What Should Investors Do About Reynolds American’s Rumoured Acquisition of Lorillard?

Source: Lorillard

According to a recent Financial Times article, Reynolds American (NYSE: RAI  ) is considering acquiring its competitor Lorillard (NYSE: LO.DL  ) . Notwithstanding the authenticity of this piece of news, this potential acquisition doesn't make much strategic sense.

Not for the e-cigarettes
Being the first among the Big Three tobacco companies to enter the e-cigarettes space with the purchase of Blu eCigs in 2012, Lorillard now accounts for nearly half of the e-cigarette sales volumes in the U.S. While Reynolds American's potential acquisition of Lorillard will greatly expand its market share in e-cigarettes, it runs contrary to Reynolds American's current actions.

Reynolds American introduced its VUSE digital vapor cigarettes into Colorado in June 2013 and has experienced very positive feedback from consumers there. VUSE is the no. 1 ranked e-cigarette brand in the state and has achieved a market share of 61.5% as of October 2013. In fact, VUSE's market share is more than three times that of Lorillard's Blu in Colorado. With a nationwide launch planned for mid-2014, it seems premature for Reynolds American to buy Lorillard now because of e-cigarettes.

Not for menthol
Another potential reason for the purchase of Lorillard will be its market leadership in menthol, given that Lorillard's Newport is the leading menthol brand in the U.S. However, Reynolds American does have exposure to the menthol segment and is doing decently well. Reynolds American's premium menthol brand Camel Menthol has seen its market share rise from below 2% in 2010 to about 3.5% now.

On the other hand, its value menthol brand Pall Mall has also increased its market share from 8.5% in the first quarter of 2011 to about 8.9% as at the end of the third quarter of 2013. Furthermore, there remains significant uncertainty as to the degree of menthol regulation in the future.

Source: Altria

Go with the leader instead
Putting acquisition rumors aside, Altria (NYSE: MO  ) , the largest U.S.tobacco company, could be a better option for investors instead. Altria's leading cigarette brand Marlboro has an estimated 43.7% market share in 2013. In fact, Marlboro sells more than the combined sales volumes of the next 11 largest cigarette brands, including Reynolds American's Camel and Lorillard's Newport.

This relative market share advantage that Altria enjoys, gives it significant economies of scale. It isn't surprising that Altria's 2013 operating margins of 45% are superior to that of Reynolds American and Lorillard which sport operating margins in the high 30s and high 20s respectively.

Given the challenges surrounding the tobacco industry in terms of regulatory pressures, lower consumer demand, and the uncertainty over new products, it pays to be cautious.

For example, Altria has taken a prudent approach with respect to e-cigarettes. It is the latest among the Big Three to join the e-cigarette market, having introduced its MarkTen branded e-cigarette products in Indiana and Arizona in August 2013 and Deceber 2013 respectively. Altria's MarkTen branded e-cigarette aim to deliver a better smoking experience using proprietary FourDraw technology, following feedback from early adopters who bought e-cigarettes produced by Lorillard and Reynolds American.

Altria has also diversified away from tobacco into alcohol. It has equity interests in SABMiller, a global beer producer, and Ste. Michelle Wine Estates, a U.S. premium wine company. It has seen its 27% stake in SABMiller stake contribute close to $1 billion of adjusted earnings in 2012, compared with half a billion dollars in 2008.

Foolish final thoughts
It is easy to get caught up in all the M&A frenzy and buy Lorillard and Reynolds American. Investors are advised to focus on fundamentals and consider Altria, the outright market leader in traditional cigarettes. Altria's diversification into non-U.S. tobacco assets and its prudent approach toward e-cigarettes make it the safest bet among tobacco players.

Is Altria the Fool's favorite stock?
A company being the target of a potential acquisition isn't necessarily a good stock. Investors should do the relevant research and assess the attractiveness of a stock before investing. My top pick in the tobacco space is Altria. The Motley Fool's chief investment officer has selected his No. 1 stock for 2014, and it's one of those stocks that could make you rich. You can find out which stock it is in the special free report "The Motley Fool's Top Stock for 2014." Just click here to access the report and find out the name of this under-the-radar company.

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Mark Lin

Mark is a private value investor and is the author of website which uses a systematic quantitative screening approach to filter the global stock markets for cheap cigar-butts and wide-moat compounders.

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