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For Lorillard, It’s 2000 All Over Again

February 2nd, 2011 No comments

Newport Menthol accounts for 90% of Lorillard's business

It’s February 2011, and the stocks market is booming. While most stocks are up, Lorillard (LO) is taking a breather. This reminds me of the pricing action for cigarette stocks in 2000. During that time, cigarette companies faced the one-two punch of declining interest against the Internet/Technology boom, plus the threat of litigation from the States and the Federal Government.

How this all played out is instructive for how to play Lorillard today. Lorillard is one of the few bright spots in the tobacco industry because it is growing market share. The reason? Customers are choosing to buy its signature product Newport Menthol Cigarettes. Critics would point out that the reason for most of this success is that menthol cigarettes are attracting newer, younger smokers.

These minty cigarettes are on the target list of the FDA, which has regulatory powers on tobacco. They’ve already eliminated other types of flavored cigarettes (which really had insignificant share anyway). A ruling is expected in March 2011 regarding how the FDA will choose to treat menthols.

Learning From A Previous Lesson

If you bought cigarette stocks in 2000 and held on to them, you would have handily beaten the market, which essentially went nowhere the next 10 years. Part of this was the unwinding of that same Technology boom which helped to depress prices in the first place, but the biggest reason is that the legal issues regarding tobacco were settled. In short, the States and the Federal Government got a whole bunch of money and the cigarette companies were given a more consistent and predictable legal environment to conduct business. So, the legal action against the tobacco companies essentially came down to money, not health issues, not teenage smoking/advertising.

Once this issue was mostly resolved, Wall Street then based its valuation for these companies more on fundamentals. The stocks boomed because the fundamentals of these businesses are quite good, they generate excellent margins and cash flow on their products.

Year 2000, Redo

If you want to invest in cigarettes, your best bet is Phillip Morris (PM), which we own in the Income Portfolio. It’s got international growth built in plus excellent management to go with a signature Marlboro franchise. However, Lorillard (LO) is attractive because it is trading at a discount to the market because of the threat that the FDA will outlaw menthol cigarettes. This depressed valuation plus the growth potential makes for a great potential investment. Here’s LO compared to its major competitors in terms of P/E:

Company

LO : 11.4

MO : 13.8

PM : 15.2

RAI: 18.5

Also, below details analyst estimates for earnings and dividends.

Lorillard Actual 2009 Estimate 2010 Estimate 2011 Estimate 2012
EPS $5.76 $6.69* $7.34* $8.1*
Payout Ratio 0.63 0.63 0.63 0.63
Dividend Estimate $3.62 $4.21 $4.62 $5.10
Dividend Actual $3.84 $4.25
Difference 6% 1%

*Mean analyst estimate used

Conclusion

It believe it is unlikely that menthol cigarettes will be outright banned. They are 30% of the total market, which is too large to ignore. If they were banned, the sales would go underground and the states would lose 30% of their tobacco settlement money, plus the associated sales taxes that go along with these products. However, between a ban and no-ban, there might be some room for further regulation. We’ll see.

Buying Lorillard today offers the potential of an investment with a 6% dividend yield with a likely bump up of 10% per year for the next few years at least. If that doesn’t entice you, the fact that you can buy these earnings for just 11X trailing 2010 earnings should convince you.

In my mind it comes down to how cheap can I buy these shares. We may get an opportunity to buy cheaper as time goes on the next month. Lorillard will be added to our Income Portfolio this month.

Here are a few other good articles that talk about Lorillard.
– Lorillard to Benefit From Reduced Risk of a Menthol Ban: Smooth Yield, Smoking Return
– A Nonhazardous Trade on Lorillard

.Lorillard Actual 2009 Estimate 2010 Estimate 2011 Estimate 2012
EPS $5.76 $6.69* $7.34* $8.1*
Payout Ratio 0.63 0.63 0.63 0.63
Dividend Estimate $3.62 $4.21 $4.62 $5.10
Dividend Actual $3.84 $4.25
Difference 6% 1%

*Mean analyst estimate used

Categories: Investing Tags:

Muni Bonds: Good Value or Value Trap?

December 30th, 2010 No comments

It’s been a roller coaster ride for bonds. Since the 2008 Great Recession, we’ve seen Treasury bonds all over the place in pricing. The most recent move to lower prices has been abrupt and significant. The 10-year note has gone from about 2.5% yield to over 3.3% yield (lower bond prices mean higher yields).

For Municipal bonds however, the story is somewhat different. Like most assets classes, they bottomed in 2009, caught a bid towards recovery and stabilized to prices that were lower than pre-recession prices but stable nonetheless.

Until the last couple of months. Prices have weakened, and yields have gone up. What to make of all of this?

Muni Value Trap?

Value or income investor know all too well about value traps. You see, when the price of an investment decreases its income yield goes up making the investment more attractive from an income point of view. Sometimes, the investment drops in price further wiping out any benefit from the higher yield. This could be for a number of reasons, but in the end the yield was a trap.

Sometimes the market is signaling that the earnings are suspect or unsustainable. Or, the market may be adjusting the multiple offered on the investment perhaps because future earnings are expected to be much lower than expected. Or, it simply could be a market mis-pricing which can occur too.

A real disaster occurs when your investment value drops and the investment lowers its income. You lose both ways. As anyone who invested in large bank stocks say 5 years ago, you lost almost all of your income and much of your capital.

Are muni’s a value trap? Most likely not, if you believe that most of these bonds, especially the higher credit quality ones, will continue to pay.

Why Buy Now?

When buying any asset, the best time to buy is when the uncertainty is highest and your confidence in the long term soundness of the investment is confirmed. It’s difficult to get the bottom, so the best strategy is to buy in smaller chunks overtime. When many other asset classes have been rising, one of the last asset classes that has faltered has been muni bonds.

For Municipal bonds, even though there is credit risk here, the reality is that the vast majority of these bonds will continue to pay, even ones of lower credit quality. If stick with bonds that are higher credit quality, you will buy an investment that offers tax free income at an attractive price with an opportunity for capital gains as well.

If they continue to pay income over time, the likely scenario is that the bonds will recover as the economy recovers.

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Portfolio Update: More Public Offerings In The Mix

December 4th, 2010 No comments

There is a healthy sign in the marketplace right now: companies are issuing new stock offerings. In the case of our Income Portfolio two of our holdings have issues new offerings: Realty Income (O) and Enterprise Products Partners (EPD).

Why would a company do this? The primary reasons are:

  • The stock price is high enough such that implied return to new investors is low. In the case of issuing common share or units, this is effectively the dividend yield. In both cases mentioned above it’s about 5%.
  • The company believes that it can adequately garner a sufficient return by using the money investing in their business. A high stock price makes this cost of capital lower. In the cases of Realty and Enterprise, their stock prices are near all time highs.
  • Because they can. One never knows how the markets will behave going forward, so it’s always good to get extra resources when times are good.

The inital reaction by the markets to these announcements is what’s called a ‘fear of dilution’, so the stocks normally trade down. More shares for the same amount of earnings effectively makes the earnings per share go down. However, over time, the extra capital should enhance earnings for all shareholders if the company is doing its job.

In this case of Realty and Enterprise, they have a long history of using their capital effectively so there is no cause for alarm.

Categories: Investing, Weekend Investor Tags:

Sizing Up The General Motors (Preferred) Stock IPO

November 21st, 2010 1 comment

General Motors just went public last week in a big hoopla of an IPO, in a dramatic return to the public markets only 18 months after the company went bankrupt. Well, it’s not the same company because the new one is called ‘General Motors Company’, while the bankrupt entity was called ‘General Motors Corporation’.

While there is a lot of coverage of the common stock, there was almost no discussion about the preferred stock. So, this post will cover the details about the preferred stock. We talk a lot about preferred stocks on this site and how they can enhance your portfolio, so I thought it would be a good idea to cover it.

To summarize it quickly, here are the key details about the preferred offering:

  • Symbol: GM-B
  • Type: Mandatory Convertible Preferred (12/2013 date)
  • Offering Price: $50 (common stock was $33)
  • Coupon Yield: 4.75%

Unlike other convertible preferreds, GM-B is a mandatory preferred, meaning that on December 1, 2013 it will convert to common stock if the holder didn’t otherwise exercise earlier. Given the specifics about its conversion, it is simple to understand the return profile for this security. Here are the possible scenarios and how the return profile looks compared to the common stock:

Common Versus Preferred

If on December 1, 2013, the common stock trades at:

  1. < $39.6 ==> Preferred holders lose/gain capital inline with common holders, but are ahead by the interest payments of 4.75%/year that were collected.
  2. $39.6 to $50 $44.99 ==> Preferred holders earn more than common holders, ending about even at $50.
  3. > $50 ==> Preferred holders give up some capital gains even after factoring in the interest payments.

The outcomes above are simplified because the return profile only applies on the end date. For dates earlier than 2013, the conversion ratio offers more common stock to compensate for the lower interest payments (as time goes on, the amount of common stock goes down to compensate for the interest payments made).

The preferred therefore has some downside protection at the expense of giving up some upside if the common stock does very well.

How To Play It

The preferred stock will likely appreciate less than the common since the conversion rate starts off low and increases over time. This will encourage holders to keep it longer term. If the common stock doesn’t perform that well, the interest payments offer the ability to salvage some return.

As far as attractiveness, the 4.75% yield doesn’t entice me because other preferreds are available at higher interest rates. Also, the common stock doesn’t interest me that much either since I don’t think that the automobile market will recover that quickly and I don’t think that GM has recovered fully to become a very competitive player in the market.

However, one way to play this would be to purchase the preferred if it sells off significantly below face value. This would offer the ability to get an effectively higher yield while at the same time getting all the upside that the common offers.

Categories: Investing Tags: ,

Weekend Investor: Protect Your Principal Now

October 10th, 2010 No comments

In the Income Portfolio, we have different types of investments that each in their own way deserves a place in your portfolio. Some of these investments become more or less attractive because that’s the way the market functions: some investments become over valued while other become undervalued.

Over the long term, you want to primarily be invested in common corporate stocks and other equity investments because they tend to do better compared to bonds and other types of debt. We don’t have bonds in the portfolio, but we do have a good chunk of preferred stocks which act a lot like bonds.

Here are the main points about equity investments:

  1. Equity gives you ownership of profits. Profits tend to go up over time, so equity prices follow.
  2. Equity gives you a stake in the dividends or other income that is produced by the business. As profits go up, dividend income tends to go up as well.
  3. The investment rides with the business, which can be both great (growing) or terrible (decay).

Here are the main points about debt investments:

  1. Owners of debt usually don’t get (or expect) significant capital appreciation.
  2. The amount of income offered is either fixed or tied to some target financial rate; therefore, it is not linked to the underlying business and therefore has no huge upside potential that equity owners get.
  3. The investment doesn’t ride with the business, in most cases a poorly performing business (but still viable) will pay its debt holders. Equity holders may be left holding the bag.

So when you look at each of these points, you see that each type of investment has its own advantages and disadvantages. Today, I want to talk about another way to take advantage of the attributes that debt instruments have: using the limit on capital appreciation (point #1 above) to protect your principal in equity investments.

What To Do When A Stock Is Overvalued

In short, what I mean is that you take an overvalued common stock, sell it and roll the proceeds into a preferred stock, or other kind of debt. Here’s why this is a good idea:

  • Equity prices do go up over time, but at times they become way over valued. When you sell you are locking in that high value profit.
  • When you roll the proceeds to an investment grade preferred stock, you still make money but because the principal value of the preferred stock will not likely be as volatile as the common stock. The expectation is that the common stock will not be able to maintain the over-valuation.
  • When the common stock comes back to a more normal valuation, do the reverse swap.

Example: Realty Income (O)

Realty Income (O) has become richly valued; it is now about 18X cash flow. The dividend yield on the stock is now about 5.0%, below its long term average. Realty Income’s preferred stocks (O-D and O-E) are each yielding between 6.5% to 7.0%. So, from an income point of view you will make more money with the preferred while the common “catches up”. It’s possible that when you combine capital appreciation, the common could catch up – but, that would require a higher sustainable price when the stock is already pretty expensive.

By swapping the common for the preferred, we get more income immediately while presumably taking less risk of principal loss.

The great thing about investing for income is that we don’t have to do anything because no matter what we still make money holding our positions now. So, another approach would be to put any new money into the preferred instead of the common stock.

Categories: Investing, Weekend Investor Tags: