Description

The price listed above is from trading just after the open this morning, just before I submitted this idea.

Lorillard's Business

Lorillard is the number three manufacturer of cigarettes in the U.S, producing just over 12% of cigarettes sold in the US.  90% of the firm's sales (by revenue, 85% by unit volume) are for its Newport Menthol brand of mentholated cigarettes (they also sell a very small number of non-menthol Newports and a few other menthol and non-menthol brands).  By comparison, menthol brands account for around 15% of Philip Morris's sales and around 20% of Reynolds American's sales.  So Lorillard is basically the menthol cigarette pure play.  Lorillard, unlike its major competitors, sells almost exclusively in the US, since they sold the international marketing rights to the Newport brand in 2008.

While cigarette sales (by number) have been declining in recent years, with price increases, Lorillard has enjoyed a 7% cumulative annual growth rate since 2006 (versus 7% for Philip Morris and 0% for Reynolds).  Sales increased 2% from 2009 to 2010 at Lorillard (compared to 2% for Philip Morris and 0% for Reynolds).

The company purchases tobacco leaf from tobacco dealers, which it uses to produce cigarettes in its single manufacturing facility in North Carolina.  The factory can produce around 50 billion cigarettes per year.  In 2010, Lorillard produced 37.4 billion cigarettes.  It sells almost exclusively through wholesale distributors.  The company employs around 2,700 persons full-time.  1,000 are unionized, including the workers in the manufacturing plant.

Tobacco Regulation

The cigarette industry has come under increasing regulatory control in the United States since the Surgeon General's determination in 1964 that smoking causes cancer.  At the federal level, the Public Health Cigarette Smoking Act in 1970 banned television and radio advertisement of cigarettes and required warning labels.  The Clinton administration tried to assert Food and Drug Administration ("FDA") control over cigarettes with regulations in 1996, though the U.S. Supreme Court held in FDA v Brown & Williamson Tobacco Corp.[1] that Congress had not delegated authority to regulate tobacco to the FDA.  Congress did give the FDA authority to regulate tobacco products with the passage of the Family Smoking Prevention and Tobacco Control Act in 2009, which specifically prevented the FDA from banning cigarettes entirely.  With this proviso, the tobacco companies largely supported the bill, which was passed by large majorities in both houses of Congress and was lauded by President Obama. 

The FDA established the Center for Tobacco Products ("CTP") as the division responsible for setting standards for tobacco products and their warning labels and advertising, reviewing applications for new and modified products, and enforcing tobacco regulations.  A few months after FSPTCA was enacted into law, the FDA banned the sale of cigarettes containing any flavor other than tobacco or menthol, on the ground that cherry and other flavored cigarettes encouraged youth smoking.  The regulator also charged a new independent advisory panel, the Tobacco Products Scientific Advisory Committee ("TPSAC," pronounced "tip sack") with advising on the regulation of menthol.  See below for more on the TPSAC's advice and the next steps in the regulatory process.[3]

Tobacco companies are also subject to litigation relating to tobacco-related health care costs and injury and death caused by tobacco use.  In 1998, the four largest US tobacco companies settled with the attorneys general of 46 states that sued to collect tobacco-related Medicaid expenditures. Under the Tobacco Master Settlement Agreement ("MSA"), the participating manufacturers (including Lorillard and Philip Morris) are subject to restrictions on advertising targeted to youth, participation in industry-wide organizations, and have to make annual payments to the participating states based on tobacco sales (one interesting play in tobacco is comparing movement in tobacco stocks to the tobacco-settlement backed bonds issued by the various states).  Most states now have bans on smoking in public places.

Finally, the specter of private litigation by smokers and their families for tobacco-related injuries, deaths, and health-care costs weighs on the entire industry.

In addition, cigarettes are taxed by the federal, state, and local governments.  The federal excise tax rate for cigarettes has been $1.01 per pack since 2009.  State taxes vary from $0.30 (in tobacco-producing Virginia) per pack to $4.35 per pack in New York.

Relative Valuation

If one discounts any differences between the regulatory risks facing Lorillard and Philip Morris, the two companies are about as good as comparables as any two firms in any industry.  Both are cash cows that pay high dividends and buy their own stock back on the open market.  They face the same risks in terms of raw material and labor prices and have nearly identical growth rates.  Immediately before TPSAC released its conclusions in March, 2011, Lorillard traded at a 25% discount to PM's PE ratio.

So, what is the value of Lorillard under various scenarios, assuming it should trade with Philip Morris in the event that there is ultimately a regulatory ban on menthol?  Contrary to some of the headlines you'll see, it would almost certainly not put Lorillard out of business.  In 2010, Lorillard's operating margin was 36%, with a pre-tax income margin of 28%.  They paid income tax at 37%.   I get my values by simulation.

The first input, the decline in sales, is the hardest to measure, and the aspect of my analysis that keeps me up at night.[4]  I assume as a base case that 65% of Lorillard's menthol smokers will either quit (10%) or switch to a non-menthol brand made by another manufacturer (55%), with 40% sticking with Newport non-menthols (which currently have negligible sales, which makes me think I may be overly generous to Lorillard here).  There's not much evidence regarding how smokers will switch (see my summary of the TPSAC report, below).  I assume that 92% of Lorillard sales are menthol-related, which gets me to 60% of lost revenues.  I model lost sales as normally distributed, with a mean of 60% and a standard deviation of 9% (10% x 92%).

On the plus side for Lorillard, with pre-tax margins at 28% of sales, should be able to recover a significant piece of the lost sales.  I've modeled this as normally distributed with a mean of 25% and a standard deviation of 5%.  In addition, since marginal tax rates are higher than average tax rates for a profitable company, I reduce the impact of lost sales by (a) one minus a marginal tax rate that is normally distributed with a mean of 32% and a standard deviation of 3%, divided by (b) one minus the 2010 tax rate of 27.6%.

In my model, I get an average decline in post-tax earnings of 42%, with a standard deviation of 12%.  If you just multiply the means, you get a decline of 39% (55% x (100%-25%) x (100%-32%) / (100%-27.6%), which is close enough given the margin of error.

At Philip Morris's 16.83 PE, but reducing earnings by 41%, Lorillard should trade around 9.8 times 2010 earnings, versus the last close at 15.4 times.  Note this ignores the impact of any transitional period, but also discounts the fact that Lorillard's sales growth comes from menthol products, not its non-menthol lines.  At 9.8 times 2010 earnings, LO's stock should trade around $69.00, with a standard deviation of $10 in my model.

Of course, a total ban on menthol is not the only possibility.  This table shows the main potential outcomes, with my wholly subjective probability of each, the mean decline in Lorillard's menthol sales decline and its standard deviation.  The last two columns show my expected value, and the standard deviation of that expected value, based on Lorillard trading at Philip Morris's PE if there is no regulation and PM's last sale as of the date of this write up of $68.99.  I also present the probability weighted average, which gets me to a valuation of $94.33, with a standard deviation of $4.36.

The no regulation and total ban scenarios are obvious.  Warning means the FDA just adding warning labels to menthol cigarettes, which is the minimum I think they will do, but still a win for Lorillard.  Limit menthol amt refers to limiting the amount of menthol that cigarettes can contain.  This is a good political solution compared to a complete ban, since nobody gets stuck without their favorite brand in this scenario, but, as mentioned below, there is no evidence regarding the impact of reduced menthol levels, so I gave it a relatively low probability.  I'll discuss why I chose these probabilities below, after I talk about the regulatory process.

You'll recognize that there is a lot of subjectivity in all aspects of my analysis.  So, if you think the chance of a total ban is only 5% and that it would, if promulgated, cause only a 20% loss in Lorillard's current menthol-related sales, be my guest and buy the stock-but you'll be making a mistake.  I would be interested in hearing from members about their impression of the inputs in my model or anything else in this write-up.

The TPSAC Menthol Report

TPSAC has held 10 public meetings since March, 2010 assessing the impact of menthol cigarettes on public health.[5]  The committee published its final report on March 18, 2011.[6]  The committee reviewed peer-reviewed literature, reports commissioned by the FDA, submissions from tobacco companies, and public comments to reach its conclusions.  They also commissioned a mathematical model to assess the impact of menthol on smoking.  Here is a very brief summary of the chapters:

• Chapter 1: Questions addressed, description of menthol cigarettes, and organization of the report.
• Chapter 2: TPSAC's approach to its investigation.
• Chapter 3: Physiological effects of menthol cigarettes. Main conclusions are that menthol reduces the harshness of tobacco smoke and makes low-tar and low-nicotine cigarettes more acceptable to smokers. There was not sufficient evidence to find that menthol had a direct physiological effect.
• Chapter 4: Patterns of menthol smoking. Menthol accounts for around 30% of all smoking, and around 47% of smoking among adolescents; use is increasing among adolescents. Menthol accounts for around 80% of smoking among African-Americans, 25% among whites, around 32% among Hispanics and Asians, with no other ethnic group except native Hawaiians and Pacific islanders smoking predominantly menthols. Women are modestly more likely to smoke menthols than are men. Low income smokers are more likely to smoke menthol than high income smokers (though the committee did not separate out the impact of race on this).
• Chapter 5: Marketing and consumer perceptions: 50% of African-American smokers smoke Newport Menthols. Tobacco companies "manipulate" menthol content to achieve desired taste, aroma, and cooling sensation based on anticipated consumer preferences. There are generally more stores per mile of road selling cigarettes in predominantly low income and minority neighborhoods than in predominantly high income and white neighborhoods. Menthol cigarettes are priced slightly higher than are non-menthols.

Cigarette promotion is done primarily by print and point-of-sale advertising, direct marketing, sponsorships, public entertainment, promotional allowances to wholesalers and retailers, and retail price promotions.  Although menthol represents only one-third of smoking, more than half of all advertising is aimed at menthol smokers.  Central themes in marketing include establishing a sense of belonging in a group, positive self image, attractiveness to the opposite sex, youthfulness, and, for menthol cigarettes, soothing feelings that connote health benefits and racial identity for African-Americans.

Marketing is targeted especially toward adolescents.  Branding and packaging affect the subjective perception of consumed tobacco.  There is not sufficient evidence to conclude that retail marketing practices are responsible for the relative increase in the number of menthol smokers versus the number of non-menthol smokers in recent years.  Consumers do perceive menthol cigarettes as safer than non-menthol cigarettes.

• Chapter 6: Effects of menthol on initiation, addiction, and cessation: Adolescent smoking has declined among both menthol and non-menthol smokers, but fell more slowly among menthol smokers. Menthol smokers do not appear to start smoking at an earlier age. Some evidence suggests that menthol smokers tend to switch to non-menthol more than vice versa, indicating that menthol to some extent is a starter product. Youth choose menthol cigarettes, particularly at lower menthol yields, mainly because of the relative ease of smoking menthol cigarettes for uninitiated smokers and because they perceive menthol cigarettes to be less harmful.

Menthols do not make nicotine more available to smokers than do non-menthol cigarettes.  Menthol cigarettes may be more likely to be abused (no, I don't really know what they consider non-abusive smoking).  There is some support that menthol smokers smoke fewer cigarettes per day than do non-menthol smokers.  The evidence regarding the effect of menthol on subjective measures of dependence are conflicting.  African-American smokers are less likely to quit if they smoke menthols than if they smoke non-menthols; this is true of other non-white groups, though at a lesser level.  The evidence relating to white smoking cessation is mixed.

• Chapter 7: Effects of menthol on disease risks. There is not enough evidence to conclude that menthol smokers face different health risks than do non-menthol smokers (this is the most positive conclusion for Lorillard in the report).
• Chapter 8: Conclusions and recommendations: The evidence does not indicate increased disease risks for menthol smokers. However, the availability of menthol cigarettes has led to an increase in the number of smokers, which has had an adverse impact on public health. The availability of menthol cigarettes increases initiation, and the high prevalence of menthol smoking among youth is concerning. Menthol smokers are less able to quit than are non-menthol smokers. The epidemiological model that TPSAC commissioned (presented in Appendix A) estimates that, by 2020, menthol will cause around 17,000 extra premature deaths and an extra 2.3 million smoking initiations in the U.S. A National Cancer Institute survey reported that 39% of menthol smokers would quit if menthol cigarettes were no longer sold, with 36% saying they would switch to non-menthol cigarettes and 8% saying they would switch to non-cigarette tobacco products (I very seriously doubt that anywhere near 39% would be able to quit in that scenario).

The committee concluded that "[r]emoval of menthol cigarettes from the marketplace would benefit public health in the United States."  However, they provided no specific suggestions for follow-up by the FDA.  The committee did not address the impact of contraband in the case of a total ban on menthol (i.e., they did not address whether the unregulated black market for menthol cigarettes or home mentholation kits would expand substantially).  TPSAC also did not address the impact of a ban on tax revenues.

TPSAC noted several gaps in its understanding of menthol cigarettes and public health that require further research.  Those areas include subliminal menthol (the menthol content of non-menthol cigarettes), menthol smoking among the severely mentally ill and other potentially vulnerable populations, genetic factors affecting menthol versus non-menthol cigarettes), and strengthening the evidential foundation of the public health on menthol cigarettes.

There was no formal final vote, but none of the voting members of the committee disagreed with the final report at the meeting in which they discussed it.

Reaction of Interest Groups

The tobacco industry has sued the FDA, claiming that TPSAC is riddled with conflicts of interest and did not follow proper procedures.  Why they are wasting their money on that lawsuit is beyond me.  They have been vocal in pointing out the things that the committee's report did not investigate, particularly the contraband issue. 

Public health advocates have been largely muted, though an op-ed in the New England Journal of Medicine was critical of the report for not recommending a ban on menthol.[7]  Jonathan Samet, the chairman of TPSAC, and committee member Neal Benowitz, responded by saying they did not have the resources to address regulatory concerns and were not charged to do so (which strikes me as strange, given that that's exactly what every other FDA advisory panel does).[8]  One analyst told me that public health advocates decided largely to wait for the FDA to take action before spending resources on the issue.

One wild card is that the House appropriations Committee approved an Agriculture Bill amendment that would require the FDA to base its product rulings on hard science and direct harm from a substance, and not on consumer behavior.  It passed by a straight-line party vote.  I doubt the bill can get through the Senate, and it would not pre-empt FDA regulation entirely, but it would render moot the main conclusions of the TPSAC advisory report.

My Impressions Of The Report

On the whole, I thought that the committee, which was composed mostly of medical doctors, was on the whole not well disposed toward tobacco.  Nevertheless, they seemed to be driven by scientific evidence, and, throughout the two-year process of compiling the report, frustrated at the lack of definitive evidence.  I thought that the report's conclusions were a minor victory for Lorillard, in that they could have recommended a total ban but did not, but still left open a serious risk of FDA regulation through the committee's unambiguous statement that menthol harms public health. 

On the whole, analysts with whom I spoke suggested before TPSAC unveiled their conclusions that, should the committee recommend that the FDA take no draconian action against menthol cigarettes, Lorillard stock should trade around the same multiple as does Philip Morris, and perhaps 20% below that should the committee simply pass the buck to the FDA.  Outside Deutsche Bank, the analysts to whom I have access uniformly thought it unlikely that the FDA would ultimately impose strong regulation on menthol cigarettes even should the panel recommend a total ban.  I was less sanguine, seeing a real risk of substantial regulation, which I still do.

I was, however, very surprised by the market's reaction to the report.

The Market's Reaction

The day after the report, which in my opinion was a modest positive for Lorillard, the discount came in to 17%, which was in my view a rational change.  Then Lorillard was, to quote my least favorite stock picker, en fuego, climbing to a low of 4% on May 27.  After the initial jump on the release of the committee's conclusions, TPSAC's chairman, Jonathan Samet, gave an interview in which he said that he thought the market seemed to think that the report signaled that the FDA should not regulate menthol, and that he thought the market was wrong to assume that, given the committee's conclusion that menthol does negatively impact public health.

Next Steps

Last week, after TPSAC announced that it would discuss modifications to its report, with drafts to be posted by on the FDA website no later than June 22.[9]  The committee will discuss those proposed changes on the morning of June 21, at their next scheduled meeting.  I have no information regarding what the report might contain.  On the whole, I think there is a significant chance that some members want to clarify that they are not recommending that the FDA take no regulatory action.  Certainly Chairman Samet's post-report interview indicates that he favors such a change.  There will probably also be several technical changes suggested.

For a contrary opinion, you might take a look at Goldman, Sach's Lorillard piece from June 2.  The suggest that there are not likely to be material changes given that TPSAC has had no meetings since the report was issued (but they always filed draft chapters before discussing them), that the pending litigation against TPSAC might have made some members want to change their wording (but I don't see how the wording of their report addresses the issues in the litigation), that there has been no incremental research published since May (I haven't found any), and that the FDA is expected to give its progress report by June 21 (actually, June 24, but the logical thing for the FDA to do is to postpone that until after TPSAC has made any revisions).

The Players

Starting at the top of the regulatory hierarchy, President Obama is no friend of the tobacco industry, though he has not said anything about menthol.  For what little it is worth, he used to smoke (and may still smoke) Newport Menthols.  While he is favored to win re-election, it is likely going to be a tight race in 2012, with only a few battleground states deciding the winner (Florida, Colorado, Pennsylvania, Ohio, Nevada, and Maine).  Democrats were disappointed with the turnout of African-American voters in the 2010 elections, and one of their core strategies is to encourage African-Americans to return to the polls in the next election.  African-Americans are a substantial force in the Florida, Pennsylvania, and Ohio electorates).  Democrats are probably going to lose several Senate seats in 2012, too, so it isn't just about presidential politics.  Encouraging the African-American vote, along with the votes of other menthol smokers, is the best reason for the FDA not to ban menthol outright, or at least to delay any such action until after the 2012 elections.  In any case, I don't think they will take any action in 2012, so we should see a decision in either 2010 or 2013.

Kathleen Sibelius, the former governor of Kansas, current Health and Human Services secretary, and a potential future candidate for President, has very little track record on tobacco.  Like most other governors, she presided over a gradual increase in cigarette excise taxes to ease state budgetary concerns.  Sibelius, who is a highly politically motivated, moderate Democrat, has not made any public statements regarding menthol.

The director of the FDA, Margaret "Peggy" Hamburg, is a direct presidential appointee.  She was the public health commissioner of New York City, where she established a strong anti-smoking reputation.  There's even some thought that Philip Morris moved its headquarters out of New York to spite Hamburg.  I don't have direct information, but second-hand sources whom I think are reliable have told me that she does not want the menthol issue to slip, but is not convinced that TPSAC evaluated everything the FDA needs to move forward with regulation.  Her term expires in early 2013, and there is no chance she's looking for a position in the tobacco industry after she leaves.  She has also made no public statements about menthol.

The head of the CTP, Laurence "Larry" Dayton, is not a political appointee.  He is also most likely a tobacco foe, though again, has made no public statements about menthol.  He

Three of the four major players (all but Sibelius) attended graduate school at Harvard, so they might be a little arrogant.

I've heard from one consultant, a former highly-placed FDA officer who has been involved in tobacco matters since he left, that the FDA is very biased against tobacco.  He puts the probability of a ban above 70%, which explains why I think there's a 50% chance of either a total ban or a restriction on the amount of menthol that can go into cigarettes.

Next Steps

The next event will be a town hall meeting that CTP will conduct with public health advocates on Wednesday, June 8.  This is part of a series of sessions that have been scheduled for well over a year, and I do not expect any significant statement from the FDA then, though I will be listening.[11]

The FDA said that it would give its initial evaluation of the science presented in the TPSAC report within 90 days of the submission of the report.[10]  This is a self-imposed deadline, so there is nothing that would stop the FDA from postponing it, particularly given the potential for changes to the TPSAC report.  When they do make their announcement, they will likely give guidance on the timing and the methods of the rest of the regulatory process.  I don't expect them to tip their hand in June, but I do expect a lot of analysts to recognize that there are real risks.

What Has To Happen For This Idea To Work

Basically, the market needs to wake up to the fact that the TPSAC report did not make the threat of regulation of menthol disappear.  They seem to be doing that now, with the Barron's article, and also a Morgan Stanley piece this weekend which, while maintaining that the FDA is highly unlikely to ban menthol, downgraded from overweight to equal weight on the run-up in price since March and the risk of TPSAC taking a stronger position against menthol in its revisions.

What If I'm Wrong?

I lose up to $10 per share.

Footnotes

[1] Text available at http://www.law.cornell.edu/supct/html/98-1152.ZS.html.

[2] Text available at http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?dbname=111_cong_public_laws&docid=f:publ031.111.pdf.  The FDA has summarized the law at http://www.fda.gov/TobaccoProducts/GuidanceComplianceRegulatoryInformation/ucm246129.htm.

[3] TPSAC's website is http://www.fda.gov/AdvisoryCommittees/CommitteesMeetingMaterials/TobaccoProductsScientificAdvisoryCommittee/default.htm.  http://www.fda.gov/AdvisoryCommittees/CommitteesMeetingMaterials/TobaccoProductsScientificAdvisoryCommittee/ucm180904.htm gives the charter of the committee, with membership available at http://www.fda.gov/AdvisoryCommittees/CommitteesMeetingMaterials/TobaccoProductsScientificAdvisoryCommittee/ucm180906.htm. 

[4] OK, it doesn't really keep me up at night.

[5] Webcasts, presentation slides, background materials, and committee reports are available for 2010 meetings at http://www.fda.gov/AdvisoryCommittees/CommitteesMeetingMaterials/TobaccoProductsScientificAdvisoryCommittee/ucm180903.htm and for 2011 meetings at http://www.fda.gov/AdvisoryCommittees/CommitteesMeetingMaterials/TobaccoProductsScientificAdvisoryCommittee/ucm237359.htm.

[6] The report is available at http://www.fda.gov/downloads/AdvisoryCommittees/CommitteesMeetingMaterials/TobaccoProductsScientificAdvisoryCommittee/UCM247689.pdf.  The three non-voting industry representatives published their dissent at http://www.fda.gov/downloads/AdvisoryCommittees/CommitteesMeetingMaterials/TobaccoProductsScientificAdvisoryCommittee/UCM249320.pdf. 

[7] Available at http://healthpolicyandreform.nejm.org/?p=14231&query=home.

[8] Available at http://healthpolicyandreform.nejm.org/?p=14233&query=home.

[9] The drafts will be posted in the July 21-22 meeting section of this page:  http://www.fda.gov/AdvisoryCommittees/CommitteesMeetingMaterials/TobaccoProductsScientificAdvisoryCommittee/ucm237359.htm.

[10] The release should appear on the CTP's website at http://www.fda.gov/TobaccoProducts/NewsEvents/default.htm.

[11]Dial is 1-877-917-9494, passcode 3405484.  Listeners can email questions before or during the meeting to CTPStakeholderSeries@fda.hhs.gov.

Catalyst

CTP scientific review of the TPSAC report possibly by June 24.

TPSAC draft revisions published by June 22, with discussion following on July 21.