Waiting for Smoke to Clear on Lorillard/Reynolds Merger Rumor

(LO, $53.61, up $4.55 at today’s market close)

(RAI, $53.29, up $2.46 at today’s market close)

Today’s financial rumors indicate that tobacco company Reynolds American Inc. (RAI, $53.29) is potentially interested in acquiring Lorillard Inc. (LO, $53.61).

Morgan Stanley commented on the rumors in a neutral manner this afternoon, indicating that the U.S. tobacco industry is already quite consolidated, and that the industry awaits FDA clarification on its position on menthol tobacco products.  Reynolds and Lorillard are purveyors of dominant menthol cigarette brands Newport and Kool, respectively.

In addition, there is a question as to whether Reynolds American will retain its corporate independence.  Here’s why:  In 2004, Reynolds purchased Brown & Williamson Tobacco Co. from British American Tobacco PLC (BAT), giving BAT a 42% ownership in Reynolds.  BAT’s 10-year moratorium on acquiring additional Reynolds shares expires this year on July 30.  Will BAT purchase enough additional shares of Reynolds to make Reynolds its subsidiary?

Wall Street expects Lorillard’s earnings per share (EPS) to grow 12%, 9%, and 7% in 2014 through 2016.  The price-earnings ratio is 15.4, in a steady ten-year range of 7-18, and the dividend yield is 4.59%.  IF Lorillard were acquired at a price reflecting a PE of 18, that buyout price would be approximately $62.82.

The reason that I have not recommended Lorillard shares at Goodfellow LLC is because the long-term debt ratio is 238%.  My goal with stock investing is to find ways to make money while also minimizing risk.  As such, I rarely recommend stocks with debt ratios higher than 40%.

 

What to do with Lorillard shares?

First off, I own shares in Lorillard.  When markets get choppy, I tend to buy big dividend stocks while they’re low, because they tend to have far less volatility than other growth stocks.  It was my previous intention to buy Lorillard during an orderly pullback in January, collect the March dividend and sell near the November high of $53.27 as the stock rebounded.

Now that the company might be in play, I’ll hold my shares and see what materializes.  I think the risk/reward ratio is in my favor, and that the near-term downside is nominal, at maybe $51.  I have no intention of purchasing additional shares at the current price, although M&A speculators would certainly have reason to consider doing so.

Goodfellow LLC rating:  Hold, Growth & Income, Public.  (03-03-14)

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Send questions and comments to research@GoodfellowLLC.com.

Happy investing!

Crista Huff

President

Goodfellow LLC

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