead Analyst Reason for Update Sneha Nahata Debasmita Banerjee Kinjel Shah Kinjel Shah Sneha Nahata 4Q14 Note Equity Research LO Page 9