Tobacco Tales: Will Lorillard and Reynolds Merge?

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Earlier last week, there were reports that America’s second largest tobacco producer, Reynolds American (NYSE:RAI), hired investment bank Lazard (NYSE:LAZ) to look into a potential acquisition of rival tobacco producer Lorillard (NYSE:LO). As is expected, Lorillard shares soared on the news, and the shares trade now at $53 each. While enthusiasm for the deal has abated somewhat, we find that there are definite advantages to the deal; but there are also pitfalls, particularly from the perspective of Reynolds American.

Let us look at the advantages. First, there is an inherent advantage in competing in a market with fewer participants. The vast majority of the tobacco market in the United States is controlled by three companies: Altria Group (NYSE:MO), Reynolds American, and Lorillard. Altria Group is by far the biggest player, and even if the latter two companies merge, Altria Group will still be bigger both in terms of market capitalization and in terms of sales. Nevertheless, the combination of the latter two companies will create a larger company that is better capitalized and better able to compete with Altria Group.

Second, there are synergies between the two companies that will almost certainly lead to significant savings, which means that the combined company would be worth more than the sum of the two companies if they don’t merge. Wells Fargo (NYSE:WFC) estimates that the combined company can save $400 million on manufacturing given that they can produce both companies’ products at one plant.

As e-cigarettes become more popular and “regular” cigarette smoking declines, this will be advantageous as the combined company can produce these products at two plants, whereas two separate companies would produce them at four separate plants. Its $400 million is a lot of savings, especially considering that these companies trade at about 17 times earnings. Assuming the multiple remains the same after the merger, this translates into $6.8 billion in market cap. Considering that the market caps of the two companies add to $49 billion, the combined company is worth 14 percent more just based on cost saving synergies.

However, Reynolds American shareholders need to watch out for one thing in particular. Lorillard is a highly leveraged company. Lorillard has negative $2 billion in equity resulting from the company’s very aggressive policy of returning capital to shareholders; it essentially borrows money to buy back its own stock given that it can borrow so inexpensively.

Reynolds American returns a lot of capital to shareholders as well as is evidenced by it 5 percent yield and the fact that it bought back $775 million in stock last year. But the book value of the combined company will be lower than the book value of Reynolds American. Furthermore, the debt burden will become greater. Given the stable nature of the tobacco industry, this may not be a pressing issue, but the new company would ultimately be more vulnerable to a sharp decline in tobacco usage in the United States.

Ultimately, it seems that the deal would benefit both companies, and there is a good possibility that it will go through. The clear winner will be Lorillard, and if you must speculate on an acquisition, then owning Lorillard shares is the way to go. However, this deal is emblematic of the lack of growth in the tobacco industry in the United States. The companies in this industry are looking to generate value by cutting costs because it is so difficult to grow revenues. This works for a while but it is not a strong long term investment thesis. True, tobacco companies do an excellent job of returning capital to shareholders, as they pay large dividends relative to the S&P 500 (roughly 5 percent versus 2 percent) and buy back their shares, but keep in mind that they do this because they are not finding opportunities to employ this capital elsewhere. Thus, while there may be an opportunity in Lorillard shares in the near term, I would stay away from the industry.

For those investors who like the shareholder friendly policies of the tobacco industry, an alternative might be the leading international player — Philip Morris (NYSE:PM). Philip Morris has taken a hit lately as investors are worried about international markets, and developing markets in particular. Philip Morris is heavily invested in these markets, and as a result the stock has been very weak lately; shares are down 8 percent for the year. However, Philip Morris has an advantage over its American counterparts in that there are many foreign nations in which tobacco use is increasing, and given that Philip Morris owns the leading Marlboro brand, it is extremely well-positioned to take advantage. Furthermore, the stock trades at just 15.25 times earnings as opposed to Reynolds American and Lorillard, which trade at around 17 times earnings. Still, investors should keep in mind that tobacco is not really a growth industry and that the tobacco stocks are good for generating steady income, but not much else. Despite the allure of outsized dividends and stock buybacks, there are better opportunities elsewhere.

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