Update: Shortly after the publishing of the following article, Reynolds American announced that it would acquire Lorillard in a deal valued at $27.4 billion, or a deal price of $68.88 per share (in-line with the high end of our fair value estimate range for Lorillard, as predicted). For more details >>
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Let’s pick up right where we left off. On May 22, we commented that Reynolds American (RAI) and Lorillard (LO) have been looking to combine operations. Here’s what we wrote at that time:
According to recent reports, tobacco giants Reynolds American and Lorillard continue to work to tie the knot. The speculated deal is rumored to be a three-way transaction that involves Reynolds’ shareholder British American Tobacco (BTI), but the timing of any deal is uncertain, and any specific pricing information has been limited. Usually, consolidation results in an industry with significantly more pricing power, but the tobacco makers already have substantial strength in this department. We would therefore expect the transaction, if consummated, to result more in cost savings than in revenue enhancements. We’d also expect the deal, if completed, to result in some divestitures to please regulators, and we think this could pave the way for either Philip Morris (PM), Vector Group (VGR), or even Altria (MO) to pick up assets on the cheap. We’re very much in favor of the transaction, though until we have more concrete information, we’re maintaining our fair value estimates for constituents across the tobacco industry.
More concrete information on the deal now seems imminent. Bloomberg reported July 11 that Reynolds American may announce its purchase of Lorillard as early as this week:
Reynolds American, the producer of Camel cigarettes, is closing in on a purchase of Lorillard and may announce a deal as soon as next week with the blessing of British American Tobacco, people with knowledge of the matter said. BAT, based in London, owns 42 percent of Reynolds and would have to approve of any merger. The transaction — which would follow months of on-again, off-again talks — is complicated by its size and the involvement of several companies, and there is no guarantee a deal will get done, said the people, who asked not to be identified because the talks are private. As part of the deal, London-based Imperial Tobacco Group Plc will buy some brands from Reynolds and Lorillard in an effort to head off any antitrust concerns that the U.S. government may have, the people said.
Reynolds American, shortly thereafter, confirmed that it is—in fact—in discussions with Lorillard regarding a possible acquisition of the company:
Reynolds American confirms that it is in discussions with Lorillard regarding a possible acquisition of Lorillard. The discussions are consistent with RAI’s strategy of considering a variety of options to enhance shareholder value. British American Tobacco, RAI’s largest shareholder, is participating in these discussions. If the transaction proceeds, BAT expects to support the transaction by subscribing for additional shares in RAI and would maintain its existing 42% equity position in RAI. Imperial is also involved in these negotiations as a possible purchaser of brands and other assets from Lorillard and RAI. There is no assurance that any agreement will be reached by any of the parties. Unless circumstances dictate otherwise, RAI does not intend to comment further on these matters.
At this point in the story, we’re waiting for the final details. We’re heard rumors that Reynolds American could pay as high as $80 per share for Lorillard, but we have little to substantiate such a price. A deal struck at such levels would imply meaningful upside to Lorillard’s current share price of about $66, but it may also mean that Reynolds American’s shares will not react as positively to such a high-ball offer. If Reynolds American overpays, existing RAI shareholders could suffer, with all of the benefits accruing to Lorillard’s shareholders.
On a standalone basis, we value Lorillard’s shares at $55 each, and we believe a suitor could offer as much as $69 per share—the high end Lorillard’s fair value range—and still receive a reasonable fair value for the price of the assets acquired. Though we’re not ruling out a high-ball offer, in the event that $80 per share is offered for Lorillard’s assets, the combined entity would have to extract significant savings in order to make the numbers work at such a price. We think Lorillard shareholders should accept $80 per share in a heartbeat.
In other news, it appears chatter has picked up again on a potential Anheuser-Busch-Inbev (BUD) and SABMiller combination, with some now forecasting a deal later this year or in 2015. Here’s what we wrote in early March:
Bloomberg reported…that AB Inbev may be considering tying the knot with fellow beer giant SABMiller – which is partially held by Altria. As economic profits are generally inversely proportional to the number of operators in a particular industry (fewer competitors, greater excess profits), we’re generally in favor of industry consolidation on any level. SABMiller CEO Clark has recently been quoted to say that “you could get the numbers to work” in reference to a transaction, which leads us to believe the beer giant is open to talks. Both AB InBev and SABMiller became giants of their respective industry via consolidation, and a tie-up is a natural extension. Though a merger of equals is certainly plausible through a stock swap, an acquisition of SABMiller will likely come with a premium in light of the company’s vast emerging-market opportunities.
How We Are Playing the Wave of Consolidation
In light of recent news, the likelihood of a Reynolds American-Lorillard combination is much greater than an AB Inbev-SABMiller tie-up, and we’re expecting an announcement soon. Holders of Lorillard’s equity are hoping for a high-ball offer from Reynolds American, while shareholders of the latter are hoping to acquire Lorillard’s shares on the cheap. Both Lorillard’s and Reynolds American’s shareholders, however, are supremely interested in the ‘new’ combination’s dividend policy.
We think a combination of AB Inbev and SABMiller makes sense as well, and in the current low interest-rate environment, funding is rather cheap. Still, the details of any proposed transaction between AB-Inbev and SABMiller are mere speculation at this time, and any announcement seems distant, albeit not unlikely.
There is one entity that benefits from industry consolidation in both the alcoholic beverage and tobacco industries: Altria. Consolidation in the tobacco space will likely reset tobacco valuations higher (as it is already doing), especially if Reynolds American overpays for Lorillard. Potential divestitures from a Reynolds-American-Lorillard merger could also open the door for industry participants such as Altria to pick up valuable assets on the cheap.
In the alcoholic beverage space, Altria holds a prized ~27% equity stake in SABMiller, and the brewer’s rumored combination with AB Inbev would be value-creative in the event of a merger-of-equals scenario (where synergies are extracted from the combination) or if AB-Inbev were to offer a premium price to SABMiller’s existing valuation. Both scenarios would be highly beneficial to Altria holders, in our opinion.
All-in, the alcoholic beverage and tobacco industries remain in flux as consolidation talks heat up in both spaces. Though the terms of any deal are not written in stone at this point, Altria remains our best idea to gain exposure to positive developments across both industries. The firm is a holding in both the Best Ideas portfolio and Dividend Growth portfolio, with shares yielding ~4.5% at the time of this writing.
What is considered a ‘Best Idea’ at Valuentum?
A best idea in Valuentum parlance is a holding in the Best Ideas portfolio and/or the Dividend Growth portfolio. We typically add shares to the Best Ideas portfolio when they register a high rating (a 9 or 10 = a “we’d consider buying” rating) on the Valuentum Buying Index and hold them until they register a low rating (a 1 or 2 = a “we’d consider selling” rating) on the Valuentum Buying Index. We don’t add all firms that register a high score on the Valuentum Buying Index to the actively-managed portfolios due to sector weighting or overall market valuation considerations, among others. The Valuentum Dividend Cushion is a key factor behind adding companies to the Dividend Growth portfolio and is used in conjunction with a company’s annual dividend yield, its price-to-fair value ratio and Valuentum Buying Index rating.
Beverages – Alcoholic: BEAM, BF.B, BUD, SAM, BORN, CCU, STZ, DEO, FMX, TAP