7/17/14

Quick thought piece to the few followers who own LO with me. This is a short term arbitrage play (3-4 week trade) that I wouldn't recommend unless you currently own the stock, given its speculative nature.

LO Sept 20 $60 Call ($1.50)

The Reynolds American (RAI) and Lorillard (LO) merger was announced two days ago. Following the release, RAI fell 6.9% and LO fell 10.5%. This unusual drop resulted from expectations of a higher purchase price

and LO divesting one of its crown jewels, Blu e-cigs. The market likely overreacted in this case. If the merger

goes through, LO shareholders will receive $67.42 based on 7/16 closing prices. RAI would have to fall to $33

to breakeven based on today's prices, given the $50.5 cash floor.

The other scenario is the merger is not approved. This could result in a number of outcomes. It could potentially stay in its current range since it would retain the Blu line. More likely, it would fall towards the mid 50's where it would be without the merger rumors. Probability  50%         Scenario #1 - Merger in current form ($67.42)                              RAI offer:                  Closing Price (7/16)      Proceeds / Share                  Cash: $50.5                 RAI: 58.14                     Cash:  $50.5                  Stock: .291 / Share      LO: 60.06                      Stock: $16.92                                                                                                      $67.42 50%         Scenario #2 - Merger does not advance. Assuming midpoint of base case ($58) & low case ($55). Expected Return: (50%*67.42) + (50%*$56.5) = $61.96 With the assumptions above, our expected return would yield an arbitrage opportunity of almost $2. While this helps our conviction, the main case for the trade in my opinion is the natural "drift" that acquisition candidates typically have during the quiet period of closing the deal and gaining regulatory approval. With little news, LO should drift towards the buyout price. Assuming a 60 day close, the Sep 20 $60 calls are probably the best way to play this. If LO pops up to $63 in a few weeks, that should yield a nice return and exit opportunity without the risk of waiting. Also, if RAI modifies the deal and offers to divest Camel, the merger approval rate would increase substantially and help our trade in the process.