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Tickers in this Article: LO
There are few sectors that consistently generate high levels of cash flow. Even fewer are reliable about returning that cash to shareholders.

#-ad_banner-#Tobacco is one such industry. As much as some investors love to hate the industry, the major tobacco companies are consistent performers regardless of the broader economy.

Investors shouldn't let the broad health concerns around traditional cigarettes deter them from investing in an industry that has substantial barriers to entry and is great at returning cash to shareholders through dividends and buybacks.

One of the big three U.S. tobacco companies, Lorillard (NYSE: LO) is giving investors an attractive entry point after missing fourth-quarter earnings expectations. The stock fell more than 5% posting earnings of $0.82 a share, missing analysts' expectations by $0.04.

However, revenue for the quarter beat consensus estimates, and it looks like the downward move in the stock might be an overreaction. After all, since Lorillard went public in 2008, the company has outperformed the S&P 500 by over 100%.



Despite Lorillard's earnings miss and the fact that wholesale cigarette volume was down 1.6% year over year during the fourth quarter, the company still expanded its U.S. market share for an 11th consecutive year. At the end of 2013, Lorillard owned 14.9% of the U.S. market, an all-time high for the company.

Lorillard has been manufacturing cigarettes for over 250 years. Its flagship brand, Newport menthol-flavored cigarettes, is the top-selling menthol brand and the second-largest cigarette brand in the U.S. The company is planning to debut a line of non-menthol cigarettes under the Newport name to help expand the brand.

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Lorillard's flagship brand, Newport menthol-flavored cigarettes, is the top-selling menthol brand and the second-largest cigarette brand in the U.S.
While cigarettes are Lorillard's cash flow generator, electronic cigarettes appear to be a great growth opportunity. Thanks to its Blu e-cig brand, Lorillard already owns half of the e-cigarette market. And during the fourth quarter, Lorillard added over 130,000 retail outlets for distribution of Blu e-cig products. Lorillard also snatched up U.K.-based e-cig company Skycig during the latter part of 2013.

Lorillard has an impressive 4.6% forward annual dividend yield, and 8% of its market cap is covered by cash. Lorillard's long-term goal is to return nearly 75% of its earnings to shareholders through dividends. With a current payout ratio is 68%, the company still has a ways to go to meet that goal.

Although many tobacco companies have solid share buyback programs, Lorillard has proven to be the most aggressive when it comes to returning cash to shareholders. In mid-2013, Lorillard approved an additional $500 million share buyback just after it completed an initial $500 million buyback program in just six months.

High margins are typical of the tobacco business. Lorillard's gross margin of 55% and operating margin of 44% mean there's more money for shareholders out of every dollar the company makes. Lorillard also has an impressive 39% return on assets, which compares quite well with competitors Altria (NYSE: MO) and Reynolds American (NYSE: RAI) at 14.5% and 9.6%, respectively.

Lorillard's stock has lost some momentum lately, but it should continue its run once investors realize the earnings miss was just a hiccup, and that the long-term growth story is still in place. After the recent pullback, Lorillard now trades at 12.5 times next year's earnings. That's now well below the industry average and the company's historical average price to earnings ratio.

Risks to Consider: One of the biggest risks to the entire tobacco industry is the rising awareness of the health risks. More specifically, Lorillard could be more adversely affected due its reliance on menthols. Another risk is that both federal and state governments continue to raise taxes on the industry, which would result in higher prices for tobacco users.

Action to Take --> Buy LO for upside to $58, a 23% premium to recent prices. That would have Lorillard trading at roughly 16.5 times this year's earnings estimate of $3.83 a share. Investors also get the company's 4.6% dividend yield while they wait for this year's earnings to take shape.

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