At the end of August last year, we recommended a long position in Lorillard, Inc. (LO), which has worked out well as the stock moved 27% in the interim. Our argument at the time rested partially on the fact that LO is uniquely positioned to take advantage of the growth in the so-called e cigarettes brands. E cigarettes use electronics to vaporize a liquid solution that usually includes nicotine and flavorings.
Smoking, or “vaping,” e cigarette brands is clearly not a safe alternative to smoking, but is it safer? We probably can’t say for sure but consumers seem to think so and the shift from traditional tobacco products to e cigarette brands is gaining momentum. This is good for LO, which owns approximately 50% of the U.S. market for e-cigarettes.
Projected to grow 5-fold by 2017 by Wells Fargo (WFC) analysts, the market for e cigarette brands in the U.S. is an important one but exposure to the international market will be even more critical. This is where LO may actually have an interesting advantage in the short term.
Rumors heating up that Reynolds American (RAI) is a likely takeover target of British American Tobacco (BTI) who actually already owns approximately 42% of RAI. That is important because the Financial Times is floating a credible rumor that RAI is investigating a buyout of LO.
British Tobacco and Reynolds American give LO a much larger international presence and a better scale to defend against the emerging e-cigarette joint venture between Altria (MO) and Philip Morris (PM) next year.
As you can see in the next chart, LO rallied significantly on the rumors, but has since pulled back a bit. This kind of price behavior is normal as investors try to price-in the potential for a merger. The premium required to acquire LO could easily be as much as 30%-35%. Considering the company has recently raised its dividend and continues to be a growth and share buyback juggernaut, such a premium isn’t a stretch.
The post-rumor volatility led to a retracement of approximately 61.8%, which is pretty standard. The subsequent bounce since March 12 happened at a multi-year trend line support level, which adds even more weight to the argument for momentum. A projection based on the same technical levels indicates an upside target in the near term of $61 per share.
What could go wrong?
Tobacco companies fall into the ‘consumer staples’ category that is a bit of a mixed blessing. On the one hand, these firms are likely to outperform if the market is a little slow or nervous. However, higher yields and a bullish market created significant headwinds for these same firms over the last year. LO and a few other featuring e cigarette brands have been remarkably productive when compared to their peers but the pull-backs have also been large.
We also have to face the fact that it is currently fashionable to remove tobacco products from store shelves, and in the U.S., state attorneys general have come out more strongly against retailers selling tobacco products this week. This issue increases uncertainty in the stock should be considered before making an investment.
Finally, we can’t fool ourselves into thinking that e cigarette brands are ‘morally superior’ to other tobacco products. Nicotine is still as addictive as heroin and these companies profit to a certain extent from people who don’t really want to use their products. Understandably, some investors find this distasteful and avoid the so-called “sin stocks” including alcohol companies. We think that adults should be allowed to make adult-decisions, but these ethical issues will also likely increase volatility.
While we have a very bullish outlook for LO, volatility is also likely to be high. This could be an interesting opportunity to use a long call option with a June expiration to take advantage of the short-term potential upside without having unlimited risk to the downside. Because of the merger rumors, liquidity in LO’s chain sheet has improved and we like the at-the-money calls, the LO June $52.50 Calls, for $3.00 or less.
InvestorPlace advisors John Jagerson and S. Wade Hansen are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next trade and get 1 free month today by clicking here.