Bold Cold: Buy Lorillard (Roberto Garcia)

Hey guys, pls find a few details on the Lorillard (LO) idea - Nik Modi was clearly the loudest voice in the research floor in my meetings last week and one of the few with very high conviction even in a rough tape.. Pls let me know what you think. I hope this helps. Thanks, RobertoWhy look at the stock now? 1) post the TPSAC overhang (still pending the 90 day FDA update due 30/6), LO is no longer a binary situation but a high quality growth story (+3/4% volume +3/4% consistent pricing) that has lagged RAI by -30% since the FDA Bill was signed in Jun'09 2) stock offers +34% total return driven by 8% annual capital return and 26% capital appreciation to $140/sh under a DCF valuation assuming +100bps upside to our 2.5% terminal growth rate (our numbers are already way above the Street) when accounting for the multiple avenue of growth detailed below (not in our official numbers) 3) LO is no longer a "Hedge Fund Hotel" (only 1 out of the top 20 holders), short interest remains high (at 8 days avg trading volume) and sell side sentiment is evenly split (only 50% +ve ratings) 4) in more traditional terms, LO trades at 14.4x'11 (in line with peers) despite being the best in class operator (42% EBIT margins vs. 30% at RAI and 40% MO), the highest capital return story (8.6% adding buybacks + dividend vs. 4.8% at RAI and 5.1% at MO) and offering 12/15% sustainable earnings growth (vs. 8% peers).Importantly, there are very strong structural drivers behind menthol including high exposure to African Americans/Hispanics consumers, increased penetration of flavoured products (consistent share gains of menthol last 3yrs) and retail support given RAI/MO's increased focus in the category. In addition, there are new avenues of growth ahead including LO's recent Non-Menthol launch (80bps share gains just 5mths post launch), increased distribution of core Menthol to the Western states (under-indexed to states west of the Mississippi) and the opportunity to better execute in the "Gold" category (only 7% total volumes vs. 52% for full-flavour industry avg). Lastly, this is NOT wishful thinking - we believe 80% of Newport's Q1 growth was driven by Newport Non-Menthol as base Newport grew volumes +1.6% and Non-Menthol grew 6.4% leading to 8% growth despite a +10% yoy comp.As for valuation, stock currently trades at 14.4x'12 (vs. 14.1x'12 US peers) despite likely posting 12/15% earnings growth (our official model embeds 10% growth vs. 8% peers), significantly higher returns of capital (8.6% buybacks/dividends vs. 6.2% peers) and an unlevered balance sheet (0.9x net debt/EBITDA vs. 1.3x peers). Moreover, our current numbers only discount +4/5% rev growth (can get there through pricing alone, assumes flat volumes) despite +5/7% rev growth achieved last few years and thus NOT providing any benefit from the avenues of growth cited above. Under a more realistic +6/8% rev scenario, LO will likely achieve +12/15% earnings growth (vs. 14% in '06/10) even assuming no volume driven operating leverage as a potential offset the -ve price mix from higher growth in the Non-Menthol category.

A few key points:1) Past the Menthol Overhang..Last week the TPSAC menthol report was released with changes large benign and in line with recent comments from the FDA spokesperson Kara Henchel in that that changes would not affect either the conclusion or the recommendation of the report. Based on our review of the FDA’s conclusions, it seems the administration has concluded that the 1) science around initiation/cessation (the area most focused on by the public health community) is largely inconclusive/mixed, 2) menthol cigarettes seem to pose no more disease risk than regular cigarettes 3) nicotine dependence seemed to have a link to menthol in younger consumers, but not more experienced smokers. Importantly, while the implied risk premium has moderated post the TPSAC report the menthol overhang will not be totally over until the FDA makes a final decision.2) But the stock has way to go!So, now it’s the time to focus on the upside potential! Like in previous high profile cases (Price/Engle), tobacco stocks have rebounded post verdict to provide significant absolute/relative returns. While the LO chart today might look overwhelming, the reality is that it has underperformed RAI by -30% since the FDA Bill as signed in Jun'09. As a simple exercise, if LO was to close that gap it would leave LO trading at $145/sh or 18.5x'11! From a fundamental perspective, there're several ways to look at this 1) a $140/sh DCF value assuming a 3.5% long term growth rate and removing the 10% FDA risk from our target 2) If LO were to trade at a 160bps spread to MO (inline with past 5yrs) would yield $128/sh 3) expected takeout value of $145/sh - this is derived by taking the present value of LO at 12.5x EBITDA two years from today.3) Unmatched fundamentals, multiple avenues of growth aheadStating the obvious but LO remains the #1 menthol brand in the US (35% share) accounting for 10.5% total market (#2 largest brand behind Marlboro) with 90% of sales driven by Newport (Maverick & Old Gold value brands accounting for the rest). LO has posted +1.5% volume growth in '07/10 (vs. -7% @ MO/RAI), 7.3% rev CAGR and captured 2.3pts of market share over the last 3yrs. What's so special about Newport? The brand ranks #1 in flavour, taste, consistency, freshness and legacy.. huge brand equity that has allowed to take share BUT more importantly will allow mgt to target new avenue of growth including Non-Menthol, Golds and an expansion in distribution to markets west of the Mississippi where the Newport brand is under-indexed.4) How to quantify the upside?The premium full-flavour non-menthol segment is a 47bn unit market dominated by Marlboro, Camel and Winston. Newport's strategy has been to launch with introductory prices inline with peers allowing them to take 80bps of share 5mth post launch in Nov'10. LO has seen 16% trial, 5% conversion and with 60% consumers future intent to purchase LO Reds based on taste (vs. 31% on price, remember that LO come inline with peers but -20% discount to Newport Menthol). Conservatively, we believe that LO could grow volumes by +3/4% in '12/14 due to flat Newport Menthol growth (have achieved +1.5% historically) and +300/400bps incremental contribution from Newport Non Menthol and Newport Gold. We believe LO can achieve 3% share in the Non-Menthol market over the next 3/4yrs, which according to mgt would be worth $200M in sales.5) The Kessler FactorMurray Kessler joined Lorillard in Sept'10 as CEO and assumed the role of Chairman of the Board in Jan'11. Previous to his arrival at LO, Murray had been CEO of UST since Jan'07 having built extensive on the ground experience as President of US Smokeless Tobacco Company (USSTC). Not only that but he has accumulated a wealth of experience in sales & marketing in various consumer groups including Campbell Soup and Clorox. What sets him apart is not only his industry experience but the fact that he's a winner, someone extremely focused on executing, delivering shareholder return and aggressive in pursuing achievable targets. As an example, having only taken the leadership CEO position at UST for 6mths he targeted a 3yr $100M cost synergy plan (on $900M in EBIT generated in '07) while previous mgt had hidden behind the fact that GMs @ UST were already at an 76% industry record.Importantly, Murray owns $10.3M in LO stock, only 9% of his compensation is salary based in '10 (vs. bonus and stock awards) and his pay is driven by both operating profit growth AND Newport market share gains (not just one factor in isolation). In fact, looking at LO's '11 incentive mgt compensation plan is driven by performance units 40% weighted by operating income, 40% Newport market share and 20% individual performance metrics. Lastly, while previous CEO Orlowsky's compensation at $10.5M in '09 was somewhat of a red flag new CEO Kessler's remuneration at $3.7M is more in line with industry practice.