Source: Wikimedia Commons.

A merger between tobacco giants Lorillard (UNKNOWN:LO.DL) and Reynolds American (NYSE:RAI) has been rumored for months, but after Imperial Tobacco (OTC:IMBBY) announced it was buying certain brands from both companies, it should have all but confirmed talks were heating up. And now Reynolds says, yes, it has indeed been in negotiations to take over Lorillard, though of course nothing remains final.

A merger of the two tobacco companies that would bring together some of the most popular brands, including Newport and Camel, would create a $56 billion cigarette behemoth, though still substantially smaller in size than rival Altria, which weighs in with an $85 billion market cap.

Among the brands that are likely to be shed to Imperial would be the smaller ones, such as Reynolds' support brands Winston, Kool, Salem, and Capri. The cigarette maker has been investing more in its growth brands, particularly Camel, and merely maintaining the others, giving them only limited marketing support. For Lorillard, Newport is its flagship premium cigarette brand and is the top-selling menthol and second-largest-selling cigarette overall in the U.S., so those brand families marketed under the Kent, True, Maverick, and Old Gold names would be the ones most likely to go.

Source: Wikimedia Commons.

Imperial has been looking to expand in the U.S. market, which it maintains is still "one of the world's largest and most profitable cigarette markets," but which Imperial only has about a 3% share of. Adding a few of these otherwise known brands to its portfolio would help it increase that stake.

However, as cigarette volumes continue to decline, the real potential for the union of the two would come from their electronic cigarette businesses. The FDA has set the ground rules for how they can be marketed, and though not optimal, the new regulations still give the industry the opportunity to witness substantial growth.

All three tobacco companies -- Altria, Lorillard, and Reynolds -- planned for big, national rollouts of new e-cig products last month as competition is intensifying. The tie-up between the two tobacco rivals would then bring together some of the biggest names in the e-cig market, including Reynolds' leading blu eCig.

The deal between Reynolds and Lorillard couldn't come any sooner, though, because British American Tobacco (NYSE:BTI), which owns a 42% stake in Reynolds, had a standstill agreement in place that expires this month. In exchange for accepting the liabilities of Brown & Williamson when it combined its assets with R.J. Reynolds a decade ago to form today's Reynolds American, BAT entered into a 10-year standstill agreement that prohibited it from acquiring any more of Reynolds' stock. Now with its expiration, BAT would be free to make its own play for Reynolds, or Lorillard, for that matter.

But in its statement saying it was negotiating with its rival, Reynolds says that BAT was a partner in the discussions, and if any deal does come to fruition, BAT will not only support it but will maintain its stake in Reynolds, which would necessitate it buying more stock.

There's no doubt going to be close antitrust scrutiny. There's certainly a bit of animus toward the tobacco companies, and helping them survive if not actually grow bigger may not be on the agenda of regulators, politicians, and activists who would rather see them die off. Yet even beyond a desire for their demise, seeing some 90% of the U.S. cigarette market consolidated into the hands of just two companies is sure to raise concerns.

Thus, even with all the rumors of a tie-up finally proving true, it doesn't mean a deal will happen, or at least not anytime soon, though the potential for a successful combination makes an investment in Reynolds American seem all the more exciting.