How You Can Profit From Possible M&A in the Tobacco Industry

Lorillard may be acquired by Reynolds American, which, in turn, may be acquired by British American Tobacco. What's the best way to profit from this consolidation, and how will the consolidated players stack up to Altria Group?

Mar 8, 2014 at 10:00AM

The Financial Times recently reported on speculation that Reynolds American (NYSE:RAI) will acquire Lorillard (NYSE:LO). If the deal goes through, it would combine the second- and third-largest U.S. tobacco companies in a move that would create the single-largest competitor to Altria Group (NYSE:MO) -- the largest U.S. tobacco company.

Moreover, a merger could provide an opportunity for British American Tobacco (NYSEMKT:BTI), which owns a large minority stake in Reynolds, to expand its U.S. footprint. If Reynolds acquires Lorillard and British American Tobacco acquires Reynolds, investors stand to benefit in multiple ways. However, only one strategy offers investors the most reliable way of making money from the takeover speculation.

Scenarios and implications
Lorillard is an attractive acquisition target for two reasons: (1) Newport is the leading menthol brand in the only stable category in the industry; and (2) Blu is the leading U.S. e-cigarette in the largest growth category in the tobacco industry.

It is not yet clear whether Reynolds intends to acquire all of Lorillard or just part of it. If it does not acquire the entire company, it will likely acquire the cigarette business. That would make Altria and Reynolds the clear No. 1 and No. 2 U.S. tobacco companies with no large competitors in sight. It would also leave Lorillard with the valuable Blu e-cigarette brand, which commands a 47% share of the nascent market.

Lorillard's menthol cigarette business, led by its flagship Newport brand, is especially attractive. Regulators have been slow to clamp down on menthol cigarettes because of the high proportion of African-Americans who smoke the cigarettes, which give a cooling sensation and minor pain relief to smokers. About half of adult menthol cigarette smokers are from minority groups and more than 70% of adolescent African-American smokers report smoking menthol cigarettes. As a result, attempts to eliminate mentholated cigarettes from the market have been met with fierce opposition in the name of racism.

The appealing cooling sensation enables menthol cigarettes to maintain sales volume even as overall cigarette volume declines. As a result, Lorillard is able to grow its market share without making acquisitions -- a rarity in the highly regulated tobacco industry.

If Reynolds acquires Lorillard's $6.7 billion cigarette unit -- which includes menthol and non-menthol cigarettes -- it would double Reynolds' sales of smokable tobacco products to $13.4 billion. That is still a far cry from Altria, which boasts nearly $22 billion in smokable tobacco sales. However, Newport, which makes up 85% of Lorillard's sales, would give Reynolds an opportunity to grow its share over time.

The true reason behind Lorillard acquisition?
Although Reynolds' acquisition of Lorillard would give it a valuable asset in Newport cigarettes -- and, if it acquires the e-cigarette business too, a leading position in a high-growth market -- there could be a deeper, slightly sinister reason behind the acquisition.

British American Tobacco, which has only a small share of the U.S. market outright, has a  stake 42% in Reynolds. After it took its stake nearly 10 years ago, British American Tobacco agreed to stop purchasing additional shares and also agreed that it would not attempt a hostile takeover of Reynolds. That agreement expires in July, exposing Reynolds to a hostile takeover.

Sometimes, in an effort to thwart a hostile takeover, management takes on debt to acquire a smaller company and make itself a less-attractive acquisition target. This is what clothing retailer Jos. A Bank likely had in mind when it bought Eddie Bauer for $825 million while being pursued by Men's Wearhouse.

Reynolds may be thinking that same thing, which could lead it to overpay for Lorillard in an attempt to get a deal done no matter what the cost. Financial Times sources say that any offer for Lorillard would have to be more than $20 billion, which is where it trades now that takeover speculation has hit the market. A $20 billion acquisition would be about 17 times Lorillard's 2013 net income. If Reynolds is forced to pay much more than this amount, it may end up overpaying.

Reynolds has $1.5 billion in cash on hand, so it would either have to raise substantial debt or acquire Lorillard with stock -- or both. My guess is that Reynolds will do a cash-and-stock offer, raising just enough debt to thwart a British American takeover but not so much that it endangers the company.

If the deal is done in all stock or mostly stock, however, Reynolds could then be acquired by British American Tobacco, making Reynolds shareholders a hefty pile of cash.

How to place your bets
It is usually not a good idea to invest on the thesis that a stock will be acquired. However, buying a decent stock that has the potential of being acquired can be a good strategy.

As it turns out, Reynolds and Lorillard are both trading at about 17 times earnings. In this case, it is better to choose the smallest fish in the pond -- the one with the highest chance of getting gobbled up. If Reynolds overpays for Lorillard, Lorillard shareholders win and Reynolds shareholders lose. In that case, Reynolds would also be less attractive to British American Tobacco, thus taking away the possibility of a quick shareholder return. As a result, investors looking to make money on possible consolidation in the tobacco industry should consider buying Lorillard.

Dividend stocks to own right now
One of the dirty secrets that few finance professionals will openly admit is the fact that dividend stocks as a group handily outperform their non-dividend paying brethren. The reasons for this are too numerous to list here, but you can rest assured that it's true. However, knowing this is only half the battle. The other half is identifying which dividend stocks in particular are the best. With this in mind, our top analysts put together a free list of nine high-yielding stocks that should be in every income investor's portfolio. To learn the identity of these stocks instantly and for free, all you have to do is click here now.

Ted Cooper 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.

1 Key Step to Get Rich

Our mission at The Motley Fool is to help the world invest better. Whether that’s helping people overcome their fear of stocks all the way to offering clear and successful guidance on complicated-sounding options trades, we can help.

Feb 1, 2016 at 4:54PM

To be perfectly clear, this is not a get-rich action that my Foolish colleagues and I came up with. But we wouldn't argue with the approach.

A 2015 Business Insider article titled, "11 websites to bookmark if you want to get rich" rated The Motley Fool as the #1 place online to get smarter about investing.

"The Motley Fool aims to build a strong investment community, which it does by providing a variety of resources: the website, books, a newspaper column, a radio [show], and [newsletters]," wrote (the clearly insightful and talented) money reporter Kathleen Elkins. "This site has something for every type of investor, from basic lessons for beginners to investing commentary on mutual funds, stock sectors, and value for the more advanced."

Our mission at The Motley Fool is to help the world invest better, so it's nice to receive that kind of recognition. It lets us know we're doing our job.

Whether that's helping the entirely uninitiated overcome their fear of stocks all the way to offering clear and successful guidance on complicated-sounding options trades, we want to provide our readers with a boost to the next step on their journey to financial independence.

Articles and beyond

As Business Insider wrote, there are a number of resources available from the Fool for investors of all levels and styles.

In addition to the dozens of free articles we publish every day on our website, I want to highlight two must-see spots in your tour of fool.com.

For the beginning investor

Investing can seem like a Big Deal to those who have yet to buy their first stock. Many investment professionals try to infuse the conversation with jargon in order to deter individual investors from tackling it on their own (and to justify their often sky-high fees).

But the individual investor can beat the market. The real secret to investing is that it doesn't take tons of money, endless hours, or super-secret formulas that only experts possess.

That's why we created a best-selling guide that walks investors-to-be through everything they need to know to get started. And because we're so dedicated to our mission, we've made that available for free.

If you're just starting out (or want to help out someone who is), go to www.fool.com/beginners, drop in your email address, and you'll be able to instantly access the quick-read guide ... for free.

For the listener

Whether it's on the stationary exercise bike or during my daily commute, I spend a lot of time going nowhere. But I've found a way to make that time benefit me.

The Motley Fool offers five podcasts that I refer to as "binge-worthy financial information."

Motley Fool Money features a team of our analysts discussing the week's top business and investing stories, interviews, and an inside look at the stocks on our radar. It's also featured on several dozen radio stations across the country.

The hosts of Motley Fool Answers challenge the conventional wisdom on life's biggest financial issues to reveal what you really need to know to make smart money moves.

David Gardner, co-founder of The Motley Fool, is among the most respected and trusted sources on investing. And he's the host of Rule Breaker Investing, in which he shares his insights into today's most innovative and disruptive companies ... and how to profit from them.

Market Foolery is our daily look at stocks in the news, as well as the top business and investing stories.

And Industry Focus offers a deeper dive into a specific industry and the stories making headlines. Healthcare, technology, energy, consumer goods, and other industries take turns in the spotlight.

They're all informative, entertaining, and eminently listenable ... and I don't say that simply because the hosts all sit within a Nerf-gun shot of my desk. Rule Breaker Investing and Answers contain timeless advice, so you might want to go back to the beginning with those. The other three take their cues from the market, so you'll want to listen to the most recent first. All are available at www.fool.com/podcasts.

But wait, there's more

The book and the podcasts – both free ... both awesome – also come with an ongoing benefit. If you download the book, or if you enter your email address in the magical box at the podcasts page, you'll get ongoing market coverage sent straight to your inbox.

Investor Insights is valuable and enjoyable coverage of everything from macroeconomic events to investing strategies to our analyst's travels around the world to find the next big thing. Also free.

Get the book. Listen to a podcast. Sign up for Investor Insights. I'm not saying that any of those things will make you rich ... but Business Insider seems to think so.


Compare Brokers