Stock Pick: Lorillard Inc. (LO) is bad for your lungs but not your portfolio

Possible FDA ban on menthols casts a cloud, however

Trailing 12-month stock chart for Lorillard Inc.

Cigarettes may be bad for your health, but they can be great for your portfolio. One company that’s done particularly well over the last 12 month is Greensboro-based Lorillard Inc. (NYSE: LO), the company behind Newport, the popular menthol smokes. It’s up 33% since this time last year.

On March 17, Goldman Sachs analyst Judy Hong upgraded the stock from a neutral to a buy. For a while, it was unclear how regulations around menthol cigarettes would affect the stock, but Hong now says that the impact of any rule changes is low and it will be a while anyway before anything’s put into place.

One of the reasons she likes the stock is the possibility that it will be acquired. There was some recent discussions of a Lorillard and Reynolds American (NYSE: RAI) merger and while nothing’s happened, she does think there’s a 15% to 30% probability of some M&A activity.

The potential of a purchase does factor into her price upgrade from $54 to $60. (It’s currently trading at $52.) “Our target embeds a $54 value for the cigarette business, a $4 value for E-cigs and a 15% M&A weighting,” she wrote in a recent report.

She also likes the company’s “highly visible” double-digit earnings per share growth outlook. The company is gaining market share in the U.S. — the company’s domestic share of cigarette market grew by 0.7% in Q4 — and it’s one of the leaders in the menthol space. Newport is a core brand name too, while Newport Gold — its light version — has been gaining ground. She expects to see 12% EPS growth in 2014.

The big risk is the possibility of a menthol ban. While Hong doesn’t see this happening, if it does then the share price will drop dramatically to $29 a share. If there is no ban, then the price could climb to $65, she writes.

Whether you think cigarettes are bad or not, smokers naturally have a hard time quitting which means they’ll continue to light up. That’s a good thing for investors.