Tuesday, October 27, 2009

Lorillard (NYSE:LO): Bounce time?

Couple of heavyweights are issuing strong defenses on Lorillard (NYSE:LO) following yesterday's sell-off:

- Morgan Stanley is issuing Research Technical Idea, saying they expect the stock 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 our forecast, we do not believe there has been any change in the Company's long-term prospects and/or value, and as a result, we believe that the 7% decline in Lorillard's share price is both an over-reaction and unwarranted. We expect strong absolute returns to be driven by: (i) Improved reported shipment volume, with a declining negative impact from trade inventory movements. We forecast LO's shipments to decline by 5.2% and 2.4% during 4Q09 and 2010, respectively. (ii) Stronger pricing (note PM USA's 3-4% hike on Friday). (iii) More favorable menthol competitive conditions (e.g., the Blend 54 launch impact will moderate). (iv) Increasing share repurchases. (v) An attractive valuation at ~8.0x 10e EV/EBITDA (=RAI), and a 5.4% dividend yield.

- UBS notes that 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. We believe 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 we have limited visibility on when Lorillard will get taken out, we would be surprised to see the company as a stand alone entity beyond 2 years. We see Reynolds American or Imperial Tobacco as logical buyers. We 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).

Pricing Environment Stable and That’s What Matters for Tobacco Stocks
We believe concerns over potential disruption in the healthy cigarette pricing environment should abate as more cigarette companies send out price increaseletters to the trade. Altria raised prices Friday night by 3-4% across its portfolio and Commonwealth Brands just raised prices Monday afternoon. We expect Lorillard and Reynolds American to follow shortly.

Valuation: Raising Target to $100 Based on Blended Methodology
We are raising our target to $100 from $80 based on adjustments to our blended valuation, which includes: 1) M&A ($108)—weighted 50%, 2) DCF Value ($90), 3) Dividend Yield ($93), and Relative PE vs. Food ($85)—the other 50%.

- Goldman Sachs reiterates their Buy rating on LO shares and views yesterdays’s selloff as an attractive opportunity for longer-minded investors to buy a premier US tobacco company with healthy fundamentals and significant balance sheet optionality at a compelling valuation. First, while reported shipments fell 6.3%, underlying shipments were only down 1%, relatively in-line with our expectations. Second, LO pricing remains healthy, as the lowernet pricing per pack relative to our estimate is a primarily a function of negative mix. Maverick grew almost 40% in 3Q09 versus Newport shipment down 10%. Third, Newport is still gaining market share and has seen relatively limited impact from new Menthol brands. Fourth, LO repurchased over $350 mn shares in 3Q09, which suggests the company could repurchase at least $1 bn of shares annually over the next few years. Lastly, valuation is increasingly attractive with shares at 11.6X 2010 P/E (80% relative), well below historical averages closer to 14X P/E (95% relative) despite a healthy 10% EPS growth in 2010.

- Credit Suisse believes that concerns about volume declines and perceived pricing weakness are overdone and consider the stock attractively valued at the current level.

Action: I usually do not like buying on defenses but this time there are a few catalysts that might make it work:
- Morgan Stanley's RTI will bring buying interest today
- Potential for cigarette price increase in the next few days
- LO is a very strong candidate for M&A and once the dust settles, I would expect the speculations to return.

Sum it up and I would expect the shares to be up around 3+% today.

33 comments:

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