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How To Profit From The Historic Big Tobacco Merger

Thursday, July 17, 2014 - 2:45pm

After six months of investors sitting on the edge of their seats, watching tobacco stock prices climb, it's finally here...

The Big Tobacco merger.

The second-largest U.S. tobacco company, Reynolds American (NYSE: RAI), has agreed to buy Lorillard (NYSE: LO), the third-largest U.S. tobacco company, in a deal valued at more than $27 billion. Assuming it passes regulatory scrutiny, the deal is expected to close in the first half of next year.

The combined company would dominate the U.S. tobacco market, producing two of the three leading U.S. brands of cigarettes: Camel and Newport. (The top-selling brand, Marlboro, is produced by Altria Group (NYSE: MO).)

It's one of the more complicated buyout offers in recent memory, involving four of the five biggest U.S. purveyors of tobacco products. To minimize antitrust issues, Reynolds and Lorillard both will sell assets to Imperial Tobacco Group (OTC: ITYBY). Concurrently, British American Tobacco (NYSE: BTI) plans to purchase a large amount of Reynolds shares.

Reynolds American
Key to the acquisition is Reynolds' reach for Lorillard's leading menthol brand, Newport, giving it 62% of the menthol market. At a time when traditional cigarette sales are consistently trending downward, menthol cigarettes are both profitable and gaining market share, currently 31.4% of total U.S. cigarette sales.

With this merger, Reynolds is signaling its lack of concern over the likelihood that the U.S. Food and Drug Administration (FDA) might restrict or even ban the use of menthol in cigarettes.
Reynolds will retain its Vuse brand of e-cigarettes, which is being rolled out nationwide.

Post-merger, Reynolds' bottom line includes about $400 million in cost savings, loss of $1.2 billion annual profit from divested brands, and a $2.7 billion income tax liability from the asset sale to Imperial Tobacco.

Morgan Stanley expects Reynolds' earnings per share (EPS) to grow 5% in 2014, followed by post-merger growth of 7.8%, 10% and 10% in the next three years.

The forward price/earnings (P/E) ratio is 17.4, at the high end of its 10-year range. The long-term debt-to-capitalization ratio is 50% and will likely increase next year with merger costs.

Typically during mergers and acquisitions, the company doing the buying sees its stock price fall or stagnate. RAI reached all-time highs this month, then fell immediately upon the buyout announcement.

Known for its substantial dividend (currently yielding 4.3%), RAI should settle into a new trading range around $56 to $60. With the merger on the horizon, the stock is extremely unlikely to surpass recent highs around $63.

When the buyout rumors materialized and LO began climbing, I urged investors to hold on to their shares, suggesting that they use tight stop-loss orders in case a buyout didn't materialize.

LO had a big run-up to new highs on half a year's worth of buyout speculation, then fell 10% when the announcement finally arrived. At price support around $59, the stock price is far enough below the buyout value that new investors could make about 15% (including the 3.8% dividend) between now and the merger's expected close next year.

LO investors who accept the exchange for cash and RAI stock (an expected $50.50 and 0.29 shares of RAI for each share of LO) should be prepared for a confusing cost-basis calculation upon their eventual sale of RAI. It would be simpler to sell LO when it peaks near the merger price, then buy RAI on its next pullback.

Imperial Tobacco Group
To help alleviate antitrust concerns, Britain's Imperial Tobacco will purchase several of Reynolds' and Lorillard's cigarette brands in a debt-financed $7.1 billion deal. Lorillard's sales force and manufacturing facilities are included with the purchase.

With the acquisition of Lorillard's e-cigarette market leader, Blu, Imperial will become the third-largest seller of tobacco products in the U.S. The company will aim to establish Blu as the leader in the growing international e-cigarette market, where there is no distinct brand leader.

In addition, Wells Fargo expects e-cigarette sales will outpace sales of tobacco cigarettes in the U.S. by 2020. The acquisition of Blu should give Imperial a leg up on this trend, but it should be noted that Blu is not yet a profitable brand.

Like most foreign stocks trading in U.S. markets, Imperial's dividend payout varies. The dividend payouts are typically split about 70/30 on two pay dates each year, in February and August, with annual increases. The current yield is around 4.5%.
ITYBY broke through long-term price resistance this spring. There's short-term support around $88.

British American Tobacco
In 2004, Reynolds purchased Brown & Williamson Tobacco Co. from British American Tobacco, giving British American a 42% stake in Reynolds. To help pay for its purchase of Lorillard, Reynolds will be issuing more stock, and British American plans to purchase $4.7 billion of RAI shares to maintain its 42% stake. Due to this expense, British American plans to suspend its £1.5 billion (about $2.6 billion) buyback plan.

As with Imperial Tobacco, this foreign stock pays dividends twice yearly, in May and October. The recent yield is a generous 5.4%.

BTI broke out to the upside in April, reached new highs this month, and has been in a trading range since May. There's short-term price support at $118 and $114.50, and upside resistance at $123.

Altria Group
Altria is the only major U.S. cigarette competitor that isn't involved in the Lorillard buyout. If the merger falls through, it's also the sole company in this group that can be expected to remain relatively stable.

Despite a mature U.S. cigarette market, Altria is increasing its earnings through cost reductions, share repurchases, and rising sales of menthol cigarettes and higher-margin smokeless tobacco products. Wall Street expects EPS growth of 6% to 8% a year over the next three years.

MO's current dividend yield is 4.5%. The stock had a nice run-up in the spring to new highs this month and is settling into a trading range between $41 and $44.

Risks to Consider: Antitrust issues could derail the Reynolds/Lorillard deal, and the FDA could take action against menthol. Of course, tobacco companies are always susceptible to health-related lawsuits, and the e-cigarette trend might fail to develop further.

Action to Take --> These tobacco stocks should appeal to income investors. RAI is likely to stagnate until the close of the merger, but it also offers the best long-term growth opportunity of these five companies. LO in the sweet spot, offering investors a 15% short-term return as the stock rebounds to the buyout price.

High-yielding stocks like these that have plenty of cash for dividend growth are the foundation for my colleague Amy Calistri's "Daily Paycheck" investing strategy. To see how Amy's used this strategy to earn more than $60,000 in dividend checks since 2010, click here.

Crista Huff does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.

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