By SANDRA WARD
The U.S. Food and Drug Administration this month is expected to make its first public statements about whether sales of menthol cigarettes should be restricted.
Lorillard is the company most at risk. It makes Newport, the top seller in the menthol category, with a 35% market share. Newport, which is also the overall No. 2 cigarette brand in the U.S., accounts for approximately 90% of Lorillard's total sales. Yet, Lorillard (LO)
Outside of the FDA cloud, it's easy to be attracted to Lorillard's strong balance sheet, robust free cash flow, high margins, dividend yield of 4.5% and share buybacks. Based on 2012 projections of earnings per share, Lorillard now trades on par with Altria Group (MO),
It has become conventional wisdom that, short of a ban, any action the FDA takes won't amount to much. Potential actions could include requiring extra warning labels, or conducting community outreach programs for children, adolescents and minorities, the groups most attracted to minty cigarettes. The industry has argued that a ban would likely produce a black market to satisfy demand. But the advisory panel, noting that kids are very price-sensitive, said that the price increases typical of a black market would discourage them smoking.
Until the smoke clears, all that is certain is "that the risk-reward profile of the stock has changed," says Philip Gorham, consumer staples analyst at Morningstar. And the "risk is to the downside." Warns Andrew Kieley, a tobacco analyst with Deutsche Bank: "At this point, we have very low visibility into how senior FDA leadership views these issues, and any long-term risk of menthol restrictions is not significantly discounted in the stock."
A taste of that risk came Thursday, when the FDA said the advisory panel's report is being revised and that the changes would become available to the public no later than June 22. On the news, Lorillard shares fell 3.5%.
In an interview with the New York Times shortly after the advisory panel released its findings, its chairman, Jonathan M. Samet, suggested that investors' enthusiasm may be premature. Samet said the panel's recommendation to remove menthol cigarettes was clear. Less clear, he said, is how the FDA will do that, given the strategies available to it under the law.
More than likely, say industry watchers, the FDA's first statement on the matter will simply be procedural, thanking the advisory panel and taking the issue under further advisement. In that event, the uncertainty would be prolonged, weighing on the shares.
Until this year, Lorillard, the third-biggest and most-profitable U.S. tobacco company and widely considered the best-run, had seen its shares languish behind the rest of the tobacco pack since June 2009, when the Family Smoking Prevention and Tobacco Control Act was passed, giving the FDA power to regulate the tobacco industry for the first time to protect the public, especially children. Lorillard, once part of Loews, was spun out as an independent company in 2008, a year before the legislation was introduced.
The FDA quickly banned cigarettes flavored with fruit, spice or candy as of September 2009, but exempted menthol. There are relatively few smokers of, say, chocolate or strawberry cigarettes. Menthols, on the other hand, represent one-third of the total cigarette market. They're preferred by African-Americans and are enormously popular among the young. Adolescents between 12 and 17 smoke menthol cigarettes at a higher rate than any other age group. Menthol, the advisory panel found, makes it easier to take up smoking and more difficult to quit. Indeed, sales of menthol cigarettes are growing in an industry that is declining over all.
LORILLARD IS FAIRLY SMALL, compared with the rest of the industry, with a $16 billion stock-market value. Though it has the industry's strongest brand and commands the highest prices-per-pack, it is largely undiversified outside of its Newport line, whose core customer base is largely on the East Coast. It recently outlined plans for a major push to extend its Newport franchise into the Western states and to build a nonmenthol brand, Newport Red, as well as a menthol-light brand. Such growth plans typically come at a cost, and could well cut into margins if the company must offer promotional pricing to build volume.
Long viewed as an attractive takeover target for such tobacco giants as Reynolds American, U.K.-based Imperial Tobacco Group (ITYBY)
Until the air is cleared, anyone plunging into the stock at its current price probably is smoking something a lot stronger than a menthol cigarette.