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Secular declining industry 1. US tobacco Industry a. Volumes have been declining 4 percent historically (expected to continue) i. Ecigs (50 bp impact ii. Shift toward people smoking less iii. Litigation risk (regulation risk) tobacoo companies being sued byt consumers for health problems (Engle Progy cASES) iv. Fda risk (looking to regulate menthol) 2. International tobacco industry a. RAI has agreements with other companies b. LO focused on US business 3. How have margins been doing? a. Gross margins are 80% (revenues-manufacturing cost) Margins have been coming down - were 87 in 2000, Operating margins are 40 costs per pack are 50 cents and revenue for pack RAI-2 and Lo-2.45 Operating income is around a dollar 4. Where would they go with the merger? a. Accretive means it could add to earnings, by combining two companies you can extrqaxt higher earnings (15% accretive) they would have margin expansion "whole is greater than sum of parts" 5. How will this affect the space? 6. Dividend would probly be maintained ( they would increase their debt, some of the cash flow would go to paying interest on debt 7. Lorillard has normal net debt at 1.7x net debt to evitda, tried to maintain abovfe investment grade 8. Reynolds would increase to 3.3 times if they acquired Merger 1. Where did they get 68$ a share a. Based on 12 times LO EV to Evitda, how much Reynolds will be willing to pay, based on looking at historic deals b. Really aggressive assumptions are not realistic - aggressive for cost synergies - RAI can finance with a lot of debt rather than issuing equity you could 2. What happenbed in the chart with up to 14X ev a. Attractive market, high market share, faster growing b. There is only somuch RAI can afford, if they paid more they would take on more debt or issue more equity which would reduce the synergies. Calculated by taking incremental earnings divided by shares outstanding. Don't think they can afford more debt. 3. What was the landscape for Altri UST a. UST was very fast growing \ b. Business is doing well but considering the price they paiud they are not seeing high enough returns, but still a good business (Raynols has American Snuff) 4. HHI color? a. Index that FTC looks at when figuring out how concentrated an industry is - ideally it would be unconcentrated so competutipon is higher better for consumer - tobacco is already high with 3 big players, already above 2500, its 3500, would go above 4000, 7 to 8 percent divestitures would bring it down 5. Time frame if it got acquired? a. Could take months - depends on FTC (2004 Reynolds acquired Williamson announced in October 2003 and closed I njuly 2004) 6. What parts would they divest? a. Reduce economic benefits, reduce synergy, would come fro mRAI, winstan, salem cool, durall, about 8% market share, in order to pass acquiring for 12x evitda and selling at 6 or 7 7. How would diverstitures affect capital gains 8. Would they have to sell divestitiures for more? 9. Would it save costs? 10. BAT's role? a. Owns 42%stake in rai - has 10 year agreement that expires 10 year agreement - this has prevented them to increase their stake, but oculd have approached board, agreement was a formality 11. Short Lo or RAI? a. More downside to raynolds, similar multiple but is a much worse business, volumes declining more, no operating profit growth, excluding one time befits operating profits haven't grown, fundamentals are worse there Company sp[eicifc 1. Menthol risks a. FDA has delaying coming out with prosed rule - if there is one wont come out until end of the year, no near term risks so stock traded ujp because people are less concerned, if FDA keeps delaying then youre gonna get into election time 2. ECIG market a. Us based brand b. Been doing okay - 38% in 4th q but 10% down in 4th , did well because it wqass new and being in stores drove growth, now you see a slowdownBlu international? 3. Ecig Growth? What am I missing? Why be bullish? What gives me confidence? Amtitrst issues a nd divestitures make it less attractive Actavist owners? One thing - Reynolds ceo stepped down in march They brought back old ceo - that woman was ceo when they acquired brown and Williamson who is seen as an integrater Possibility but more likely reason is that bat who owns 42 % she used to work there and business did very well under her and RAI operating profit and performace has been pretty bad, he was asked to leave because business wasn't performing well Catalyst oculd be Deal happens at a lower priuce Time passes with nothing being announced Deal announced at 65 - stock would probably trade down with limited upside and risk Operating profit grew 8 percent Taking pricing even though volumes declining but les than rest of companies only declined half a percentage point, and rasing prices over 4% A class action suit claiming that the members of the class had been injured by their cigarette usage was filed in May 1994, representing an estimated 100,000 smokers who were said to have been turned into nicotine addicts by a tobacco industry that did not warn them of the risks of the habit. Fewer than one in five people are still smokers: Rates fall below 20% for the first time in 80 years • A national survey of 22,167 adults found just 19.3% were smokers in 2013 • It is believed to be the first time in decades fewer than one in five smoke • In 1962, 70% of men and 40% of women smoked Read more: http://www.dailymail.co.uk/health/article-2557223/Fewer-one-five-people-smokers-Rates-fall-20-time-80-years.html#ixzz35m8d0Ivf Follow us: @MailOnline on Twitter | DailyMail on Facebook Source: Company Data, Morgan Stanley Research; Note: The above table reflects fully realized synergies of ~$300 million. Assume that the divested brands are used to finance the purchase of LO on an after tax basis. All debt is financed at 5.5% regardless of the leverage. Definition of 'Herfindahl-Hirschman Index - HHI' A commonly accepted measure of market concentration. It is calculated by squaring the market share of each firm competing in a market, and then summing the resulting numbers. The HHI number can range from close to zero to 10,000. The HHI is expressed as: HHI = s1^2 + s2^2 + s3^2 + ... + sn^2 (where sn is the market share of the ith firm). The closer a market is to being a monopoly, the higher the market's concentration (and the lower its competition). If, for example, there were only one firm in an industry, that firm would have 100% market share, and the HHI would equal 10,000 (100^2), indicating a monopoly. Or, if there were thousands of firms competing, each would have nearly 0% market share, and the HHI would be close to zero, indicating nearly perfect competition. The U.S. Department of Justice uses the HHI for evaluating mergers. Ads • Time Is Right For M&A corp.bankofamerica.com/MandA Learn Why Middle Markets Are Ripe For Economic Growth In 2014. Investopedia explains 'Herfindahl-Hirschman Index - HHI' The U.S. Department of Justice considers a market with a result of less than 1,000 to be a competitive marketplace; a result of 1,000-1,800 to be a moderately concentrated marketplace; and a result of 1,800 or greater to be a highly concentrated marketplace. As a general rule, mergers that increase the HHI by more than 100 points in concentrated markets raise antitrust concerns. We believe divestitures are necessary considering that the US cigarette industry already substantially exceeds the highly concentrated threshold, as measured by the Herfindahl Hirschman Index (HHI). The US cigarette market currently has a 3,632 HHI, which would increase to 4,489 in cigarettes and 5,939 in menthol if RAI-LO combined without any divestitures. According to the U.S. Department of Justice: "...agencies generally consider markets in which the HHI is in excess of 2,500 to be highly concentrated...Transactions that increase the HHI by more than 200 points in highly concentrated markets are presumed likely to enhance market power under the Horizontal Merger Guidelines issued by the Department of Justice and the Federal Trade Commission." (Click here for DoJ discussion of HHI). Even in our divestiture scenario the HHI increases by ~421, but in reality that may be insufficient to appease regulators. DOJ The term "HHI" means the Herfindahl-Hirschman Index, a commonly accepted measure of market concentration. The HHI is calculated by squaring the market share of each firm competing in the market and then summing the resulting numbers. For example, for a market consisting of four firms with shares of 30, 30, 20, and 20 percent, the HHI is 2,600 (302 + 302 + 202 + 202 = 2,600). The HHI takes into account the relative size distribution of the firms in a market. It approaches zero when a market is occupied by a large number of firms of relatively equal size and reaches its maximum of 10,000 points when a market is controlled by a single firm. The HHI increases both as the number of firms in the market decreases and as the disparity in size between those firms increases. The agencies generally consider markets in which the HHI is between 1,500 and 2,500 points to be moderately concentrated, and consider markets in which the HHI is in excess of 2,500 points to be highly concentrated. See U.S. Department of Justice & FTC, Horizontal Merger Guidelines § 5.2 (2010). Transactions that increase the HHI by more than 200 points in highly concentrated markets are presumed likely to enhance market power under the Horizontal Merger Guidelines issued by the Department of Justice and the Federal Trade Commission. See id.

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1. Name/School/Desk 2. Description a. Lorillard is a leading cigarette manufacturer and seller of cigarettes in the United States. You probably know it through it's Newport brand of menthol cigarettes, as well as the Blu Electronic Cigarette 3. Thesis a. Threefold - Lorillard is operating in an industry undergoing secular decline, potential M&A has made the stock jump 25%, and I believe that a deal is not very probable and if it does go through it is already priced in, and lastly, going off of that, Lorillard presents some company specific risks that do not warrant its current evaluation 4. What I'm predicting a. I'm predicting a 15-20% decline in the share price in a time horizon of around 3 months. 5. Secular Decline a. Us cigarette volume is currently declining 4% YoY, and that trend is expected to continue. This is occurring for a few reasons.

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1. Name/School/Desk 2. Description a. Lorillard is a leading cigarette manufacturer and seller of cigarettes in the United States. You probably know it through it's Newport brand of menthol cigarettes, as well as the Blu Electronic Cigarette 3. Thesis a. Threefold - Lorillard is operating in an industry undergoing secular decline, potential M&A has made the stock jump 25%, and I believe that a deal is not very probable and if it does go through it is already priced in, and lastly, going off of that, Lorillard presents some company specific risks that do not warrant its current evaluation 4. What I'm predicting a. I'm predicting a 15-20% decline in the share price in a time horizon of around 3 months. 5. Secular Decline a. Us cigarette volume is currently declining 4% YoY, and that trend is expected to continue. This is occurring for a couple of reasons. 1. Unlike international, there is a shift toward people smoking less - 19.3% of adults smoke Rates fall below 20% for the first time in 80 years while that number is gradually changing, over 70% of males smoked in the 1960s 2. ECIGs, though they haven't impacted the space as much as expected, add to that decline by about 50bps each year b. margin contraction 1. Margins are generally very high in this industry, as cigarettes are generally extremely cheap to produce. Gross margins are currently 80%G, yet have been coming down. In 2000 they were 87%. (Operating margins are 40 costs per pack are 50 cents and revenue for pack RAI-2 and Lo-2.45 Operating income is around a dollar) 6. M&A a. The real meat of my argument is with this potential merger b. To set the stage, early March there was a rumor on a European blog that RAI was considering hiring investment bankers and lawyers to consider a potential acquisition of LO. Since then, the stock has traded as high as 30%, and currently trades about 24% higher. For a defensive stock that is attractive to value investors for it's steady nature and high dividend of 4%, this is impressive. c. The deal is only a rumor, as neither firm is yet to comment on its validity. d. Personally, I think there are too many roadblocks that will prevent this deal from occurring. 1. Antitrust issues. Currently, there are only three big players in the space, the other, being the producer of Marlboro, Altria. Combining two of the three large players would be a tough pitch to FTC. To describe this I use the HHI, which is a commonly accepted measure of market concentration. The scale is from 0 to 10,000, and to put it in perspective, if there were only one firm in an industry, that firm would have 100% market share, and the HHI would equal 10,000 indicating a monopoly. Or, if there were thousands of firms competing, each would have nearly 0% market share, and the HHI would be close to zero, indicating nearly perfect competition. As you can see in the bottom left of my deck, the cigarette market is already extremely concentrated, with a score over 3600. The U.S. Department of Justice considers a market with a result of less than 1,000 to be a competitive marketplace; a result of 1,000-1,800 to be a moderately concentrated marketplace; and a result of 1,800 or greater to be a highly concentrated marketplace. As a general rule, mergers that increase the HHI by more than 100 points in concentrated markets raise antitrust concerns. Without divestitutes it would increase by 857. This brings me to my second point, necessary divestitures. In order to get approval, they would need to divest at least 7 or 8% of their market share. Not only does this dilute the synergy they would be hoping to gain, but they would need to sell businesses at a more expensive multiple than they are worth. LO is currently trading well above its fundamental value, which is expected due to the potential merger. Yet, at 12.5 EV/EBITDA, this is one of the more expensive deals in the history of the space. As youll see on the chart, historical tobacco M&A have an average multiple of 10X. The most comparable deal would be Altria's acquisition of UST, a chewing tobacco growth name, which was acquired for 12x and was considered extremely expensive. And, at the time, the company was gaining momentum and considered to have a ton of growth, much more than Lollilard. That is why I say that even if a deal is announced, there is no guarantee that it would be approved. And if it were, it may already be priced in. Finally, there are company specific risks to an acquisition of Lorillard. First, menthol risk. For a while now the FDA has been delaying coming out with a proposed rule, yet something is expected. Menthol cigarettes are considered much more harmful to one's health, and this has been looming over the company, which really only focuses on menthol cigarettes, for a while now. Second, the ecig market is not growing as expected. Though sales of the BLU increaded by nearly 40% in Q4, they have decreased by 10% in Q1. This seems like a lot less attractive of a piece then it did six months ago, and with revenues of 200 million compared to 6 billion for the company, it is not there yet. My catalysts would be either an acquisition announcement for a price below what is expected, or simple passage of time. Also, because short interest is low because it's considered a safer stock with a high dividend, cost of borrow is cheap. To sum it up, I believe this is a short because D D D Thank you. Questions? What is average divestitures?

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Margins Margins are generally very high in this industry, as cigarettes are generally extremely cheap to produce. Gross margins are currently 80%G, yet have been coming down. In 2000 they were 87%. (Operating margins are 40 costs per pack are 50 cents and revenue for pack RAI-2 and Lo-2.45 Operating income is around a dollar) Debt This is really reflected within Lorillard's numbers. For the three months ended March 31 Lorillard's Blu reported sales of $51 million for this year; this was down slightly from the $57 million reported in the year ago period. b. To set the stage, early March there was a rumor on a European blog that RAI was considering hiring investment bankers and lawyers to consider a potential acquisition of LO. Since then, the stock has traded as high as 30%, and currently trades about 24% higher. For a defensive stock that is attractive to value investors for it's steady nature and high dividend of 4%, this is impressive. c. The deal is only a rumor, as neither firm is yet to comment on its validity. d. Personally, I think there are too many roadblocks that will prevent this deal from occurring. 1. Antitrust issues. Currently, there are only three big players in the space, the other, being the producer of Marlboro, Altria. Combining two of the three large players would be a tough pitch to FTC. To describe this I use the HHI, which is a commonly accepted measure of market concentration. The scale is from 0 to 10,000, and to put it in perspective, if there were only one firm in an industry, that firm would have 100% market share, and the HHI would equal 10,000 indicating a monopoly. Or, if there were thousands of firms competing, each would have nearly 0% market share, and the HHI would be close to zero, indicating nearly perfect competition. As you can see in the bottom left of my deck, the cigarette market is already extremely concentrated, with a score over 3600. The U.S. Department of Justice considers a market with a result of less than 1,000 to be a competitive marketplace; a result of 1,000-1,800 to be a moderately concentrated marketplace; and a result of 1,800 or greater to be a highly concentrated marketplace. As a general rule, mergers that increase the HHI by more than 100 points in concentrated markets raise antitrust concerns. Without divestitutes it would increase by 857. This brings me to my second point, necessary divestitures. In order to get approval, they would need to divest at least 7 or 8% of their market share. Not only does this dilute the synergy they would be hoping to gain, but they would need to sell businesses at a more expensive multiple than they are worth. LO is currently trading well above its fundamental value, which is expected due to the potential merger. Yet, at 12.5 EV/EBITDA, this is one of the more expensive deals in the history of the space. As youll see on the chart, historical tobacco M&A have an average multiple of 10X. The most comparable deal would be Altria's acquisition of UST, a chewing tobacco growth name, which was acquired for 12x and was considered extremely expensive. And, at the time, the company was gaining momentum and considered to have a ton of growth, much more than Lollilard. That is why I say that even if a deal is announced, there is no guarantee that it would be approved. And if it were, it may already be priced in. The E-cig Market Is About to Light Up By Rupert Hargreaves | More Articles June 26, 2014 | Comments (0) The electronic cigarette or e-cig market is about to explode. Over the next few weeks, Reynolds American (NYSE: RAI ) is rolling out its in-house e-cig brand, VUSE, across the nation in Big Tobacco's latest drive to dominate the market. The war for a share of the $2.5 billion e-cig market is getting hotter. Tobacco companies are rushing to get their products to market and make a quick buck before regulators or public health groups have the devices banned . As of yet there is much talk but no action with regard to banning the devices. National roll out Reynolds began testing VUSE in Colorado last year and has since been experimenting with the product in order to meet customer demands. The nation's second largest publicly traded tobacco company will go head to head with smaller peer Lorillard (NYSE: LO ) in the e-cig market. Reynolds is actually in the process of trying to buy Lorillard; you can find your one-stop guide to the potential Reynolds American-Lorillard merger here. Lorillard already dominates the domestic e-cig market with its Blu e-cigs brand, which it acquired in 2012 for $135 million. So far, the brand's growth has been explosive. When Lorillard acquired Blu, the start-up had combined sales of only $50 million and the product was only available within 12,000 retail outlets. Lorillard quickly threw its weight behind Blu and the company now dominates the U.S. domestic e-cig market. Blu's annual sales now exceed $200 million and the product is available in just under 150,000 retail outlets. Blu e-cigs have a leading market share of approximately 50%. With Reynolds and sector behemoth Altria about to enter the national market, Lorillard is going to have its work cut out for it. The entrance of the sectors big two players should, according to Wells Fargo analyst Bonnie Herzog, "catapult growth of the entire category." The big winners The big winners from this e-cig war will be the media agencies. Tobacco advertising, especially on television, has been banned since 1971, although e-cig advertising is allowed. Marketing spending on e-cigarettes more than tripled to $79 million in 2013. This is really reflected within Lorillard's numbers. For the three months ended March 31 Lorillard's Blu reported sales of $51 million for this year; this was down slightly from the $57 million reported in the year ago period. However, as marketing spending increased, the company was catapulted from an operating profit of $7 million reported during 2013 to a loss of $11 million for 2014; that's a big difference. Unfortunately, it would appear that things are only going to get worse for Lorillard as Reynolds and Altria enter the market. More and more cash will have to go towards advertising, and this will only push margins down further. Regulatory concerns There is also the FDA's position on e-cigs to consider. In April, the FDA issued proposed rules banning the sale of e-cigs to anyone under 18 and requiring all companies to list their ingredients. FDA rules will also soon require e-cigs to be branded as "tobacco products," an extensive and expensive process . Luckily, being big tobacco companies, Lorillard and Reynolds have plenty of experience dealing with regulators. It should not be too hard to alter the products to fit FDA requirements. Still, this will be yet another expense that will push margins down. On the other hand, stringent FDA regulations are likely to push smaller peers out of the e-cig market. Foolish summary It would appear that the e-cig market is set to explode over the next few months as Reynolds and Lorillard go head to head. This clash of tobacco titans will lead to a surge in advertising spending, which should hopefully increase awareness of the products. Rising advertising spending is crushing profit margins, however, and this will be the deciding factor; will big tobacco continue to chase e-cig customers if it means making a loss? That said, it's not likely that big tobacco will leave the e-cig market anytime soon. Expect to see an explosion in e-cig sector activity over the next few months. 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