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

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 (NASDAQ: JOSB  ) likely had in mind when it bought Eddie Bauer for $825 million while being pursued by Men's Wearhouse (NYSE: MW  ) .

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.

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