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Cigarette maker Lorillard Inc. (LO - Analyst Report) reported adjusted earnings of 69 cents per share in the first-of quarter 2014, up 4.5% from the prior-year quarter. The rising market share of its brands, higher sales and lower share count owing to share buyback activity led to growth in earnings in the reported quarter. However, earnings missed the Zacks Consensus Estimate of 72 cents by 4.2%, possibly due to lower sales in the e-cigarette segment.

Net sales in the reported quarter went up 1% year over year to $1.6 billion on the back of improved pricing and market share gains of regular cigarettes. Revenues comprehensively beat the Zacks Consensus Estimate of $1.2 billion by 33%.

Gross profits declined 13.2% to $619 million in the quarter, due to unfavorable pricing mix and higher costs in the e-cigarette segment, which offset the higher margin in the cigarette segment. Adjusted operating income grew 2.1% to $447 million, driven by operating efficiencies at cigarette segment.

Segment Details

Cigarettes: Despite lower cigarette unit sales volumes, the company managed to increase its cigarette sales by 1.4% year over year to $1.54 billion. The increase was driven by higher average net cigarette selling prices.

Total wholesale cigarette volumes declined 2.9% to 8.96 billion units in the first quarter including Puerto Rico and U.S. shipments. We note that Puerto Rico and U.S. Possessions accounted for about 23% of the decline as there has been a $1 per pack tax increase in Puerto Rico since Jul 1, 2013, which has affected volumes. Apart from this, reduction in factory pack promotions also accounted for 25% of the volume decline. In addition to this, severe weather during February and early March and change in the holiday timing led to a decline in volumes.

In the reported quarter, Lorillard's domestic retail market share climbed 0.3 share points to 15.2%, backed by strong gains in the company's flagship brand – Newport – whose domestic retail market share also increased 0.4 share points to 13.0%. Newport 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 Smooth Select and Newport Non-Menthol Gold in 2013. Lorillard's domestic retail share of the menthol market however was flat at 40.7% in the reported quarter but up 80 basis points sequentially.

Adjusted gross margin increased 100 basis points to 37.1% in the quarter, owing to tight cost controls, highlighted by a reduction in factory pack promotions. Adjusted operating income also grew 4.9% to $452 million in the quarter.

Electronic Cigarettes: Lorillard formed this segment following the acquisition of the blu eCigs brand on Apr 24, 2012. Net sales during the first quarter declined 10.5% to $51 million. The decline was due to unfavorable pricing mix owing to lower price of rechargeable kits that were introduced in the third quarter of 2013, which more than offset the increase in unit volume in the reported quarter. The company’s acquisition of Skycig, a leading premium brand of electronic cigarettes in the UK in Oct 2013, generated $2 million in sales in the first quarter.

Lorillard continued to aggressively expand its e-cigarette offerings across its U.S. stores. In the first quarter, the company was able to reach 149,000 retail stores. blu eCigs enjoyed 45% market share in the U.S., an increase of 10 share points from the year-ago quarter.

Adjusted gross margin declined significantly by 540 basis points to 31.4% in the first quarter, due to the unfavorable mix impact of the new, lower priced rechargeable kits as well as higher retail distribution costs. Adjusted operating loss was $5 million, higher than $3 million loss incurred in the sequentially preceding quarter. This was due to higher selling, general and administrative costs and incremental investments to expand the blu brand in the U.S. as well as to prepare for the launch of blu in the U.K.

Other Financial Updates

On Mar 10, 2014, Lorillard increased its quarterly dividend by 12% to 61.5 cents per share, which was paid to shareholders of record as of Feb 28, 2014.

During the quarter, the company repurchased approximately 3.2 million shares at a cost of $158 million under the $1 billion share repurchase program. The company had $156 million worth of shares remaining under its share buyback program as of Mar 31, 2014.

Lorillard carries a Zacks Rank #2 (Buy). We are impressed with the company’s dominance in the cigarette industry owing to its strong brands and significant market share. It is quite well placed in the electronic cigarette industry too as smokers are shifting their preference to electronic cigarettes due to rising health concerns. 

However, recently as per media reports, the Food and Drug Administration has 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.

Though Lorillard has been in favor of regulating the sale of e-cigarettes to minors, we believe that the regulatory pressure on e-cigarettes will weigh on tobacco biggies like Altria Group Inc (MO - Analyst Report), Philip Morris International Inc. (PM - Analyst Report) and Reynolds American Inc (RAI - Analyst Report), which are already facing challenges in the form of strict anti-smoking campaigns launched by governments around the world. Tobacco companies are increasingly relying on packaging to build brand loyalty and grab consumer attention, especially after the government curbed advertising in magazines and on billboards and TV.

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