In a long-awaited announcement, Reynolds American (NYSE:RAI) finally disclosed that it would acquire Lorillard (UNKNOWN:LO.DL) in a deal that has wide-ranging implications for the tobacco industry. Imperial Tobacco (OTC:ITYBF) will acquire a number of brands as part of the deal, including Lorillard's blu eCigs. The deal has important implications for Altria Group (NYSE:MO) and the rest of the tobacco industry.

Just the facts
Lorillard shareholders will receive $50.50 in cash and 0.2909 Reynolds American shares for each share of Lorillard. That values the deal at $68.88 per Lorillard share based on the closing price before the deal was announced, but it may come out to a little more or a little less depending on Reynolds American's share price when the deal closes.

As part of the deal, Imperial Tobacco will acquire Reynolds American's Kool, Salem, and Winston brands. In a shocking twist, Imperial will also acquire Lorillard's blu eCigs. Imperial will pay $7.1 billion for the brands.

Newport dominates the menthol category. Image source: Lorillard.

Changing competitive dynamics
The merger and divestments have implications in the U.S. and international tobacco markets. Reynolds American and Lorillard will combine for the second-largest market share, behind Altria's 51% market share. Altria's Marlboro has a 44% share, far more than Lorillard's Newport, which commands a 13% share of the U.S. market. Reynolds American's Camel and Pall Mall brands combine for a 19% share of the cigarette market. After divestments, the combined company will have a mid-30s market share.

Although no brand comes close to matching Altria's Marlboro, the merger creates a powerhouse in the menthol category. Newport commands a 40.7% share of the menthol market, while Camel captures a 4.2% share. Instead of competing head-to-head with Altria in the cigarette market, the new Reynolds American has a chance to exploit its dominant position in the menthol category. Altria may focus on traditional Marlboros while Reynolds American focuses on gaining share in the menthol category. If this were to develop, all shareholders would benefit.

While Altria and Reynolds American may not become fierce competitors, the side deal with Imperial Tobacco adds a meaningful competitor in the U.S. Imperial will acquire brands that have a 10% share of the U.S. market, making it the third-largest U.S. tobacco company and the only company with sufficient scale to compete with Altria and Reynolds. This is similar in size to Lorillard, which commands a 15.2% cigarette market share. As a result, the merger may enable Reynolds and Lorillard to exploit synergies and add diversification, but the overall level competition in the U.S. market is unlikely to be affected.

Imperial Tobacco acquired blu as part of the merger. Source: blu eCig.

E-cigarette shocker adds competition
Although the Reynolds-Lorillard combination had been speculated on for months, few expected Lorillard's market-leading blu eCigs to be divested as part of the merger. In fact, blu was thought to be one of the key attractions of the acquisition. The leading U.S. e-cigarette brand commands a 45% share of the domestic market. Instead, Imperial will own blu and has international ambitions for the brand.

However, the blu divestment may indicate that Reynolds is having success with its e-cigarette brand, Vuse. Reynolds began rolling out Vuse nationwide last month, not long after Altria began its own nationwide e-cigarette rollout.

In reality, blu's early lead may not be of much value. The largest tobacco companies are expected to use their advantages in distribution and capital flows to dominate the e-cigarette market. Most likely, blu, Vuse, and Altria's MarkTen will compete with one or two other e-cigarette companies and capture similar market shares. If this occurs, the blu divestment may have been a good decision after all.

Foolish takeaway
The Reynolds-Lorillard merger is the most exciting thing to happen in the industry since the advent of e-cigarettes. The merger reshapes the U.S. tobacco landscape, creating a larger and more diversified No. 2 to Altria's lead, while granting a U.S. foothold to Imperial Tobacco. The divestment of blu is disappointing for Reynolds shareholders, but may not matter in the end. Altria and Reynolds can leverage their scale and superior U.S. distribution to capture e-cigarette share from the market leader. As a result, Altria is hardly affected by the merger, while Reynolds American, Lorillard, and Imperial Tobacco shareholders all have reason to cheer.