Is British American Tobacco the Real Beneficiary of a Reynolds American and Lorillard Merger?

Reynolds American might soon acquire Lorillard, and if so another tobacco giant might be the company that gains the most.

Jun 21, 2014 at 9:00AM

Reynolds American (NYSE:RAI) and Lorillard (NYSE:LO) merger talks have cooled in recent weeks, but according to analyst Bonnie Herzog there's a 90% chance the deal will occur...and soon. While investors frantically try to determine the best way to play this merger of giants, British American Tobacco (NYSEMKT:BTI) is waiting in the shadows and might stand to gain the most.

Why acquire Lorillard?
The outcome of a Reynolds American and Lorillard merger would be a company with more than $13 billion in annual revenue and the distribution of top brands like Camel and Newport. While these things are great, the driving force behind Reynolds American's interest is the fast-growing e-cigarette market. According to Bloomberg, the U.S. e-cigarette market grew 72% in the last 52-weeks ended in June after generating estimated sales of $1.7 billion in 2013.

In a tobacco industry that lacks year-over-year growth, controlling this e-cig market is likely a top priority. Furthermore, Lorillard's Blue e-cigarette brand commands 40% of the total market, which is why the company's expected year-over-year growth of 4.8% and 4.4% over the next two years, respectively, trumps its tobacco peers.

E-cigarettes: The future? 
Reynolds American is preparing to launch an e-cigarette brand of its own in the coming months but will significantly lag Lorillard in market share. Therefore, an acquisition could catapult the company's launch and keep margins high rather than both companies having to spend hundreds of millions on marketing campaigns to compete against each other.

With that said, Reynolds American is not the only tobacco company that wants to own this space. The tobacco industry as a whole continues to face increased criticism due to the adverse health effects of its products. Therefore, with e-cigarettes being proven as safer alternatives and increasing a user's chances to quit smoking by 60%, there might eventually be a public relations benefit to dominance in this market.

Albeit, British American Tobacco investors might have the most to gain in this proposed merger, not Reynolds American or Lorillard longs.

Why British American Tobacco?
One fact that has seemingly been forgotten in the speculation of a Reynolds and Lorillard merger is the fact that British American Tobacco owns approximately 42% of Reynolds American. This ownership occurred in 2004 following a merger of a British American asset to Reynolds. Under the terms of the agreement, British American Tobacco was unable to increase its stake until July 30, a date that is nearing.

British American Tobacco is a much larger, $113 billion company with $25.8 billion in revenue during the last 12 months. The company owns a wide array of brands and estimates that one in eight adult tobacco users around the world uses its products. However, the e-cigarette is one asset it lacks.

With British American already owning 42% of Reynolds and historically being an acquisitive company, there might be some logic in assuming that it'll make a run at acquiring Reynolds regardless of whether it acquires Lorillard or not. For investors this could be far more lucrative than a Reynolds and Lorillard merger alone.

Two reasons make British American better
British American Tobacco trades at just 17 times earnings versus a 20 times multiple or more for both Reynolds and Lorillard. Hence, there is more value in shares of British American naturally. Another reason that British American has more upside potential in the event of an acquisition is due to its location; the company's headquarters are in the United Kingdom.

As we've seen in various industries such as biotechnology, tax inversion has become a popular practice among large U.S. companies. In this particular case, British American would acquire a company that pays a corporate tax rate of 35% and relocate it to a country where the rate is only 20%. Ultimately this means much higher profits...and a higher stock price.

Foolish thoughts
If Reynolds pays $80 a share for Lorillard, then investors will obviously see gains in the latter. Then, Reynolds could likely create shareholder value by remaining a leader in an e-cigarette market that experts believe will eventually surpass the tobacco industry in annual sales.

However, British American Tobacco is the sleeping giant in this equation, a company that already owns a large stake and has much to gain by making a move for Reynolds when able. If so, large gains should be the outcome.

Should tobacco stocks be in your dividend portfolio?
The smartest investors know that dividend stocks simply crush their non-dividend paying counterparts over the long term. That's beyond dispute. They also know that a well-constructed dividend portfolio creates wealth steadily, while still allowing you to sleep like a baby. Knowing how valuable such a portfolio might be, our top analysts put together a report on a group of high-yielding stocks that should be in any income investor's portfolio. To see our free report on these stocks, just click here now.

Brian Nichols 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.

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