3 Reasons Why Lorillard's Days as a Top Dividend Stock Are Over

Source: Lorillard.

Dividend investors have long counted on the tobacco industry to deliver some of the most attractive payouts in the stock market, as the cigarette business generates huge amounts of cash flow that companies like Lorillard (LO.DL) have been more than happy to return to shareholders in the form of dividends. In the six years since conglomerate Loews (L -0.08%) spun off the cigarette maker, Lorillard has doubled its quarterly payouts, establishing itself among the elite in the dividend-stock world.

Yet, despite its pedigree, Lorillard no longer deserves to be considered among the elite dividend payers of the stock market. Because of its proposed deal with Reynolds American (RAI), would-be shareholders face a dilemma, and neither outcome will give them the dividend income they truly want. Let's take a look at three reasons why Lorillard has fallen out of favor as a dividend stock.

1. If the Reynolds American deal goes through, Lorillard shareholders will have to decide how to replace the dividend income they used to receive.
There's no disputing that Lorillard shareholders got a nice one-time boon from Reynolds American when it made its buyout offer to unite the No. 2 and No. 3 domestic tobacco manufacturers. Prior to initial speculation early this year about a potential merger, Lorillard stock traded below $50. After the announcement of the merger, shares briefly spiked above $65, and they've stayed in the $60 range in the subsequent months.

As valuable as one-time capital gains can be, the Reynolds deal will force Lorillard shareholders to figure out how they want to reinvest the proceeds from the merger. For each 100 shares of Lorillard stock, investors will get just 29 shares of Reynolds American stock, in addition to $5,050 in cash. That will cut the net dividends received from $61.50 quarterly for those Lorillard shares to just $19.43.

Obviously, one option investors have to replace those dividends would be to choose to spend it buying more Reynolds American shares. But it won't be automatic -- and the post-merger Reynolds will lack some valuable parts of what made Lorillard such a promising dividend stock in the long run, most notably, its blu eCigs brand in the budding electronic-cigarette space.

E-cig brand blu is an integral part of Lorillard that will be sold if the merger with Reynolds goes through. Image source: Lorillard.

2. If the Reynolds deal doesn't go through, Lorillard shareholders could suffer substantial capital losses.
The flip side of the merger dilemma for Lorillard shareholders is that the stock currently has a portion of the value of a potential deal priced in. If the deal falls through, then it would be natural for Lorillard stock to fall back to where it traded prior to the merger announcement. At current prices, that would imply a 10% to 20% drop.

Increasingly, investors have gotten more skittish about the prospects for the merger not going through. Recently, the price of Lorillard stock was 11% below the implied value of the cash that Reynolds stock investors would receive if the deal closes as planned. That gives buyers now more of a margin of safety, but it still leaves them potentially exposed if shares fall back to where they traded before merger speculation surfaced.

3. Trends in the industry could hurt Lorillard even if it stays independent.
Beyond the Reynolds merger, Lorillard investors have to consider the state of the tobacco industry. The combination of increased regulation and higher taxes on cigarettes have put pressure on Lorillard, Reynolds American, and Altria (MO 1.12%) to keep marketing their premium cigarettes to increasingly cash-strapped consumers.

So far, even substantial cigarette tax increases over the years haven't diminished brand loyalty to premium brands like Lorillard's Newport, and that bodes well for Lorillard's long-term prospects. But in Australia, premium cigarette maker Philip Morris International (PM -0.54%) has seen some moves toward discount cigarettes as a result of the nation's plain-packaging regulations. Even though courts have ruled in favor of U.S. companies to defend their rights to the design of their packaging thus far, future campaigns could be more successful, and jeopardize Lorillard's success.

With the Reynolds merger pending, dividend investors should look beyond Lorillard for reliable long-term dividends. With an immediate cash-out coming if the merger goes through, and the risk of losses if it doesn't, risk-averse dividend investors have better options for their money at this time.