Will Reynolds American’s Dividend Be Safe After Lorillard Merger? (RAI)

On Tuesday, Reynolds American Inc. (NYSE:RAI) announced that the Federal Trade Commission had approved its merger with Lorillard, Inc. (NYSE:LO). The deal is expected to close in June, but certain concessions must be met to gain approval by the FTC. Reynolds American (NYSE: RAI)

RAI must sell four cigarette brands and the blu eCig brand to the Imperial Tobacco Group. When the proposed merger was initially announced last summer, Reynolds and Lorillard had already agreed to sell these brands to Imperial in an attempt to get ahead of regulators.

Imperial will pay $7.1 billion for the blu, Kool, Winston, Maverick, and Salem brands. Selling those brands not only helped appease regulators, but also gives Reynolds more cash to make the Lorillard purchase.

How the Lorillard Deal Will Affect RAI Stock

Let’s look at the numbers. Reynolds is paying $27.4 billion for Lorillard in a part-cash, part-stock deal. Each Lorillard share will receive $50.50 in cash and 0.2909 shares of RAI stock. The cash portion amounts to a little more than $18.1 billion. Subtracting the $7.1 billion Imperial is paying for the cigarette brands, Reynolds still needs $11 billion in cash to make the deal.

When we combine that $11 billion in cash that RAI needs to raise with $10.7 billion in Reynolds’ total liabilities, along with Lorillard’s total liabilities of $5.7 billion, Reynolds ends up with $27.4 billion in liabilities. Therefore, after the merger takes place, the new Reynolds will be roughly a $66 billion company that is expected have net income of roughly $2.5 billion ($1.4 from RAI and $1.1 LO, figure is prior to selling any brands) … but it will also carry a heavy debt load.

Due to share dilution as part of the merger deal, Reynolds will now have 104 million more shares outstanding, increasing the 532 million outstanding shares by 20%. Those extra shares mean a lot more mouths to feed with each dividend payment.

Let’s say Reynolds new share count sits at 636 million and the company does bring in $2.5 billion in net income. Assuming the payout ratio stays at its current 70% (based on projected 2015 earnings), RAI shareholders would be looking at $2.75 per share in the next year — good for a 3.5% dividend yield at current prices.

A 3.5% yield from the new Reynolds isn’t much changed from what the old Reynolds pays out, and it’s certainly less than U.S. competitor Altria Group Inc.’s (NYSE:MO) current yield of 4.1%.

Not to mention, RAI would be carrying much more debt than MO — $23 billion compared to just $13 billion — and would still be trailing MO in U.S. cigarette market share — 40% compared to Altria’s 47%.

And while a 70% payout ratio doesn’t make the dividend unsustainable, it does cap how much room Reynolds has to make significant increases in the payout.

At the end of the day, Reynolds shareholders don’t seem to have much to worry about when it comes to their dividend. RAI has been paying a dividend for the past 16 years and has regularly increased its amount, so we know management is dividend-friendly. But, there are still a number of factors to keep an eye on, particularly the payout ratio, debt levels and net income.

At this time, I believe Altria’s dividend is the safer bet, at least until we see how RAI performs after the merger.

As of this writing, Matt Thalman was long Altria. Follow him on Twitter at @mthalman5513.

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Article printed from InvestorPlace Media, https://investorplace.com/2015/05/rai-stock-lorillard-dividend/.

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