On Monday July 14, we learned that Reynolds American (NYSE:RAI) intends to buy rival tobacco company Lorillard (NYSE:LO). The shares of both companies — and shares of Lorillard in particular — fell pretty dramatically on the news.
The fact that Lorillard shares fell (and they fell by 10 percent) might be puzzling to some. After all, the stock had been trading below the acquisition price of about $68/share. Specifically, owners of Lorillard will receive $50.50 in cash and 0.2909 shares of Reynolds American for each share. But the shares traded down to around $60/share and today they trade at just over $61/share. Even with the decline in Reynolds American shares the deal is still worth $67/share. Why, then, are the shares so weak?
I think there are at least three reasons for this. The first is that a lot of traders piled onto Lorillard in anticipation of this deal, and this pushed the price up so that the final deal price was only a couple percentage points higher than Lorillard’s closing price on the previous Friday. With the trade being over, several traders took their positions off the table, and this put downward pressure on the stock.
Second, Lorillard has been aggressively buying back shares of its own stock, and when the deal was announced, this stopped. This took a great deal of demand out from under the stock, and this is probably responsible for some fo the downside pressure.
Third, there is reason to believe that the deal may not go through. Some traders are concerned that the FTC may not approve of the deal due to anti-trust legislation. After all, if the deal goes through, there will only be 2 major tobacco players in the sector. Furthermore, many Lorillard shareholders are upset by the deal, and they either think that they should have gotten more or that the combined company isn’t as attractive as Lorillard as a stand-alone company. After all, Lorillard and rival tobacco company Altria Group (NYSE:MO) have been taking market share from Reynolds American. Furthermore, as part of the agreement the combined company will be selling some growth products to rival company Imperial Tobacco (ITYBY), and this makes the combined company even less attractive.
Given all of these points, there is a risk that the deal will not go through, and for this reason Lorillard stock trades about 9 percent below the deal price. But with that in mind, I think there is a good opportunity for traders in Lorillard. In all likelihood, the deal is going to go through. While there have been several complaints regarding the deal none of them have come from large institutional holders of Lorillard, and by now they would have come out to say publicly that they are voting their shares against the deal. Most of the complaints are coming from retail investors who own a few hundred or thousand shares who don’t want to give up this outperforming tobacco stock from their portfolios.
So the only real threat to the deal is that the FTC blocks it, and I think it is in part for this reason that Reynolds American agreed to sell part of its portfolio to Imperial Tobacco, which will grow its American presence (it is a British company.) With this in mind, I think that Lorillard stock can rise about 9 percent over the next few months as the deal closes.
But what if the deal falls through? What is the downside risk? The downside risk is difficult to pinpoint. On the one hand, Lorillard shares with a multiple that is in line with its peers — about 19-20 times earnings. On the other hand, tobacco stocks have been rising because the deal would make the industry less competitive, and if the deal fell through, the values of these companies would likely decline. While it is difficult to say, I think that $48/share is a reasonable downside target in the event that the deal falls through. This is the level that Lorillard shares traded at prior to the merger rumors.
Now this seems like a lot of downside to risk ($13/share) in order to make $6/share. But the chance that the deal will not go through is relatively small. Even if the deal doesn’t go through, Lorillard will be able to resume purchasing its shares on the open market, and all the while it would have been growing. With this in mind, $48/share is a relatively conservative downside target. With this in mind, I think investors should consider buying Lorillard shares on any weakness.
Disclosure: Ben Kramer-Miller has no position in Lorillard or in any of the stocks mentioned in this article.