Is the Tobacco Industry About to See a Wave of Consolidation?

Something strange is happening within the tobacco sector. After years of lawsuits, court appearances, regulations, and fines, industry experts now have proclaimed that the risk of litigation against tobacco companies is declining. Indeed, big tobacco companies such as British American Tobacco (NYSEMKT: BTI  ) , Reynolds American (NYSE: RAI  ) , and Imperial Tobacco (NASDAQOTH: ITYBF  ) are now reporting a lower number of cases being filed against them, as they have proven that they can fight back.

The war is coming to an end
Apart from the recent order from a federal court ordering the major U.S. tobacco companies to publish a series of corrective statements through advertisements on television, newspapers, and the Internet, data from Reynolds American shows that the number of court cases against big tobacco is declining. Specifically, the number of pending "smoking and health" cases against Reynolds had fallen from 352 in 2001 to just 69 in the third quarter of 2013. The number of health-care reimbursement cases fell from 62 to two over the same period.

With the war against tobacco cooling down, this has raised the question as to whether or not big tobacco companies, which were forced to separate to protect investors from litigation, should now reunite.

Reynolds and British American would be first in line for a merger if industry consolidation were to gain traction.

An attractive target
Reynolds was created back during 2004, when British American merged its Brown & Williamson division with R.J. Reynolds, leaving British American with a 42% stake in the newly created Reynolds American. This deal also included a standstill agreement, preventing the Anglo-American company from increasing its stake in Reynolds until July 30. With the end of the standstill agreement fast approaching, a merger between Reynolds and British American could be in the cards.

This consolidation would be a continuation of an industry trend after a brief period of zero M&A in the tobacco-majors sector. For example, the tobacco majors of the world at present, and I'm talking here about Philip Morris and British American, were only able to push to sector-leading positions via industry consolidation.

For example, back in 2008, the year for which the most recent data is available, Philip Morris controlled 17.4% of the global cigarette market, up from 15.5% eight years earlier. British American's share of the market stood at 12%, up from 11% during 2000, and Japan Tobacco's share stood at 9.6%, up from 7.2% eight years before. It would appear that these tobacco giants were able to establish this growth through industry consolidation.

These giants have been acquiring smaller, regional, or local cigarette producers, which saw their share of the global cigarette market fall from 32.2% during 2000 to only 19% as of 2008. Testament to this consolidation strategy is Imperial Tobacco, the world's fourth-largest tobacco company, which during the eight-year period from 2000 to 2008 saw its share of the global tobacco market rise from 0.8% to 4.9%. Imperial did this by acquiring smaller regional cigarette producers within the United States, Norway, Germany, France, the UK, Sweden, Canada, and Africa, all of which were previously independent.

Unfortunately, if British American were to acquire Reynolds, it would bring the company into direct competition with its London-listed peer Imperial Tobacco, which is also pushing into the U.S. market.

British invasion
Imperial Tobacco bought Commonwealth Brands, the US' fourth-largest tobacco company back in 2007, and, as of yet, the company has failed to make a significant impact on the market--even with its international backer.

However, after six years of waiting, it would appear that Imperial is ready to throw its weight behind Commonwealth and start stealing market share from the likes of Altria, Reynolds, and Lorillard.

In particular, during an interview with CNBC after the recent release of Imperial's fiscal full-year results, CEO Alison Cooper stated that Imperial saw huge potential within the US market and the company was looking to drive sales growth within the region. She also revealed that during the last year or so, Imperial had put in place a new sales team for the US market and redeveloped the company's product offering. Both of these actions were ahead of a major sales drive planned by the company.

Domestic manufacturers should be worried, as Imperial is a force to be reckoned with. Indeed, Imperial has a huge amount of firepower behind it. During fiscal 2013, the company reported revenue of more than GBP 28 billion, or $45 billion at current exchange rates, which is more than the revenue of Altria, Lorillard, and Reynolds combined.

Foolish takeaway
So with the number of court cases against tobacco declining, it could be time for the industry to start reuniting after a period of forced separation. A deal between Reynolds and British American looks likely due to the Anglo American giant's holding in Reynolds. However, this consolidation would bring British American into direct competition with its British peer, Imperial tobacco, which is also trying to increase sales within the US. Whatever the outcome, it would appear that the tobacco sector is about to come alive again.

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