Tuesday, July 15, 2014

Reynolds - Lorillard merger arbitrage considerations

Background. On 7/15/2014, Reynolds (RAI) announced that it plans to buy Lorillard (LO) for $50/share in cash and 0.2909 share of RAI stock. The cash portion will be funded with debt raise, investment from BAT, as well as selling off Blu eCig & other brands to Imperial. LO stock traded down to $60/share.  RAI traded down to ~$59.

o    The trade:  Buy LO; short 0.2909 shares of RAI.  Pay $60 for LO, get ~$18 for shorting RAI = Net cash outflow of ~42/share. This effectively locks in $50 of cash for an 18% gain if deal closes.

·         I have not decided to enter this trade - still taking notes and gathering some considerations here. Regardless, due to the asymmetric risk and reward profile, this would not be a large position.

RAI-LO merger arbitrage considerations
o    Deal expected to close 1H 2015. Let's say June and we're looking at a little less than a year, so IRR will be > 18%.  Call it 20%.

o    Likelihood of success?
·         Lots of approval needed.  From shareholders of LO/RAI/Imperial, as well as FTC. Should be no problem from RAI' end as it is 42% owned by British Tobacco.  But will LO shareholders approve?  LO shareholders might not like that they'll be selling off Blu brand..
·         Does the deal make sense?    I question the value of the deal without Blu, and the fact that RAI just took on more menthol risk.
o    Risk of failed deal - partially protected/offset by RAI short.
·         Regulatory approval is an issue but in that case RAI would get hurt as well.
·         Both Imperial Tobacco PLC and RAI will be using debt financing so there's a capital market risk

o    Risks that are not protected by RAI short
·         If menthol regulation get worse then that would hurt LO disproportionally. This risk has been around for at least 3 years and all parties are well aware of it.
·         Due diligence finds something wrong with LO.
·         Management positions beyond CEO roles are still being sorted out.  Politics could sink the deal.
·         LO has union employees who might oppose this.

Risk & Reward: 
o    18% gain if deal closes.
o    What kind of losses am I looking at if deal fails?  If LO falls back to ~$48 (before media speculation started), then we're looking at 20-40% loss depend on cost of closing out RAI short. I think losses would be at the better end of that range since RAI stock also had benefited from the potential merger.

o    Correlation between the stocks increases the chance that shorting RAI will be an effective hedge 

Notes on deal impact
  • Combined RAI/LO:  
    • Camel and Pall Mall, Natural American Spirit, Grizzly and VUSE; + Newport
    • Pro-forma: $10 billion in revenue, ~32% market share
  • Imperial gets
    • KOOL / Salem  / Winston  / Maverick  / blu brand.
    • In addition to the brands, Imperial will acquire certain assets currently owned by Lorillard including our headquarters, manufacturing and R&D facilities in Greensboro, North Carolina, as well as LO's facility in Danville, Virginia and approximately 2,900 employees, including its national sales force.
  • Management placement:
    • RAI’s CEO, Susan Cameron, will lead the combined RAI / Lorillard.
    • Murray Kessler, Lorillard’s CEO, will be joining the Board of Directors of RAI.
    • Martin Orlowsky, former CEO of Lorillard, will be joining as Executive Chairman Designate of Imperial’s U.S. business 
    • The remaining management positions will be named at a later time. 
  • $800 mm of cost saving on runrate basis - I question how this works as RAI will have no job reductions and LO will have minimum cuts...Can this really be just from selling to Imperial?
  • LO Retirees:   "no effect on your pension or benefits. All retiree benefits are fully-funded and you will continue receiving all payments and benefits as you usually do."
  • RAI side:
    • RAI to its employees:  "shut up its none of your business"
    • Reynolds American will be raising $9 billion of new debt to finance the transaction. The company anticipates leverage of 3.6x debt/EBITDA at closing, moving to less than 3x within 24 months.  They are confident the IG rating will be maintained
    • R&D and technology-sharing initiative with BAT

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