Why Lorillard's Stock Is up Over 20% in 2014

Lorillard's shares have surged during the first half of 2014 but will this performance continue; it's unlikely.

Jul 3, 2014 at 10:51AM

Lorillard (NYSE:LO) has put in an impressive year-to-date performance. The company's shares have jumped just over 21% since the beginning of the year, outperforming the wider S&P 500 by nearly 15% --  excluding dividends.

However, as we roll into the second half of the year, will Lorillard's outperformance continue?

A strong performance
Lorillard's strong performance so far this year stems from two factors. Firstly, the company has been the subject of bid rumors. The rumors claim that larger peer Reynolds American (NYSE:RAI) is putting together a deal to buy out its smaller peer.

Secondly, Lorillard's performance has been boosted by strength across the tobacco sector. Yield-starved investors look to tobacco stocks for their hefty dividend yields to generate income for their portfolios. 

Indeed, Lorillard's peers Reynolds and Altria have both seen their shares jump this year as investors seek out yield in the market.

Reynolds and Altria have added on 21% and 10% year to date respectively -- excluding dividends.

Still, Lorillard's proposed deal with Reynolds is what's really putting a rocket under the company's stock right now.

Merger mania
According to sources with knowledge of the matter, Reynolds is in "active discussions" to acquire Lorillard in a complicated three-way transaction. However, this deal will not be as simple as it first appears .

For starters, if Reynolds-Lorillard combined the US domestic tobacco market would be dominated by two companies, Altria and Reynolds-Lorillard. This is bound to attract the attention of antitrust regulators.

So Reynolds will likely have to sell off some non-core brands to reduce its dominance over the market. Luckily, divestment of non-core brands is exactly what Reynolds has been trying to do over the past few years so this would work well with its core strategy. The remaining brand portfolio would center on Reynolds' Camel and Lorillard's Newport brands.

Rumors also claim that the UK's Imperial Tobacco has plans in place to acquire Reynolds' unwanted brands.

Still, the companies must navigate around another issue, Reynolds' majority shareholder British American Tobacco.

Anglo-American owner
British American owns around 42% of Reynolds, which it acquired a decade ago. For the past ten years it has agreed not to interfere in Reynolds' business. Nevertheless, due to the size of the Lorillard deal and Reynolds' already stretched balance sheet, Reynolds plans to use its own stock to pay for part of the deal. As a result, British American's holding would decrease if the merger goes through.

The British giant is unlikely to be happy with a deal in which it loses out. As a result, speculators argue that British American would either fund the deal or just acquire Reynolds.

Still, the deal is by no means set in stone just yet and it contains many moving pieces. It could all fall through.

Foolish summary
In conclusion, over the past six months Lorillard's shares have jumped 20%, outperforming the wider market. The company has outperformed due to bid interest but the deal's three parties remain in discussion and as of yet, no deal is on the table. Unfortunately, this means that Lorillard's share price could fall back to earth if the deal falls through.

At present, Lorillard is trading at a historic P/E of 20.2 compared to its five-year historic average of 14. If the deal falls through it is reasonable to assume that Lorillard's share price could fall back to its historic valuation -- 25% below current levels .

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Rupert Hargreaves owns shares of Altria Group. 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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