Pair Trade: Long Lorillard (LO) vs. Short Philip Morris (PM)

12/12/13 09:31AM EST

As we head into year-end, one pair trade we like in particular is long LO and short PM (Note: LO is already in our portfolio; we’re waiting on price with PM).

Below is a breakout of the two names:

Lorillard:

  • Outperformance based on an advantaged cigarette portfolio and leading share in the e-cig category.
  • Continued strong demand for its full-flavored offerings and dominant share of menthol (~85% of its portfolio). Both are contributing to volume outperformance versus the industry (in the last quarter LO’s vol. +3.5% versus industry’s avg. -4%).
  • Growth in menthol supported by positive demographic shifts to the menthol category:
    • According to 2012 data from the National Survey on Drug Use and Health (NSDUH), over the last decade, the number of adult African-American menthol smokers has increased at a 2% CAGR, and at a 7% CAGR for Hispanics.  As of 2012, this equates to 84% of African-American smokers smoke menthol; the figure for primary menthol smokers among Hispanics is 47%.
    • Over the last decade, the adult African-American smoking population has increased at a 0.4% CAGR, whereas the adult Hispanic smoking population has increased at a 0.3% CAGR. We expect these trends to continue which should support the outperformance of LO’s menthol portfolio.
  • Lorillard continues to push gross profit margins higher through pricing and cost savings, improving 80bps to 37.1% in the quarter.  
  • The domestic retail share of the menthol market rose to 40.4%, an increase of 0.8 share points versus the prior-year quarter.
  • We’re bullish on Lorillard’s rollout of “Newport Gold” – a non-menthol compliment to “Red.”
  • We expect the FDA to punt on banning menthol cigarettes over the intermediate term given the lack of definitive and recognized studies that menthol is more harmful than non-menthol cigarettes. We also believe that the EU Parliament’s decision to ban menthol does not provide a useful guide to FDA policy given the sheer market size difference (Menthol = 31% of the U.S. cigarette market vs. 1-2% in Europe).
  • E-cigs: Lorillard was the first Big Tobacco company to market with the acquisition of “Blu” branded e-cigs in April 2012 for $135MM.
  • Despite only representing 4.9% of the portfolio, last quarter Blu saw strong sales growth of 11% quarter-over-quarter (+350% year-over-year) to $63MM.
  • LO CEO Murray Kessler’s e-cig strategy appears to forgo short-term profits for long term gains: he sold e-cigs at break-even in the quarter and was able to boost Blu’s market share to 49% from 40% in the previous quarter. We expect similar trends as LO attempts to capture brand loyalty. Over time, we do think that e-cigs can be margin-enhancing to the combined cigarette category.
  • The company became an international e-cig dealer through its purchase of UK-based SKYCIG in October 2013 for £30MM in cash, plus an additional £30MM to be paid in 2016 based on the achievement of certain financial benchmarks.
  • SKYCIG is a three year old company with ~ 300,000 users in the UK (there exists around ~ 10MM smokers in the country) that also happens to have nearly identical branding to Blu.
  • LO is trading above our intermediate term quantitative TREND level of support. We see the stock appreciating to $60 to $65 over the intermediate term.

Pair Trade: Long Lorillard (LO) vs. Short Philip Morris (PM) - vvv. LO

Philip Morris:

  • PM is plagued by a series of headwinds. To wit: a weak macro environment, challenging FX, excise tax hikes, and volume declines in key geographies.
  • While last quarter the company saw the top line perform in line with consensus, and showed a big improvement sequentially of +0.1% versus -2.5% in Q2 2013, Q3 was against a very easy comp of -5.3% in Q3 2012. We see tougher comps ahead.
  • PM is taking volume declines: last quarter -5.7% was a deceleration vs the previous quarter’s -3.9% and underperformed the industry’s -4%. We expect Philip Morris has taken much of its pricing and will struggle to stem volume declines.
  • We expect weakness in core geographies to continue to weigh on results, not least of which is the EU which is forecast to be down -7% to -8% in 2014. France has been a negative outlier and we continue to believe that the tax policy of President Francois Hollande will impair consumer confidence.
  • PM will also be hit with increased excise taxes in key geographies like Russia (the impact to volume est. -9% to -11%) and the Philippines (no guidance, could be larger than Russia),
  • Philip Morris recently disclosed that there has been an uptick in illicit trade, which we expect to push higher alongside additional tax hikes. 
  • In December, PM announced that it is acquiring a 20% interest in Russian Megapolis Group for $750M. Longer-term, we believe this is positive for the company (Russia is the world’s second largest market behind China and Megapolis handles 70% of Russia’s cigarette volumes through its distribution agreements).
  • PM also announced in late November that it will accelerate the launch of an electronic cigarette to mid-2014 (versus previous guidance of 2016/7) at a cost of $100MM.
  • We see 2014 setting up to be a year of investment (Russian acquisition and e-cig platform) and 1H results to drag in concert with this investment and the continuation of broader macro headwinds.
  • The level of uncertainty in PM’s earnings power has been clearly reflected in its EPS guidance: the company has revised its 2013 guidance lower over each of the last three straight quarter this year! Consensus is currently at $5.57 for 2014.
  • PM is trading below our intermediate term quantitative TREND level of resistance. We’ll be managing its trading range on the downside.

Pair Trade: Long Lorillard (LO) vs. Short Philip Morris (PM) - vvv. PM

Matthew Hedrick

Associate

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