July 1 (Bloomberg) -- Speculation that Lorillard Inc. will strike a deal with Reynolds American Inc. is heating up the options market.
Demand for bullish calls on Lorillard, the maker of Newport and Maverick cigarettes, reached a four-year high last month relative to puts, according to data compiled by Bloomberg. Short sellers have abandoned the stock during a 20 percent rally this year, leaving bets on declines at a one-year low, data from Markit Securities Ltd. show.
Reynolds explored the purchase of Lorillard for several months with its efforts stymied by the complexity of a potential agreement, people with knowledge of the matter said in May. Imperial Tobacco Group Plc’s decision to sell assets in Spain may alleviate antitrust concern between the biggest sellers of tobacco after Altria Group Inc.
“It wouldn’t surprise me if something gets announced soon,” Bonnie Herzog, an analyst with Wells Fargo & Co. in New York, said in a phone interview yesterday. “There’s no question that you have tremendous synergies and cost savings.”
Traders have increased ownership of bullish options as Lorillard rallied, and now own 1.1 calls for every put, the highest ratio in a year, data compiled by Bloomberg show. Among the eight contracts with the highest ownership, six were calls.
Combining Reynolds and Lorillard would rank as the biggest-ever tobacco merger, creating a company with more than $13 billion in annual sales to rival Altria’s nearly $18 billion in yearly revenue, according to data compiled by Bloomberg.
Robert Bannon, director of investor relations at Lorillard, didn’t immediately respond to a phone call or e-mail requesting comment on the options trading. Jane Seccombe, a spokeswoman for Winston Salem, North Carolina-based Reynolds, declined to comment on merger speculation.
Discussions of a merger may be helped by Imperial’s plans to sell as much as 30 percent of its stock in its Madrid unit, Compania de Distribucion Integral Logista Holdings SA, next month, according to Francis Alexander, a fund manager for Alexander Capital Management and Jacob Asset Management’s Wisdom Fund. The stake sale puts Imperial in a better position to purchase assets that Reynolds and Lorillard may have to offload, he said.
“That may be the catalyst that could allow the two to merge,” Alexander said by phone June 30.
Bullish options are getting more expensive. Calls betting on a 10 percent increase in Lorillard’s shares cost 2.11 points more than puts betting on a similar-sized drop, according to three-month data compiled by Bloomberg. The spread, known as skew, dropped to 0.93 on June 19, the lowest since July 2009.
The change in skew “definitely could be representative of investors anticipating a potential bid for Lorillard,” Jim Strugger, a derivatives strategist at MKM Partners LLC in Stamford, Connecticut, said by phone.
The Chicago Board Options Exchange Volatility Index, the gauge of S&P 500 options prices known as the VIX, fell 3.6 percent to 11.15 today.
Short sellers are pulling out of Lorillard, with the number of shares borrowed and sold to speculate on declines down 62 percent this year. About 4.2 million Lorillard shares were sold short at the end of last week, the fewest since May 2013, according to Markit data.
There’s a good chance that a deal won’t happen and the shares decline, according to David Hayes, a London-based analyst at Nomura International PLC. Reynolds could agree to manufacture Lorillard’s products at its factories, increasing efficiency and reducing costs, he wrote in a June 18 note.
“Perhaps their aim is not a full merger but simply extended cooperation to boost efficiency,” Hayes wrote in a June 18 note.
The stock has rallied 24 percent since March and gains have been steady, with shares rising in every quarter since 2010 except one. The Greensboro, North Carolina-based company trades at 20 times profit, almost 50 percent higher than a year ago.
The tobacco industry may see more deals as companies focus on the fast-growing e-cigarettes and noncombustible products, including snuff, as cigarette sales decline, according to Bloomberg Industries analysts Kenneth Shea and Noel Hebert. Low borrowing costs and strong credit among companies could also fuel mergers and acquisitions, they wrote in a June 30 note.
Global acquirers made more than $913 billion of purchases last quarter, the busiest quarter for mergers and acquisitions since the third quarter of 2007, data compiled through June 27 show.
British American Tobacco Plc, the London-based cigarette maker, owns 42 percent of Reynolds. A standstill agreement barring the British company from increasing its stake ends in July. That could open the door to the companies working closer together amid a broader push for industry consolidation.
“People are getting bullish because they’re looking at the landscape and wondering what the next big deal is,” Sachin Shah, a special situations and merger-arbitrage strategist at New York-based Albert Fried & Co., said by phone June 27.
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