Is It Still Worth Betting on Big Tobacco?

The potential merger of the nation's second- and third-largest tobacco companies has been the hot topic among M&A speculators. Shares of Lorillard (NYSE: LO  ) and Reynolds American (NYSE: RAI  ) have spiked on the news.

Reynolds American is the second-largest tobacco company in the U.S., and Lorillard is third, though rumor has it that Reynolds is looking to snatch up Lorillard. Such a deal would mean that Reynolds would own 42% of the U.S. tobacco market share. That's still below the leader, Altria Group  (NYSE: MO  ) , which has 50% market share.

The deal gains traction
Imperial Tobacco, which owns 42% of Reynolds, sold off 30% of its Compania de Distribucion Integral Logista Holdings holding. This could add close to $800 million to its coffers, which it can then use to buy up divested assets from the Reynolds American-Lorillard merger. By selling off certain assets to Imperial, Reynolds and Lorillard are more likely to get the deal approved by the FDA. 

Back in May, Reuters noted that British American Tobacco could play a key role in the merger. Bloomberg has reported that British American Tobacco has already given the thumbs up for the deal. However, other reports note that British American could buy the 58% of Reynolds American that it doesn't own, making the deal for Lorillard obsolete. The latest news suggests that the rumors of British American buying Reynolds American might be less likely.

Bonnie Herzog, a Wells Fargo analyst, believes there's a 90% chance the deal gets done. What's more is that Herzog believes Reynolds American will pay upward of $80 a share for Lorillard. That suggests there's still 25% upside to Lorillard's stock.

The e-cig market
The e-cigarette market is in full swing and is expected to be the next major growth avenue for the industry. Reynolds American and Altria seem to be a bit behind, where Lorillard owns the e-cig market leader, Blu eCigs, which it acquired in 2012 for $135 million. Blu owns more than 40% of the e-cig market share.

Lorillard's large market-share presence is a positive, giving the company a first- mover advantage. This is key since, unlike the conventional tobacco industry, which has large barriers to entry, the e-cig market has none.

Reynolds American is rolling out VUSE this summer as Altria rolls out MarkTen. The e-cig market has grown roughly 72% over the last 52 weeks.

E-cigs represent a big market, considering the FDA has little restrictions on marketing and also allows for the sale of various flavors, both of which are not allowed with traditional tobacco. Tobacco companies are also yet to break into the vaporizer market. 

How shares stack up
Both Lorillard and Reynolds American shares are up more than 23% year to date, while the market leader, Altria, is only up 11%. However, based on next year's earnings estimates, all three trade in line on a P/E-ratio basis. But they are separated by their dividend yields. Altria offers a 4.6% dividend yield, and Reynolds American is at 4.4%. Meanwhile, Lorillard is at the bottom with a 4% yield.

Bottom line
The tobacco industry has long been a great place for high dividend yields. However, the merger speculation has made it a place for rising stock prices. The big fear for investors should be that the takeover premium on Lorillard shares offers little upside if a deal is done. In addition, if it becomes apparent that no deal will take place, there will likely be a pullback in Lorillard shares. Even still, for investors looking to play the long-term growth of the industry, Lorillard is worth a closer look.

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