Here's What you Need to Know About the Reynolds American-Lorillard Deal

Reynolds and Lorillard are planning a merger, and here's what you need to know about the deal.

Jul 19, 2014 at 10:00AM

Reynolds American (NYSE:RAI) and Lorillard (NYSE:LO) announced their intent to merge earlier this week, ending months of speculation by investors and analysts alike.

However, it seems as if the deal has not quite gone according to plan. At the time of writing, Lorillard's shares traded at only $61 each, down 9.3% on the day and 11.4% below Reynolds' offered price of $68.88 per share. This signals that investors believe that the deal might not go ahead .

The details
As covered above, Reynolds is offering $68.88 per share for Lorillard, and this values the company at $27.2 billion. Lorillard shareholders are set to receive $50.50 in cash and 0.2909 of a share in Reynolds for each Lorillard share they own. According to Lorillard's press release on the matter, the offer price:

...represents a premium of 40.4% to the stock price on February 28th, the last trading day prior to initial media speculation around a possible transaction...

Following the transaction, the enlarged Reynolds is projected to have over $11 billion in revenue and approximately $5 billion in operating income. And something the company's press release fails to mention, a huge pile of debt.

Indeed, ratings agency Standard & Poor's estimates the debt pro forma for the proposed transaction will total about $17.6 billion -- around 3.5 times the company's estimated operating income. Standard & Poor's does not seem bothered by this high debt level, but Moody's and Fitch have slammed Reynolds for its decision to pay for Lorillard using debt. Both ratings agencies have placed the company's credit rating on review for downgrade  .

Divesting assets
As part of the deal, Reynolds has inked an agreement with Imperial Tobacco (NASDAQOTH:ITYBY), the world's fourth-largest publicly traded tobacco company. Imperial is paying $7.1 billion for the KOOL, Salem, Winston, Maverick, and blu eCigs brands. This deal should help reduce antitrust concerns and give Reynolds some much needed cash. What's more, Imperial will acquire Lorillard's manufacturing and R&D facilities as well as approximately 2,900 employees, including a national sales force.

After these divestments, the new Reynolds-Lorillard will be left with the Newport, Camel, Pall Mall and Natural American Spirit cigarette brands; Grizzly in smokeless tobacco; and the VUSE e-cig brand.

Pleasing all parties
British American Tobacco
(NYSEMKT:BTI), Reynolds' largest shareholder, has given its blessing to the merger and agreed to vote its shares in favor of the transaction. British American will maintain its 42% ownership in Reynolds through an investment of approximately $4.7 billion.

Additionally, British American and Reynolds have agreed upon a technology-sharing initiative which concerns the development of next-generation tobacco products, including e-cigs and reduced risk products.

All in all, the merger is expected to be earnings accretive in the enlarged company's first full year of operation. Strong double-digit earnings accreditation is expected by the second year of combination. However, according to Lorillard's press release on the merger, all of the transactions regarding the deal are not expected to close until the first half of 2015, assuming everything runs smoothly. With this being the case, unfortunately it could be two years before investors start to see the benefits. Still, Reynolds' forecasts suggest that the group will be able to drive cost savings of $800 million from the deal, above previous estimates that the deal would only achieve $400 million in cost savings synergies.

The bottom line
So the bottom line is that Reynolds American is acquiring smaller peer Lorillard for $68.88 per share. The deal is a complicated transaction that involves four parties, and Reynolds is selling off a good portion of its current business to larger peer Imperial Tobacco in order to seal the deal.

Nevertheless, it seems as if Reynolds has gotten the go ahead from its largest shareholder, British American, and the merger will create a company with a market share of around 30% of the US cigarette market.

I should say, however, that the transaction is still subject to customary closing conditions, including approval by shareholders of both companies as well as regulatory approval. So it's not a done deal yet.

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Rupert Hargreaves has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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