Why Is No One Excited About Lorillard?

| About: Lorillard, Inc. (LO)
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Summary

Reynolds is buying Lorillard for cash and stock.

At today's prices Lorillard is trading at a significant discount to the purchase price.

There is limited risk of the deal not going forward.

This summer there was a quiet press release from Reynolds American Inc. (NYSE:RAI) that they would be purchasing Lorillard (NYSE:LO) for stock and cash. While LO has been slowly rising in price since the announcement, the price is highly discounted from the Reynolds offer price, a discount that I find an attractive investment opportunity.

The proposed transaction is this: for each share of Lorillard the shareholder will receive $50.50 and .2909 shares of Reynolds. Other important terms include these:

1. British American Tobacco (NYSEMKT:BTI) will buy $4.7 billion worth of RAI shares. Following this transaction LO shareholders will own 15% of RAI. BTI currently owns 42% of RAI and this $4.7 billion purchase allows them to maintain their ownership percentage in RAI at 42%.

2. RAI will sell to Imperial Tobacco (ITYBY) several well-known brands (Kool, Salem, Winston) and LO's eCig brand, Blu, for $7.1 billion dollars.

Surprisingly LO is trading at a 9.1% discount to the transaction price, based on the closing prices 12/01/14: RAI $65.65 and LO $63.25. The value of the remuneration to the LO shareholder at this RAI price is $69.59, computed as follows: 0.2909 x 65.65 plus $50.50.

This discount seems particularly large considering that 72.5% of the remuneration to LO shareholders is in cash; only 28% is subject to marketplace fluctuations of RAI stock. (Computed based on current deal value for each LO share of $69.67).

An examination of the risks to the transaction will decide if this deep 9.4% discount is reasonable or if the market has mispriced these shares.

Risks include these:

Financial resources: RAI will need $18.164 billion dollars cash to pay the LO shareholders. But RAI is getting $4.7 billion from BTI and $7.1 billion from Imperial. Add to this $2.2 billion in cash which RAI and LO currently have. Thus RAI already has $14 billion of the $18.2 billion cash needed. With its investment grade rating and the proposed substantial savings arising from the merger of the two companies, RAI's ability to finance the balance of the cash required, $4.2 billion, is highly probable.

Shareholder support: RAI claims that the price to LO is a 40.4% premium to LO's price before rumors and anticipation of a deal boosted the value of LO shares. That is a big premium, especially when the number of possible buyers for LO is small. As to RAI, it's their deal, but the full support of their 42% owner, BTI, cannot be more clearly stated than BTI's willingness to provide $4.7 billion in support of the transaction.

Antitrust barriers: The proposed transaction has some remarkable pro-competition elements. Imperial tobacco today has only 3% of the US tobacco market, with net revenue of $0.5 billion. After this proposed deal, Imperial jumps to a 10% share and $2 billion in net revenue. (See Imperial presentation at www.imperial-tobacco.com). Imperial is a global company and appears a stronger long-term competitor than LO, with US revenues only 24% of the company's total net revenues post-transaction.

I must emphasize that I am not an antitrust expert, but while this transaction on the one hand eliminates the #3 competitor in the US cigarette market, it also takes Imperial from the #5 position with only 3% of the market to the #3 position with 10%. It sells to Imperial many well-known brands, such as Kool, Winston, and Salem. Note that Imperial is picking up those brands directly from RAI. RAI's menthol brands go to Imperial. LO's eCig business also goes to Imperial. Another characteristic of the transaction is that it involves multiple brands. If there were some antitrust concerns, there is more opportunity in this transaction to make changes to satisfy federal regulators. I rate antitrust action as a real risk but with a low probability of blocking the transaction.

Regulatory risk: The cigarette industry always has some degree of risk from the FDA announcing new rules and/or a new inquiry as well as risk from the courts of lawsuits filed and judgments announced. RAI and LO do not tell us what provision for this risk is made in the transaction agreement. However, except for some continuing concern over FDA action on "menthol" brands, the risks would seem to apply to all parties and therefore have a low probability of derailing the transaction.

While the discount embedded in LO's current share price is 9.1% measured using the total value of LO stock at today's transaction value of $69.59, the upside for someone buying LO at $63.25 and waiting for the deal to complete is higher: 10% based on the $6.34 difference between LO's current price and LO's current deal remuneration for each LO share, plus one or two dividends of $.615 on LO stock before the transaction closes, which would represent an additional gain of approximately 1% for each dividend.

None of the risks discussed in this article explain why LO is trading with a 9.1% discount to the RAI offer. According to Reynolds this deal is expected to close in the first half of 2015. With no significant risk factors and an expected 11.1% return (including at least one dividend payment before the close) in a period of approximately 6 months, this seems to be an excellent opportunity to buy shares in LO, receive a nice chunk of cash in the near-term, and end up with a stable dividend paying stock, RAI.

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.