Wells Fargo Weighs In On Potential Reynolds American Acquisition of Lorillard

Wells Fargo Securities notes a merger may be more likely.

Reynolds American Inc. (RAI) is rumored to be making a bid for Lorillard (LO), according to a report by the Financial Times, which noted RAI was allegedly making a bid for $60 a share.

Wells Fargo Securities weighed in on the potential acquisition.

“Though we have long believed LO may combine with another tobacco company and this has been part of our long-term bullish thesis on the stock, we question the timing of this since we’d think RAI would wait for further clarity on the FDA’s potential recommendation on menthol regulation, and e-cig regulation to a lesser extent, before pursuing a deal,” noted Wells Fargo Securities LLC.

Wells Fargo did point out the benefits of the acquisition:

(1) LO and RAI together would be stronger to compete against industry leader MO; (2) Substantial cost savings and synergies;

(3) The general tobacco environment could become more rational.

“Therefore, we think a fair takeout price would be much higher than the $60 RAI is rumored to be offering. Bottom line—we reiterate our Outperform rating on LO ($51.10) and $56-58 valuation range and believe there are many reasons to own LO—a potential deal would just be icing on the cake,” Wells Fargo added. The company later increased its estimate, noting it believes RAI could pay up to $80 a share for LO.

Wells Fargo questioned the mechanics of the potential acquisition, such as how RAI would finance the deal, and noted the more likely deal could be a merger between LO and RAI as opposed to an acquisition. Wells Fargo also pointed out that British American Tobacco (BAT), which currently owns ~42% of RAI’s stock, could take a majority stake in RAI after the standstill ends in July 2014.

“While we believe the most likely scenario is that BAT and RAI could reach a strategic partnership to market/sell e-cigs globally, we wouldn’t rule out BAT taking a majority stake in RAI. Furthermore, if this occurs, BAT could help finance a potential acquisition of LO,” Wells Fargo reported.

With FDA action on menthol still pending, and likely to be a ways down the road, Wells Fargo noted that the FDA could use its authority to limit levels of menthol in combustible cigarettes over time, but Wells Fargo does not predict a ban on menthol. LO’s market share of U.S. menthol is 40.3% and RAI’s is around 26%.

“Currently, LO and RAI together own 67% of the menthol market. If an agreement were to be reached between LO and RAI, we believe the FTC would ultimately approve a deal/combination taking cues from the beer industry, though it’s likely brands would need to be divested,” Wells Fargo reported.

Wells Fargo lists LO as its top U.S. stock pick. “LO is playing a leading role in revolutionizing the tobacco industry and its Newport franchise is strong and should get stronger as growth accelerates driven by incremental growth from Newport Gold. Given the elimination of the Federal Buyout fee later this year, some of which we expect could drop to the bottom line, we think LO is poised to generate strong double-digit EPS growth over the next few years which, importantly, sets it apart from its peers. Therefore, we continue to favor LO despite the menthol and regulatory uncertainty given its strong Newport franchise, first mover and leading advantage in e-cigs, EPS growth well above its peers and discounted valuation,” Wells Fargo concluded.

 

 

 

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