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Where to Place Your Bets for the Tobacco Industry's Next Wave of Consolidation

By Rupert Hargreaves – Mar 21, 2014 at 9:53AM

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Recent chatter that Reynolds American will acquire peer Lorillard has sparked speculation that other companies could walk down the same path.

Recent rumors that Lorillard (LO.DL) could be about to receive a takeover bid from domestic peer Reynolds American (RAI) has sparked a huge amount of speculation in the tobacco industry. Many analysts have been eagerly awaiting the industry's next wave of consolidation take overs as companies struggle to grow while the number of cigarettes sold around the word continues to decline .

Four companies under scrutiny
Analysts believe that investors should keep an eye on four companies that could spark the next wave of consolidation. Due to recent speculation, Reynolds American and Lorillard are two companies to keep an eye on. However, there is now also speculation that London-listed Imperial Tobacco (NASDAQOTH: ITYBF) could make a bid for Lorillard, as Imperial seeks to expand its presence within the U.S. following the acquisition of Commonwealth Brands (the fourth largest tobacco company in the United States) several years ago.

What's more, there is further speculation that British American Tobacco (BTI -0.48%) could pounce on Reynolds American, as it holds a 42% share in the company from an acquisition ten years ago. Speculation surrounding a deal of this kind has recently increased, as when British American originally acquired its holding in Reynolds, the company signed a standstill agreement, preventing it from increasing the holding for ten years, this ten year period finishes during July of this year.

Seeking permission
Unfortunately, as British American controls around half of Reynolds, analysts have started asking whether or not the Anglo-American company will allow Reynolds to make a move for Lorillard. In particular, analysts have raised concerns over the current situation regarding menthol cigarettes.

The potential regulation, or even banning of menthol cigarettes, has been a burning issue for the tobacco industry during the last few years and the FDA is expected to make a decision on the matter in the near future. More than three quarters of Lorillard's sales are menthol cigarettes, so the company is bound to feel an impact from any FDA decision. I have covered the menthol argument further here.

It is not just the potential regulation of menthol cigarettes that has analysts concerned about the potential Reynolds-Lorillard deal, however; the other issue is funding. With a debt to equity ratio of 100% already, it remains to be seen if Reynolds will be able to stump up the cash to acquire the company's smaller peer. Analysts believe that a fair price for Lorillard would be in the region of $20 billion, a sum that will put additional strain on Reynolds' balance sheet.

As a result, it is widely expected that Reynolds will either seek a merger with Lorillard, using stock as currency, or ask British American for help. Being the larger company with a cleaner balance sheet, British American could have the final say on this deal.

Still, a combination between Reynolds and Lorillard is likely to achieve somewhere in the region of $350 million in cost synergies for the two companies.

Other consolidation
As I mentioned briefly above, it is widely speculated that this talk of a deal between Reynolds and Lorillard could kick off a wave of consolidation within the tobacco industry. Imperial Tobacco is company most analysts believe will see merger activity although whether or not the company will become the hunter or the hunted is still up for debate.

With operations around the world that include both tobacco and logistics, it is believed that Imperial could make a juicy snack for a larger peer. It is unlikely, however, that the company will be taken over whole. Instead, analysts believe that Imperial will be brought out by a consortium of its larger peers such as British American, Philip Morris International, and Japan Tobacco.

The reasoning behind this belief is simple: Philip Morris International is unlikely to want Imperial's U.S. business, but its distribution network within Asia and Europe is attractive. Meanwhile, British American could be interested in Imperial's U.S. business while Japan Tobacco would be interested in acquiring Imperial's operations within Europe to increase its exposure on the continent. Nevertheless, I should remind you that this all remains speculation.

Foolish takeaway
As the volume of cigarettes sold around the world continues to decline, tobacco companies are struggling to find growth. This has sparked speculation that the industry could be set for a wave of takeovers. It would appear that Reynolds, Lorillard, and Imperial tobacco and the three companies most likely to become prey of larger peers.

Rupert Hargreaves has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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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