When it was announced that Reynolds American (NYSE:RAI) was arranging a bid for smaller peer Lorillard (UNKNOWN:LO.DL), the market celebrated. Now that the party has died down, some have started to ask if the deal will actually occur.
Taken by surprise
Without a doubt, Reynolds' rumored swoop on Lorillard was a surprise for many. Lorillard's best-selling product is the Newport brand of menthol cigarettes, which continues to report rising annual sales. This bucks the general trend of a long-term decline in U.S. smoking rates. However, there is still uncertainty over the U.S. Food and Drug Administration's stance on menthols, and there remains a chance that the FDA could move to ban or regulate menthol cigarettes; such a move would decimate Lorillard. It is widely expected that the FDA will release a decision on the menthol matter soon, although it appears Reynolds does not want to wait.
Unlikely to go ahead
The menthol debate is part of the reason Citigroup analysts believe this deal is unlikely to happen. Citi's opinion on this matter is important; unlike private investors, Citi's analysts met with Reynolds' management recently to get a feel for what the company's plans are.
All in all, Citi believes that Reynolds is unlikely to make a bid for Lorillard, and this is a view I share. There are several important factors to consider. These include the uncertainty currently surrounding the regulation of menthol cigarettes as well as the problems Reynolds would face getting approval for the merger from British American Tobacco (NYSE:BTI), Reynolds' largest shareholder. What's more, it is unlikely that Reynolds could secure sufficient financing to offer an attractive price for Lorillard.
The overriding factor here is British American's majority ownership of Reynolds. Fortunately, British American has a reputation for good management, so it is unlikely that it would give the green light on a Reynolds-Lorillard deal until 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 year-end, 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.
The other option
The other option is, of course, the possible takeover of Reynolds by British American. Citi's analysts have reiterated this case, stating, "[T]he fundamentals of Reynolds' business increase the company's attractiveness." In analyst speak, this means that Reynolds is a well-run, profitable business with good long-term prospects.
Specifically, Reynolds has good relations with its customers and an attractive electronic-cigarette segment, which would complement British American's existing offering and global presence. However, Citi believes that a joint venture between Reynolds and British American is more probable than a takeover, as this would allow British American to access Reynolds' e-cig technology without having to jump over regulatory hurdles.
Citi believes that if British American does acquire Reynolds, the Anglo-American company would then make a swoop on Lorillard. Such a move would consolidate its position within the U.S. tobacco market and put it in a great position to take on industry behemoth Altria Group.
In conclusion, it would appear that Reynolds American is the most attractive takeover target in the tobacco industry currently, and many analysts agree. Unfortunately, this makes a deal with Lorillard unlikely in the near future. But if a deal between British American and Reynolds occurs, Lorillard could be next in line.
Rupert Hargreaves owns shares of Altria Group. The Motley Fool owns shares of Citigroup. 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.