Tobacco Becomes a Hub of M&A Rumor Activity

Momentum is building for a megamerger to happen.

May 14, 2014 at 9:45AM

Despite the growth of the electronic cigarette market, the tobacco industry must still deal with the immediacy of declining sales of traditional combustibles. That's leading to greater speculation that M&A may be the route the smoking giants take. The latest focus of such rumors is British American Tobacco (NYSEMKT:BTI), the London-based owner of brands such as Lucky Strike, Kent, and Pall Mall, which is said to be eyeing a megamerger in the U.S. market.

According to the London Times, British American Tobacco hired Deutsche Bank to consult on pursuing and financing a deal across the pond. With the value of any deal rumored to be in the billions of dollars, it would likely be a company such as Reynolds American (NYSE:RAI) or Lorillard (NYSE:LO) that would be the target, and it's more than just speculation to think it might be the former tobacco company as opposed to the latter.

A decade ago, BAT's Brown & Williamson subsidiary combined its assets with RJ Reynolds Tobacco to form the current Reynolds American, which gave the U.K. cigarette company a 42% stake in its American rival. In exchange for accepting the liabilities of B&W, British American Tobacco entered into a 10-year standstill agreement that prohibits it from acquiring any more of Reynolds' stock. As that agreement expires at the end of July, it explains why we're suddenly hearing more about possible M&A activity in the tobacco industry.

Back in March it was rumored Reynolds might be interested in acquiring Lorillard in a megadeal rumored to be valued in excess of $20 billion. Since BAT's voting bloc could nix any sort of deal it would make, we might not see anything happen until the standstill agreement expires. But at that point British American Tobacco could also make a play for Reynolds and afterward go after Lorillard.

Yet it's also possible BAT might not only allow Reynolds to acquire Lorillard first, it could even help finance the transaction, particularly if it sought a majority position in Reynolds beforehand. There seem to be endless combinations possible.

One can't ignore the e-cig market, either, in any of this. Lorillard's blu eCig is the biggest name in the business with a 45% share of the market, but in June both Reynolds and Altria plan to roll out nationally new e-cig brands. Following its successful debut in Colorado and Utah, Reynolds will be going national with its Vuse brand. Similarly, Altria will be taking its new MarkTen brand national then as well, but it also partnered with Philip Morris International to market e-cigs globally. British American Tobacco has its own electronic cigarette, Vype, but a partnership with Reynolds to market or distribute e-cigs is also a distinct possibility.

The real concern here is tobacco, though, as the M&A rumor-mongering is predicated on countering slowing growth. Industry cigarette shipment volumes fell 2.7% last quarter, though after adjusting for wholesale inventory changes, they were down 4.4%. Reynolds says they're down about 3.5% over the past several years. Whether British American Tobacco buys Reynolds, Reynolds buys Lorillard, or there's a three-way combination of the above, it's clear industry investors stand to profit handsomely from some major M&A activity about to be unleashed.

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4 in 5 Americans Are Ignoring Buffett's Warning

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Jun 12, 2015 at 5:01PM

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David Hanson owns shares of Berkshire Hathaway and American Express. The Motley Fool recommends and owns shares of Berkshire Hathaway, Google, and Coca-Cola.We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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