Cigarette manufacturer Lorillard (LO) is to be bought out by Reynolds American (RAI) for $69 per share, causing Morningstar analysts to raise their fair value estimate for Lorillard to the same price.
In connection with the deal, Imperial Tobacco (IMT) will acquire cigarette and electronic cigarette assets from the combined Reynolds-Lorillard entity for $7.1 billion. Strategically, we believe this is a sound move for Reynolds, creating a duopoly with Altria, which is good for pricing power and moats.
Although at 12 times pre-tax earnings, Reynolds has paid a full price to grab Newport, one of the crown jewels of the U.S. tobacco industry. We are maintaining our narrow moat rating for Reynolds at this time, but may consider revising it as we think this deal significantly improves Reynolds' competitive positioning.
The deal is also transformative for Imperial Tobacco, and although we will review the assumptions in our model, we doubt the deal will have a material impact on our valuation. Imperial will become a distant third player, with 10% share, and in our view the clear price taker.
British American (BATS) will retain its 42% holding of Reynolds by providing $4.7 billion of funding for the deal, an investment we do not expect to move the needle on our fair value estimate.
The biggest surprise, in our opinion, was the acquisition by Imperial of Lorillard's Blu e-cig business. The sale suggests that Reynolds is not chasing e-cigs at all costs, but instead regards them as a hedge against the loss of market share of cigarettes to these emerging technologies. We believe Blu was the sweetener to persuade Imperial to take the cigarette brands Reynolds wanted to dispose of rather than one of its marquee brands Camel or Pall Mall.
We are sceptical that the combined Reynolds-Lorillard company can achieve management’s estimated synergies of $800 million over two years, above our $400 million-$500 million estimate.
The deal values Lorillard at $27.4 billion, or 12 times 2013 pre-tax earnings, although given that we believe Reynolds stock, which will make up 27% of the funding, is currently 50% overvalued, we estimate the underlying valuation to be 11.2 times pre-tax earnings.
The headline valuation is in line with historical deals in mature tobacco markets, which have averaged 12.5 times since Imperial acquired Reemstma for 12.7 times pre-tax earnings in 2002, and we think it represents solid value for Lorillard shareholders. Although we are sceptical that the use of menthol will be banned by the U.S. Food and Drug Administration, and view the menthol risk factor as minimal, the risk still exists and we believe this valuation prices Lorillard at a level that overlooks that risk.
