Tobacco Tales: Will Lorillard and Reynolds Merge?

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Earlier last week, there were reports that America’s second largest tobacco producer, Reynolds American (NYSE:RAI), hired investment bank Lazard (NYSE:LAZ) to look into a potential acquisition of rival tobacco producer Lorillard (NYSE:LO). As is expected, Lorillard shares soared on the news, and the shares trade now at $53 each. While enthusiasm for the deal has abated somewhat, we find that there are definite advantages to the deal; but there are also pitfalls, particularly from the perspective of Reynolds American.

Let us look at the advantages. First, there is an inherent advantage in competing in a market with fewer participants. The vast majority of the tobacco market in the United States is controlled by three companies: Altria Group (NYSE:MO), Reynolds American, and Lorillard. Altria Group is by far the biggest player, and even if the latter two companies merge, Altria Group will still be bigger both in terms of market capitalization and in terms of sales. Nevertheless, the combination of the latter two companies will create a larger company that is better capitalized and better able to compete with Altria Group.

Second, there are synergies between the two companies that will almost certainly lead to significant savings, which means that the combined company would be worth more than the sum of the two companies if they don’t merge. Wells Fargo (NYSE:WFC) estimates that the combined company can save $400 million on manufacturing given that they can produce both companies’ products at one plant.

As e-cigarettes become more popular and “regular” cigarette smoking declines, this will be advantageous as the combined company can produce these products at two plants, whereas two separate companies would produce them at four separate plants. Its $400 million is a lot of savings, especially considering that these companies trade at about 17 times earnings. Assuming the multiple remains the same after the merger, this translates into $6.8 billion in market cap. Considering that the market caps of the two companies add to $49 billion, the combined company is worth 14 percent more just based on cost saving synergies.

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