Reynolds American (NYSE:RAI) recently announced, after much speculation, that the company will be acquiring Lorillard (NYSE:LO). This acquisition has caused the stock to move down from $63 to $56 as the news caused those speculating on the acquisition to flee the stock. I believe that now is the time to buy the stock, as the long term investors are the only ones left holding the stock. Short term news won't cause the stock to have further gyrations. Now that we are able to focus on the long term, it is easy to see how this acquisition makes the company poised for earnings growth as the product portfolio has gained significant strength. With the markets getting hit because of concerns over in Ukraine, it seems as if now is the perfect time to look at a defensive stock like Reynolds American.
I will now describe the acquisition and then I will go into what it means for the company in the long term. The acquisition actually involves four companies. Besides Lorillard and Reynolds American, the acquisition also involves British American Tobacco (NYSEMKT:BTI) and Imperial Tobacco Group (OTCQX:ITYBY). Reynolds is acquiring Lorillard for $27.4 billion and British American Tobacco is maintaining its 42% ownership stake in the company. This maintenance of ownership required the company to make an investment of $4.7 billion. Reynolds said on the conference call that British American Tobacco would need to acquire all of Reynolds' shares to be able to control the company, which it does not plan on doing. Lorillard shareholders will own 15% of the shares of the combined two companies. Lorillard shareholders will get $50.50 in cash and 0.2909 of a share of Reynolds American. This would be the equivalent to $68.88 per share of Lorillard or a 40.4% premium to the stock based on the February 28th closing price. This is the day before the media started to report the possible transaction, which altered how the stock would have been traded. The acquisition will certainly be approved by Lorillard shareholders because the 13 times 2013 EBITDA multiple is on the high end for acquisitions in the tobacco industry.
The main reason behind Reynolds pursuing this deal was because they wanted to acquire the Newport brand which is the second largest cigarette brand in America and the number one mentholated cigarette brand by market share. As of the second quarter of 2014 Newport had a 12.8% market share in the cigarette industry in America and had a 37.1% market share in the menthol cigarette category. The brands that Reynolds will own after the deal is completed are the following: Newport, Camel, Pall Mall, and Natural American Spirit in the combustible category; Grizzly in the smokeless tobacco category; and Vuse in the e-cigarette category. The forecasts are for the combined companies to have $11 billion in revenues and $5 billion in operating income.
Because of possible FTC concerns Reynolds American wanted to show that this transaction will not hurt competition within the industry. Therefore, the company divested the brands KOOL, Salem, Winston, Maverick, and blue Cigs to Imperial for $7.1 billion in cash. This makes Imperial into a legitimate number 3 competitor in the industry as the company will go from having 3.5% market share in America to a 10% market share. Reynolds believes that since Altria (NYSE:MO) is still the largest player (about 50% market share) and it sets prices, having a legitimate competitor to it and adding a solid third player in the industry would be good for competition. The deal would give the combined companies a 34.1% market share in the U.S. tobacco market.
Citi states that the deal has 55% to 60% chance of getting approved by regulators. I believe that it will be approved by regulators because Reynolds is selling the market leader in electronic cigarettes, blu, to Imperial. In 2013 the market for e-cigarettes was $520 million and blu had a 39% market share. As of last quarter blu had a 40.9% market share; it is gaining share in a category that is the one bright spot in a negative growth industry. In a less complicated deal in 2003, Brown and Williamson merged with RJ Reynolds Tobacco giving the combined companies a 32% market share. Since this was approved, I believe that the acquisition of Lorillard will be approved.
This merger has many moving parts which means that the company's management cannot spike the football and say that the deal is great for Reynolds, but it will hurt another party. It's just like when a trade is announced in sports. The general manager praises the player that he/she is giving up, but clearly he/she did not value that player highly or else he would have never have traded him/her. Reynolds cannot start claiming that the company will obliterate the market share of blu because it is a key piece to the FTC allowing the deal to go through. The deal will be decided upon sometime in the first half of next year.
Besides the regulatory hurdle, there are three main problems that investors have with this acquisition. I will quell these worries. The first is that the company paid too much for Lorillard. To put the 13 times EBITDA multiple in perspective, Imperial Tobacco is buying the divested brands that Reynolds is selling for 9 times EBITDA before tax considerations. The second problem that investors have with this deal is the worry that the menthol cigarettes category could face serious regulation issues. The third issue is that the company is giving up the blu brand, which left investors scratching their heads since blu was the market leader in the only category that has significant growth ahead of itself in the tobacco industry. The first issue on price I will be further discussing as I analyze the company's prospects going forward. In short, the Newport brand makes the valuation acceptable because it is gaining market share in the menthol category which is losing sales at a slower rate than non-menthol cigarettes. This makes the assets more valuable than the assets that Reynolds divested. Those assets were declining significantly more quickly than Newport is. The issue that regulators would ever make menthol cigarettes illegal is not significant. In a nation that is on the cusp of legalizing marijuana, it would be counterintuitive to start making products such as menthol cigarettes illegal or have sales restrictions on them. I can go through the case by case examples of each FDA study on mentholated cigarettes, but I feel that it is not necessary. Simply the fact that millions of Americans love flavored menthol cigarettes and that the tobacco industry employs the best lawyers in America is enough for me to believe that this would never happen.
The third issue is the most exciting for Reynolds American because it represents a growth opportunity, not a loss of an important business. With my analysis of the Vuse brand I will be segueing into my full analysis of the company after this transaction is complete. Vuse is the digital cigarette brand that Reynolds is banking on to transform the tobacco industry. Currently Vuse is in only 21,000 retail stores and it will be fully expanding to 140,000 stores by the first quarter of next year. A huge ramp up in stores will occur in the first week of September. The confidence that I have in this brand stems from the firm's results in Colorado which Vuse is already in. In Colorado the Vuse products have a dominant market share position. Vuse has a 67.6% market share, while the blu e-cigarettes only have a 15.6% market share. Vuse is also the market leader in Utah. These are the only two states that Vuse has been sold in and has data on. The reason why I am very optimistic about the possibility of Vuse replicating this success throughout the nation is the fact that of the over 50% of smokers that try e-cigarettes only 1.5% keep using them. Consumers are clearly not satisfied what is currently on the market and this leaves Vuse with a great opportunity to take control of the market. The acquisition is at a perfect time because the Reynolds can say that they are selling the market leader in blu to Imperial. In fact, blu will likely no longer be the market leader in two years in the e-cigarette category.
Vuse is a digital cigarette; it is fundamentally a different product from the other e-cigarettes. You can watch a demonstration of the product in this video. Vuse is actually the world's first digital vapor cigarette. The Vuse product contains a microprocessor that controls the precise temperature of the cigarette. The power unit costs $10 and the fluid cartridge costs $6 for two. Each liquid cartridge is the equivalent of a pack of cigarettes. The liquid connects nicely to the power unit with a magnet. Reynolds is partnering with British American Tobacco in a joint technology sharing strategy, so the company will be able to maintain its innovative edge that it currently has in this category.
RJ Reynolds stands to garner $800 million in cost savings from this deal. More importantly this deal is a part of a transformation in the growth profile of the company. As you can see in these pie charts the company went from having 25% of its brands in growth categories to having 90% of its brands in growth categories after this transaction is complete.
The Newport brand has experienced spectacular share gains since 2003. The Newport market share in menthol cigarettes has gone from 32.2% in 2003 to 37.1% in 2Q 2014. The other two brands that are considered to be in the growth category that the company is focusing on and have a significant market share are Camel and Pall Mall. The Natural American Spirit brand is actually the fastest growing brand in America, but it only has a 1.6% market share. The Grizzly brand is the number one brand in the moist-snuff industry. It gained 0.7% in market share last quarter to currently have a 31.4% share in the space. Going back to the Newport acquisition, as you can see in this chart the company has complementary geographic sales strengths with Lorillard.
After this acquisition is complete the company will be able to compete with Altria in every single region in the country.
The company plans to remain investment grade during this acquisition. It will be lowering its dividend payout from 80% to 75% of net income until it pays off the new debt that it is incurring. The leverage ratio will go to 3.6 times equity after this transaction. The company plans to lower this ratio to below 3 within 2 years.
I recently purchased this stock on the pullback after the announcement was released. The stock is a solid bet in the market we are currently in. Ukrainian based fears will not cause this stock to go down, so it can be your safe haven. The company is in a great position to capitalize on the future changes in the tobacco industry. Newport is a brand that is more popular with younger smokers. This will certainly help the company since having older people smoking your product does not bode well for your long term profitability considering the mortality rate among smokers. The Vuse product will also help the company's future profits as the rate of smoking is decreasing by about 4% each year. Holding a stock with over a 4.5% dividend yield is a great decision for the long term health of your portfolio.
The main risk to this thesis is the deal not going through because of regulatory concerns. There is also a lawsuit for almost $24 billion against Reynolds American that is currently undergoing an appeal from the company. The chance of it being upheld is very low, so I don't think that it is an issue worth worrying about.
Disclosure: The author is long RAI. 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.