Lorillard (NYSE:LO) shares popped nearly 12% Tuesday on hopes that federal regulators may back off demands to require the company to pull menthol from its cigarettes. Is this a signal that you should add it to your portfolio?
The Food and Drug Administration is holding a July meeting at which it will discuss the future of menthol cigarettes. The FDA had earlier concluded that taking out menthol would benefit public health. The unexpected surprise was that the FDA said that changes are not imminent and could not happen until rule-making, requiring public comment, had occurred.
This matters to Lorillard because 90% of its sales come from Newport, a menthol-flavored premium cigarette. This delay means Lorillard can keep selling its menthol-flavored cancer sticks. And selling Newports is a big business. In the last 12 months, for example, the company generated $6.1 billion in revenue and $1 billion in net income, and posting five-year average growth rates of 10.7% and 7.8%, respectively.
Lorillard’s recent financial performance has been solid. In the first quarter, net income rose 6.9% to $248 million ($1.71 a share) — 9% above analysts’ estimates of $1.57 — from $232 million ($1.50 a share) in 2010’s first quarter. And its revenue rose 12.9% to $1.53 billion.
And Lorillard’s ability to boost cash flow above its cost of capital is strong. In the last year, Lorillard has been creating so-called Economic Value Added momentum, a sign that the company is generating cash flows that exceed the capital required to finance its operations. Bennett Stewart coined the term — it’s a number calculated by dividing the change in EVA [Net Operating Profit After Tax – (Total Assets – Current Liabilities) x the Weighted Average Cost of Capital)]/Beginning Period’s Revenues.
The best companies create value in excess of their cost of capital — generating a positive EVA momentum. The higher the EVA momentum, the faster management is creating value. And Lorillard’s EVA Momentum is a solid 2%. This figure comes from subtracting Lorillard’s 2009 EVA of $881 million from its 2010 EVA of $973 million and dividing the difference by its 2009 revenue of $5.2 billion.
Does the market fully recognize Lorillard’s ability to create value — making it too expensive to be worth adding to your portfolio? To think about that, we can look at their price-to-earnings-to-growth (PEG) ratio — a way to determine whether the value that the market assigns a stock is justified by the rate at which it expects the company’s earnings to grow. I think a PEG of 1.0 is a fair price, and anything below that is a bargain.
Lorillard stock is fairly expensive, trading at a PEG of 1.63. Its P/E is 16.3 and its earnings are forecast to grow to $8.50 a share in 2012. Even though its reported earnings have been beating expectations for the last five quarters, the extent of that upside surprise is fairly modest.
It looks like Tuesday’s pop priced in the value of the FDA’s stay of Newport’s execution (In early Wednesday trading, the stock was off 2.5%). Too bad the same can’t be said for Newport smokers. If that doesn’t bother you, wait for a market dip to inhale this stock.
Peter Cohan has no financial interest in the securities mentioned.