After the rumor mill got running that Lorillard (NYSE:LO) was a possible buyout candidate earlier this year, shares of the cigarette maker started to climb and when Reynolds-American (NYSE:RAI) finally proved the rumors true and made its $27.4 billion offer the stock jumped even higher.
But as you can see, the tobacco giant was on the move higher even before talk of a potential merger started and after a year Lorillard's shares are now 42% above the previously traded level.
So with a merger on the table and its stock trading at elevated prices, is there any further room for it to move higher still?
A "cigar-stub" industry
Cigarette sales are a dwindling business, with industry volumes on a protracted decline. And though, at times, Lorillard is able to generate a positive turn in shipments, its volumes are also declining, even among its best-selling Newport menthol brand.
Eventually, industry tobacco sales will fall to such a level that analysts at Wells Fargo (NYSE:WFC) believe the electronic cigarette sales will surpass it. That won't come for some time yet, but e-cigs are expected to hit $10 billion by 2017 -- still just a relatively small percentage of the overall $100 billion tobacco industry -- but with triple-digit growth rates still in its future, and tobacco sales declining, the two will end up crossing over.
Although Lorillard currently has the leading electronic cigarette in blu eCig, and also bought the SkyCig brand in the U.K., market share is falling. Despite a national advertising campaign, blu's market share fell to 40.9% in the second quarter from 45% in the first and its peak of 49% in the third quarter of 201.
Partially that's a result of new competition entering the market as both Reynolds and Altria (NYSE:MO) rolled out nationally their own e-cig brands, but the swiftness of the fall suggests consumers weren't happy with the product to begin with and were looking for an alternative.
That may be the reason Reynolds agreed to sell blu to Imperial Tobacco Group as part of the merger agreement, preferring instead to stick with its own Vuse brand.
Vaping is also on the rise and the tobacco giants see enough of a threat to their e-cig sales that they're calling either for strict regulation or an outright ban. Personal vapor systems, as they're called, are open-system formats that often feature a liquid capsule that is inserted into a cartridge whereas e-cigs are battery-powered devices that heat a liquid nicotine solution in a self-contained disposable cartridge and create a vapor that is inhaled.
Although Lorillard remains far and away the industry leader in menthol cigarettes, with its Newport brand commanding a 37.1% share of the menthol market (up slightly from a year ago), and 12.8% of the total cigarette market, making it the second-best selling brand behind Altria's Marlboro, it does face the potential of new regulation.
The FDA really does want to ban menthol cigarettes, believing that while they create no more of a health hazard than regular cigarettes, they serve as a gateway to smoking for teens.
Because the mint-flavored cigarettes mask the harshness of tobacco, it's felt as though teenagers may be more willing to start smoking and get addicted to smoking, thus making it harder to quit. It was one of the reasons the agency banned flavored cigarettes, such as those infused with candy, fruit, or spice flavors (it's also one of the measures the tobacco companies want imposed on their vaping rivals, which face no such prohibition).
In the end, it's hard to see there being much upside left in Lorillard's stock beyond the disparity between Reynold's offer price and where the stock trades now. While it still generates sizable profits, despite its hurdles, and pays dividends that yield over 4% annually, it appears that there is a lot more downside risk facing the stock, and should the merger fail to beat the odds against it, Lorillard's stock would fall.
Rich Duprey has no position in any stocks mentioned. The Motley Fool recommends Wells Fargo. The Motley Fool owns shares of Wells Fargo. 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.