Tobacco Deals May Light Up After Six-Year Lull: Real M&ATara Lachapelle
Tobacco takeovers may be about to catch fire again after smoldering for six years.
Lorillard Inc., the maker of Newport cigarettes, rose 9 percent this week through yesterday amid speculation that Camel maker Reynolds American Inc. will bid for the $19 billion company. While neither confirmed deal talks, Stifel Financial Corp. said the second- and third-biggest cigarette sellers in the U.S. would fit well together and Lorillard’s growing Newport brand would help Reynolds with its declining market share.
Americans have cut tobacco spending by 15 percent since the industry’s last major deal, when Marlboro owner Altria Group Inc. agreed to pay about $10 billion for UST Inc. to add Skoal snuff, according to data compiled by Bloomberg. British American Tobacco Plc -- which owns 42 percent of Reynolds and can raise its stake after July -- could help finance a purchase of Lorillard, Exane BNP Paribas said. Reynolds could also sell some brands to Japan Tobacco Inc. to focus on Newport, the No. 1 U.S. menthol cigarette, Nomura Holdings Inc. said.
“If the growth rates are going to be coming down meaningfully in this industry, I’d expect M&A activity to pick up,” said Timothy Pettee, Jersey City, New Jersey-based chief investment strategist for SunAmerica Asset Management Corp., which oversees about $28 billion and owns shares of Lorillard and Reynolds. “Slower growth and large cash reserves -- that’s where this is coming from. These companies are awash in cash and as they look at slower growth, they’re going to deploy that cash.”
Representatives for Winston-Salem, North Carolina-based Reynolds, Greensboro, North Carolina-based Lorillard, and London-based British American Tobacco, known as BAT, declined to comment on the companies’ takeover plans. Representatives for Tokyo-based Japan Tobacco didn’t immediately respond to requests for comment.
Lorillard jumped 9.3 percent on March 3, its biggest one-day gain in two years, after the Financial Times reported that Reynolds hired Lazard Ltd. investment bank to explore a bid, citing unidentified people familiar with the situation. An offer could value Lorillard at more than $20 billion, though it’s unclear if Reynolds plans to buy the entire company, according to the paper.
Lorillard’s Newport cigarettes accounted for 85 percent of last year’s revenue, which was about $5 billion after excise taxes. Its other brands include Maverick and Kent, as well as two types of electronic cigarettes.
U.S. tobacco companies are grappling with declining smoking rates, sales taxes and a shift toward e-cigarettes. Last year, Americans spent $88.9 billion on tobacco products, down from about $111 billion a decade earlier, according to data compiled by Bloomberg from the Tobacco Merchants Association. The prevalence rate of smoking in the U.S. also slid to 18 percent in 2012 from 22.5 percent in 2002, according to the most recently available data.
The need to diversify and restore long-term growth may drive consolidation, said Kenneth Shea, an analyst for Bloomberg Industries in Skillman, New Jersey.
“The tobacco industry could be a fertile area for M&A activity,” Shea said in a phone interview. “There’s a lot of permutations of things that could happen.”
A tie-up of Reynolds and Lorillard is one possibility, and the merged company may even appeal to BAT, he said.
As the industry faces a shrinking population of smokers, analysts predict Lorillard is poised for more growth than some of its competitors. Lorillard’s sales will climb 16 percent over the next three years, versus about 3 percent for both Reynolds and BAT, analysts’ estimates compiled by Bloomberg show.
A standstill agreement barring BAT from increasing its 42 percent stake in Reynolds ends in July, opening the door to the companies working together more closely.
Reynolds has long explored a merger with Lorillard though any such deal is unlikely right now, a person familiar with the matter said. BAT has also studied the merger because it would have an impact on the value of Reynolds and could require financing support from the British cigarette maker, said this person.
“Though there has been some speculation on BAT buying out Reynolds, helping Reynolds to buy Lorillard would make a lot more sense from a returns perspective,” James Bushnell, an analyst at Exane BNP Paribas in London, wrote in a March 4 note to clients.
Reynolds could pay as much as $80 a share for Lorillard, assuming about $400 million of synergies and cost reductions from a deal, which may boost earnings beginning in 2015, according to Bonnie Herzog, a New York-based analyst at Wells Fargo & Co.
An $80 bid would be a 65 percent premium to Lorillard’s average price in the 20 days leading up to the FT report. That would value Lorillard at almost $31 billion including net debt, or 14.6 times its trailing 12-month earnings before interest, taxes, depreciation and amortization, data compiled by Bloomberg show. Acquirers have paid a median of 13.3 times Ebitda for tobacco takeovers in the last decade, the data show.
A combination of Reynolds and Lorillard “makes a partnership even more compelling” for BAT and could be a “win/win for all parties” to market and sell e-cigarettes globally, Herzog wrote in a March 4 report.
Lorillard, which closed at $53.48 a share, isn’t worth more than $62 a share in a takeover, especially given the regulatory concerns surrounding menthol cigarettes, according to Chris Growe, a St. Louis-based analyst at Stifel. The company may face limits on selling menthol cigarettes in the U.S. after the Food and Drug Administration determined in a preliminary evaluation last year that the minty flavoring may encourage people to start smoking.
Today, Lorillard shares fell 2 percent to $52.39.
Reynolds and Lorillard “fit well together and could lead to significant cost reduction,” said Growe. At the same time, a takeover may be more appropriate after the FDA provides more clarity on its proposed rulemaking for menthol, which may happen later this year or in early 2015, he said.
There would be antitrust hurdles to a merger in the U.S. because it would reduce the number of major sellers from three to two, according to Thilo Wrede, a New York-based analyst at Jefferies Group LLC.
Japan Tobacco, which owns the Camel and Winston brands outside of the U.S., may seek to buy those brands from Reynolds, allowing Reynolds to acquire Lorillard and its Newport brand, David Hayes, a London-based analyst at Nomura, wrote in a March 4 report. Japan accounts for more than half of Japan Tobacco’s annual sales, data compiled by Bloomberg show.
“While selling Camel in the U.S. to Japan Tobacco may seem like selling the heart and core of the business, perhaps there is an argument to be made,” Hayes said. It would “provide Japan Tobacco with U.S. distribution, including a platform for e-cigarette development, something we argue Japan Tobacco and all the majors need.”
After reducing debt from its 2007 purchase of Gallaher Group Plc, Japan Tobacco is in “better shape for making another acquisition,” said Mikihiko Yamato, deputy head of research at JI Asia in Tokyo. “It’s more likely that they’d prioritize expanding their shares in Europe or the Middle East than suddenly entering the U.S. market, which is already competitive.”
A deal would be less compelling for Reynolds if it were forced to divest brands to satisfy antitrust authorities, said Erik Bloomquist, a London-based analyst at Berenberg.
“We’re relatively skeptical of all the bid speculation at the moment,” Bloomquist said in a phone interview. “We’re not convinced of the logic of Reynolds acquiring Lorillard, we’re not convinced of the logic of BAT acquiring Reynolds, and we’re certainly not convinced that Japan Tobacco would step in and buy brands that were sold off by Reynolds.”
Tobacco companies account for a large portion of U.S. tax revenue, which may give them more power in negotiating with regulators than some other industries have, Shea of Bloomberg Industries said. The U.S. tobacco industry pays more than $15 billion to the U.S. Treasury each year and more than $17 billion in local and state taxes, he said.
With e-cigarettes being lauded as a safer alternative and even considered by some to be smoking-cessation devices, it may be in the U.S. government’s interest to support the industry’s push into that market, according to Shea.
“There’s a lot of chatter about Reynolds and Lorillard and whether these two could even pass Justice Department muster,” he said. The tax revenue generated from tobacco sales and prospects for expanding e-cigarettes “are two big arguments that could dissuade a Federal Trade Commission decision to automatically throw a yellow flag if Reynolds and Lorillard decide to team up.”