Is a Major Tobacco Merger in the Works?

Several media outlets, including CNBC and Reuters, are reporting that tobacco giants Lorillard, (NYSE: LO  ) and Reynolds American (NYSE: RAI  ) are in advanced merger discussions. While these are just rumors as of now, the possibility of these two industry titans pursuing a partnership represents a shot across the bow at tobacco leader Altria Group (NYSE: MO  ) .

Lorillard and Reynolds joining forces would involve the second- and third-largest U.S. tobacco companies coming together to better combat the industry heavyweight Altria. If Lorillard and Reynolds American were to merge, the combined entity would collectively generate sales of more than $15 billion annually, bringing them much closer competitively to Altria's $24 billion in yearly revenue.

While a merger has yet to be officially announced, it makes great sense for both Reynolds American and Lorillard if they want to get serious in the fight for U.S. tobacco domination.

Reason for Lorillard to worry
Lorillard relies almost entirely on menthol-cigarette brand Newport, which is concerning because of the increasing level of scrutiny of menthol. The Food and Drug Administration has been studying menthol for several years. Should the FDA decide to get more involved in menthol, Lorillard would have a lot to lose since it generates more than 80% of its revenue from menthol products.

It's true that Lorillard is the market leader in electronic cigarettes through its multiple acquisitions. Lorillard already commands nearly half the market share in the electronic-cigarette category through its Blu brand. Its international market presence will be boosted by last year's acquisition of SKYCIG, a U.K.-based manufacturer of e-cigs.

While electronic cigarettes are a new and exciting product evolution, the category is still in its infancy. The tobacco industry is dominated by traditional cigarettes. For instance, Lorillard's sales of e-cigs totaled $230 million last year, representing just 3% of its total sales.

A deal is far from a guarantee
Any merger in which the No. 2 and No. 3 players would join forces obviously faces regulatory hurdles. For all intents and purposes, Lorillard and Reynolds American coming together would turn the tobacco industry in the United States into a duopoly.

Altria, maker of Marlboro, commands nearly half the retail share in the United States. Lorillard and Reynolds American make up approximately 27% and 15% market share, respectively, meaning Altria and a combined Lorillard-Reynolds American entity would control almost the entire tobacco industry. As a result, it goes without saying that the deal would face intense antitrust concerns.

Benefits of the deal are plain to see
Still, the possible deal would bring a slew of benefits to both Lorillard and Reynolds American. As previously mentioned, Lorillard is tethered to menthol cigarettes and would be given valuable diversification with Reynolds American's traditional tobacco brands, such as Camel and American Spirit. 

Meanwhile, Reynolds American would be granted a formidable position in e-cigs. While e-cigarettes are still a fledgling corner of the industry, they could be on the forefront of incredible growth should the technology gain traction. This seems likely given the persistent decline in smoking rates in the United States and the fact that e-cigs are generally perceived as safer alternatives to cigarettes.

Reynolds American has been notoriously late to the e-cig game. Its Vuse product is still available in just two states, and while it's about to roll out nationwide, time to gain a foothold with consumers is running out. Altria's MarkTen is in the process of going national, and Lorillard already dominates the category.

The bottom line
It makes a lot of sense for Lorillard and Reynolds American to team up. Both companies have glaring weaknesses that could be instantly solved by a merger. Lorillard would be given valuable flexibility within its tobacco offerings, as it's almost entirely reliant on menthol. That's a concern now that FDA scrutiny of menthol cigarettes is really heating up.

Meanwhile, Reynolds American can gain traction in e-cigs, a product category poised for tantalizing growth but one in which the company is still trailing.

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