Once again rumors swirl that LO is going to get taken out. Late into yesterday’s close Reuters reported that RAI remains the interested party, caught in a 3-way with BAT that owns 42% of RAI. LO ripped +10% higher on the unconfirmed source (rumors began in March of this year), however the stock has given up some of its move intraday (down ~ -4%); we think the market is getting over its ski tips on an imminent timetable for a deal given acquisition challenges.
We maintain our Best Idea Long Call Lorillard (presented on March 4 of this year). We think investors are best served to ride out the rumor mill pushing the stock higher as we don’t expect an imminent deal, and maintain that LO is fairly valued as a stand-alone or takeout target at $80/share (more below).
We view a hypothetical deal (especially an imminent one) between RAI and LO as challenged on three main factors:
- Our main flag is that a combined RAI + LO would own ~ 67% of U.S. menthol market, which we believe should trigger anti-trust flags.
- Big tobacco is already a highly concentrated industry in the U.S. across the big three – MO has a leading ~51% of market share; a combined RAI + LO would equate to ~ 42% share.
- BAT may look to maintain or increase its ownership in RAI (for the remaining 58%), however it cannot act until July of this year when a 10-year standstill agreement between it and RAI expires.
A scenario suggests that RAI could look to divest such menthol brands as Kool, Winston and Salem (~5% total market share), which could serve to change the consideration of the FTC/DOJ, however all of this shopping would take time.
As part of the Best Idea’s thesis we did not consider a RAI + LO deal. We think the decision to replace CEO Daan Delen with Susan Cameron, who held the CEO seat for 7 years ending in 2011, is contributing fuel to the speculation that she wants to come out of the box “strong” with this deal.
Our thesis is built on the superior fundamentals of the Lorillard portfolio:
- We do not see Menthol Regulation Risk from the FDA over the medium term (1-2 years) and assign less than a 20% probability over the long term.
- We expect blu e-cigs to benefit from first mover advantage and maintain leading market share despite competitive pressures from Big Tobacco’s entry into the category. Looking out 5 years to 2018, we model blu’s earnings contributing 31% to total LO, and accelerating earnings growth in the combined company.
- We expect strong and stable menthol fundamentals driven by lasting consumer and demographic trends that differ from traditional tobacco.
Below we’ve outlined the earnings power of a combined base business plus the blu e-cigarette business and a scenario table on EPS estimates five years out, as outlined in our original presentation. A fair value $80/share target would equate to a price 30% higher than today’s, so we think it pays to hold on to LO amidst the rumor winds!