Why Reynolds American Is Buying Rival Lorillard

America's second-largest tobacco company, Reynolds American (NYSE: RAI  ) , has announced that it plans to buy the third-largest tobacco company, Lorillard (NYSE: LO  ) , for roughly $27.4 billion, in a deal that is one of the largest ever seen in the tobacco industry. If regulators agree to the acquisition, the deal will likely reshape America's tobacco industry. Clearly, both companies think bigger is better when competing against Altria Group, currently the largest tobacco company in America. But why exactly is Reynolds acquiring Lorillard?

Source: Reynolds American.

The deal
As the deal is extremely complex, it may take several quarters to complete the acquisition process. Lorillard shareholders are expected to get $50.50 in cash and 0.2909 Reynolds American shares per Lorillard share. This represents $68.88 per Lorillard share, which is equivalent to a total enterprise value of $27.4 billion. 

After the acquisition is done, Lorillard shareholders will own approximately 15% of the new entity. British American Tobacco, which currently owns 42% of Lorillard, will invest $4.7 billion to fund the transaction, which will allow this competitor to keep its 42% ownership in Lorillard.

Dealing with regulators
Needless to say, this massive deal will likely face scrutiny from regulators. To persuade antitrust regulators to approve the merger, Reynolds plans to sell some of its brands to competitor Imperial. The brands to be divested include KOOL, Salem, Winston, and Maverick. 

The purpose
As Brian Solomon from Forbes notes, the deal will finally create a credible second-place challenger to Altria. Note that Altria is the owner of Marlboro, the largest selling brand of cigarettes in the world. It has a huge marketing budget, economies of scale, and a well-known portfolio of tobacco brands, making it difficult for single players to compete.

By merging with Lorillard, Reynolds will be able to improve its product mix. For example, it will own the Newport menthol line, which is quite popular in urban areas. The new entity is also expected to have greater geographic diversity, as Reynolds has been traditionally strong in the west, while Lorillard has been stronger in the east.

The deal could also help the new entity to have more pricing power, although the probability of seeing a rise in tobacco prices is low, as that could be objected by the government.

At any rate, the merger will create a huge entity with annual revenue of more than $11 billion, or roughly two-thirds the yearly sales volume of market leader Altria -- and which is likely going to have better economies of scale than Reynolds or Lorillard.

Goodbye E-cigs?
Perhaps the most shocking part of the deal is that it includes the sell-off of Lorillard's blu, which is America's leading e-cigarette brand.

By selling blu to Imperial, Reynolds will lose a huge opportunity to gain extra exposure to one of the fastest-growing segments in the tobacco industry.

However, this may not be a completely negative factor, as e-cigarettes usually have lower profit margins than traditional cigarettes. More important, it should be noted that Reynolds has its own e-cig brand, Vuse, which is currently in the process of a national rollout.

Final Foolish takeaway
The largest deal in the tobacco place will create a huge company with more than $11 billion of annual revenue. Reynolds will likely see product mix improvement, and it is also expected to gain geographic diversity, because Reynolds has been traditionally strong in the west, while Lorillard has been stronger in the east. However, it should be noted that the deal is not only a huge opportunity for Reynolds to win market share, it is also full of risks regarding changing regulations.

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