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Consumer Staples
BEST IDEA: LONG LORILLARD (LO)
March 4, 2014
HEDGEYE 2
DISCLAIMER Hedgeye Risk Management is a registered investment advisor, registered with the State of Connecticut. Hedgeye Risk Management is not a broker dealer and does not make investment recommendations. This research does not constitute an offer to sell, or a solicitation of an offer to buy any security. This research is presented without regard to individual investment preferences or risk parameters; it is general information and does not constitute specific investment advice. This presentation is based on information from sources believed to be reliable. Hedgeye Risk Management is not responsible for errors, inaccuracies or omissions of information. The opinions and conclusions contained in this report are those of Hedgeye Risk Management, and are intended solely for the use of Hedgeye Risk Management’s clients and subscribers. In reaching these opinions and conclusions, Hedgeye Risk Management and its employees have relied upon research conducted by Hedgeye Risk Management’s employees, which is based upon sources considered credible and reliable within the industry. Hedgeye Risk Management is not responsible for the validity or authenticity of the information upon which it has relied. TERMS OF USE This report is intended solely for the use of its recipient. Re-distribution or republication of this report and its contents are prohibited. For more detail please refer to the appropriate sections of the Hedgeye Services Agreement and the Terms of Use at www.hedgeye.com
LEGAL
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1). Company Overview 2). Industry Trends 3). Why We Like LO
Menthol Fundamentals
Menthol Ban Unlikely
Blu & E-cigs 4). Financials 5). Valuation
TABLE OF CONTENTS
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• Strong and stable fundamentals on advantaged menthol portfolio.
Menthol’s outperformance driven on lasting Consumer and Demographic trends that differ from traditional tobacco.
• We do not see Menthol Regulation Risk from the FDA over the medium term (1-2 years) and assign less than a 20% probability over the long term.
Our conviction is substantiated by the work of a prominent Washington, D.C. law firm specialized in tobacco that we retained to assess the FDA’s position on menthol.
• We view blu (and broadly electronic cigarettes) as a disruptive technology to replace the industry’s declining cigarette volumes and as a long-term growth category.
We expect blu to benefit from first mover advantage and maintain leading market share
despite competitive pressures from Big Tobacco’s entry. We see blu’s earnings growth contributing to a re-rating of its multiple higher
KEY TAKE-AWAYS BEST IDEA: LONG LORILLARD (LO)
HEDGEYE 5
RECENT NEWS BOOSTS LO ACQUISITION RUMORS AND MORE E-CIG INVESTMENT • RAI was rumored to be making a bid for LO at $60/share (on 3/3/14) The stock rose +9.3% to $53.61 on the news RAI + LO would control 67% of menthol market RAI + LO = 43% share of U.S. cigarette market (could better compete w/ MO) However, uncertainty around Antitrust issues • NJOY received $70 million capital injection from Brookside Capital and Morgan Stanley on (2/28/2014) • Deal values NJOY’s enterprise value at $1B implies blu’s EV of 2.3B, and adds more investor excitement around the e-cig category
COMPANY OVERVIEW
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COMPANY OVERVIEW COMPANY SNAPSHOT • Founded in 1760; public company June 10, 2008
• #3 U.S. Cigarette Company (behind PM and RAI) • #1 U.S. Menthol Brand (Newport) • #1 U.S. Electronic Cigarette (blu) • 2013 Sales: $4.97 billion (excluding excise) • 2014 EPS Estimate: $3.60 (consensus $3.40)
• Market Cap: $17.7 billion • Short Interest: 5.01% • Dividend yield: 5.10% • Debt/EBITDA: 1.7x •Dividend Payout Ratio Target: 70-75% • FCF: $1.13 billion
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COMPANY OVERVIEW COMPANY’S STATED FORMULA
Chart Source: Lorillard Presentation, CAGNY 2/18/14, pg 56
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COMPANY OVERVIEW MENTHOL IS LORILLARD’S PROFIT ENGINE
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COMPANY OVERVIEW AND IN EARLY DAYS TO DIVERSIFY THE BRAND & PORTFOLIO
Premium Non-Menthol Full-Flavor (FF) • 0.9% market share • 2.4 billion units in 2013 • Pricing up +35% since 2010 launch
Premium Non-Menthol Non-Full Flavor • Shipments began in OCT 2013 • Priced in line with Newport Red
Premium Menthol Non-Full Flavor •11% share of category • 2.4 billion units in 2013 • Pricing up 35% since 2010 launch
Newport Red Newport Gold Newport Menthol Gold & Smooth Select
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COMPANY OVERVIEW BLU E-CIGS GROWTH OPTION FOR THE COMPANY
INDUSTRY TRENDS
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INDUSTRY TRENDS THE WORLD IS SMOKING LESS
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INDUSTRY TRENDS AND U.S. TOBACCO SALES FLAT-LINING
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INDUSTRY TRENDS AS U.S. TOBACCO VOLUMES STABILIZE
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INDUSTRY TRENDS BUT, U.S. MENTHOL GAINING MARKET SHARE OF INDUSTRY
-310bps
+310bps
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INDUSTRY TRENDS AS DOWN-TRADING MODERATING ACROSS CIG INDUSTRY
Chart Source: RAI 11/18/13 Presentation, pg 90
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INDUSTRY TRENDS DEMOGRAPHICS DRIVING MENTHOL = AFRICAN AMERICANS
MENTHOL FUNDAMENTALS
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MENTHOL FUNDAMENTALS AND MENTHOL IS LORILLARD’S PROFIT ENGINE
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MENTHOL FUNDAMENTALS MARKET SHARE GAINS ACROSS LORILLARD AND NEWPORT
+ 460 bps
+ 320 bps
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MENTHOL FUNDAMENTALS NEWPORT MARKET SHARE STRONG & GROWING ACROSS AGE GROUPS
Chart Source: Lorillard Presentation, CAGNY 2/18/14, pg 22
Source: National Survey on Drug Use and Health (NSDUH) 200-2012
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MENTHOL FUNDAMENTALS NEWPORT VOLUME OUTPERFORMS THE INDUSTRY
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MENTHOL FUNDAMENTALS GROWTH SUPPORTED BY POSITIVE DEMOGRAPHIC SHIFTS 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.
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MENTHOL FUNDAMENTALS AND COMMANDS HIGHER PREMIUM AVG. RETAIL PRICE/PACK
Chart Source: Lorillard CAGNY 2014 Presentation
Chart Source: Lorillard Presentation, CAGNY 2/18/14, pg 21
MENTHOL REGULATION LIMITED
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• Whether menthol cigarettes are more addictive than other cigarettes is a subject of ongoing scientific debate
• Some studies suggest that menthol smokers are less likely to quit than non-menthol smokers
However, this could be for reasons other than menthol
• Other studies suggest quitting smoking is difficult regardless of the type of cigarette
MENTHOL REGULATION LIMITED SCIENCE & HEALTH CONSIDERATION INCONCLUSIVE
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•On June 22, 2009 President Obama signed the Family Smoking Prevention and Tobacco Control Act, which for the 1st time, gave the FDA the authority to regulate tobacco products.
• The Act banned the sale of flavored cigarettes, but explicitly exempted menthol flavorings.
• In 2010, the FDA formed a scientific advisory panel to review hundreds of studies on menthol cigarettes and provide a recommendation to the FDA.
• In March 2011, the panel issued a 250-page report finding:
scientific evidence did not show that menthol smokers inhale more toxins or have increased risk of disease vs. non-menthol smokers
the report offered “no specific suggestions” on how the FDA should respond to its findings
MENTHOL REGULATION LIMITED QUICK HISTORY OF FDA’S CONSIDERATION
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•In July 2013, the FDA took its first steps to regulate or ban menthol by issuing a 153-page “preliminary scientific evaluation” on the effects of menthol
prepared by experts within FDA’s Center for Tobacco Products (CTP)
public comment was solicited
the FDA’s assessment echoed the panel report and also found that menthol masks the harshness of tobacco and makes it easer to get addicted and hard to quit
However, the FDA did not clearly indicate banning menthol as a solution
• The public comment period was extended to November 22, 2013
the FDA received 174,796 comments 99.5% of the comments were against a ban on menthol
• Based on 2009 law the FDA can opt to regulate, ban, or do nothing with respect to menthol
MENTHOL REGULATION LIMITED QUICK HISTORY OF FDA’S CONSIDERATION (CONT.)
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Against Ban • Lost government revenue
• Rise of the illicit market
Increase in crime
Increase in enforcement costs
Job reduction at retail level
Inability to enforce quality assurance
No age verification at retail increased underage use For Ban • Menthol increases healthcare costs
MENTHOL REGULATION LIMITED ECONOMICS SKEW TO NO BAN
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AGAINST Ban • Invasion of purchasing freedoms • American sentiment against “big daddy” government • FDA action against menthol could have significant impact on African American enthusiasm for the Democratic Party • Washington’s political element (including lobbyists) is a force not to underestimate in this decision making process Reasons For Ban • Menthol should not be given an exception under the Family Smoking Prevention and Tobacco Control Act (2009), and be treated like any other flavoring Divided • Opinions from the African American community, including such groups as the NAACP and National Black Chamber of Commerce
MENTHOL REGULATION LIMITED POLITICS – DIVIDED AND LEANS TOWARDS NO BAN
HEDGEYE 32
Science is inconclusive after years of study on menthol expect any further studies to be counted in years The EU’s ban on menthol unlikely to influence U.S. policy makers few smoke menthol in EU (~ 5%) so unequal racial, economic, and law enforcement concerns
Public Comments to FDA decidedly against a ban Economics point to more harm from illicit trade; tax implication significant Washington is a politically charged environment, with African American President and divided African American community on menthol doing nothing is “easy”
FDA is not forced to make a decision on menthol, and we don’t think there’s any risk to a change in stance on menthol for conservatively 1-2 years, but likely much, much longer.
MENTHOL REGULATION LIMITED CONCLUSION: MENTHOL IS HERE TO STAY!
BLU & E-CIGS
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E-CIGS THE NEXT INDUSTRY GROWTH ENGINE
Chewing Tobacco 1880s
Unfiltered Cigarettes 1920s
Filtered Cigarettes 1950s
Reduced Tar Cigarettes 1970s
Next Big Shift = E-cigs Now
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• A primitive, battery-operated “smokeless non-tobacco cigarette” was patented as early as 1963 and described in Popular Mechanics in 1965. • Though disputed, the first commercially marketed e-cig was created by a Chinese pharmacist, Hon Lik, and introduced to the Chinese market as a smoking cessation device in 2004.
E-CIGS WHAT IS AN ELECTRONIC CIGARETTE?
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E-CIGS AS % OF TOBACCO INDUSTRY SHARE ~1%, AND GROWING
Chart Source: RAI 11/18/13 Presentation
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E-CIGS GLOBAL SALES TO DOUBLE EVERY YEAR FOR NEXT 5
For Reference: In 2018, $48 billion in e-cig sales will equate to ~4% of Global Tobacco sales (assuming CAGR of 8%)
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E-CIGS BIG TOBACCO’S E-CIGARETTE BIRTH, BLU’S LEAD
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• U.S. is largest market, fragmented with hundreds of independent producers with recent entrance of Big Tobacco with sales estimated at $1.5B in 2013.
Big Tobacco’s entry into the e-cig market lends credibility to the category, and should spur innovation and promote good manufacturing practices
a handful of select private companies (such as NJOY, Mistic, Krave, Logic, Victory) stand to strongly compete with Big Tobacco for category share
E-cig category is estimated to double in the U.S. in the years ahead • U.K. 2nd largest global market, fragmented (like the U.S.) with sales estimated at $300MM in 2013.
Huge global opportunity with the Global tobacco industry worth $800B annually
E-CIGS E-CIG MARKETPLACE
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E-CIGS BROAD DEMOGRAPHIC APPEAL, SIMILAR TO CIG SMOKER
Chart Source: RAI 11/18/13 Presentation
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E-CIGS AGE PROFILE ALSO SIMILAR TO CIG SMOKER
Chart Source: RAI 11/18/13 Presentation
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E-CIGS AND SIMILAR ON IN EDUCATION AND INCOME
Chart Source: RAI 11/18/13 Presentation
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E-CIGS AWARENESS & TRIAL HIGH; ADOPTION LOW. ENTER E-CIG 2.0
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E-CIGS OPPORTUNITY TO REPLACE LOST & NEW CIG CONSUMPTION
HEDGEYE 45
Highly fragmented industry: Big Tobacco’s entrance to influence industry consolidation Huge opportunity to win brand loyalty with a truly new, disruptive innovation Attractive Category:
• “Healthier” alternative to tobacco cigarettes
• Typically 30-40% more affordable than traditional cigarettes
• Highly attractive for retailers based on margin; gross margins of rechargables to move towards 50% range
• 30% of smokers report “trying to quit” each year The Need innovation toward 2.0 or “Next Generation Products” to better meet form, function, and experience in-line with a traditional cigarette.
E-CIGS THE OPPORTUNITY IN CONTEXT
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Industry is bracing for regulation from the FDA. Currently not regulated like Tobacco How might the FDA come down on e-cigs? • Ban online sales • Ban advertising • Require age verification standards at retail • Limitations Flavors (beyond tobacco and menthol) • Require health/safety certifications and issue labeling and marketing requirements Other Considerations NYC and Chicago banned e-cig use in indoors and in public spaces (effective March – May 2014), and raised age to purchase to 21 New Jersey, North Dakota, Utah and Arkansas treat e-cigs as cigs re indoor smoking bans Minnesota issues tobacco-like taxes on e-cigs 5 Senators (CA, Ill, CT, MA, and IA) introduced legislation to protect children from e-cigs (2/26/14) Brazil, UAE, Singapore, Egypt, Lebanon have banned e-cigarettes outright
E-CIGS POTENTIAL HEADWINDS?
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#1 Category Share = 47% of market in 2013 blu’s 2013 Revenue = ~5% of Lorillard’s Revenue Offering disposable and rechargables available in 136,000 retail stores in the U.S. nationwide and online
Flavorings include: traditional tobacco flavoring, menthol, Peach Schnapps, Java Jolt, Vivid Vanilla, Cherry Crush, and Piña Colada
Strategy:
Take advantage of leading share and maintain category leadership
Willing to sell at loss (or breakeven) over the next 2-3 years to win brand loyalty
Expand internationally, first in the UK (Acq. of SKYCIG in OCT 2013) and then into continental Europe
Grow razor-razorblade model of rechargeable e-cig with replacement cartridges over disposables
Achieve gross margins for rechargables in 40-50% range
Marketing Stephen Dorff and Jenny McCarthy in TV ads and media print ($40M spend in 2013)
BLU BLU’S FIRST MOVER ADVANTAGE
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BLU SALES CHANNELS; GOAL SHIFT AWAY FROM DISPOSABLES
Source: Lorillard, Q1 2013 Source: Lorillard, Q4 2013
HEDGEYE 49
BLU E-CIGS AS AN OPTION ON THE COMPANY
• Slowdown in Q4 2013 Sales mirrored across e-cig industry
• LO says slowdown due to inventory building of its new rechargable kits in new retailer doors (peaking at 136k) at promotional/discounted prices
HEDGEYE 50
BLU REBOUND AFTER NEW RECHARGABLES LAUNCHED IN Q2 ‘12
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• 1st of Big Tobacco to U.S. market First company to 136K retail outlets; leverage existing cigarette network • Strong Advertising Dollars Celebrity endorsements (Jenny McCarthy & Stephen Dorff) & TV commercials; opportunity with marketing dollars to quickly build brand loyalty • Scale & Leverage Can “afford” to sell at a loss through promotion and discounting to build market share during early years • Global Opportunity can acquire to expand (SKYCIG), and fund Next Generation products through internal development
• SKYCIG Rebranding Transition SKYCIG brand to blu in the UK and expand blu throughout continental Europe • Building blu into a global brand. 1st in Europe.
BLU CATEGORY LEADERSHIP AND GROWTH POTENTIAL
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BLU A RUNWAY TO ENHANCE SHAREHOLDER VALUE
FINANCIALS
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FINANCIALS VOLUME STABLE AND POSITIVE OVER NEXT 4 QUARTERS
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FINANCIALS SALES TRENDS HIGHER, +5.7% IN 2014
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FINANCIALS OPERATING MARGIN GRINDING HIGHER IN 2014
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FINANCIALS DOUBLE DIGIT EPS TO CONTINUE
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FINANCIALS SHAREHOLDER FOCUS: 70-75% DIVIDEND PAYOUT RATIO
VALUATION
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VALUATION UNDERAPPRECIATED BY THE STREET
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VALUATION MULTIPLE EXPANSION ON REGULATORY RISK UNLIKELY
Forward P/E PM 15.6x RAI 14.8x MO 14.0x LO 13.9x 15.2x
Jumped 130 bps in 1 day on RAI acquisition rumor (on 3/3/14)
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VALUATION BLU’S CONTRIBUTING 31% OF TOTAL EARNINGS BY 2018!
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VALUATION BLU CONTRIBUTION TO LO MASSIVE!
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VALUATION FAVORABLE RISK/REWARD
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VALUATION BULLISH QUANTITATIVE SET-UP
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VALUATION INDUSTRY INVESTMENT IDEA
FOR MORE INFORMATION CONTACT:
[email protected] 203.562.6500