Don’t Chase Tobacco M&A Rumors, Buy for Dividends and New Growth Opportunities

Tobacco companies have seen their shares rise over the last two weeks as rumors popped up about possible merger and acquisition activity. The latest rumor had Reynolds America (NYSE: RAI  ) buying Lorillard (NYSE: LO  ) , combining the number two and three players in the U.S. tobacco market. This combination would take on the market leader Altria (NYSE: MO  ) and create a duopoly for the American tobacco market. While a deal could be quased due to possible antitrust issues, investors should continue to pour money into the three companies to chase high dividend yield

Taking on a giant
A rumored deal to combine Reynolds and Lorillard would create a company with 41% market share in the United States. This would put the company at better odds against Altria, which commands 51% with its strong brands like Marlboro. The combined Reynolds and Lorillard company would hold brands like Camel and Newport.

I don't see a deal between the two companies passing. If a deal does go through, it would likely come with the No. 2 and No. 3 players having to sell off brands to make the merger complete. This would give the combined company an even smaller market share than 40%.

Lorillard growing
In the fourth quarter, Lorillard saw sales grow 2.3% to $1.74 billion. For the full fiscal year, total sales grew 4.9% to a record $7.0 billion. More impressively, Lorillard saw its market share increase for the 11th straight year to 14.9%. Lorillard has been helped by the success of Newport and also being a key player in the e-cigarettes market.

In the fourth quarter, Lorillard had a 48% market share of the ever growing e-cigarette market. Total e-cigarette sales grew 39% to $54 million. For the full fiscal year, e-cigarettes represented $230 million. While this represented around 3% of Lorillard's annual sales, it is the segment that is spurring the Reynolds merger rumors and also the greatest source of upside for investors.

Lorillard became the first of the big three tobacco companies to join the e-cigarette market when it acquired blu eCigs. The company paid $135 million to acquire the company in 2012. Blu has seen its market share start to shrink as others join the market. In the last 16 weeks, blu had a share of only 25.5%, hurt by the national rollout of VUSE.

Reynolds looking to VUSE for growth
Reynolds has strong brands in Camel and Pall Mall, which each have a market share around 9%. The company's Grizzly chewing tobacco has a large 30% market share. Reynolds saw declining sales in the fourth quarter and full year. The company reported sales of $2.04 billion in the fourth quarter, which was a decline of 1.9%. Full-year sales declined less than 1% to $8.24 billion.

Reynolds also has looked to alternative forms of smoking for growth. The company's VUSE digital vapor leads the Colorado market in terms of share. VUSE, which is currently available in Colorado and Utah, is expanding into national distribution. After four months in Colorado, the brand was in 1,800 retail outlets, which shows the strong growth of the brand and how nationally it can be a force to reckon with.

Chasing yield
Cigarette stocks have long been known for their strong dividend yields. Despite years of up and down sales, due to fewer smokers and increasingly tough regulations, cigarette companies have remained faithful to paying out strong dividends.

Lorillard currently yields 4.6% and already raised its quarterly payout at the start of 2014. Reynolds offer a dividend yield north of 5% and continues to raises its quarterly payout one to two times a year. Market leader Altria continues to be the best yielding stock of the three with a dividend yield at 5.2%. The company continues to increase its dividend and has also rewarded investors with spin-offs of Kraft Foods and Philip Morris International.

Conclusion
The e-cigarette market tripled to $1.5 billion in 2013. The market now expects e-cigarettes to see sales double annually through 2018 and 10% a year through 2028. By 2028, the market could see sales of $124.5 billion and the overtaking of conventional cigarettes. 

Lorillard and Reynolds America both offer key e-cigarette brands in blu and VUSE. Altria also acquired the Green Smoke brand and continues to look for additional entries in the e-cigarette market. Investors can continue to chase small over the counter stocks in the e-cigarette market or make the safer bet with the three big tobacco giants. These three companies already have strong relationships with vendors and key distribution deals that can fend off competitors. Investors will be rewarded with high dividend payments along the way. 

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