Reynolds American and Lorillard – A Merger to Ignore

This marriage of tobacco stocks reportedly is closer to becoming reality, but there's little to be excited about

   
Reynolds American and Lorillard – A Merger to Ignore

Rumor is getting closer to reality. The Wall Street Journal reported on Thursday that tobacco stocks Reynolds American (RAI) and Lorillard (LO) are in “advanced” talks on merging.

Lorillard Reynolds American and Lorillard   A Merger to IgnoreIf the two tobacco stocks are able to work out a deal, the combined company would control about 42% of the U.S. cigarette market. Altria (MO) — the owner of the iconic Marlboro brand — currently has 51% of the market.

Here’s what this means for investors — both current and looking.

Back in March, I questioned the wisdom of a merger for Reynolds American, as Lorillard’s menthol cigarettes have become something of a regulatory and political lightning rod. Perhaps RAI has handicapped its odds (or has, ahem, inside knowledge based on conversations with regulators) and found that a ban on menthol is unlikely.

I certainly would hope that is the case. Because Lorillard is highly dependent on its menthol lines, such as Newport, and their ban would mean, for all intents and purposes, the end of Lorillard as we know it today.

I understand the appeal of securing market share in a declining market. As I wrote in March:

“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.”

It’s hard to see a lot to get excited about here, and it appears that Mr. Market agrees. Normally, when a merger is announced, the share price of the company to be acquired — in this case, Lorillard — jumps while the share price of the acquirer falls slightly.

But today, both LO and RAI declined on the news of the rumored merger.

What’s the Trade?

Really, there’s not one. At least not now.

I would recommend avoiding LO stock for the time being. Given the political risk associated with its primary product, there is little upside and potentially disastrous downside. Were Lorillard trading at a significant discount to its peers, I might consider it worth the risk. But it’s not. In fact, at 4%, LO stock has the lowest dividend of the three Big Tobacco stocks mentioned in this article.

Frankly, I would also avoid RAI. The move for Lorillard seems reckless to me, and I’d rather look elsewhere for my income stocks. Why accept the political risk of big tobacco stocks for a yield of less than 5% when you can build a portfolio of safe, solid REITs with rising payouts with comparable current yields?

If you put a gun to my head and force me to buy a Big Tobacco stock, I’m going with Altria. It’s the biggest and best managed of the lot, and also the most diversified. Altria owns a 27% interest in global beer giant SABMiller (SBMRY).

I own MO stock in a handful of dividend-focused portfolios I manage. But I should be clear: I don’t recommend making any major new purchases at current prices. I would like to see the stock drop a good 10% to 20% before making any major additions.

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 held MO in some client accounts. 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.


Article printed from InvestorPlace Media, http://investorplace.com/2014/05/reynolds-american-rai-lorillard/.

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