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Balanced Risk-Reward for Lorillard

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On Mar 31, 2014, we issued an updated research report on Lorillard Inc . This cigarette maker reported fourth-quarter 2013 results on Feb 12.

Lorillard’s fourth quarter sales beat the Zacks Consensus Estimate by 30.8% and increased 2.3% from the prior-year period on the back of higher sales of electronic and regular cigarettes. Adjusted earnings of 82 cents per share exceeded the prior-year earnings by 3.8% driven by the strong performance of the cigarettes segment and lower share count owing to share buybacks.

Though slightly missing earnings expectations in the fourth quarter, Lorillard posted better-than-expected results in the first three quarters of 2013. The rising market share of the company’s brands, tight cost control measures and the success of the company’s electronic cigarette brand – blu e-Cigs – have proved to be Lorillard's strength. Higher sales of electronic cigarettes have been driving the company’s sales since the last one year.

Though Lorillard has been witnessing a decline in cigarette volumes since the past many quarters, we are encouraged by the company’s dominant share in the cigarettes market owing to its flagship brand Newport and the lower-priced Maverick brand. Lorillard’s Newport brand is the top selling menthol and second largest selling cigarette brand in the U.S. based on gross units sold in 2013. The brand has also been able to increase its domestic market share since 2009, despite charging premium prices. Further, Lorillard has launched many new products amid the declining tobacco industry in order to boost sales, primarily new varieties under the Newport brand.

Lorillard is also quite well placed in the electronic cigarette industry as smokers are shifting their preference to electronic cigarettes due to rising health concerns. With the acquisition of the e-cigarette brand blu e-Cigs in Apr 2012, the company expanded its footprint in the profitable electronic cigarettes market. Lorillard took a step further in its e-cigarette business with the acquisition of SKYCIG, a leading brand of electronic cigarettes in the UK on Oct 1, 2013. This will further boost Lorillard’s sales as the e-cigarette segment is evolving rapidly. In addition, the company has been striving to expand the distribution of e-cigarettes across stores in the U.S. and Canada.

However, Lorillard and other tobacco makers like Altria Group Inc (MO - Free Report) , Reynolds American Inc and Philip Morris International Inc (PM - Free Report) are facing the brunt of increased regulation on packaging (graphic warning labels) in some international markets and heightened Food and Drug Administration (FDA) concerns about the effects of menthol and electronic cigarettes.

Amid declining volumes and tough regulations, Reynolds American is considering taking over Lorillard, as per a Financial Times report on Mar 4. The report also stated that the purchase price could be more than $20 billion. However, it is unclear whether Reynolds plans to bid for the whole company or only a portion of it. The deal has not been finalized yet, but if it materializes, the combination of Reynolds and Lorillard could change the industry dynamics – possibly creating one of the strongest global tobacco companies. The combination of two leading U.S. cigarette makers might also pose a threat to Altria, which makes Marlboro cigarettes and is the biggest tobacco seller in the U.S currently. Lorillard holds a Zacks Rank #3 (Hold).

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