Menthol Threat Creates a Smoking Deal

01/17/2011 12:28 pm EST

Focus: STOCKS

Jack Adamo

Editor, Jack Adamo's Insiders Plus

The receding threat of a ban on menthol cigarettes has burned a hole in shares of Lorillard, writes Jack Adamo of Jack Adamo's Insiders Plus.

The stock of cigarette maker Lorillard (NYSE: LO) has been beaten up recently on the news that the Food and Drug Administration was considering banning or restricting the sale of menthol cigarettes. Newport, a menthol brand, accounts for 92% of Lorillard's revenues. An outright ban on menthol would devastate the company.

In my opinion, this will never happen. Although the FDA would not require legislation to ban the flavoring, the political climate—given the recent elections—is for easier government relations with business. But even more telling, the FDA's advisor on tobacco resigned recently. She had been a harsh critic of menthol and other flavorings in cigarettes. Her departure, while allegedly for personal reasons, is as clear a sign as you'll ever see that the political will to fight this battle is simply not there.

At its current price, Lorillard yields 5.8%. Since its spin-off from Loew's Corp. (NYSE: L) in 2008, it has raised its dividend from $0.92 to $1 in 2009 and $1.125 in 2010. It has huge profit margins and returns on equity, and no net debt. At less than 5% of operating cash flow in 2009, capital expenditures are minuscule. That enables a payout ratio of 67% with comfort to spare. That's less than many utilities—and Lorillard doesn't have their high debt to contend with.

In short, from a financial perspective, the company is an incredible investment. Cigarette revenues will continue to grow worldwide, and nothing short of a huge turnaround in mass psychology will change that. Those things simply don't occur overnight.

The stock is at $77.07, down from its high near $90 before the menthol issues. I believe it's likely to get back to its high within a year, and perhaps as soon as a few months. It should soon become clear the menthol ban won't happen.

Buy Lorillard up to $82.

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