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Lorillard reported Q1 2014 results yesterday that were lukewarm, missing Street estimates on the top and bottom lines, however the stock closed up on the day. Our long-term bullish outlook remains unchanged and built on 1.) the strength and profitability of its advantaged menthol portfolio, 2.) our belief in the limited menthol regulatory risk over the longer term, and 3.) upside growth in its blu e-cigarette business that commands leading share in the U.S.

CEO Murray Kessler commanded a confident tone in reviewing the quarter, yet clearly knew the company didn’t hit the cover off the ball, citing numerous headwinds that impacted results: for cigarettes lower wholesale inventory levels, severe weather affecting core markets, a tax increase in Puerto Rico and holiday timing (Easter), as well as in e-cigs lower prices of its rechargables kits and pipeline inventory build versus the year ago-quarter. 

All that said, LO had impressive price/mix of +5.8% to offset total cigarette volume decline of -2.9% (outperforming the total industry at -4.0%). Total LO retail market share in the quarter rose 30bps to 15.2%, its highest level ever and its first quarter above 15%, and Newport’s share grew 40bps to 13% while LO’s share of the menthol market was flat Y/Y at 40.7%, but improved 80bps sequentially.

Although Newport Gold continues to struggle (share was not qualified on the call), and blu contributed a $0.02 loss in the quarter, we remain committed to LO’s long-term opportunity to lead the e-cig market in the U.S. and U.K. (more below), as we remain committed to LO’s industry-leading fundamentals, built on its core menthol business. As we outlined in our Best Ideas long call on LO in March, we see the stock trading to $80 over the longer term. 

On blu E-Cigs


Net sales for blu declined -10.5% y/y to $51MM, versus flattening growth across the entire category (slowing to +10% in the quarter). The loss was a contribution of lower prices of its rechargeable kits and a pipeline inventory build versus the previous year quarter.

The results show two straight quarters of slowing, and reflect an increased competitive and promotional environment as e-cig manufacturers spare for share and brand loyalty – both RAI and MO plan to launch nationally with Vuse and MarkTen, respectively, in June, and we like blu’s first to market leadership advantage.

In the quarter, blu commanded a leading 45% share of the market in the U.S., or 10 points higher versus the year-ago period, according to Nielsen channel data which the company switched to in the quarter to measure sales.

The big news was LO’s decision to step up marketing and distribution in the U.K to launch blu this quarter. It announced a $10-20MM spend over next 6 to 9 months to rebrand SKYCIG as blu and continue to support incremental brand building for blu in the U.SWe like LO’s strategy to invest early to become category leaders. They’ll match up against BAT, who is also in the process of rolling out a national launch. The U.K. is the second biggest e-cig market behind the U.S. and currently highly fragmented, with no brand greater than a 5-6% share, according to Kessler. Unlike in the U.S. with the acquisition of blu, the company has to pay for a sales force to support its rebranding and sales efforts. Kessler underlined that to create the U.K. branding of blu, they expect the business to be break-even in the near term.  

In the U.K. as in the U.S., the longer term strategy of the e-cig business is clearly not selling blu at break-even or a loss, however in the near term the company is willing to take the charge and investment now to win long term brand loyalty in a category with huge growth potential -- we support this strategy.

Other announcements and e-cig category color:


On vaporizers (tank/open/etc.) taking share from “tradition” format e-cigs like blu, Kessler said he believes vaporizers -- sold primarily at vape shops -- are taking some share from blu and other “traditional” style e-cig players (the format Big Tobacco is using today), because the products deliver a better experience at a lower price point. Although he was quick to note that this e-vapor format comes with regulatory challenges – in fact reading the tea leaves we think Kessler was betting the FDA was going to put more prohibitive measures on this format and e-vapor juice.  (For more see yesterday’s note FDA Finally Proposes E-Cigarette Regulations - They’re Surprisingly Mild!). Because the FDA largely didn’t touch non-traditional vaporizers and e-vapor juice, Kessler was quick to counter that LO is considering the landscape, and was suggestive that though the current traditional e-cig is the company’s format of choice, his team is currently working on devises that deliver superior vapor and battery life to close what may be a widening sales gap with non-traditional e-cig formats. He expects these improvements to be rolled out over the next 6 months, and to hit the market piece by piece, rather than a giant roll out (similar to how new razor blades come out for the same razor). Note: we’ll be doing survey work in the coming weeks to better understand the trends of non-traditional e-cig usage.

On proposed deeming regulations from the FDA, Kessler said he was pleased that the FDA is taking a science based approach with its proposed regulation. On the banning of sampling, he said the company will have a chance to comment on that and hopes it’s overturned. 

On any read-through on the FDA’s stance on menthol, Kessler said it was a positive read-through – the FDA is taking a science based approach on flavors – can’t say they’re an “issue”/more addictive than traditional tobacco flavor without the science. 

On any merchandizing shift for blu with MarkTen and Vuse being rolled out nationally, Kessler said that it looks like his major competitors are choosing to place e-cigs alongside their cigarettes, whereas blu wants to remain in stand-alone cases, and he’s perfectly fine if his competitors’ e-cigs are not near blu.  

Call or email with questions,

Matt

Howard Penney

Managing Director

Matt Hedrick

Associate

Fred Masotta

Analyst