Lorillard’s Profits Require No Smoke

The most prof­itable prod­ucts tend to be addic­tive. If given the choice, few sales­men would turn down the oppor­tu­nity to sell an addictive prod­uct ver­sus one that was not addic­tive. Throw in the fact that cig­a­rettes are rel­a­tively cheap to pro­duce and you have an even more com­pelling value proposition.

I am not a Kent smoker or tobacco user, and I do not like to be around smok­ers. How­ever, that prejudiced does not blind me from the fact that Loril­lard (LO) is a “very attrac­tive” stock.
I rec­om­mend investors buy it as well as the fol­low­ing ETFs because of their large allo­ca­tions to LO and their attractive-or-better invest­ment ratings:

As one of May’s most attrac­tive stocks, LO is both prof­itable and cheap.

And when I say prof­itable, I mean that LO’s prof­its over the past two years rank in the top 1% among com­pa­nies in the US equity mar­kets. The com­pany achieves this finan­cial feat by being one of only 23 com­pa­nies of the 3,000-plus we cover with eco­nomic earn­ings that are both pos­i­tive and greater than reported account­ing earn­ings over both of the last two fiscal years.

The company’s return on invested cap­i­tal (ROIC) is 450%, which also ranks among the very best in the U.S. and beats firms like Apple (AAPL) and Google (GOOG) – both of which also earn our ‘very attrac­tive” rating.

Most investors are likely to over­look the prof­itabil­ity of LO’s busi­ness model because it is not as evi­dent on the company’s income state­ment as it is on its bal­ance sheet. LO’s super high ROIC comes more from its cap­i­tal effi­ciency than profit mar­gins. Don’t get me wrong, LO’s net oper­at­ing profit after tax (NOPAT) mar­gins are impres­sive at 18.5%, but its invested cap­i­tal turns are off the charts at 24.3. The figure below high­lights how Loril­lard is grow­ing rev­enues with­out requir­ing much incre­men­tal cap­i­tal, which trans­lates into very strong cash flow generation.

And just look­ing at LO’s bal­ance sheet is not enough because most of the cash that LO car­ries is not needed to run its busi­ness and is, there­fore, excluded from invested cap­i­tal, the denom­i­na­tor in the ROIC cal­cu­la­tion. I call the excluded cash “excess cash”.

LO has $1.9 billion of excess cash as of the end of fis­cal year 2010, which equals nearly 12% of the company’s mar­ket cap when the stock price is below $113 a share.

Speak­ing of the stock price, the val­u­a­tion of LO is mouth-wateringly low. At $113, the val­u­a­tion of LO’s stock implies the company’s prof­its will permanently decline by nearly 20%. I say the mar­ket is set­ting the bar quite low for LO’s management.

Assum­ing no future profit growth, LO’s stock is worth over $137.

I do not think investors should be dis­cour­aged by the recent adverse legal deci­sion out of Jack­sonville, Florida, which will not derail the LO busi­ness model. And I think peo­ple will still buy cig­a­rettes no mat­ter what the warn­ing labels say. Really, is there really any­one out there who thinks smok­ing is good for them…in the long term? Have you seen the warn­ing labels that are on tobacco prod­ucts in Europe? Those warn­ing labels do not pull any punches, and yet there are still many smok­ers in Europe.

Even if one assumes that cig­a­rette smok­ing is declin­ing, it is hard to agree with the stock price’s pre­dic­tion that it will per­ma­nently decline by nearly 20% in 2011.

The risk/reward of this stock is quite com­pelling. Down­side risk is low as the val­u­a­tion at $113 a share already implies a per­ma­nent 18% decline in prof­its. Upside reward poten­tial is strong as the stock has to go over $137 a share to trade at a value that implies the company’s prof­its will expe­ri­ence a 0% decline, still a no-growth scenario.

Lorillard’s stock presents an excel­lent buy­ing oppor­tu­nity at cur­rent lev­els because it mean­ing­fully under­es­ti­mates the future cash flow poten­tial of the company.

For details on what causes the dif­fer­ence between eco­nomic ver­sus account­ing prof­its dur­ing the last five fis­cal years, see Appen­dix 3 on page 10 of our report on LO. See Appen­dix 4 to learn how LO increased net oper­at­ing profit after tax (NOPAT) and its NOPAT mar­gin. Appen­dix 7 shows LO’s ROIC over the past five years.