Reynolds American (NYSE:RAI) and Lorillard (UNKNOWN:LO.DL) have confirmed that they are in conversations regarding the possibility of a multibillion-dollar merger that could be a game-changer in the U.S. tobacco industry, representing a considerable challenge for market leader Altria (NYSE:MO). Although this sounds like a smart move, investors need to be very careful when considering investment decisions in the tobacco sector.
A big deal
Reynolds and Lorillard are the second and third players in the industry, so a merger between the two companies could materially affect competitive dynamics in the business, while generating a big challenge for industry leader Altria.
Altria is currently the undisputed heavyweight champion in the U.S. tobacco industry thanks to the wide popularity of its Marlboro brand, which owns a huge market share of 43.8%, meaning Marlboro is larger than the next 10 brands combined.
Reynolds American is the second largest player in the business; the company owns the second- and third-best-selling brands in the U.S.: Camel and Pall Mall. In addition, Reynolds American owns a variety of smaller brands such as Winston, Kool, Doral, Salem, Misty, and Capri.
Lorillard comes in third place; the company's flagship product is its Newport branded cigarettes, and it also manufactures under brands such as Kent, True, Maverick, and Old Gold.
According to Citi Research, as quoted by The Wall Street Journal, Altria owns 51% of the U.S. cigarette market, versus 27% for Reynolds American and 15% for Lorillard. A merger between Reynolds American and Lorillard would position the combined company as a bigger challenger to Altria, with a combined market share of 42%.
A smart deal
Closing the competitive gap versus Altria could be a really smart move by Reynolds American and Lorillard. The two companies together could own a leadership position in menthol cigarettes, since Lorillard's Newport and Reynolds' Kool are the two most popular brands in the category. This would give them considerable pricing power in a particularly profitable segment of the market.
E-cigarettes is another promising segment of the industry where Reynolds American and Lorillard are particularly well positioned. Lorillard's blu eCig brand is estimated to own a leading market share of 45% in the U.S., while Reynolds American said in its latest earnings conference call that performance of its VUSE e-cigarette product is "is exceeding even our own high expectations."
Optimizing their brand portfolio and consolidating their distribution networks could offer clear benefits for Reynolds American and Lorillard. Economies of scale and cost savings in different areas are a crucial factor to consider in the cigarette business; sales volumes have been consistently declining over the last several years, so companies are increasingly relying on operating efficiencies and cost reductions to generate earnings growth.
A bad investment idea
Reynolds American and Lorillard would clearly be stronger together, as a merger would fortify their competitive position and provide opportunities for synergies and cost efficiencies in different areas. However, none of these alone means investors should invest in the sector, with or without a merger.
Cigarette sales are on a long-term decline, and there is no reason to expect a pickup in demand anytime soon. This is affecting different companies operating all over the world, so it's a matter of a declining industry as opposed to competitive dynamics among different companies.
Market leader Altria reported a 2.5% decline in total shipment volume during the first quarter in 2014, to 28.75 billion units from 29.5 billion units in the same quarter during 2013. Sales volumes of Marlboro products fell 2.4% to 24.8 billion, while other premium brands declined 8.6% to 1.6 billion, and discount cigarette sales increased 0.9% to 2.3 billion. Total revenue fell 0.2% versus the same period in the prior year, to $5.5 billion.
Reynolds American reported a 3.8% decline in cigarette shipment volume during the last quarter, as increased market share for Camel and Pall Mall was not enough to compensate for falling industry sales. Net sales declined 2.8% to $1.94 billion during the quarter.
Lorillard reported a 2.9% decline in total wholesale cigarette volume during the first quarter, to 267 million units during the period. Domestic sales volume declined 2.3% during the quarter, which was better than the 2.7% decline the company estimated for the industry as a whole. Lorillard compensated for declining volume with higher prices, so total revenue increased 1.4% to $1.54 billion during the quarter.
A merger between Reynolds American and Lorillard could be a positive move for both companies, and it would also create increased competitive pressure for Altria. However, in my opinion that would hardly be enough reason to invest in any of these companies; cigarettes sales are declining across the industry, and no merger is going to change that.