Tuesday, October 27, 2009

Lorillard (NYSE:LO): UBS raises target to $100, sees takeout in 2 yrs- Bounce?

Lorillard (NYSE:LO) is getting some surprisingly positive commentary from analysts this morning after yesterday'd hefty sell-off:

- UBS is raising their target to $100 from $80 noting every stock has its role in a given portfolio. Investors own companies because they are best-in-class, others look for cash return/income stories and another type of investor looks for event driven ideas. Lorillard has all 3 of these traits. UBS believes Monday’s 7% (unwarranted) pull back offers many types of investors an opportunity to buy a best in class company that is a legitimate M&A candidate.

How Much Do You Get Paid to Wait for the Take-Out? 15% Per Year
While they have limited visibility on when Lorillard will get taken out, they would be surprised to see the company as a stand alone entity beyond 2 years. Firm sees Reynolds American or Imperial Tobacco as logical buyers. They estimate investors waiting for an eventual take out can expect 15%+ total shareholder return per year to wait (10% EPS growth, 5-6% dividend yield).

What’s Driving Lorillard’s Fundamentals?
The key pillar to UBS investment thesis on Lorillard is beatable and sustainable EPS growth targets of 5-7% per year, driven in large part by the company’s exposure to the Newport brand (91% of total company sales). Below are summary points about the key drivers of Newport’s growth:

It’s menthol: The primary driver of Newport’s growth is the migration of smokers towards menthol products (Newport is the highest share menthol brand). Menthol has been gaining share of total cigarette volumes for several years and we expect that to continue over the next few years.

It’s more popular than other menthol: On top of the share gains that the menthol category has been capturing from non-menthol cigarettes, Newport has been gaining share within the menthol segment, despite already being the largest menthol brand.

Plenty of “white-space” for menthol left: While menthol cigarettes compose 28% of all cigarettes smoked in the US, there is a distinct geographic skew to the menthol smoking population. Most menthol consumers are east of the Mississippi. They believe there is an opportunity for menthol brands in the Midwest and the Western US. This is evidenced by the fact that menthol gained share in 43 states during 2008 (based on insights from UBS' industry contacts and other data sources). UBS thinks that as the menthol category goes westward, so will Newport.

Economics Are Why Holders Shouldn’t Be Fazed By FDA
UBS reiterates that their views on a potential menthol ban are guided primarily by the economic implications of such a ban, and secondarily by political motivations or the semantics of the actual FDA regulation bill. They are hard pressed to see how state and federal governments could part ways with the large sums of tax/MSA revenue generated by menthol cigarettes (30% of total cigarettes).

All in, they estimate banning menthol would: 1) cost the federal government over $2 billion in annual tax revenue ($5.5 B in excise and sale tax revenues for states), and 2) likely create a large underground/illegal market for menthol that could not be taxed or regulated.

- Morgan Stanley is out with a positive Research Tactical Idea (RTI) on LO saying they believe the share price will rise in absolute terms over the next 30 days.

This is because the stock has traded off recently, making short term valuation much more compelling. Although LO's 3Q09 results trailed MSCO forecast, they do not believe there has been any change in the Company's long-term prospects and/or value, and as a result, they believe that the 7% decline in Lorillard's share price is both an over-reaction and unwarranted.

Firm expects strong absolute returns to be driven by: 1) Improved reported shipment volume, with a declining negative impact from trade inventory movements. They forecast LO's shipments to decline by 5.2% and 2.4% during 4Q09 and 2010, respectively. 2) Stronger pricing (note PM USA's 3-4% hike on Friday). 3) More favorable menthol competitive conditions (e.g., the Blend 54 launch impact will moderate). 4) Increasing share repurchases. 5) An attractive valuation at ~8.0x 10e EV/EBITDA (=RAI), and a 5.4% dividend yield.

Morgan Stanley estimates that there is about a 70% to 80% or "very likely" probability for the scenario.

Notablecalls: I think that following these two comments (there are several other defenses from tier-1 firms) LO has a decent chance of getting a bounce going.

The $100 target from UBS will get attention. Takeout speculation isn't nothing new but with UBS saying they are convinced a deal will take place in the next 2 yrs adds some fuel to the fire.

Also, LO is kind of a defensive stock. People are increasingly looking for plays like LO to generate them good dividends and medium growth.

LO is a tough stock to trade but given the comments and with some help from the general market I think it can retrace at least half of yesterday's losses. That's about $76-$77 range.


bl said...

Good call and good options

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