Rumors are circulating around tobacco stocks today — namely, that Reynolds American (RAI) was preparing to acquire competitor Lorillard (LO), sending shares of LO stock and RAI up sharply higher today. Lorillard shares were up 9% as of this writing, and RAI stock was up 4.5%.
I should be clear, as of now these are rumors — nothing more, nothing less — and a Wells Fargo analyst that covers Big Tobacco has already publicly said that a merger is unlikely, citing the uncertainty surrounding the FDA’s regulation of Lorillard’s menthol cigarettes, among other concerns.
Still, what would a merger amid these huge tobacco stocks, if it were to happen, look like?
Reynolds American is the second-largest tobacco company operating in the U.S. after Altria (MO), the owner of the Marlboro brand, among others. Reynolds and Lorillard currently have market caps of 28.2 billion and $18.8 billion, respectively. So, the combined entity would hypothetically have a market cap, at $47 billion, that still was significantly smaller than Altria, at $73 billion.
But a couple points bear mentioning immediately.
Tobacco Stocks: Too Big, Too Many Issues
The regulatory concerns surrounding Lorillard’s menthol cigarettes aside, LO would be a hard acquisition to swallow for Reynolds American given its size. If financed by debt, Reynolds would likely have to more than double its debt load, currently at about $5.1 billion. The M&A market is heating up, but that would be a tough sell for even the most risk-seeking of bankers.
Secondly, it’s not clear what Reynolds would gain from the deal. LO stock and RAI stock trade at similar valuations based on trailing earnings, forward earnings and sales. So an acquisition would not be significantly accretive to Reynolds’ earnings per share.
“Economies of scale” and “synergies,” the justifications often given for mergers, also wouldn’t be much of a factor here, as tobacco marketing is severely restricted. Outside of perhaps combining logistical operations, it’s hard to argue that these two companies would be worth more together than separate.
There is the issue of e-cigarettes. Lorillard is the best positioned among the major Big Tobacco players to profit from the rise of e-cigs and has an estimated 49% share of the e-cig market. But let’s get serious here. Lorillard did $6.95 billion in sales last year, and e-cigs accounted for an almost insignificant $230 million.
Don’t expect that gap to be bridged any time soon. By Bloomberg estimates, e-cigs won’t surpass traditional smokes until 2047, and that assumes that nothing changes on the regulatory front or, for that matter, that cigarettes in any form still exist three decades from now.
Long story short, I don’t see much value in a merger, and I don’t see it happening.
But with that said, a broader question is whether you should invest in tobacco stocks, and to that, I have two thoughts:
For one, be careful over the next few days. As mentioned before, LO stock and RAI are up big on the merger hopes. When those hopes are dashed, I expect prices to come back down to earth.
And lastly, given current dividend yields, I consider Big Tobacco stocks decent (though not spectacular) income investments for the next several years. While I do have a position in Altria that I’ve had on “autopilot,” reinvesting dividends for the past several years, I consider a good portfolio of REITs and MLPs to be a better long-term income option with less risk.
Charles Lewis Sizemore, CFA, is the editor of Macro Trend Investor and chief investment officer of the investment firm Sizemore Capital Management. As of this writing, he was long MO. Click here to receive his FREE weekly e-letter covering top market insights, trends, and the best stocks and ETFs to profit from today’s best global value plays.