When it was announced that Reynolds American (NYSE:RAI) was putting together an offer for smaller peer Lorillard (UNKNOWN:LO.DL), the market celebrated. Now that the party's died down, though, some have started to ask if the deal will actually go ahead.
Taken by surprise
Without a doubt, Reynolds' rumored swoop on Lorillard was a surprise for many. You see, Lorillard's best-selling cigarette brand is the Newport brand of menthol cigarettes, which continue to report rising sales year after year and have bucked the general long-term decline in U.S. smoking rates. However, there is still uncertainty over the FDA's stance on menthol cigarettes and the FDA could move to ban regulate menthols; such a move would decimate Lorillard. It is widely expected that a decision on the menthol matter will be released by the FDA soon, although it appears Reynolds does not want to wait.
Lorillard was also a first mover in the U.S. e-cig market, which has allowed the company to grab a near 50% share of the country's still juvenile market. Reynolds could be attracted by this. The deal would lead to billions of dollars of synergies for Reynolds, allowing it to compete more effectively with industry behemoth Altria.
Not Reynolds' decision
Unfortunately, the final decision on this deal could be out of Reynolds' hands as Reynolds is 42% owned by Anglo-American company British American Tobacco (NYSE:BTI). As a majority shareholder, British American would have to give the go-ahead on a deal as large as this.
Fortunately, British American has a reputation for good management. It is unlikely that they will give the green light on a Reynolds-Lorillard deal unit the menthol issue is sorted. What's more, it's possible that Reynolds would have to ask British American for help funding the deal. Based on year-end 2013 numbers, it is questionable if Reynolds can afford to make the deal itself. This makes a request for funding or a cash call likely. Reynolds had $1.5 billion of cash at the end of the year, long-term debt of $5.1 billion, and a debt-to-equity ratio of 100%. Even if Reynolds were to stump up 50% of the estimated $20 billion needed to acquire Lorillard, the company's balance sheet would be put under immense strain.
More deals could follow
Of course, this deal chatter could be just the beginning of further consolidation within the tobacco industry.
As the volume of cigarettes sold around the world continues to decline, British American Tobacco is searching for growth. For this reason, it is likely that the company will make a move to acquire the part of Reynolds that it does not already own. At present, though, British American is not allowed to increase its ownership of Reynolds as there is a standstill agreement still in place from when the initial stake was acquired ten years ago. The agreement prevents British American from boosting its share in Reynolds until expiration. The agreement is scheduled to expire during July of this year.
Unlike Reynolds, British American has a relatively clean balance sheet and the company would be easily able to find the cash to acquire Reynolds without having to ask anyone's permission. This means that a deal between these two companies is looking increasingly likely.
Rupert Hargreaves 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.