Worst Kept Secret on Wall Street – RAI Buys LO

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In a deal that is likely not a surprise to anyone, Reynolds American (RAI) this morning announced that it would be acquiring Lorillard (LO) for ~$69 per share in cash and RAI stock;

  • The complexity of the deal shows us why it took so long to consummate – 4 companies (Imperial Tobacco is buying brands from RAI/LO and British American Tobacco is making an investment in order to maintain its level of ownership of RAI), multiple brands, all with an eye toward appeasing shareholders, employees and regulators;
  • The price likely comes as a disappointment to many investors, with LO takeout values near $80 being bandied about – we never saw that as likely, as the value leakage on any brand sales (only one likely buyer for what are essentially tail brands) was almost certainly going to be significant (and it was, with after-tax proceeds from Imperial to RAI of approximately 5.5x the EBITDA of the brands sold – ouch)

The deal specifics are not AT ALL favorable to RAI in the short-term;

  • As mentioned above, the company is selling $800 million of EBITDA (according to the Imperial Tobacco press release) for after-tax proceeds of approximately $4.4 billion (5.5x);
  • So, net, the company is acquiring ~$1.4 billion in EBITDA (before synergies) for approximately $23 billion, or 17.0x EV/EBITDA – ouch, again
  • RAI also assumes any ongoing risk associated with menthol regulation, and while we can debate the magnitude and likelihood of such regulation, it certainly does not appear to be reflected in the EBITDA multiple paid by the company.

The conference call was a bit surreal, with as nearly as much time spent talking about the benefits of the transaction to Imperial as was spent talking about RAI and LO:

  • We get that establishing Imperial’s bona fides as a strong #3 competitor was one of the goals of this transaction and that echoing that belief during (throughout?) the conference call made some sense, but it struck as overkill nonetheless;
  • We think the time would have been better spent convincing investors that there are actually revenue synergies in the U.S. cigarette industry;
  • As we have written in the past, we are skeptical of revenue synergies, as a rule, and even more so in an industry where companies can’t communicate with consumers;
  • And while the discussion of the relative geographic foot prints of the two companies was interesting (RAI’s strength in the West versus LO’s strength in the East), it wasn’t unknown and our view is that LO’s relative weakness in the West isn’t due to lack of effort or ability, but rather a function of Newport’s position as an East Coast, urban brand.  That equity positioning is going to be difficult to change in an environment where advertising isn’t available as a tool to encourage brand switching.  In sum, don’t buy RAI for the revenue synergies.

The cost savings ($800 million, over time) are likely achievable, given the success that RAI has had in the past managing its cost structure, even in the face of meaningful volume declines (the company’s long-term volume profile has certainly improved with this transaction).

  • However, the forecasted synergies will only replace (and again, over time), the EBIT sold to Imperial, so the company will have to execute to get back to where it was (or could have been pre-divestitures).

RAI is no doubt a better company in the long-run for entering into this transaction with a superior top line profile, but we struggle to see the company’s valuation as anything but full in the short-run and would happily suggest that that long/short investors look to run MO or PM long versus RAI, or look elsewhere in the tobacco space for value, specifically PM.  Even assuming that RAI deserves a higher multiple of EBITDA due to a more robust long-term top line profile, the incremental debt and shares as well as divested EBITDA (only to be recovered over time via cost savings and organic growth) gets us to a fair value closer to $50 per share.  The company’s secure dividend of $2.68 per share likely precludes it trading at that level (indicated yield at $50 per share of 5.3%), but another 10% down from current levels is certainly possible.

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