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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Glaser: Dave, when we look at the financial strength of the company, how do you think it would be impacted by any ruling coming from the FDA?
David Sekera: Well, right now we have a BBB rating on Lorillard and that rating does include the risk that there could be some additional rules and regulations that do come out, that could impact the company's financials. That's already encapsulated in the Company's base case and our forecast.
But if you look at Lorillard's credit metrics, they are currently, and based on our forecast, the strongest of the three. Now, conversely, we do believe the company will probably do some additional share buybacks; we have enclosed in our model that they'll probably raise some additional debt next year. But even that in our base case, we still look at them as being the strongest of the three.
Glaser: So if they have the strong financial position and if we think it's a relatively small chance the FDA panel is going to completely ban menthol cigarettes, does that mean that there are some opportunities for bondholders?
Sekera: Exactly. Right now the bonds are probably trading about Treasuries plus 350 and that's including the downside of risk that there could be additional rules and regulations. And if they do come out and they're a little bit more stringent than we think, and the stock trades down, the company goes to our bear case scenario, where we would expect top line maybe to fall 20% to 22%, EBITDA or cash flow could get cut in half. Even in that scenario, while we probably would downgrade the bonds a couple of notches, we probably expect them to trade somewhere into maybe the BB type area.
So the bonds at Treasuries at plus 350 based on our base case scenario, we think the bonds could trade as tight as 250, 100 basis points tighter than where they are trading right now. And that would probably get us more in line with where maybe the Altria bonds are trading, which are trading near about 250 over, right now. So, you have 100 basis points of upside and price terms that's worth about 7 5/8 points. Conversely, based on our downside model, we think the bonds could trade as wide as maybe 450 over, puts us in the BB category and we trade down probably about 7.25 points.
Now, while that looks like you have almost equal up, equal down, on a probability weighted basis we think this is a very attractive trade based on the risk and reward, because we do think it's a low probability that our base case comes true.
Glaser: And Phil, if you think about the equity, are there any opportunities there right now?
Gorham: The stock looks a little cheap with the risk that draconian measures might be taken against the industry. I would wait and see if the stock pulls back any more before jumping in.
Glaser: So look for a larger margin of safety in the equity, but it sounds like the bonds have a nice risk-reward tradeoff.
Gorham: Right. Correct.
Glaser: Gentlemen, thanks so much for talking with me today.
Gorham: Thanks.
Sekera: Thank you.
Glaser: For Morningstar.com, I'm Jeremy Glaser.
