S&P Affirms Ratings on Lorillard (LO) Following Reynolds American (RAI) Deal

Standard & Poor's Ratings Services affirmed all of its ratings on Greensboro, N.C.-based Lorillard (NYSE: LO), including the 'BBB-' corporate credit rating, and removed them from CreditWatch, where we had placed them with negative implications on May 22, 2014. The outlook is stable.

At the same time, we affirmed all of our ratings on Winston-Salem, N.C.-based Reynolds American Inc. (NYSE: RAI), including the 'BBB-' corporate credit rating, and removed them from CreditWatch, where we had placed them with negative implications on May 22, 2014. The outlook is stable. We estimate debt pro forma for the proposed transaction will total about $17.6 billion.

"The Lorillard rating affirmation reflects our view that as a part of RAI, the company's competitive position and profitability will strengthen and its growth prospects will improve," said Standard & Poor's credit analyst Gerald Phelan.

The action also factors in the continued exposure to menthol cigarettes, which could be subject to unfavorable regulatory developments over the next few years. We also believe that litigation will remain an ongoing risk for Lorillard as a part of RAI. These factors result in the combined entities' business risk assessment remaining in the "satisfactory" category. Our ratings are based on preliminary terms and could change if the company's financial profile differs from our current assumptions. The proposed acquisition is subject to regulatory approval and, if permitted, is expected to close around mid-2015.

The outlook is stable. We expect the combined entity to realize the planned transition synergies within 18 months of close and gain share for certain cigarette brands in underrepresented markets, enabling it to improve profitability and generate meaningful discretionary cash flow to restore credit ratios to levels more indicative of our "intermediate" financial risk profile.

We could lower the ratings if the regulatory environment worsens considerably, particularly with respect to menthol cigarette proposals; if the legal environment deteriorates particularly pertaining to Engel progeny, individual smoking and health, or lights class action lawsuits; or if cigarette volume declines accelerate or the competitive environment intensifies, which lead us to forecast that the combined entity will be unable to improve credit ratios, including leverage approaching 3x.

The probability for a higher rating over the next two years is remote since--assuming the transaction closes--RAI will need to integrate Lorillard, reduce its high pro forma debt levels, and improve credit ratios to maintain the current rating.

If the transaction does not close, we would likely affirm the ratings on the company, subject to economic conditions, industry developments, and our expectations for future financial policy.

SUMMARY:

• Lorillard Inc. announced that it expects to be acquired by competitor Reynolds American Inc. (RAI) for a total transaction cost of about $28.5 billion including assumed debt and fees. We expect Lorillard Inc. and its primary operating entity Lorillard Tobacco Co. to become subsidiaries of RAI.
• We expect the proposed transaction to be funded with $11.1 billion of new RAI common stock, $9 billion of new RAI senior unsecured debt, $4.4 billion of after-tax proceeds from the divestiture of certain brands to Imperial Tobacco Group PLC, the assumption of $3.5 billion existing Lorillard debt, and $0.5 billion cash on hand.
• Assuming that regulators approve the acquisition, Lorillard will become part of a larger company with a better portfolio of brands, greater scale, and improved diversification. Potential unfavorable regulation pertaining to menthol cigarettes remains the most significant risk, although we view this as a medium-term factor. Its financial risk profile weakens to "significant" from "intermediate" due to the meaningful increase in debt and pro forma credit ratio deterioration.
• We are affirming all of our 'BBB-' ratings on Lorillard and removing them from CreditWatch, where we had placed them with negative implications on May 22, 2014.
• The stable outlook reflects our forecast that as part of RAI, Lorillard's credit ratios will strengthen within two years following close, including reducing leverage to about 3x from the low-4x area pro forma for the transaction.

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