Lorillard Is Smoking Philip Morris in Profitability

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Cigarette makers are sitting pretty. The top five companies by market cap are averaging year-to-date gains of 27.7% as of Oct. 27 compared to less than 4% for the S&P 500. Can they keep it up into 2012? That remains to be seen. What I can say is that investors should consider selling Philip Morris International (NYSE:PM) and buying Lorillard (NYSE:LO) in its place. Here’s why:

Earnings

Philip Morris International beats while Lorillard misses. The third-quarter results hardly seem like an argument in favor of Lorillard. Nonetheless, I believe there’s a silver lining in all of this. I’ll explain.

First, Philip Morris is a much bigger company doing business in various parts of the world outside the U.S. Lorillard is exactly one-fifth its size, operating solely in the U.S. America is hardly an accommodating jurisdiction for cigarette sales.

Sure, Lorillard is able to carry on a profitable business, but not without the constant threat of litigation. Almost all of Philip Morris’ revenues derive from jurisdictions that either turn a blind eye to their “dirty” business or at least have laxer anti-smoking legislation (some exceptions being Canada, Australia and Singapore) than exists in the U.S. Not to mention cigarette consumption in Asia continues to hold steady if not increase. It makes sense that Philip Morris’ revenues in the third quarter grew 15.9% compared to 3.5% for Lorillard.

But was PM more profitable? Not a chance. Philip Morris’ net margin in Q3 was 11.5% versus 16.5% for Lorillard. LO might be smaller, but it knows how to make money.

Share Repurchases

Both companies were busy buying back stock in the third quarter. Unfortunately, neither did a very good job. Philip Morris paid an average of $68.27 per share for the 21.2 million it repurchased — a price that was 95.3% of its high for the quarter compared to Lorillard, which paid $109.15 a share for the 4 million it bought back, paying on average 96% of its high for the quarter. Both stocks currently are trading above the price paid per share, so shareholders can breathe a little easier.

Since May 2008, when Philip Morris started its repurchase program, it has bought back $20.3 billion in stock at an average price of $50.81 per share. Since its spinoff in March 2008, PM has reduced its share count by 359 million shares, or 17%. Since July 2008 through September 2011, Lorillard has reduced its share count by 21.2%, buying back 39.4 million LO shares at an average price of $98.25 per share.

I’ll give it to Philip Morris International — although it didn’t reduce its share count by as much, it did a much better job of repurchasing its shares. Unfortunately, Lorillard still delivered a higher total annual return over the past three years.

Net Debt

Right in Philip Morris’ third-quarter press release, it references its net debt-to-EBITDA ratio being 1.02. Lorillard’s is 0.46, less than half PM’s, and that’s after issuing $750 million in senior notes in the third quarter. The interesting thing is Philip Morris generates far more free cash flow. You would think given its $9 billion in free cash in the first nine months of the year on $6.7 billion in net income — compared to $659 million in free cash for Lorillard on $809 million in net income — that its net debt-to-EBITDA ratio would be lower.

But it’s not. That’s because Philip Morris is spending $1.8 billion per quarter to buy back stock — stock that isn’t outperforming Lorillard despite the ample buys. I bet if Philip Morris cancelled its share repurchases for the next two years, it could get its debt paid off entirely. It won’t, because that doesn’t goose earnings per share — something Lorillard is equally as guilty of doing. Having said that, because Lorillard is not growing as fast and yet is making more from every pack of smokes, it can afford to do a little buying here and there; with the exception of dividends, there really isn’t anywhere else for it to put its money. That’s not the case with Philip Morris. Its management clearly is wasting cash.

Bottom Line

By almost every valuation metric except the PEG ratio, Lorillard is cheaper. My bet is the next three years in terms of stock performance will be much like the last three. This favors Lorillard.

As of this writing, Will Ashworth did not own a position in any of the aforementioned stocks.

Will Ashworth has written about investments full-time since 2008. Publications where he’s appeared include InvestorPlace, The Motley Fool Canada, Investopedia, Kiplinger, and several others in both the U.S. and Canada. He particularly enjoys creating model portfolios that stand the test of time. He lives in Halifax, Nova Scotia.


Article printed from InvestorPlace Media, https://investorplace.com/2011/10/lorillard-lo-is-smoking-philip-morris-pm-in-profitability-tobacco-stocks/.

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