Reynolds American Finally Buys Lorillard; Now What?
For months now, we have been hearing rumors that Reynolds American (NYSE:RAI) — the country’s second largest tobacco producer — would acquire Lorillard (NYSE:LO), the country’s third largest tobacco producer. So it shouldn’t surprise anybody that the deal was finally announced. Reynolds American is going to be buying Lorillard for $27.4 billion in cash and stock.
The impetus behind the deal was twofold. First, the merger would eliminate competition. Now there are just two primary tobacco producers in the United States – Altria Group (NYSE:MO) and Reynolds American/Lorillard. Since the industry has fewer major players, it should be less competitive and the remaining players should have more pricing power.
Second, the merger would be accretive. The two companies produce products at different facilities. But now it can manufacture its products at the same facilities, and it can do so in a way that maximizes savings. Early on in this merger saga, we learned that the combined company could save $400 million per year. That doesn’t sound like a lot considering that Reynolds American is buying Lorillard for $27.4 billion, but if you put a 22 price to earnings multiple on the net savings (this is the same multiple that the market is assigning the two stocks) the value comes to $8.8 billion, and that is substantial.
We also see that the deal is mostly in cash. Each Lorillard share will be exchanged for $50.50 in cash and 0.2909 shares of Reynolds American. In other words, over $18 billion of this deal is in cash. But as of the end of March, Reynolds American had just $1.8 billion in cash, which means that it is going to have to borrow this money. Now given the relative stability of the tobacco industry and given the current low interest rate environment, this shouldn’t be a problem. While this will add to Reynolds American’s annual interest obligation the added earnings from Lorillard, the aforementioned savings, and the “original” company’s earnings can easily cover this burden.
So on all of these fronts we see value creation, and it is no wonder that the tobacco stocks have been outperforming the rest of the stock market this year. However, what we ultimately have is a one-time benefit that results from shifting assets around and from the current low interest rate environment, and this cannot change the fact that tobacco use in the United States is declining at about 3 percent per year.
This makes the industry rather unattractive from an investment standpoint, and I think that those who have participated in the strong performance of the tobacco stocks over the past several years need to realize that this performance has been due to timely stock buybacks funded by low interest rates and other asset shifting strategies such as the deal between Reynolds American and Lorillard. While this has worked thus far, one can see how it is unsustainable. There can’t be any more mergers unless the new Reynolds American merges with Altria Group, which would create a monopoly.
As long as interest rates remain low, I suspect that we will continue to see the tobacco companies attempt to manufacture earnings per share growth by borrowing money to buy back stock. But this is probably the only tool left in their toolboxes. While a lot has been made about e-cigarettes, for most consumers this is a cigarette replacement, and people aren’t simply going to go out and try e-cigarettes unless they are viewing them as a step away from cigarettes and other tobacco products. In short, this new market is going to cannibalize other tobacco sales.
Meanwhile, fewer young people are smoking cigarettes and older smokers are either trying to quit or dying off. The bottom line is that this is an industry that is slowly dying, and while the stock performances look strong and while there is recent earnings per share growth there is no market to support this longer term. Investors who have ridden the wave are urged to take profits in the coming days and weeks. Others are encouraged to avoid the sector and to look for opportunities elsewhere.
Disclosure: Ben Kramer-Miller has no position in the stocks mentioned in this article.