Big Tobacco is among the most hated and controversial industries on earth.

It has been vilified as the leading cause of cancer, forced to pay profit-crushing settlements, and even coerced into launching ad campaigns against its products. Despite massive government pressure and strong public disapproval of its products, Big Tobacco still generates an estimated $500 billion in annual revenue and $35 billion in annual profits.

I was surprised to learn that close to 15% of all Americans still use tobacco. In developing nations, 49% of men and 11% of women use tobacco, according to the World Health Organization. Within these numbers lies opportunity for savvy investors. In fact, a special situation is about to occur within the U.S. Big Tobacco sector that promises solid profits for those investors who are prepared to make their move. I’ll let you in on this special situation later.

First, let’s look at the facts behind Big Tobacco’s current adverse environment.

Between 1964, when the U.S. surgeon general’s office published its first report proving the negative health effects of smoking, and 1994, more than 800 private suits were filed against Big Tobacco in state courts. In 1998, a master settlement was reached between the tobacco companies and the states. The settlement included upfront payments of $12.7 billion, another $206 billion in payments spread out over 25 years, and a variety of marketing controls and other punishments. While this settlement severely impacted the tobacco business, it does serve to define the amount of litigation-related costs to be paid out by Big Tobacco.  

To help soften the financial blow of the settlement, Big Tobacco companies are branching into other industries. One example is Altria Group (NYSE: MO), which has expanded into wine, transportation leases, real estate and manufacturing. In addition, these firms are focusing on the undiminished tobacco demand of developing nations. Most exciting is Big Tobacco’s move into the electronic cigarette space.

I first learned of the money-making potential of the electronic cigarette industry from Andy Obermueller, Chief Investment Strategist of StreetAuthority’s premium Game-Changing Stocks newsletter. Andy explained how Altria is purchasing e-cigarette maker Green Smokes and how he thinks e-cigarettes will continue to grow in popularity.

	Flickr/Lindsay-Fox
	Lorillard has several competitive advantages that Reynolds may be seeking to purchase, such as the successful e-cigarette brand, Blu.

Other innovation includes hybrid systems of e-cigarettes and real tobacco designed to provide users their nicotine fix with a supposed reduced health risk. Phillip Morris International (NYSE: PM) is currently testing these new products. The company plans on investing up to $688 million for a manufacturing facility designed to make up to 30 billion units per year by 2016.

Phillip Morris calls these new hybrid products the greatest growth opportunity in years. In fact, CEO Andre Calantzopoulos has said, “this product has a very real potential to transform the industry.” While I have seen a few of these e-cigarette-type products on the street, the verdict is still out on whether the public will accept them over the long run.

While I applaud the tobacco companies’ verve and commitment to stockholders by innovating new products and entering new businesses, the fact remains that the tobacco business is one in decline. Maybe things can be turned around, maybe they can’t over the long run — but a special situation in the tobacco industry is providing savvy investors a profitable opportunity.

Reynolds American (NYSE: RAI) is thought to be preparing a bid for rival Lorillard (NYSE: LO). Timothy Pettee, the chief investment strategist for SunAmerica Asset Management, explained to Bloomberg that declining cigarette sales and slower growth, combined with large cash reserves, have created fertile grounds for merger and acquisition activity. “These companies are awash in cash and as they look at slower growth, they’re going to deploy that cash,” Pettee said.

While each of the companies has declined to comment on the speculation, if the merger occurs it will combine the second and third largest U.S. tobacco companies into one entity. This will effectively reduce the number of U.S. Big Tobacco companies to two and create the largest single competitor to the largest U.S. tobacco company, Altria Group. In fact, due to Altria’s multiple businesses, the merger will create the largest pure tobacco company in the United States.

Lorillard has several competitive advantages that Reynolds may be seeking to purchase. First, consider Lorillard’s successful e-cigarette brand, Blu.

Blu has first-mover advantage in the e-cigarette market with 47% market share. Secondly, over 80% of Lorillard’s sales are from its menthol cigarette brand, Newport. Believe it or not, menthol cigarette use has been rising in the United States, making the Newport brand a valuable asset.

Most interesting is the potential for a Reynolds bid for Lorillard to create an international bidding war for the company. Possible suitors include Japan Tobacco and Imperial Tobacco. In addition, it’s critical to note that British American Tobacco (NYSE: BAT) owns 42% of Reynolds, as well as controls five seats on its board of directors.

Roadblocks such as regulatory approval and a pending clarification of FDA rules regarding menthol cigarettes create headwinds for the possible merger. However, investors are focused on any roadblocks being surmounted pushing both companies shares sharply higher on the takeover chatter.
Shares of Lorillard soared from $49 to just under $57, marking all-time highs in the three sessions after the possible takeover news. Price has since fallen back into the $53 range. Reynolds share price has followed the exact pattern after the takeover rumor hit the wire. Shares soared from $49 to $56 before falling back to support at $53.

Both of the companies offer solid dividend yields, but Reynolds has a slight lead with a yield of 5.3% compared with 5% for Lorillard.

Risks to Consider: In the U.S., the tobacco industry faces public disapproval headwinds. Despite progress being made with electronic cigarette products, cities such as Los Angeles have already banned their use in public spaces. In addition, it’s only a matter of time until the negative health effects of smoking are understood by developing markets helping to squelch the demand. Be sure to always use stop-loss orders and to diversify when investing.

Action to Take –> This potential takeover has merger arbitrage possibilities written all over it. However, this strategy can be very risky without further knowledge of what is expected to happen. Analysts estimate that Reynolds will purchase Lorillard for between $60 and $80 a share. This number could potentially increase if a foreign brand starts a bidding war. Remember, these foreign firms may be seeking exposure in America through Lorillard’s menthol cigarette line.

While both companies have followed very similar price patterns, the investor’s advantage lies with purchasing the takeover candidate, Lorillard. Buying after a pullback into the $52.50 to $53.50 range makes solid investment sense. Initial stops should be set at $49 with a 12-month target price of $71.

P.S. If you’re excited about the investment potential of e-cigarettes, wait until you see what Andy Obermueller has been working on. Andy has identified five trends with the potential to revolutionize the way we live our lives — and make early investors a killing. Among these technological developments: robots that perform surgery with microscopic precision… machines that can “replicate” objects seemingly out of thin air… and a pair of technologies that will change the face of transportation forever. To learn more about these developing technologies — and the companies behind them — follow this link.