Tobacco companies are highly sought after by income investors for their high dividend yields. Tobacco stocks like Lorillard (NYSE:LO) operate profitable businesses with low capital requirements. This allows them to produce enough profits to pay high dividend yields, even though they are struggling to produce revenue growth in light of the decline in smoking in the United States. To compensate for this, tobacco companies are pursuing consolidation to produce growth.
This is why Lorillard is about to be acquired by rival Reynolds American (NYSE:RAI) in a deal worth $27 billion. Assuming the deal closes, and it's scheduled to be completed in the first half of 2015, a main consideration for investors is the ongoing safety of the combined entity's dividend. Fortunately, it looks like dividends should remain intact and continue to grow.
Teaming up to battle the industry giant
Lorillard revenue is flat over the first three quarters of 2014. Profits are down 4% in this period. Of course, it should come as no surprise that the main culprit for this is the ongoing decline in smoking in the United States. Lorillard's wholesale volume for Newport cigarettes fell 2% over the first nine months.
The merger makes a lot of sense from a business and a financial perspective. Lorillard is the top menthol cigarette company, as maker of the Newport brand. But menthol is facing increasing scrutiny, and it makes sense for Lorillard to diversify. Lorillard will join forces with Reynolds American, maker of cigarette brands including Camel, Pall Mall, and Natural American Spirit, and the two combined companies will, it is planned, be stronger together. The tobacco industry's No. 2 and No. 3 largest by revenue, both companies are trying to team up to more effectively combat the industry leader, Altria Group, maker of the Marlboro brand. Lorillard shareholders will receive $50.50 in cash and 0.2909 shares of Reynolds American per share as part of the deal.
Lorillard is a profitable company, and it holds strong brands. Total Lorillard retail market share of cigarettes increased to 15% last quarter. This is why Reynolds American wants its top brand, Newport, and the two companies' scale opportunities provide for additional cost cuts to boost profits.
Synergies to help grow earnings
Until Lorillard is acquired by Reynolds American, its dividend is safe. (Lorillard stock currently offers a 3.9% yield with a $2.46-per-share annual dividend while Reynolds American stock offers a 4.1% dividend yield with a $2.68-per-share annual dividend.) After the merger, the key question is how the combined company performs. In that regard, there seems to be little for investors to worry about.
Joining forces with Reynolds American will only strengthen Lorillard and create additional value for shareholders. Since they share virtually identical manufacturing and distribution processes, the combined entity should be able to shed a great deal of overlapping costs. Lorillard cut selling, general, and administrative costs in its cigarette unit by 10% last quarter, and this should continue after the merger. The two companies have identified $800 million in annual savings going forward, primarily as a result of eliminating corporate expenses.
In addition, the combined entity will cut the under-performing blu electronic cigarette brand. As part of the deal, Reynolds American is selling a number of Lorillard's brands, including blu e-cigarettes as well as Kool, Salem, Winston, and Maverick, to Imperial Tobacco Group. This will actually serve to boost profits, since blu has been a money-loser for Lorillard all year. In fact, Lorillard lost $48 million from blu over the first nine months of 2014, as compared to a $9 million profit in the same period in 2013. Reynolds American is keeping its Vuse e-cigarette brand.
Once Lorillard and Reynolds American merge, the combined company is projected to have over $11 billion in annual revenues and approximately $5 billion in operating profit. While investors won't have a view of the combined entity's future dividend until the transaction closes, it's very likely a 4%-5% yield will be a good bet. This is fairly average across the tobacco sector, and based on synergies, the company will likely be able to grow earnings enough next year to justify a dividend increase. Reynolds American expects the deal to be accretive to earnings in the first year. Lorillard and Reynolds American remain safe dividend stocks.
Bob Ciura owns shares of Altria Group. The Motley Fool has no position in any of the stocks mentioned. 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.