The acquisition of tobacco giant Lorillard (UNKNOWN:LO.DL) by rival Reynolds American (NYSE:RAI) may be dominating the headlines, but the complicated $27.4 billion deal also includes the equally big news that Lorillard's leading electronic cigarette brand, blu eCig, will be sold off to make the deal work. 

Blu eCig was acquired by Lorillard in April 2012 and quickly established itself as the leading brand on the market. According to Nielsen dollar-share results, blu eCig commanded a 45% share of the market as of March 15, and though that was down 10 share points from the previous quarter as a profusion of competitors entered the market, Lorillard was planning its own national marketing campaigns as well and had purchased last October the SkyCig brand, which will not be part of the transaction.

Buying blu eCig will be Imperial Tobacco Group (OTC:IMBBY), the fourth-largest tobacco company, which is paying $7.1 billion for the electronic cigarette, as well as regular tobacco brands such as Kool, Salem, and Winston. The brands themselves are also small in terms of their market size, but the cumulative effect more than triples its share of the U.S. cigarette market and will make it a significant competitor for the first time. The expanded U.S. business will be around 24% of its combined tobacco net revenues.

  • The premium Winston brand is the world's second-biggest brand behind Altria's Marlboro, but is currently No. 7 in the U.S. with 2.2% share of the U.S. market.
  • Menthol brands Kool and Salem have a 1.9% and 1.2% share, respectively, of the U.S. market.
  • Value brand Maverick has a 2% share.

Blu eCig, as mentioned, is tops in its class. The e-cigarette market has exploded to become the tobacco industry's salvation, assuming it doesn't get wrecked by further regulation. It's already grown beyond just a smoking alternative and is quickly becoming a lifestyle choice. Analysts forecast sales will hit $10 billion by 2017, still small compared to the overall $100 billion tobacco industry, but with triple-digit growth rates still projected, e-cigs may yet surpass tobacco sales.

It's somewhat surprising Reynolds was willing to let go of the leading e-cigarette on the market, but having invested a lot of time and money into its own Vuse brand, the potential for cannibalizing sales just as it rolled out the e-cig to some 15,000 store locations nationwide was possibly more than it wanted to risk. Imperial, though, has big plans for blu and will build on the international marketing strategy Lorillard initiated earlier this year with its introduction to the U.K. 

The other manufacturers have also expanded their e-cig product lines. As mentioned above, Lorillard acquire SkyCig last October. Altria got a late start, but bought its way in with the acquisition earlier this year of Green Smoke, and rolled out nationally its new MarkTen brand last month. 

Imperial is financing the acquisition solely through debt, yet it expects to maintain its investment-grade credit rating because of the strong cash flows the acquired assets generates. Importantly, the product liability attached with the cigarettes is excluded from the deal as Reynolds has indemnified Imperial from it.

In all, Imperial anticipates a return of over 10%, well in excess of its cost of capital in its first full year, and further expects the deal to significantly enhance per-share earnings in the first full year after its completion.

The acquisition of the U.S. tobacco brands is a major milestone for Imperial Tobacco, but it could be snaring blu eCig that becomes the transformative part of the deal. With electronic cigarettes growing in importance to all tobacco companies, having the leading brand in its portfolio gives this upstart a shot at the throne.