In processing the events surrounding the Lorillard, Inc. (NYSE:LO) acquisition by Reynolds American, Inc. (NYSE:RAI), it seems as if the market didn't necessarily agree that this was considered a "done deal." I tried to find information to help decide which direction this might fall. I have to give credit to Seeking Alpha commenter Andrew Hutsell. While I believe he found what could arguably be one of the most helpful pieces of information on this acquisition, I think he may have missed the bigger implication. I decided to write this article in order to expound on the details.
This is also the second time that Reynolds American has acquired the third largest cigarette manufacturer in the market, which occurred last time with a unanimous FTC vote. Many similarities exist with the prior acquisition.
It All Begins With Menthol
It appears that Hutsell found something interesting in a discussion about the FDA targeting menthol cigarettes. The FDA has banned other flavors of cigarettes, and now the focus has turned to menthol cigarettes. Hutsell's argument was that menthol cigarettes compose 85% of Lorillard's sales, and thus a ban would shutter Lorillard's sales to the point where they are no longer contributing money for the Master Settlement Agreement. Many states depend on this for financing a variety of projects, so the FDA/federal government has some incentive to ensure there is no ban on menthol cigarettes.
Master Settlement Agreement
In May 1994, Mississippi Attorney General Mike Moore sued 13 tobacco companies under the premise that they should reimburse the state for medical costs incurred as a result of treating people who had illnesses related to tobacco products. After awhile, 40 other states had also begun litigation against the tobacco companies. The Master Settlement Agreement was the vehicle to combine all of those lawsuits and reach one agreement. In the end, 46 states were a part of the agreement, which includes ~$200 billion paid out over 25 years. Some further quick reading on the Master Settlement Agreement can be found here.
So How Does It Affect the Acquisition?
One of the provisions in the MSA is that the Original Participating Manufacturers can reduce their payment based on their market share and cigarette sales volume. The market share was set in 1997. As a company reduces their market share below their percentage in 1997, they are granted a discount on the amount they pay each year. If the volume of cigarettes sold in a particular year is lower than what was sold in 1997, they receive another discount. When this money is paid out to the settling states, there are no stipulations on how the money is spent.
As cigarette sales declined sharper than expected in the years after the MSA, it is in the best interest of the government to encourage acquisitions to increase an Original Participating Manufacturers' cigarette sales. This limits the sales volume discount. There isn't necessarily money lost to the states by having multiple competitors, as each pays a percentage of their market share, but as each has a lower volume of cigarette sales, it decreases the payments.
Bonds Come Into Play
States wanted to have their money up front. They were able to put together bond offerings on the future income from the MSA. As the income from the MSA decreased, this has put these bonds into the junk bond category. Moody's reported in July 2012 that 74% of these bonds are at risk for default. As states have backed these bonds in secondary pledges, it will force payments by the states if the industry status quo is maintained. If the FTC intervenes and blocks the acquisition, states stand to lose twofold: first for the continued decrease of tobacco income from the settlement, and the next for backing the bonds.
History Repeats Itself
How can we find insight into what will happen with the FTC decision? Look back in time. It's scary how closely this acquisition resembles the 2004 acquisition of Brown and Williamson by R.J. Reynolds Tobacco Holdings, Inc. (now Reynolds American). At the time, Phillip Morris had 50% market share, and Reynolds expected to rise to 30% market share after the acquisition. Reynolds anticipated $10 billion in annual sales (they've since decreased it seems) and $500 million in savings from synergies. Jones Day acted as the legal counsel for Reynolds, and achieved a unanimous vote from the FTC on the acquisition.
They argued that since the MSA the cigarette market had been diluted by smaller manufacturers. Since the previous acquisition, we have clear evidence that it did not create a duopoly. Altria now has 51% of the market share, and Reynolds American hopes to have 33% market share after the acquisition and divestiture of some brands. They expect $10.9 billion in revenue, and $800 million in savings from synergies. In addition, the market has recently been flooded with electronic cigarettes that have decreased cigarette sales, akin to the argument that there were smaller manufacturers in 2004.
Imperial Wins Big
While it seems that this acquisition will move forward, it appears that the biggest winner of all is actually Imperial Tobacco Group Plc (ITYBY). Imperial will purchase the Kool, Salem, Winston, Maverick, and Blu e-cigarette brands, along with Lorillard's operations. This will cost $7.1 billion. The 2013 net sales of these divestitures was $2.4 billion. Reynolds American just spent $27 billion to increase their sales by $4.3 billion (based on 2013 net sales). It appears Yellen's comments that day didn't sit well with investors because even Imperial Tobacco Group decreased 5.16% on this news. This should be a quite a catalyst for Imperial, whose net sales last year were $1 billion.
Imperial increases their net sales 300%, while Reynolds American only adds back 60% of their current net sales. In addition, everyone is looking to the divestiture of Blu e-cigarettes. This has the largest market share of the growing e-cigarette market in the U.S., but Reynold's is banking on the 67% market share Vuze had in the test-bed state of Colorado as indicator that it will be more successful. While Reynolds may do very well with the acquisition, Imperial definitely gets the bargain here.
Disclosure: The author is long LO. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
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