A Mega Tobacco Merger in the Works?

Although there's the likelihood that the electronic cigarette market is in for significant regulatory oversight and the menthol cigarette market is facing a possible ban, that's not stopping tobacco giant Reynolds American (NYSE: RAI  ) from making a play for Lorillard (NYSE: LO  ) and potentially becoming a titan in both those markets.

Source: Securities and Exchange Commission.

According to a rumor making the rounds, Reynolds is said to be planning to offer $60 a share for its rival, which values Lorillard at more than $20 billion. Some analysts worry that an acquisition now before the regulatory questions are settled is a risky maneuver. However, if the rumor is true, I see it as smart, and it probably indicates a belief on Reynolds' part that any e-cig controls will be manageable, at least if it's a larger company, while the menthol drama is probably overblown.

Altria may have the industry-leading position with its Marlboro brand of cigarettes, but it's the e-cig niche that's exploding and where the real future of the industry lies. It's why anti-smoking crusaders are worried about their proliferation and are scrambling to impose regulations or even outright bans on e-cig use.

Electronic cigarettes are generally thought to be safer because you're not inhaling smoke or ingesting tar, which is where the bulk of the health risks of cigarettes lie, but rather inhaling a vapor. E-cigs contain 450 times lower levels of toxicants in their vapors than cigarettes have in their smoke.

Lorillard was the first major tobacco company to see where the future of cigarettes was heading, and due to its early adoption, it's been able to capture a better than 40% share of the market. Although e-cigs still have just 1% of the sales tobacco does, analysts see the market growing to a monstrous size, soaring somewhere between $3 billion and $10 billion over the next five years and possibly surpassing regular cigarette sales within the next decade.

The other major tobacco companies have jumped in as well, with Reynolds introducing its Vuse brand and Altria unveiling its MarkTen brand. The former was introduced into the Colorado market late last year and reportedly captured a 62% share almost immediately.

By acquiring its rival, Reynolds would also gain just as big of a commanding lead in the menthol cigarette market, since Lorillard also owns some 40% of the segment with its top-selling Newport brand (which also accounts for more than 85% of the cigarette maker's own revenues). Reynolds' own Kool brand along with Lorillard's Kent and Salem brands distantly trail Newport's lead (British American Tobacco, which is Reynolds' largest shareholder, owning about 42% of its stock, markets Kent globally).

While pending regulation of both markets creates uncertainty, it may be that Reynolds sees a combined company as better equipped to handle the situations, whereas remaining independent might see both companies crippled.

The FDA is poised to hammer the e-cig market with regulations. Virtually unregulated since their creation, electronic cigarettes have been described as the "wild, wild West of tobacco," and the FDA is setting itself up as the new sheriff riding into town to restore order. Much of that "order" will undoubtedly be regulation that's damaging to the market. 

Source: Wikimedia Commons.

With one U.S. senator recently proclaiming e-cig marketing "Joe Camel all over again," harkening back to the industry's alleged marketing of a cartoonish camel to entice kids to take up smoking, it mirrors the bid to impose tighter controls over menthol cigarettes -- or ban them altogether -- since they're seen as a gateway toward smoking. However, a ban seems unlikely, as an estimated 80% of African-American smokers prefer menthol cigarettes, so to protect itself against charges of racism, the FDA would likely sidestep a ban and enact other controls instead.

Thus a tie-up between the two companies at this time, when there is so much regulatory uncertainty, seems risky, but in fact would make a lot of sense. With a sizable share in both markets at stake, even if it had to jettison certain brands and properties to smooth over the feathers of the antitrust crowd, the move could still be a winning gambit.

A combined Reynolds-Lorillard tobacco company would be big enough to effectively compete against Altria's dominance, fend off regulation, and while perhaps not stubbing out the competition, could certainly smoke it in the e-cig market.

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