After months of speculation and rumor-mongering, Reynolds American (NYSE:RAI) announced that it's finally acquiring rival Lorillard (NYSE:LO) in a cash-and-stock deal worth some $27.4 billion. The news comes just days after the two tobacco giants confirmed they had been in negotiations.
Under the terms of the deal, Reynolds will pay $68.88 in cash and stock for every share of Lorillard -- a 40% premium to the cigarette maker's stock price on Feb. 28, the last trading day before the media began speculating about a possible tie-up. It also represents a nearly 13% premium to Lorillard's share price on July 2, the date there was even more speculation about a potential merger. Reynolds will also assume Lorillard's debt.
The combined company is expected to have more than $11 billion in revenue and approximately $5 billion in operating income, with Reynolds expecting the transaction to be accretive to earnings in the first full year of the merger, and enjoying strong double-digit percentage accretion in the second year and beyond.
Yet it's not going to be an easy transaction. The merger will end up creating a U.S. tobacco industry in which just two companies, Reynolds and Altria (NYSE:MO), control 90% of the market, a situation surely to invite close antitrust scrutiny, not to mention the ire of anti-smoking activists who would rather see tobacco companies go out of business than consolidate and perhaps thrive.
Moreover, two other players are party to the deal, and while it shouldn't complicate matters, it adds more moving parts. Foremost is Imperial Tobacco Group, the fourth largest tobacco company, which will be paying $7.1 billion for several brands, including Kool, Salem, and Winston, as well as Lorillard's leading electronic cigarette brand blu eCig, acquisitions that will triple the size of its business.
The second player is British American Tobacco (NYSE:BTI), the largest shareholder in Reynolds American with a 42% stake, which signed off on the merger. There had been rumors that it might want to make an acquisition itself, but with a decade-long standstill agreement in place preventing it from acquiring any more Reynolds stock until it expired this month, it was clear nothing would happen without its say-so.
BAT has endorsed the acquisition, though, and says it will maintain in the new company the same size stake it currently owns by spending about $4.7 billion to buy additional shares.
The resulting tobacco company will be a formidable opponent to Altria, which owns the biggest-selling brand in Marlboro, a brand that alone accounts for nearly half of all U.S. cigarette sales. The new tobacco giant will have the best-selling menthol cigarette in Newport, which has a strong 13% share of its own in the overall cigarette market, but a nearly 38% share of the menthol market.
While the sale of blu eCig was something of a surprise, considering its industry-leading status, Reynolds obviously felt wedded to its own Vuse brand that its R.J. Reynolds Vapor subsidiary recently introduced nationwide. Having successfully test-marketed it in Colorado and Utah, where the size of the total e-cig category grew with Vuse's introduction in both states -- along with higher sales of replacement cartridges -- Reynolds believes consumers tried and adopted its brand and can do the same nationally.
Considering traditional cigarette sales keep falling, tobacco companies are looking to electronic cigarettes to not only make up the difference but also run ahead with higher sales. Reynolds probably thought blu eCig would cannibalize Vuse sales, but putting the brand into the hands of a competitor, which has plans to build upon the international growth strategy Lorillard started when it introduced the e-cig into the U.K. earlier this year, may prove problematic down the road.
Assuming the deal goes through as structured, not a sure thing by any stretch, Reynolds should come out stronger in the end -- but this is a story that has more chapters yet to be written.
Rich Duprey has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.