Lorillard Bet on Merger Nod Offers Arb Payoff: Real M&A

The takeover of cigarette maker Lorillard Inc. is offering one of the biggest profit opportunities for investors willing to bet the deal won’t go up in smoke.

Lorillard’s stock closed 11 percent below the value of Reynolds American Inc.’s bid yesterday. The $7.58-a-share spread leaves more than $2 billion of potential profit up for grabs provided the Federal Trade Commission approves the transaction. The odds are good, because the combination probably won’t reduce competition, according to analysts from firms including Morningstar Inc. and Cenkos Securities Plc.

The deal spread is the widest among U.S. acquisitions bigger than $10 billion, including others being scrutinized over competition concerns such as Comcast Corp.’s purchase of Time Warner Cable Inc. and AT&T Inc.’s takeover of DirecTV. Even though Lorillard’s shares could drop about 20 percent if its merger gets scuttled, the risk-reward is compelling and losses could be minimized by Lorillard repurchasing shares in the absence of a deal, the analysts said.

“The market is mispricing the probability that the deal closes,” Philip Gorham, an Amsterdam-based analyst for Morningstar, said in a phone interview. “While there is downside -- and more downside than upside at this stage -- the probability of the deal closing is favorable enough that it’s worth a punt here.”

Big Merger

A representative for Greensboro, North Carolina-based Lorillard declined to comment. A representative for Winston-Salem, North Carolina-based Reynolds didn’t respond to a request for comment. The companies said in a statement last month that they still expect the merger to close in the first half of 2015.

Reynolds agreed in July to pay $50.50 in cash and 0.2909 of its stock for each Lorillard share, or about $24 billion, to combine the second- and third-biggest American tobacco companies. The merger would leave the U.S. with two competitors -- Reynolds and Altria Group Inc., the maker of Marlboro -- selling nine out of every 10 cigarettes.

To help ease antitrust concerns, Bristol, England-based Imperial Tobacco Group Plc will purchase the Kool, Salem, Winston, Maverick and Blu e-cigarettes brands from Reynolds and Lorillard. That will help make Imperial a more formidable competitor in a market where it currently has less than a 5 percent share.

‘Sensible Competitor’

“It is definitely the case, as far as I’m concerned, that the enlarged Imperial business can be considered a sensible competitor in the U.S. marketplace,” Rae Maile, a London-based analyst at Cenkos Securities, said in a phone interview. “From the point of view of the FTC and where the price leadership is in this industry, you’re not touching the market share of Altria. It’s got 50 percent and is still the market leader.”

Even so, the scrutiny has kept some investors at bay. Last month, Reynolds and Lorillard were asked for additional information from the FTC in what’s referred to as a second request. It gives the agency more time to vet the transaction, which caused some traders to abandon their bets while creating an opportunity for others who are still bullish the deal can pass regulatory muster.

Deal Concern

The Reynolds-Lorillard spread was about 13 percent yesterday, versus a low of 9 percent in July. It’s wider than that of other pending megamergers such as AT&T-DirecTV at 10 percent, Medtronic Inc.-Covidien Plc at 7.7 percent and Comcast-Time Warner Cable at 7.5 percent, according to data compiled by Bloomberg.

Each of those deals carries risk for investors -- DirecTV and Time Warner Cable because of the impact on consumer pricing, and Covidien because of the government crackdown on tax inversions. None offer as large of a return as Lorillard.

“The market seems to be pricing in some concern that the deal won’t get done,” Gorham of Morningstar said. “I think it will.”

Today, Lorillard shares rose 0.3 percent to $59.92 at 10:36 a.m. New York time.

The FTC will study how Reynolds’ and Lorillard’s various brands compete with one another, as opposed to making a decision based solely on their combined market share, according to Beau Buffier, a New York-based partner at Shearman & Sterling LLP and co-head of the law firm’s global antitrust group.

“It’s going to come down to analyzing scanner data and what that says about consumer-buying patterns,” Buffier said in a phone interview.

For instance, Lorillard’s Newport menthol cigarettes don’t compete on price with non-menthol brands, he said. “If you’re a menthol smoker, you’re probably not going to switch to non-menthol cigarettes in response to a small change in price.”

Pricing Issues

The merger may even benefit cigarette consumers, according to Gorham. Imperial will need to rejuvenate the tired brands it’s gaining, and one way to do that is to lower prices, which would force market leaders Altria and Reynolds to do the same, he said.

On the other hand, there’s a public-health benefit to increased cigarette costs because that can discourage smoking, so regulators may look favorably on the deal even if it means higher prices, he added. The prevalence rate in the U.S. has already been dropping, to 17.6 percent in 2013 from 20.9 percent a decade ago, according to data compiled by Bloomberg Intelligence.

Taxing Tobacco

Given that the tax on cigarettes partially determines their cost, it would be contradictory for one set of regulators to say a deal will cost consumers, while another branch of government drives up the price, according to Sachin Shah, a special-situations and merger-arbitrage strategist at Albert Fried & Co.

The federal excise tax increased to $1.01 per cigarette pack in 2009 from 24 cents in 1995 and the average state excise tax rose to $1.20 per pack from 32.7 cents, according to the Centers for Disease Control & Prevention.

“You’re talking about an industry that has some stagnancy to it and whose pricing is being controlled by the government,” Shah said in a phone interview. “How can the government complain that the deal isn’t in the best interest of consumers when you are charging the consumer a high tax to try to stop them from smoking?”

If the FTC does push back on the merger, Reynolds could always offer to sell off more brands, such as Natural American Spirit, Gorham said. The company’s main products include Camel and Pall Mall.

“The team from Reynolds are very, very smart people and this isn’t a deal that Reynolds has to do -- this is a deal which it would like to do,” said Maile of Cenkos Securities. “It would have never started this process unless it felt that there was at least a fighting chance that a deal could be structured in such a way that it could get FTC clearance.”

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