Here's the Real Winner of the Lorillard/Reynolds American Merger

In their eagerness to seal the deal, Lorillard and Reynolds American allowed Imperial Tobacco to swoop in and buy Lorillard's high-growth brand.

Bob Ciura
Bob Ciura
Jul 20, 2014 at 9:00AM
Consumer Goods

After several weeks of speculation, the big tobacco merger is happening. Tobacco giant Reynolds American (NYSE:RAI) will buy out close rival Lorillard (UNKNOWN:LO.DL) for $27 billion. The deal involves the second- and third-largest tobacco companies joining forces to take on the industry leader, Altria Group (NYSE:MO). Reynolds American's Camel brand and Lorillard's Newport brand will come together to try to unseat Altria's Marlboro as the No. 1 brand in the United States.

But unfortunately, it's not quite this simple. The acquisition involves some key aspects that investors weren't anticipating in the weeks leading up to the deal. The deal requires Lorillard to sell off its major growth engine. This leaves the combined entity even more vulnerable to an increasingly harsh view of menthol cigarettes.

That's why Lorillard shares collapsed by more than 10% on the day of the announcement. Despite the benefits it's getting in return, it's giving up a prized asset to get the deal done. That's why the real winner of the deal is Imperial Tobacco Group plc (NASDAQOTH:IMBBY).

Merger mania takes hold
In the aftermath of the deal, investors might be extremely surprised by what happened to tobacco stocks. Tobacco stocks across the board sunk, and Lorillard led the pack with a double-digit percentage loss. Considering the benefits of the deal, these moves came as a big surprise.

The deal brings a slew of benefits to both Lorillard and Reynolds American. As previously mentioned, Lorillard is tethered to menthol cigarettes and would be given valuable diversification with Reynolds American's traditional tobacco brands, such as Camel and American Spirit.

In addition, both companies are likely to see significant cost synergies. Since they share virtually identical manufacturing and distribution processes, the combined entity should be able to shed a great deal of overlapping costs. This should boost earnings soon after the merger closes.

Investors in Lorillard will receive $50.50 in cash and 0.2909 shares of Reynolds American per share as part of the deal. At the market close on July 15, the value of the merger stands at about $67.61 for each Lorillard share.

And yet Lorillard shares fell all the way to $60 per share.

What gives?
Investors in Lorillard will receive more than $67 per share if the deal closes, but Lorillard trades 10% below the deal price. Here's the reason for the discrepancy.

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First, regulatory concerns exist. As is usually the case when two large companies within the same industry combine, antitrust regulators may stop the deal. This isn't likely to happen, however. For better odds of getting regulatory approval, Lorillard sold off several brands. This is exactly what results in an unlikely winner, hidden beneath the headlines.

Imperial Tobacco Group will buy the Kool, Salem, Winston, Maverick, and Blu brands for $7.1 billion. This gives Imperial an instant foothold in the United States which represents a solid entry for a company with broadened international exposure. This purchase will triple its share of the cigarette market in the United States.

Even better, the acquisition gives Imperial the leader in electronic cigarettes. Lorillard had previously been a leader in e-cigs through its Blu brand, which was an important new category. Growth of e-cigs is really heating up in the United States, and Lorillard is effectively giving up its leadership position. Prior to the deal, Lorillard held nearly half of the e-cig market share.

Lorillard is putting its fate in Vuse
Lorillard isn't walking away from the e-cig market. Reynolds has its own e-cig brand called Vuse, which the combined company will retain. Both companies have high hopes for Vuse, since Lorillard was willing to let Blu go to get the deal done.

Vuse did enjoy a successful debut, which prompted Lorillard's faith. In its first two test markets, Colorado and Utah, Vuse was the top-selling brand. That gave Reynolds American enough confidence to take the product national, and presumably gave Lorillard confidence as well.

Vuse's innovative features include technology that monitors and adjusts heat and power to deliver a more consistent experience.

This could be a difference-maker that propels Vuse to the top, which Lorillard is counting on. If that doesn't happen and Blu continues to dominate the fast-growing e-cig market, Lorillard is going to look foolish for allowing Imperial to snatch up its prized asset.