By Teresa Rivas

The Street may not have been excited about the official announcement of a merger between Reynolds American (RAI ) and Lorillard (LO ), but Morgan Stanley thinks that there is too much pessimism  about the potential deal.

Analyst David Adelman and his team upgraded both stocks today from Underweight to Equal Weight, writing that risk-reward is more balance for both names now.

Adelman cites a lower-than-expected acquisition price, given the stocks’ double-digit declines since the merger’s announcement, and writes that while there are still concerns that regulators would block a deal, he sees more opportunity than he did in late June, when he downgraded the stocks.

More from his note:

We downgraded LO and RAI on June 24, then taking the view that the market was already pricing in an extremely optimistic M&A scenario, which created a negative risk-reward skew. While a transaction was ultimately announced on July 15, LO and RAI’s share prices have subsequently declined 10% and 11%, respectively. This in our view reflects a lower-than-expected acquisition price for LO (

$67) and accretion/ returns for RAI that would be muted by diseconomies of scale on synergies and $2.7B in taxes on divestitures.

Several of our prior concerns about the transaction remain valid. With little visibility into the timing or outcome of the FTC review process, LO likely trades at a reasonably wide spread until at least early 2015. We remain concerned with a low transaction ROIC (

6% in Y1) for RAI and an effective multiple with fully realized synergies (with the loss of $1.2B in GM contribution from divested brands) of

13x EV/EBITDA for Newport.

For LO, despite capturing directionally appropriate FTC risk, the current market discount appears high, presenting a

16.7% IRR (or a 50% probability of deal closure, on our estimates). Our more optimistic view reflects: (i) The companies’ independent anti-trust evaluations (which could certainly be incorrect); (ii) Fundamentally different consumer bases for Newport, Camel and Pall Mall; (iii) The persistence of a viable #3 manufacturer; and (iv) Technical aspects of the deal that boost the likelihood of completion (RAI committed).

For RAI, we also now see a more balanced risk-reward, as our updated analysis suggests

10% EPS accretion by 2017, and a pro-forma 2015e EV/EBITDA multiple of

11x. Despite our ROIC concerns, RAI should emerge with a profoundly stronger portfolio (but at an extremely high cost) and better growth prospects.

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