We remain bullish on LO over the medium term despite disappointing Q4 cigarette volume results (-1% vs the consensus’ estimate of +1.8%) and sequential slowing sales trends of its e-cig Blu business. We however continue to expect LO’s profitability to be driven behind its category leadership in menthol and strong Newport brand loyalty, with continued outperformance on volume results versus the industry alongside competitive pricing.
What we Like:
In Q4 cigarette sales (excluding excise) were up +3.6% or +1.4% (including excise) with pricing partially offsetting volume declines. In the quarter, LO’s -1% volume performance compared to the industry’s decline of -6.2% and on the year was up +0.5% vs -4% for the industry, outperformance that we expect to continue in 2014 as the industry braces for volume declines in the -3% to -4% range.
In the quarter Newport increased its domestic retail market share of 0.8 share points to 12.7%, and grew its domestic retail share of the menthol market to 39.9%, an increase of 1.6 share points compared to the fourth quarter of 2012. Newport’s market share gains continue to be strengthened by Newport menthol in its core geographies. Full-year for Newport volume was up +0.6%
What We Didn’t Like:
Slowing e-cigs trends remain a concern (more below) however we expect Blu to maintain its category leadership and offset losses with the strength of Newport menthol.
From a quantitative standpoint LO broke its intermediate term TREND line of $48.68 today. We’d be long term TAIL buyers of the stock closer to its support line of $45.09, or around 4% to 5% lower than its current price. While we see slightly more challenging Q1 gross margin and operating profit comparisons in Q1, Q2 moderates and both Q1 and Q2 have much easier sales comps. We'll look to its presentation next week at CAGNY (2/18 at 5:30pm EST) to get a better sense of its FY outlook.
Update on E-Cigs:
Blu’s Q4 operating income was a net loss of -9MM on sales results that disappointed at $54MM versus $63MM last quarter and market share that dipped to 48% from 49% in Q3. CEO Murray Kessler chalked up the results as somewhat expected given the inventory build associated with adding 30K new stores (now at a peak of 130k stores nationally) selling at a lower price to encourage trialing and adoption of its new rechargeable unit.
Below is E-cig Q&A commentary from Kessler:
- Outlook 2013 vs 2014: LO had a leading 47% market share of total e-cig industry sales of $1 billion (including internet sales) in 2013. Kessler says he’s bullish that the increase of competition (MO and RAI rolling out offerings in test markets late last year) will “lift all boats” in 2014. He remains committed to sell Blu at a break-even (or loss) over the next few years to win share and band loyalty to support what he says is the greatest harm reduction offering ever presented to smokers. He sees the continued expansion of new rechargeable kits flowing against dollar revenues in Q1 as well, and that e-cigs had about 1% negative impact on cigarette volume in 2013, which could rise slightly in 2014.
- On Purchase Behavior: He’s encouraged by incidence of repeat purchasing which he expects to grow as earlier e-cig versions were not as good as what’s on the market now and the strategy remains growing the higher margin rechargeable business (razor/razorblade model). Blu’s cartridges account for 30% of sales.
- On slight slowdown of e-cig category and what is driving it: says slowdown is the nature of a new category and lots of distribution building. He also said that things like vape shops and internet sales are creating a lot of sales that are not being measured/counted.
- On indoor bans: Kessler sees the bans (most recently in NYC and Chicago) as draconian, however not impacting results as the measures don’t take effect until the April/mid-year time frame. He is unclear how the FDA will act, but said you’re starting to get knee-jerk reactions from the state and municipal level as regulation from the FDA is taking longer than previously expected.
- On deeming regulation: Kessler is unclear on the timing of regulation and says if you tax it like traditional tobacco, prevent marketing, and ban indoor use people will go back to traditional tobacco, which is completely backwards thinking in terms of public health.
- On SKYCIG and international expansion: optimizing portfolio and rolling out in the UK before expanding to other European markets. Will be transitioning SKYCIG brand to Blu and wants to make Blu a global brand. Having purchased SKYCIG it is optimistic it can accelerate its international roll-out by mid-year, versus a much longer runway of 1-2 years had it decide to go at distribution alone without the SKYCIG acquisition.