An Investor's Guide to the Reynolds American and Lorillard Merger

The much-rumored deal between Lorillard (NYSE: LO  ) and Reynolds American (NYSE: RAI  ) has been announced. Reynolds will buy Lorillard in a partially debt-financed transaction for around $28 billion.

Of course, the deal still has to be approved by regulators, which could take some time; there is also always the chance that it will be blocked . If the transaction does go through, however, the U.S. tobacco industry will change forever.

Better positioned
Assuming that the transaction goes through, Reynolds will have acquired itself an improved product portfolio. The company's new cigarette portfolio will consist of the Newport, Camel, and Pall Mall brands, which are some of the fastest-growing cigarette brands within the U.S. There's also the company's ultra-premium cigarette brand, Natural American Spirit, which is growing rapidly, although it still has a less than 1% market share.

Reynolds is also retaining ownership of Grizzly, the U.S.' no. 1 smokeless tobacco brand, as well as its VUSE e-cig brand. All in all, Reynolds is set to capture a 37% market share of the domestic cigarette market and a 30% share of the smokeless market when the deal is completed.

However, the most important factor about Reynolds' market share is its improved quality. What do I mean by this? Well, the Newport, Camel, and Pall Mall brands are some of the fastest growing brands within the domestic cigarette market, and they have a strong appeal with smokers under the age of 30. The company is well placed to drive growth.

Menthol is once again an issue
One of the biggest issues with Reynolds' new portfolio is its exposure to menthol. According to ratings agency Standard & Poor's, around 60% of Reynolds' operating income after the transaction will be derived from the sale of menthols.

Unfortunately, this presents a medium-term risk as the FDA is currently investigating the health impacts of menthol. There is also a movement trying to force the FDA to ban menthol products. If the FDA decides to make a move and ban or regulate menthols, Reynolds could face a serious problem.

Rising debt 
While the deal will boost Reynolds' product portfolio, from a financial standpoint, the company's financial profile will deteriorate. Debt is the issue here.

According to S&P, Reynolds' leverage is expected to expand to 4 times after the deal completes, from around 2 times at present. That said, there will be significant cost synergies to be gained from the deal. Analysts believe that these synergies will allow the company to begin reducing its leverage within two years after the deal completes.

S&P's analysts believe that Reynolds' leverage could fall to 3 times within the next few years, while interest coverage from earnings before interest, tax, amortization, and depreciation would fall into the 6 times region over the same period. It is believed that the company will generate around $1 billion per annum in free cash flow after the payment of dividends, allowing for the repayment of debt.

Shocking move
What really shocked the market about the Lorillard/Reynolds deal was the revelation that Lorillard would be selling its market-leading Blu e-cig brand. As it turns out, the sale of Blu was essential for the deal to go ahead.

Why? Well, Imperial Tobacco, the world's fourth largest publicly traded tobacco company, has agreed to buy the cigarette brands Reynolds and Lorillard need to divest in order to appease antitrust concerns. It turns out that Imperial's acquisition of these brands was dependent upon the sale of Blu as well.

What about Altria?
The deal between Reynolds and Lorillard, the country's second and third largest cigarette companies, has got investors asking what effects this will have on the nation's largest cigarette company, Altria (NYSE: MO  ) .

To some extent, Altria is not worried. One of the biggest risks going forward for Reynolds will be the menthol issue, as any menthol regulation is likely to hit Reynolds' income significantly. As Reynolds is taking on additional debt from this deal, a menthol ban could lead to a default.

Altria has around a 50% market share of the cigarettes market, with the well-known premium Marlboro brand making up around 45% of this share. The company has little menthol exposure.

There is also Altria's smokeless division to consider, which has a 50% market share with its two brands. In comparison, Reynolds' Grizzly brand (which is the market leader) only has a market share of 30%.

Altria also has a stronger credit position, with leverage of less than 2 times. It also has its holding in SABMiller, which is valued at more than $20 billion.

The bottom line
The Lorillard/Reynolds deal will change the face of the U.S. tobacco industry forever. The new, larger Reynolds will have a stronger product portfolio, but it will also have a large amount of debt (though this should fall over time.) Altria is not worried about the impending deal, however, as the company already has a leading market share and lower debt that gives it more room to maneuver.

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