Smoke Coming from Cigarette Industry Merger Fire
On 7/15/14 (following market speculation since March 2014 and specific reports late in the negotiations), Reynolds American Inc. (NYSE-RAI) announced a cash-stock transaction to acquire Lorillard, Inc. (NYSE-LO) for $50.50 cash and 0.2909 RAI per LO share (~75%/25% stock/cash split). The deal value was ~$68.88/share based on the RAI closing price of $63.18 on 7/14/14; the RAI share price declined 7.2% by the end of last week which implied a $67.56 deal value. The stated deal value is a 40.4% premium to the LO $49.04 closing price on 2/28/14 (last trading day prior to rumors of a potential sale); the RAI stock price increased 24% over the same period. The deal spread VWAP during over the first five trading days post-announcement was $6.65, a 10.9% gross return (excluding net dividend pickup of $0.42/quarter) of LO’s $61.05 VWAP over the same timeframe. The deal spread has mostly traded in the $5.75-$7.50 range and closed yesterday at $6.37 (10.4% gross return); we are using mid-2015 for our estimated closing date.
The deal involves the participation of two other tobacco industry players – British American Tobacco p.l.c. (LSE-BATS) and Imperial Tobacco Group PLC (LSE-LMT). BATS, RAI’s largest holder (222.3M shares / ~42% S/O), signed a voting support agreement and will invest an additional ~$4.78B (at $60.16/share) to maintain its percentage ownership in RAI post-closing. The two companies also have an agreement-in-principle to pursue an ongoing technology-sharing initiative. IMT, the fourth largest international tobacco company, has agreed to purchase a number of brands as well as other assets and liabilities from RAI for $7.1B ($4.4B in proceeds net of taxes); RAI and IMT have a contract manufacturing agreement for a transition period. The LO/RAI transaction requires both shareholder approvals; there is a separate vote required from IMT shareholders on the asset acquisition. The LO deal requires HSR approval (as does the divestiture to IMT); closing is also subject to the IMT deal closing. RAI expects the transactions to close in the first half of 2015; the deal has an initial 7/15/15 term date (extendable for antitrust to 1/15/16).
We feel the current risk/reward is favorable relative to the current 50%-65% implied probability of deal completion (based on a $50-$55/share LO downside value). The LO stock price has dividend support (4.0% current yield) and a limited downside (14% at our $52.50/share midpoint) to offset the industry, market, headline and antitrust transaction risks that the deal could face over the next year. The litany of deal- and industry-related issues, including a $23B Florida jury verdict (for punitive damages) against RAI (reported days after the LO deal was announced), have resulted in the wide trading spread. We feel this transaction is the natural evolution of a highly regulated domestic industry that is in secular decline, burdened by marketing and sales restrictions; the cigarette business is not quite a failing industry but may be considered a flailing industry. In addition, we would not rule out (but not wildly speculate) potential for a third party bid from a foreign tobacco company if the LO stock price continues to trade at a greater than 10% gross discount to the stated deal price (and well below the low-mid $70s/share pre-deal expectations). Last, we sense the companies and their advisors would have not moved forward with an industry-transforming deal based on coin toss odds (or slightly better); the advertising phrase “4 out of 5 doctors recommend” provides a much more convincing view than “1 out of 2” or “2 out of 3” and conveys “fairly certain with caution” rather than “wreckless riverboat gambler.” Other general observations at the early stage of the transaction follow:
• LO shares, which traded up to the $65-$67 range on speculation of an imminent deal with a value in the low-mid $70s, sold off hard post-announcement due to the disappointing high-$60s value; the deal size, anti-trust risk, headline risk and expected long time-to-close should keep the deal spread wide (at least in 2014);
• RAI shares, which had steadily traded up from the high-$40s after merger rumors began circulating in March 2014 to the low-$60s pre-deal, now has overhang from the additional shares to be issued to BATS (whose non-competition agreement with RAI expires on 7/30/14) along with an unanticipated loss of equity value from the taxes resulting from the planned asset divestiture to IMT;
• The planned divestiture of LO’s blu eCigs brand to IMT (in favor of keeping RAI’s VUSE Digital Vapor Cigarettes brand) appears to have been totally unanticipated; the e-cigarette market is rapidly expanding and consumers seem to be embracing this alternative nicotine delivery system (which may ultimately be to the bane of tax-backed bonds that rely on a pre-rolled cigarette tax revenue agreement); and
• While most of the risks of smoking have been fully vetted and understood for at least a generation, the LO/RAI transaction may serve as a “call of duty” for both mainstream and grassroots political groups to come out and actively/vocally oppose the transaction as well as muddy the antitrust waters; we would not underestimate to potential visceral reaction to this deal and the menthol smoking issue adds another level of complexity to the full-bodied acquisition bouquet.
• LO shares, which traded up to the $65-$67 range on speculation of an imminent deal with a value in the low-mid $70s, sold off hard post-announcement due to the disappointing high-$60s value; the deal size, anti-trust risk, headline risk and expected long time-to-close should keep the deal spread wide (at least in 2014);
• RAI shares, which had steadily traded up from the high-$40s after merger rumors began circulating in March 2014 to the low-$60s pre-deal, now has overhang from the additional shares to be issued to BATS (whose non-competition agreement with RAI expires on 7/30/14) along with an unanticipated loss of equity value from the taxes resulting from the planned asset divestiture to IMT;
• The planned divestiture of LO’s blu eCigs brand to IMT (in favor of keeping RAI’s VUSE Digital Vapor Cigarettes brand) appears to have been totally unanticipated; the e-cigarette market is rapidly expanding and consumers seem to be embracing this alternative nicotine delivery system (which may ultimately be to the bane of tax-backed bonds that rely on a pre-rolled cigarette tax revenue agreement); and
• While most of the risks of smoking have been fully vetted and understood for at least a generation, the LO/RAI transaction may serve as a “call of duty” for both mainstream and grassroots political groups to come out and actively/vocally oppose the transaction as well as muddy the antitrust waters; we would not underestimate to potential visceral reaction to this deal and the menthol smoking issue adds another level of complexity to the full-bodied acquisition bouquet.
The primary antitrust concern is the potential addition by the number two player (with a ~26% overall market share) to add Newport (the leading menthol-driven cigarette brand with an overall ~12% U.S. market share) to its product portfolio; the planned divestitures (KOOL, Salem, Winston, Maverick brands) have ~4% market share. By combining Newport with the core Camel brand, RAI should be better able to compete (in a government-regulated industry sense) with Altria Group Inc. (NYSE-MO), which had ~49% of the U.S market in 2013. Blocking the deal would be like blaming the victim for the injury to their business; RAI has restructured (by eliminating brands, reducing manufacturing and operating expenses as well as developing new tobacco-related products) to address market regulations and further industry consolidation is the logical next step. The smokeless tobacco market is already highly concentrated; RAI is the second largest player (33% market share in 2013) behind U.S. Smokeless Tobacco LLC (56% market share), which was acquired by MO in 2009 ($10.4B cash deal).
We feel the already restrictive regulatory environment in the U.S. for cigarette sales and marketing has already fostered a consolidated market; penalizing the deal on the basis of too much market concentration completely contradicts public policy that over decades has legislated limiting competition and increasing prices to further a public health agenda. There should be heated discussions on further concentration in an industry that produce, markets and sells politically-incorrect tobacco products; none-the-less, cigarette sales continue to be an important source of state and local government tax revenues. Despite all the health and well-being rhetoric, civic institutions that have been trying to save citizens from the “ravages” of cigarette smoking are themselves addicted to the steady source of tax income from cigarettes. Government agencies have spent decades prohibiting and/or modifying prior industry behaviors (such as health claims/warnings, the type/placement of advertising and preventing underage smoking). The pre-rolled cigarette market already has limited competition and high barriers of entry; the current market structure is the handiwork of federal and state regulations. The symbiotic relationship between government and the cigarette manufacturers is not likely to be severed any time soon. We feel the standard antitrust review analysis may morph into Punch and Judy puppet-like routine, with the deal ultimately being approved (possibly with some behavioral restrictions).
The stated $68.88/share deal value ($26.7B EV) implies LO consensus 2015E multiples of 4.8x EV/Revs ($5.52B, up 4.7% YoY), 11.4x EV/EBITDA ($2.33B, ~42% margin, up 6.4% YoY) and 18.1x P/E ($3.80 EPS, up 9.8%, 1.8x PEG ratio using a 10.3% LT growth rate). Assuming $500M LO-specific deal savings, the adjusted deal multiples are 9.4x EV/EBITDA ($2.83B) and 14.8x P/E (4.67 EPS). Based on a 20 prior day averaging closing price of $63/share ($34B market cap), RAI had implied 2015E multiples of 4.5x EV/Revs ($8.19B, up 1.4% YoY), 10.8x EV/EBITDA ($3.45B, ~40% margin, up 6.5% YoY) and 17.2x P/E ($3.66 EPS, up 8.3%, 2.6x PEG ratio at 6.7% LT growth). LO gets 85% of its revenues from Newport sales; the high brand concentration combined with the ongoing menthol-related issues (health impact and demographic skew) discounts are reflected in our LO downside value which we estimate to be $50-$55/share (multiples of 9x EV/EBITDA and 14x P/E at the $52.50/share midpoint). In comparison, industry leader MO at $42/share ($83.45B market cap) has 2015E implied multiples of 5.2x EV/Revs ($17.9B), 11.1x EV/EBITDA ($8.5B, 47% margin) and 15.2x P/E ($2.76 EPS, 2.3x PEG). Absent the asset divestiture to IMT ($4.4B net cash proceeds after taxes) but including the full $800M savings estimate, P/F debt leverage would be 3.8x adjusted EBITDA (3.3x net of cash but excluding deal expenses). RAI is currently at the low end of the investment grade credit rating scale; the BATS $4.8B equity should support the company in not becoming a non-investment grade issuer post-closing.
The wide deal spread reflects the large deal size and complexity, as well as the deal being on the tail end of a large number of announced major mergers and acquisitions (above $10B market cap). The “risk” has come back to “risk arbitrage” with LO/RAI being embolic of a complex transaction that until recently had not been put forth in great numbers during this abnormally long low interest rate environment. The current risk/reward seems favorable; LO shares have dividend yield support and a limited downside which should support the stock price relative to industry, market, headline and antitrust risks that may be encountered in the deal review.
