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Why Reynolds American Is up 20% in 2014

Reynolds American's (NYSE: RAI  ) shares have put in an impressive performance year to date.

Indeed, since the beginning of this year the company's shares have jumped 20%, excluding dividends. Including dividends, the gain rises to 23%, an impressive total return. In comparison, over the same period the S&P 500 has only returned around 8%, including dividends.

But what is the reason for this outperformance and will Reynolds continue to motor higher?

Merger mania
Only one thing has really sent Reynolds' stock higher this year: the proposed merger of Reynolds and smaller peer Lorillard (NYSE: LO.DL  ) .

The merger rumors started on March 3, and all you need to do is look at the trading volumes to see that this was big news.

Both Lorillard and Reynolds spiked more than 10% when rumors started to circulate. Since then, both companies have seen their shares churn steadily higher as the companies thrash out a deal and the market gets more information .

What do we know?
What do we know about the deal so far? Well, we know that Reynolds could pay up to $70 per share for Lorillard, a premium of at least 15% to the current share price.

As a result of the deal, Reynolds expects cost savings synergies of $400 million per annum. What's more, the combined Reynolds-Lorillard entity will control around half of the US domestic cigarette market and have a leading position in the country's electronic cigarette market.

However, this is where some issues with the deal start to emerge.

Firstly, with Reynolds-Lorillard controlling about 50% of the domestic cigarette market and sector behemoth Altria holding the other 50%, antitrust regulators are likely to demand that Reynolds sell off some of its existing brands. This will increase competition within the market.

Luckily, this conforms with Reynolds' strategy of focusing on key brands. The company could sell off non-core brands, which would leave it with a core portfolio focused around the Pall Mall and Newport brands. These two brands are arguably two of the strongest cigarette brands within the US market, aside from Altria's Marlboro of course.

Further, analysts believe that Anglo-American company Imperial Tobacco has financing in place to acquire any unwanted brands from the Reynolds-Lorillard deal.

Show us the money
Aside from antitrust issues, one of the most important factors of a deal between Reynolds and Lorillard is the availability of financing. 

Reynolds has a stretched balance sheet, there is no other way of putting it, so it has limited options. For example, Reynolds' debt-to-equity ratio stood at 100% at the end of the first quarter and if the company paid in excess of $22 billion for Lorillard, its debt pile would spiral out of control, from $5 billion to just under $30 billion -- a crippling level of debt.

Indeed, ratings agency Standard and Poor's has already threatened to cut Reynolds' debt rating to junk if the deal goes ahead.

Usually, instead of cash, Reynolds would be able to acquire Lorillard using an all-stock transaction. But there is a problem with this approach as well.

Anglo-American tobacco giant British American Tobacco owns around 50% of Reynolds. An all-stock transaction would dilute the company's holding -- British American's management has made quite clear that it does not want its ownership of Reynolds to be diluted in any way. Unfortunately, this rules out the possibility of a traditional all-stock merger.

So possibly British American could either loan Reynolds the cash for Lorillard or just buy Reynolds. As of yet, it is not clear which path the companies will take. One thing is for sure though, this deal is rather complex.

Foolish summary
All in all then, Reynolds' performance this year can be traced back to the current merger chatter. However, as of yet it's not clear if this deal will go ahead.

The Reynolds-Lorillard deal has many moving parts and according to some sources, the deal has come close to falling apart several times. With this in mind, I feel that Reynolds' year-to-date performance is unlikely to continue into the second half .

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Rupert Hargreaves

Rupert has been writing for the Motley Fool since December 2012. He primarily covers tobacco and resource companies with a passion for value-oriented investments. .

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