Rumors are swirling that Reynolds American (RAI) will make a bid for its smaller peer, Lorillard (LO.DL).

It is believed that Reynolds will make this swoop for two reasons; firstly, the merger will give Reynolds ownership of Lorillard's highly prized Newport brand of cigarettes. And secondly, it is estimated that a deal between the two companies could generate up to $400 million in cost saving synergies.

Bucking the industry trend
Lorillard is somewhat of a phenomena within the cigarette industry. The company has been bucking the wider industry trend during the past few years as sales of its Newport brand of cigarettes have continued to expand, while peers have seen their sales volumes decline.

This means that Lorillard has the potential to grow earnings at a much faster rate than its peers. You see, Lorillard's peers, including Reynolds have been forced to increase the prices of their cigarettes in recent years, to offset declining sales volumes. Lorillard has followed suit but the company's cigarette sales are still rising. So, not only is the company benefiting from rising sales volumes but its margins are expanding as it hikes cigarette prices in line with peers.

Further, Lorillard's e-cig brand has global potential, indeed, it already has a strong presence within Europe and the company's price hikes on cigarettes, along with rising sales volumes have insured that the company's net income and sales have grown at the fastest rate within the industry.

The final say
So, even if Lorillard and Reynolds do not combine, Lorillard has serious potential. But there's also the question of British American Tobacco (BTI 1.22%), which owns nearly 50% of Reynolds and will have the final say in any deal.

According to Bonnie Herzog, analyst at Wells Fargo, if Reynolds and Lorillard were to cut a deal, British American would do one of two things.

Firstly, British American could enter into a strategic partnership with Reynolds giving the company exposure to the US market without having to pay a premium for Reynolds stock.

Secondly, British American, which has the stronger balance sheet of the two, could offer Reynolds financing for the deal, in exchange for certain benefits such as convertible debt, or a distribution agreement .

A third and final option, is that British American would have the opportunity to acquire the share of Reynolds it does not already own, making it major player within the US tobacco market.

Either way, it's likely that British American will come out on top of any deal between Reynolds and Lorillard. There is no way that an international tobacco giant such as British American would see its interests diluted by Reynolds making an acquisition that it was not happy with.

Still, there are multiple arguments against the merger. For example, Reynolds and Lorillard have roughly a 25% and 15% share of the US tobacco market, which means that Altria and a combined Reynolds/Lorillard will control 90% of the cigarette market, a transaction that's sure to attract the attention of the FTC .

To get around this, and to help finance the deal, Reynolds could sell some smaller brands, fitting in with the company's strategy to focus on a smaller number of brands, such as Camel and Pall Mall. These two 'focus' brands, along with Lorillard's Newport brand would be an attractive portfolio for any cigarette company.

There is also the question of costs. Reynolds' balance sheet is already stretched and further debt would likely see it downgraded to 'junk' status. British American would be against dilution through an all-share merger.

Foolish summary
All in all, a deal between Reynolds and Lorillard would create a new tobacco giant, able to hold its own against current market leader Altria.

However, the deal is likely to be fraught with complications and it will be no simple acquisition. There are many hurdles to overcome before a deal is finalized and investors shouldn't get their hopes up just yet.