Rumors Make a Market: Reynolds American-Lorillard Merger Heats Up

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For several months now, we have seen rumors pop up regarding a consolidation in the tobacco space. The second-largest American tobacco company, Reynolds America (NYSE:RAI), is supposedly in talks with investment banks and the third-largest American tobacco company, Lorillard (NYSE:LO), in hopes of consolidating the two companies.

The goal here is to save money on production costs. The two firms could produce cigarettes at fewer locations if they were allies rather than competitors, and this would mean an estimated $400 million in cost savings. But because these stocks are trading at 20 times earnings, this could generate $8 billion in market capitalization versus Reynolds American’s and Lorillard’s current valuations of $33 billion and $23 billion, respectively.

On Thursday, CNBC’s David Faber reported that this deal is approaching and that it could be completed by the end of the month. This sent shares of tobacco companies soaring. Even Altria Group (NYSE:MO), the maker and distributor of Marlboro cigarettes in the United States, rose dramatically on the news. The reason is that with less competition in the marketplace, all of the major players will have added pricing power.

Not only did these stocks rise on Thursday, but they have been rising all year in hopes that a deal would take place. Year to date, Lorillard is up 27 percent and Reynolds American is up 23 percent, so trading this rumor has been extremely profitable. However, I think that investors who have benefitted should consider taking profits soon, and they certainly shouldn’t hold the stocks after a merger is announced.

There are two reasons for this. The first is that when the market is confronted with such rumors, it often bids up the stocks of the companies involved in anticipation of an acquisition or merger. But once it is actually announced, these investors jump ship because the catalyst — their reason for owning the stock — is now in the past. This follows a common trading strategy known as “buy the rumor and sell the news,” whereby you buy a stock into an anticipated positive event and sell just before or shortly after it takes place. It has worked time and time again, and the tobacco consolidation rumor is no exception.

The second reason is that tobacco stocks have simply become overextended. They used to trade at a significant discount to other consumer staple companies because there has always been regulatory risk. Now they trade in line with consumer staple companies because the recent optimism has overshadowed this regulatory risk. But this regulatory risk remains. I should further note that tobacco use is declining at about 3 percent per year in the United States, and this is a powerful headwind that the tobacco companies must face. While they have overcome it though price increases and timely stock repurchases, these are only temporary measures, and an industry cannot grow if it is not adding customers.

Thus, investors who are in tobacco stocks now should consider selling in the near future. There are other places to find stable cash flow streams that don’t come with the aforementioned risks. Investors who insist on owning a tobacco stock should consider Philip Morris (NYSE:PM), which has had a rough year, but it is the only American tobacco company with exposure to emerging markets in which there is growing tobacco demand. It also trades at a far more reasonable valuation: 16 times earnings, or a 20 percent discount to its peers.

Disclosure: Ben Kramer-Miller has no position in any of the stocks mentioned in this article.

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