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By Jeremy Glaser | 08-11-2010 02:34 PM

Lorillard Bonds Attractive Ahead of FDA Ruling

Worries about the FDA's ruling on the relative safety of menthol cigarettes have left Lorillard's bonds looking attractively priced according to Morningstar's Dave Sekera.

Jeremy Glaser: For Morningstar.com, I'm Jeremy Glaser. I'm joined today by Senior Securities Analyst, Dave Sekera and Equity Analyst, Phil Gorham to look at Lorillard and how potential regulations from the FDA could impact bondholders.

Gentlemen, thanks for joining me today.

Philip Gorham: Thank you.

Glaser: So Phil, first off, can you talk a little bit about what makes Lorillard a little different from lot of other tobacco companies out there?

Gorham: Sure. It's focused exclusive in the domestic U.S. market. So it competes directly with Altria and Reynolds American, but what makes Lorillard different is that it operates almost exclusively in the menthol category in this country. So as, whereas Altria and Reynolds both have smaller menthol brands, 94% of Lorillard's top line comes from menthol tobacco. So that's what really differentiates this Company.

Glaser: Now, if we look at stock performance year-to-date, Lorillard has been lagging some of their peers by quite a wide margin. What explains that disconnect?

Gorham: It's a fat tail risk, the risk that the FDA who has announced that they are going to investigate the menthol category may come out and impose some disproportionate restrictions on menthol versus the rest of the industry. What the FDA have done is to establish a panel that will investigate whether the use of menthol in tobacco is either any more addictive or harmful than normal tobacco product, and the outcome of that panel will determine the future of Lorillard.

Glaser: When is the panel expected to make its recommendation?

Gorham: I'm expecting to hear in the fourth quarter what the outcome is.

Glaser: And if you look at a few of the possibilities, what we think would be a best case for the company and what would be the absolute worst case?

Gorham: Yeah. There is a really wide range of potential outcomes here. I think the best that Lorillard can hope for is that the FDA just leaves them alone, doesn't impose any greater restrictions on menthols than they do every other type of products.

At the other end of the scale, the FDA could potentially ban the use of menthol altogether, which would be disastrous for Lorillard, obviously. I think that that's a pretty low probability event, though. I think more likely the outcome will be somewhere in the middle, and we'll see either higher taxes on menthol products or tighter marketing restrictions.

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