The Reynolds American - Lorillard Deal Is Threatened By The FDA

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 |  Includes: LO, MO, RAI
by: Rupert Hargreaves

Summary

The Reynolds - Lorillard deal is not done yet and there are still threats ahead.

The FDA is considering regulating menthol cigarettes, which would hit the new, larger Reynolds hard.

Debt and anti-trust issues are also a concern.

The announcement of the much anticipated deal between Reynolds American (NYSE: RAI) and Lorillard (NYSE:LO), raised mixed emotions from investors.

On one hand, the deal will create a tobacco giant to rival industry leader Altria (NYSE:MO), potentially usurping Altria's dominance over the U.S. tobacco industry. On the other hand, some believe that the merged company will reduce competition within the market. Some also believe that Reynolds' offer undervalues Lorillard.

There is a more pressing issue that could derail the whole deal, not necessarily now but at any point over the next decade. This issue is the U.S. Food and Drug Administration's position on menthol cigarettes.

The FDA makes a stand

The FDA tried to make a stand on menthol cigarettes last year, when the agency opened up a 60-day public comment period back during July, intended to help inform the rule-making decision.

The European Parliament recently introduced a law banning the sale of menthol cigarettes from 2022 -- this increases pressure on the United States to act.

However, demand from the public to express the opinion was so strong that the agency extended the comment period to Nov. 22nd, after receiving numerous complaints from consumers that 60 days was not enough to gather sufficient evidence.

Along with this comment period, the FDA began funding three different menthol related studies in order to put together sufficient evidence that will allow the agency to make an informed decision. The studies are as follows:

  1. To look at whether genetic differences in taste perceptions explain why certain racial and ethnic populations are more likely to use menthol cigarettes.
  2. To compare exposure to smoke-related toxins and carcinogens from menthol and nonmenthol cigarettes.
  3. To examine the effects of menthol and nonmenthol compounds in various tobacco products on both tobacco addiction and toxicants of tobacco smoke.

The ethics of both tobacco investing and smoking in general are two touchy subjects, but when talking about menthol cigarettes, the situation becomes extremely complicated.

Complex debate

Not only are menthol cigarettes blamed for converting youngsters to the habit of smoking, but they are also popular among African-American smokers, which has fired up the race debate. It is estimated that 83% of African-American smokers use menthol cigarettes; by comparison, just 24% of white smokers use menthol cigarettes. Further, some analysts have made claims that menthol cigarettes are extremely popular with African-American, Asian and Hispanic children with higher smoking rates than white children.

Not only are menthol products an ethical minefield when it comes to race, it has been claimed that younger smokers prefer the 'softer' menthol flavor. With 88% of adult smokers claiming that they started smoking before the age of 18, menthol products become a big target in the war against tobacco. The FDA believes that if you remove the flavoring, you remove the desire for under 18s to start smoking, cutting smoking rates.

According to the University of Michigan 2013 Monitoring the Future study, there seems to be no evidence to support this claim. During 2009 the FDA banned all cigarettes with characterizing flavors, based on the thesis that flavored cigarettes, make smoking more palatable. According to the Monitoring the Future study, there was almost no change (outside of the current trend) in smoking prevalence among 8th, 10th and 12th graders following this ruling.

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Oddly, over the same time period, the prevalence of marijuana usage rose around two percentage points across the three sample groups; That's a debate for another day.

Every debate always has two sides and in this case, the argument to keep menthol products on the shelves is supported by law enforcement agencies.

Plenty of support

Law enforcement agencies have taken the side of big tobacco, stating that a ban on menthol cigarettes could lead to a rise in organized crime and black-market activity -- something the agencies do not want to contend with, especially when there are many other things they could be spending their time on.

This information, and the debate goes back to 2013, since then both sides of the argument have been relatively quiet on the issue. Paul Carey III, chief of enforcement for the Northern Virginia Cigarette Tax Board, wrote to the FDA to express his concerns last year. He stated that

"The contraband market would thrive under a ban, and would increase criminal activity, including activities by organized crime and terrorist groups,"

These comments have also been supported by the 1,000-member Alabama State Troopers Association, a former supervisory U.S. Marshal from North Carolina, and Michael Robertson, former director of the North Carolina Alcohol Law Enforcement Agency and previously, the 40,000-member National Troopers Coalition, an advocacy group for state troopers and highway patrol officers, as well as the National Organization of Black Law Enforcement Executives, both of which warned that a menthol ban "would create flourishing criminal enterprises."

Most recent development

The most recent development in the menthol debate, is the landmark move by a judge, which ordered that a recent report from the U.S. advisory board on tobacco was null and void. The court found that members of the panel advising on the report had conflicts of interest.

Specifically, the court found that three of the nine panel members, which advised on the report, had advised the FDA on smoking cessation products. Further, it was found that several panel members had served as paid expert witnesses in lawsuits against tobacco firms. As a result, the judge ordered the panel reconstituted and barred the use of its findings on menthol cigarettes.

The findings of the study, which have now been barred, were published within the 2011 Tobacco Products Scientific Advisory Committee's report. The report stopped short of recommending a full ban on menthol products. However, the report did conclude that the presence of the flavoring within cigarettes, makes it more likely that people will start smoking and less likely that they will quit.

These finding have their roots in the September 22nd 2009 ruling from the FDA banning cigarettes with characterizing flavors, a consequence of the Family Smoking Prevention and Tobacco Control Act. This particular ban was based on the thesis that flavored cigarettes, make smoking more palatable.

How will this affect big tobacco?

According to ratings agency Standard and Poor's, the menthol issue is the single biggest threat to the Reynolds - Lorillard merger -- an easy conclusion to draw.

Around 90% of Lorillard's income is derived from the sale of Newport branded menthol cigarettes. As a result, the combined Reynolds - Lorillard will rely on menthol sales for a significant portion of its income, especially as the two tobacco giants are divesting a number of smaller brands to appease anti-trust concerns -- around 30% of Reynolds' sales are menthol, through the company's Camel menthol brand.

Assuming the transaction goes through, Reynolds will have acquired itself an improved product portfolio overall. The company's new cigarette portfolio will consist of the Newport, Camel and Pall Mall brands, which are some of the fastest growing cigarette brands within the U.S.

Then there is the company's ultra-premium cigarette brand, Natural American Spirit, which is growing rapidly, although it still has a less than 1% market share.

And finally, Reynolds is retaining ownership of Grizzly, the U.S.' Number One smokeless tobacco brand. This is not to mention Reynolds' own VUSE e-cig brand. All in all, Reynolds is set to capture a 37% market share of the domestic cigarette market, and a 30% share of the smokeless market when the deal completes.

Still, according to Standard & Poor's, around 60% of Reynolds - Lorillard operating income after the merger will be derived from the sale of menthol cigarettes.

Altria is not as exposed to menthol. Specifically, only around 20% of Altria's sales are menthol cigarettes, the company's menthol Marlboro brand.

The biggest risk that Reynolds - Lorillard now face going forward is the possibility of menthol regulation. Most analysts agree that the FDA will make a move on menthol before the end of the decade. A total ban is unlikely, although regulation of some degree is expected. The chances are that regulation on menthol will either lead to a) higher costs, b) falling sales, either way, profits will take a hit.

As Reynolds is about to take on a large pile of debt following its acquisition of Lorillard, an FDA-induced fall in menthol sales is the last thing the company needs.

Rising debt

Once again, according to S&P, Reynolds' leverage is expected to expand to 4x after the deal completes, from around 2x at present. That said, there will be significant cost synergies to be gained from the deal. Analysts believe that these synergies will allow the company to begin to reduce leverage from within two years after the deal completes.

S&P's analysts believe that Reynolds' leverage could fall to 3x within the next few years. While interest coverage from earnings before interest, tax, amortization, and depreciation would fall into the 6x region over the same period. It is believed that the company will generate around $1 billion per annum in free cash flow, after the payment of dividends, which will allow for the repayment of debt.

Reynolds' own forecasts put forward similar figures.

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Taken from Reynolds' 'REYNOLDS TO ACQUIRE LORILLARD' presentation.

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As a quick comparison, Altria has a current leverage ratio of 2x.

With so many variables, it's not possible to analyze how much of an effect a move by the FDA on menthols will have on Reynolds - Lorillard.

For example, we don't know what action the FDA will take; how this will affect sales, how income will be affected, how Reynolds' creditors will react, how Reynolds' long term credit profile will change -- all are unknown.

And then there is the issue of anti-trust regulators. There is no denying that Reynolds - Lorillard has gone some way to appeasing concerns, due to the sale of brands to Imperial Tobacco, but risks still remain. According to an article published by CBS earlier this month, in which an anti-trust law expert weighed in on the matter, the two companies will have a hard time getting the deal past enforcement agencies.

Since the merger will result in two major companies controlling 90% of the cigarette market, which could result in consumers paying higher prices, the deal will be thoroughly scrutinized. According to Joseph Bauer, a professor of law at the University of Notre Dame Law School:

"…Their attorneys must know something that I don't know if they think they are going to get it past the enforcement agencies…It's hard not to imagine them challenging this particular transaction…"

All in all, the risk of investing in Reynolds, or even Reynolds - Lorillard is unquantifiable. Altria would be a better pick.

Conclusion

So overall, the biggest risk facing the Reynolds - Lorillard deal going forward is the menthol issue. There is no telling when the FDA will make a move on menthol flavored cigarettes and the enlarged Reynolds could be caught out if it does not keep its debt pile under control.

In the near term, Reynolds has more pressing issues, such as getting the deal with Lorillard past anti-trust regulators, which could be harder than it seems.

Disclosure: The author is long MO. 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.