Is the Reynolds-Lorillard Deal Really a Good Idea?

As Reynolds American (NYSE: RAI  ) tries to take over Lorillard (NYSE: LO  ) . many analysts have speculated that the driving force behind the deal is Lorillard's dominance over the e-cig sector. But is this really the case?

(If you're not already familiar with the Reynolds/Lorillard deal, a previous article entitled "Your One-stop Guide to the Potential Reynolds American-Lorillard Merger" can be found here and contains all you need to know on the deal.)

Indeed, while Lorillard does control around 50% of the US' domestic e-cig market, e-cigs remain a relatively small part of Lorillard's business. Further, the profit from Lorillard's e-cig sales has all but evaporated during the past few quarters.

Explosive growth
There is no denying that the growth of Lorillard's Blu brand has been explosive. When Lorillard acquired the tiny start-up two years ago, Blu had 10% market share of the US market with annual sales of $50 million. The brand was only available within 12,000 retail outlets, which is limited exposure.

However, two years on and Blu has grown into a monster. Based on the most recent figures, Blu is now available in around 150,000 outlets around the country and controls 50% of the market. Its annual sales have hit $200 million .

Lorillard has followed this success with the acquisition of British brand SKYCIG and together, Blu and SKYCIG present an attractive bundle for Reynolds. According to analysts at Morningstar, blu is currently worth $500 million-$1 billion, though it may account for a higher number in any deal with Lorillard, which has a current market value of about $22 billion.

Own brand
Reynolds is actually in the process of rolling out its own e-cig brand, Vuse. The company is taking the brand national over the next few months after an initial trial period within some key states. 

As Reynolds rolls out its own brand, however, it seems silly that the company, after much testing and development, would acquire Lorillard. It would have made sense to just snap up Lorillard before spending the cash to develop Vuse.

Is the success of Lorillard's e-cig venture enough to justify an acquisition? True, some Wall Street analysts believe that the e-cig market could overtake the traditional tobacco market within the next six years. A Reynolds-Lorillard merger would put the two companies in a prime position to assault this market but with a price tag of $22 billion many risks remain to be considered before the deal goes ahead.

Risks remain
A merger between Lorillard and Reynolds would mean that the two companies would have to divest some key brands due to antitrust laws. Then there's the question of debt and funding for the deal; S&P has already threatened to downgrade both Lorillard and Reynolds to junk if the deal goes ahead.

Further, there is the FDA's still unknown position on the sale of menthol products (Lorillard's best-selling product is the Newport brand of menthol cigarettes). And finally, the elephant in the room is the possible regulation of e-cigs as many health organizations remain against the devices. Specifically, both the FDA and the CDC have spoken out against the use of the products. I've covered the threat of e-cig regulation in more detail here

Consolidation is the name of the game
The other pressing factor that could be driving a deal between Reynolds and Lorillard is the need for consolidation within the tobacco sector. You see, with the number of smokers within the US declining almost daily, mergers are going to be the only way for tobacco companies like Lorillard and Reynolds to expand. 

Nevertheless, with current forecasts predicting that the e-cig market is set to overtake the traditional cigarette market within the next decade, consolidation of e-cig brands is likely to be the driving force behind this deal. 

Foolish summary
Considering these facts then, it would seem as if Reynolds is taking on more risk than necessary by acquiring Lorillard. The company will have to pay a premium for Lorillard, for which it will face a credit rating downgrade, and there is the risk that both menthol cigarettes and e-cigs could be banned by the FDA. All in all, the move may not be worthwhile for Reynolds or its shareholders.

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