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We’ve written about Lorillard stock (NYSE: LO) a few times this year.
First my colleague Marshall Hargrave included it in a list of four undervalued dividend stocks. I’ve written about it a few times now, first as a way to invest in eCigarettes and most recently in an overview of the tobacco industry.
But times are changing for Lorillard. Is it a stock worth buying today?
Confirming months of rumors, Reynolds American (NYSE: RAI) announced in July that it intends to buy Lorillard.
That is, of course, if the acquisition offer is approved by Lorillard shareholders, Reynolds American shareholders, shareholders of Imperial Tobacco Group (OTCMKTS: ITYBY) and antitrust authorities in both the US and UK.
Needless to say, it could take a while. In fact the deal isn’t expected to go through until at least the first half of 2015, if at all.
News of the deal sent shares of both Lorillard and Reynolds American significantly lower, Lorillard by 10.49% and Reynolds American by 6.87%. Clearly investors thought Lorillard would fetch a higher offer than the one put forth by Reynolds.
For Lorillard shareholders the key takeaway was the offer price. Reynolds American agreed to pay $25 billion for Lorillard – $68.88 per share in a mix of cash & Reynolds American stock.
To make the deal happen Imperial Tobacco agreed to pay $7.1 billion to acquire Winston, Kool, Salem, Maverick and Blu eCigs.
British American Tobacco agreed to invest an additional $4.7 billion to maintain its 42% stake in Reynolds American.
If the offer is for $68.88 per share, why is it trading around $60 per share?
This is the key question. Why does it appear that Lorillard is trading at a discount? If the offer is for $68.88 per share is it not a total no-brainer to be buying shares right now?
The short answer is: Probably, but not for the reasons you might think.
If something is clearly worth $68.88 and is only trading for $60 then the market is missing something it will eventually wake up to. Trading spreads like this actually has a name, “arbitrage.” In the case of Lorillard, the difference between the offer price of $68.88 and the current trading levels around $60 would be a 15% jump in shares.
But what if the deal doesn’t go through? Is Lorillard still worth $68.88?
While some arbitrage investors seem willing to make the bet, others seem to have major reservations about the deal going through as advertised. Hence, the apparent discount of Lorillard shares.
There is so much regulatory and shareholder approval necessary here that there is good reason to believe the deal won’t go through. For starters, there is significant concern that the deal would create a duopoly in the US tobacco market, a situation regulators may try to block.
The table below that the Wall Street Journal put together illustrates this point beautifully.
Source: The Wall Street Journal
If the deal goes through the new Reynolds American would control just over a third of the US tobacco market while Altria (NYSE: MO) controls almost half. Clearly there are investors in the market who feel regulators will not allow two companies to control 82% of a single market.
I wouldn’t buy Lorillard because it has a potential acquisition price of $68.88.
But I would buy Lorillard because today, at around $60 per share, it trades at a PE of 19.67 and a forward PE of just 15.48. By comparison, Altria’s PE and forward PE are 21.30 and 16.81 respectively. Reynolds American trades at a PE and forward PE of 19.80 and 16.16 respectively.
This suggests that Lorillard is cheap relative to its peers.
Additionally, Lorillard was buying back a lot of stock over the past year, repurchasing $1 billion worth of shares before the acquisition was announced and further buybacks were suspended. Lorillard also pays a 4.13% dividend. That said, it is slightly lower than that of both Altria and Reynolds American at 4.54% and 4.55% respectively.
Buying Lorillard stock today gives you a reasonable shot at a 15% bump if the Reynolds American acquisition is approved. But I’d only buy it if you would be comfortable owning a relatively inexpensive, high-yielding tobacco company with the #2 cigarette brand in the country that is showing signs of strength in an otherwise declining industry and has one of the stronger brands in the booming eCigarette industry.
Frankly, Lorillard stock looks like a good buy either way.
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