It's been a big year for Lorillard (LO +0.00%). The company has made a series of strategic moves during the past 12 months to shift its business toward high-growth businesses, in response to a tough environment for tobacco companies. Smoking is on the decline in the United States, which means tobacco companies are in a bind to produce growth. In response, they're turning to new categories, such as electronic cigarettes. One year ago Lorillard acquired SKYCIG for $48 million to boost its international presence in e-cigs, which complemented its existing blu brand.
However, Lorillard didn't stop there. In an industry such as tobacco, in which growth is slowing and markets are saturated, consolidation typically follows. That's exactly what is happening in this case. Earlier this year, Lorillard announced it will be bought out in a massive deal. With all this in mind, here are two key things Lorillard shareholders need to know right now.
Lorillard is about to be acquired by a major competitor
In a complex transaction worth $27 billion, Lorillard is going to be taken over by close rival Reynolds American (RAI +0.00%). The rationale for the deal is that, because sales of cigarettes are stagnating, companies can strengthen by joining forces. This way, the combined entity can utilize its increased size and scale to reduce costs and raise prices as a means of producing revenue and earnings growth. In this instance, Reynolds American, maker of cigarette brands including Camel, Pall Mall, and Natural American Spirit, will absorb Lorillard's flagship Newport menthol brand.
Announced back in July, the terms of the deal would give Lorillard shareholders $50.50 in cash and 0.2909 of a share in RAI stock for each share of Lorillard stock.
The logic of the deal is clear. As the tobacco industry's No. 2 and No. 3 largest by revenue, both companies are trying to team up to more effectively combat the industry leader, Altria Group. Once the deal closes, which is expected to be in early 2015, the new Reynolds American will generate more than $11 billion in revenue, and $5 billion in operating profit.
Operationally, the merger presents a number of benefits to Lorillard shareholders, as well, as the stand-alone company is dependent on menthol cigarettes that are under increasing regulatory review. Lorillard is almost entirely dependent on Newport. During the first nine months of the year, Newport accounted for 84% of Lorillard's total cigarette shipments.
This is a precarious position, because the regulatory scrutiny of menthol cigarettes has heated up. A 2011 report from the Food and Drug Administration stated that banning menthol cigarettes would benefit public health. Lorillard would be given valuable diversification with Reynolds American's traditional tobacco brands.
But there's another key aspect of the deal that makes it much less appealing for Lorillard investors.
The blu brand will be divested
As part of the deal, Reynolds American will sell a few of Lorillard's other brands to Imperial Tobacco Group (ITYBY 0.45%), maker of various brands including Davidoff and USA Gold. A few of the brands that Reynolds American will divest include the KOOL, Salem, Winston, and Maverick cigarette labels. Unfortunately for Lorillard shareholders, Reynolds American will also sell the blu e-cig brand to Imperial Tobacco Group.
Reynolds American will receive a tidy sum for these brands -- $7.1 billion in cash. But it's worth noting that it's also giving up Lorillard's major growth engine. The blu brand has seen huge success due to the boom of the e-cig product.
Electronic cigarettes represented one of the first true organic growth opportunities for the tobacco industry in a long time. According to Lorillard, blu held a 30% market share in the United States e-cig category last quarter.
Presumably, Reynolds American is jettisoning the blu brand to Imperial Tobacco because it feels it has a better shot with its own e-cig product, called Vuse, which the combined company will retain. Reynolds American believes Vuse has innovative features, including technology that monitors and adjusts heat and power to provide a better user experience.
Reynolds American presumably feels good enough about Vuse that it doesn't see the need to carry two e-cig brands competing against each other in the same product line. Going forward, Reynolds American and British American Tobacco, which is Reynolds American's largest shareholder with 42% ownership, will share technology for developing future products in the e-cig and vapor categories. If Vuse flops and blu retains the top spot in the e-cig industry, getting rid of blu will be a very bad decision.
