A Deal Between Reynolds and Lorillard Could Be Fraught With Complications

Reynolds American (NYSE: RAI  ) is set to buy Lorillard (NYSE: LO  ) ! Or that's what the headlines said anyway. As it turns out, the deal has not been confirmed.

These rumors started at the beginning of March and have continued to swirl around the market, but the question is, will a deal actually go ahead?

Not clear-cut
Based on information supplied by CNBC, if Reynolds and Lorillard were to make a deal then Reynolds would have to divest some, or all, of its menthol brands.

According to CNBC, around 80% of Lorillard's sales come from the Newport brand of cigarettes. Reynolds also owns several menthol brands, including Kool, Winston, and Salem; these account for around 30% of its sales. 

To navigate antitrust rules and other competitive hurdles, Reynolds would likely have to divest some, or all, of its menthol brands before it acquired Lorillard.

Still, analyst Bonnie Herzog of Wells Fargo Securities believes that the Reynolds/Lorillard deal could produce synergies of up to $400 million for the combined entity, and she believes that Reynolds could pay up to $80 per share for Lorillard before the deal would become too expensive.

What's more, Lorillard's national e-cig business is a great asset and Reynolds could use it to leverage its growth throughout the U.S. Indeed, now that the Food and Drug Administration has come out and said that it will regulate e-cigs, the company knows where the regulator stands and this clears up a certain amount of uncertainty within the industry.

That being said, Lorillard still has the FDA's ax hanging over it in regard to menthol-tobacco products.

You can read more about the menthol issue here. It could be several years before the FDA arrives at a decision on whether or not it should regulate menthol-tobacco products.

On the other hand
Citigroup analysts believe that this Reynolds/Lorillard deal is unlikely to happen. Citi's opinion on this matter is important; unlike private investors, Citi's analysts have been able to meet with Reynolds' management recently to get a feel for the company's plans.

Overall, Citi believes that there are several important factors to consider. These include the uncertainty currently surrounding the regulation of menthol cigarettes, as well as the problems Reynolds would face in getting approval for the merger from British American Tobacco (NYSEMKT: BTI  ) , Reynolds' largest shareholder.

It is also unlikely that Reynolds could secure sufficient financing to offer an attractive price for Lorillard.

As a result, it's possible that Reynolds would have to ask British American for help with funding the deal. Based on year-end 2013 numbers, it is questionable if Reynolds can afford to make the deal itself. This makes a request for funding or a cash call likely.

Reynolds had $1.5 billion of cash at year-end, long-term debt of $5.1 billion, and a debt-to-equity ratio of 100%. Even if Reynolds were to stump up 50% of the estimated $20 billion needed to acquire Lorillard, the company's balance sheet would be put under immense strain.

The final option
The other option is, of course, the possible takeover of Reynolds by British American. Citi's analysts have reiterated this case, stating:

 [T]he fundamentals of Reynolds' business increase the company's attractiveness.

In analyst-speak, this means that Reynolds is a well-run, profitable business with good long-term prospects.

Reynolds has good relations with its customers and an attractive electronic-cigarette segment, which would complement British American's existing offerings and global presence.

However, Citi believes that a joint venture between Reynolds and British American is more probable than a takeover, as this would allow British American to access Reynolds' e-cig technology without having to jump over regulatory hurdles.

Foolish summary
So overall, it would appear that as of yet a deal between Reynolds and Lorillard is unlikely to go ahead. Additionally, even if a deal does take place, Reynolds will have to make some changes to its business in order to satisfy regulators. 

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