It appears the buyout of Lorillard (NYSE: LO ) by Reynolds American (NYSE: RAI ) is still one of the hottest topics in the M&A market. Rumors have surfaced that the two are now in "advanced" talks of a merger. Speculation first rose a couple months ago, and after the latest news, shares of both comapnies have spiked.
Specifically, shares of Lorillard rose nearly 10% on the news. With the help of the buyout speculation, Lorillard and Reynolds American have seen their respective shares move upwards by 20% or more year to date. Meanwhile, their U.S. peer Altria (NYSE: MO ) is up only 5%.
What the deal means
A Reynolds American-Lorillard merger gets somewhat complicated, given British American Tobacco has a 42% stake in Reynolds American. British American Tobacco could get involved by helping Reynolds American finance the purchase.
The combined market capitalization of Reynolds American and Lorillard is still only $52 billion, and well below Altria's $80 billion market cap. In order to buy Lorillard, Reynolds American would have to dilute British American Tobacco's ownership.
The deal would also require some divesting of assets and brands in order to get regulatory approval. Even a combined Reynolds American-Lorillard would only have 42% of the U.S. tobacco market share. This compares poorly to the leader, Altria, which owns over 50% of the market.
Wells Fargo is one of the biggest supporters of the deal. The bank believes the deal has a 90% chance of being completed. It also believes that Lorillard could sell for as much as $80 a share. That's a 30% premium from where it currently trades.
The bright side of a merger
The deal would give Reynolds American a stronghold in both e-cigarettes and menthol cigarettes, which could be both good and bad for Reynolds American. On the negative side, there has been previous speculation that the FDA could ban menthol cigarettes. Over 85% of Lorillard's sales are of its menthol brand, Newport. On the positive side, the deal would put Reynolds American as a leader in one of the fastest growing tobacco markets.
Lorillard owns the leading e-cigarette maker blu eCigs, which has 40% of the market. Reynolds American is launching its own e-cigarette brand, VUSE, in the second half of this year. This kind of presence in the e-cigarette market is another key positive factor considering recent research in Britain, which suggests that e-cigarette users have a 60% higher success rate when quitting smoking than those using another method.
Where does that leave Altria?
Being the largest cigarette manufacturer gives Altria pricing power, but it is behind when it comes to the e-cigarette market. Altria plans to launch MarkTen, its own brand of e-cigarettes, during the second quarter. To give it an immediate presence in the e-cigarette market, Altria recently bought up e-cigarette maker Green Smoke. Philip Morris International will also be selling Altria's e-cigarettes outside the U.S. Meanwhile, Altria can sell Philip Morris' heated tobacco products.
No discussion of the tobacco industry is complete without mentioning the dividend yields. These stocks offer some of the highest dividends in the market. The all trade with similar P/E ratios, between 18 and 21, but the dividend yields vary. Lorillard pays a 3.9% dividend yield, while the other two are a bit higher. Reynolds American pays a 4.5% dividend yield and Altria's is 4.7%.
Bottom line
Consolidation in an industry is a positive. It can lead to better pricing and higher margins. The top three U.S. tobacco companies offer very attractive dividends. A Reynolds American-Lorillard merger would put the combined company in a better position to compete with Altria. Investors looking for a strong dividend paying stock, as well as exposure to the tobacco industry, should take a closer look at Reynolds American.
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