Recently it was announced that Reynolds American (NYSE:RAI) had struck a deal to acquire fellow tobacco-giant Lorillard (UNKNOWN:LO.DL) in a merger that combines the No. 2 and No. 3 U.S. tobacco companies. The merger comes with a surprising divestiture, which Imperial Tobacco (NASDAQOTH:IMBBY) is more than happy to acquire, that makes the price Reynolds is paying an even more unexpected feature of the deal. Now, a Lorillard shareholder is suing to block the merger. Given these facts, Lorillard shareholders may wonder if they're getting a raw deal.
A big surprise
Before getting to the price of the deal, let's investigate the biggest surprise in the combination: Lorillard is relinquishing blu eCigs, the leading U.S. e-cigarette company, as one of a handful of brands that will be sold to Imperial Tobacco to consummate the merger. Imperial is paying $7.1 billion for the brands – which also include KOOL, Salem, Winston, and Maverick cigarettes – from which Reynolds expects to net $4.4 billion after tax.
Lorillard acquired blu eCigs in April 2012 for $135 million. It captured a 47% market share in 2013 and is sold in over 136,000 retail outlets. Although Lorillard's entire e-cigarette segment – which includes U.K.-based SKYCIG as of October – generated just $230 million in sales in 2013, the category has demonstrated explosive growth that makes blu eCigs a valuable piece of the tobacco company's portfolio.
With blu eCigs now going to Imperial, Lorillard loses its key differentiator and essentially becomes a bigger Reynolds American. The main difference is that it retains exposure to menthol cigarettes. Given what they have to give up, Lorillard shareholders should be skeptical of the deal.
Is the price right?
Bloomberg reports that Lorillard shareholder Vincent Valentino is suing to block the merger. Valentino wrote in his complaint that, "[t]o the detriment of the company's shareholders, the terms of the merger agreement substantially favor Reynolds and are calculated to unreasonably dissuade potential suitors from making competing offers." He went on to explain that the deal materially undervalues Lorillard. Although it is not immediately clear what prevents a private equity firm or another company from making a bid, Valentino's claim that the deal is underpriced may have merit.
First, Imperial got a great price on its deal. The bundle of cigarette brands gives Imperial a 10% U.S. market share. By comparison, Lorillard's first-quarter cigarette share was 15%. Since blu eCigs was also swapped in the transaction, Imperial essentially recreates Lorillard's competitive position – albeit with smaller cigarette brands and without a stronghold on menthol cigarettes – for just $7.1 billion. Lorillard's market capitalization was about $17.8 billion before rumors started flying in early March. In other words, Imperial gets a $10.7 billion discount on Lorillard for 5% less market share and less exposure to menthol cigarettes.
Moreover, Lorillard shareholders may not have been compensated for the blu eCigs divestiture. Before the deal was announced, tobacco analyst Bonnie Herzog believed that Reynolds could pay as much as $80 per share – a price that assumed that blu eCigs would be transferred to the combined company. The actual price will be about $67 per share, depending on Reynolds American's stock price when the deal closes. Even if Herzog's value estimate was off by $13 per share, Lorillard shareholders do not derive any value from the sale of blu eCigs.
Not clear either way
Valuation can be difficult when high-growth subsidiaries and low interest rates are involved. The market is unimpressed with the price; Lorillard is down 9.5% since the news broke. Reynolds American and Imperial are also trading slightly lower. It seems that no company is getting as good of a deal as the market expected.
After the transaction goes through, Lorillard shareholders end up with $50.50 per share in cash and 16.44% ownership of a company that is expected to generate $5 billion in annual operating income. After multiplying $5 billion by 16.44%, you'll find that Lorillard shareholders will lay claim to $822 million of the combined company's operating income – about 40% of Lorillard's 2013 operating income. Reynolds American paid about $18.3 billion in cash for the remaining $1.2 billion of Lorillard's 2013 operating income, or a healthy 15 times earnings before interest and taxes.
By comparison, the market valued all of Lorillard's operating income at less than $18 billion before rumors of the acquisition began. That's a pretty good price, but you also have to consider what a great deal Imperial got on its acquisition – and that a better price for those assets might be out there.
Lorillard shareholders are not getting ripped off, but they could certainly be getting a better deal. Imperial established a strong U.S. base at a bargain price and Lorillard now has to compete with the leading U.S. e-cigarette manufacturer. Lorillard shareholders are getting paid much more than the market had previously valued its earnings, however, indicating that Reynolds American's price is far from a ripoff. As a result, shareholders should cheer Valentino's lawsuit if it paves the way for additional bids, but jeer it if it prevents a merger from going through.