Lorillard is a Bad Deal for Reynolds American Investors

And then there were two.  Two of the three remaining American “Big Tobacco” companies announced today that they would be merging: Reynolds American (RAI) will be buying Lorillard (LO) for $27.4 billion, including debt assumed.

Reynolds and Lorillard combined have sales of $13.3 billion and a market cap of $55.3 billion as of yesterday’s prices, leaving Altria (MO), the maker of Marlboro and other iconic brands in the number one spot.  Altria has annual revenues of $17.7 billion and sports a market cap of $84.5 billion.  Breaking it out by market share, the new Reynolds will control about 42% of the U.S. cigarette market, Altria will control about 51%, and smaller and foreign brands will make up the rest.

I’ll be brutally frank here: I question the value of this merger.  Reynolds is paying a high price for what is, we should remember, a business in terminal decline.  As of yesterday’s close, Lorillard shares traded for 21 times earnings and at a dividend yield of only 3.8%—quite low by the standards of a tobacco company.

Let me be clear on something: I’m not necessarily opposed to buying stocks in industries that are in terminal decline.  Under the right set of conditions—barriers to new competitors, dominant market position, minimal need for new capital investment, ample cash flows for dividends and buybacks, etc.—stocks with shrinking businesses can be excellent investments.

But the key here is price.  An investment in a shrinking company only makes sense if it is priced at a deep discount to the broader market.  And Lorillard—as implausible as this is—trades at a slight premium to the S&P 500.

Forgetting price for a moment, the Lorillard deal also brings with it regulatory risk.  85% of Lorillard’s sales come from its menthol brands, and these have become a lightning rod in recent years.  The U.S. Food and Drug Administration has already banned most flavored cigarettes and reported last year that it believes menthol cigarettes contribute to youth smoking.

Reynolds is effectively making a $27.4 billion bet that the FDA will leave menthol cigarettes alone.  That seems reckless to me; it’s a bet with modest upside and potentially disastrous downside.

Is there a trade to make here?

Yes: Sell Reynolds if you own it and move on.

I’m not the biggest fan of tobacco stocks at current prices.  I have shares of Altria and Philip Morris International (PM) that I have owned for years as part of a dividend reinvestment strategy, but I haven’t invested any significant new money in these positions in years because I see better income options elsewhere, such as in REITs.

If you feel you must own tobacco stocks, then I would go with Altria or Philip Morris International.  While neither are fantastic bargains these days, neither have the potential regulatory time bomb that Reynolds does in its exposure to menthol.  At time of writing, MO and PM sport dividend yields of 4.5% and 4.1%, in line with RAI’s 4.3%.

This article first appeared on InvestorPlace.

Charles Lewis Sizemore, CFA, is the editor of Macro Trend Investor and chief investment officer of the investment firm Sizemore Capital Management. 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. 

 

Disclaimer: This material is provided for informational purposes only, as of the date hereof, and is subject to change without notice. This material may not be suitable for all investors and is not intended to be an offer, or the solicitation of any offer, to buy or sell any securities nor is it intended to be investment advice. You should speak to a financial advisor before attempting to implement any of the strategies discussed in this material. There is risk in any investment in traded securities, and all investment strategies discussed in this material have the possibility of loss. Past performance is no guarantee of future results. The author of the material or a related party will often have an interest in the securities discussed. Please see Full Disclaimer for a full disclaimer.

,