Cigarette maker Lorillard Inc. (LO) reported adjusted earnings of 84 cents per share in the second quarter of quarter 2014, up 3.7% from the prior-year quarter. Higher cigarette sales and lower outstanding share count owing to share buyback activity led to earnings growth in the reported quarter. However, earnings missed the Zacks Consensus Estimate of 88 cents by 4.5%, possibly due to lower sales in the e-cigarette segment.
Net sales in the reported quarter declined 0.3% year over year to $1.8 billion due to a decline in net sales of electronic cigarettes, partially offset by a marginal increase in net sales of regular cigarettes. Revenues comprehensively beat the Zacks Consensus Estimate of $1.3 billion by 34%.
Gross profits improved marginally to $683 million in the quarter due to unfavorable pricing mix and higher costs in the e-cigarette segment, which offset the high margin in the cigarette segment. Adjusted operating income grew 0.6% to $532 million, driven by operating efficiencies at the cigarette segment.
Segment Details
Cigarettes: Despite lower cigarette unit sales volumes, the company managed to increase its cigarette sales by 0.9% year over year to $1.76 billion. The increase was driven by higher average net cigarette selling prices.
Total wholesale cigarette volumes declined 3.4% to 8.96 billion units in the second quarter including Puerto Rico and U.S. shipments. We note that Puerto Rico and U.S. Possessions accounted for about 39% of the decline as there has been a $1 per pack tax increase in Puerto Rico since Jul 1, 2013, which has affected volumes. Excluding Puerto Rico and U.S. shipments, total wholesale cigarette volumes declined 3.4% in the quarter.
In the reported quarter, Lorillard's domestic retail market share climbed 0.2 share points to 15.0%, backed by strong gains in the company's flagship brand – Newport – whose domestic retail market share also increased 0.3 share points to 12.8%. Newport’s market share was driven by continued strengthening of Newport Menthol in its core geographies, continued success in expansion markets and improved volumes after the launch of Newport Smooth Select and Newport Non-Menthol Gold in 2013. Lorillard's domestic retail share of the menthol market increased 0.3 share points to 40.3% in the reported quarter.
Adjusted gross margin increased 50 basis points to 37.7% in the quarter, owing to a 6% increase in net average cigarette prices. Adjusted operating income grew 4.2% to $549 million in the quarter, while margin grew 1 percentage point driven by strong net pricing realization and tight cost control measures.
Electronic Cigarettes: Lorillard formed this segment following the acquisition of the blu eCigs brand on Apr 24, 2012. Net sales during the second quarter declined 35.1% to $37 million. The decline was due to unfavorable pricing mix owing to lower price of rechargeable kits that were introduced in the third quarter of 2013 as well as a decline in unit volume in the reported quarter.
The company’s brand blu (U.K.) (formerly known as Skycig, a leading premium brand of electronic cigarettes in the UK which was acquired in Oct 2013) generated $4 million in sales in the second quarter. During the quarter, the product offering in the U.K. was re-branded as "blu" and launched at retail and online.
In the second quarter, blu's domestic market share of electronic cigarettes decreased 1.1 share points to 40.9% due to list price reduction on rechargeable packs and increased competitive activity.
Gross margin declined significantly by 730 basis points to 24.3% in the second quarter due to the impact of an unfavorable mix of new, lower priced rechargeable kits as well as higher retail distribution costs. Adjusted operating loss was $17 million in the reported quarter compared to operating profit of $2 million in the second quarter of 2013. This was due to higher selling, general and administrative costs.
Other Financial Updates
During the quarter, Lorillard paid a quarterly dividend of 61.5 cents per share to shareholders of record as of May 30, 2014.
During the quarter, the company repurchased approximately 2.7 million shares at a cost of $156 million and thus completed its $1 billion share repurchase program.
Merger Update
On Jul 15, Lorillard and peer Reynolds American, Inc. (RAI) entered into an agreement per which Reynolds agreed to take over Lorillard for $27.4 billion, including assumption of net debt.
In connection with the transaction, Reynolds also announced that it has reached an agreement with Imperial Tobacco Group PLC, the fourth-largest international tobacco company. Per the agreement, Imperial agreed to purchase the Kool, Salem, Winston, Maverick and blu eCigs brands and other assets and liabilities from Reynolds and Lorillard for $7.1 billion in cash.
The combined entity might pose a threat to its peer Altria Group Inc. (MO), which manufactures Marlboro cigarettes and commands more than 40% market share in the U.S. The companies expect the transactions to close in the first half of 2015.
Lorillard carries a Zacks Rank #3 (Hold). A better-ranked stock in the consumer staple sector is Treehouse Foods, Inc. (THS), which holds a Zacks Rank #1 (Strong Buy).
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