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Tobacco Industry Reshaped as Reynolds American, Inc. and Lorillard Inc. Win Deal Approval

By Rich Duprey - Jun 1, 2015 at 12:44PM

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The tobacco industry shrinks to just two major players with dominant market share.

Investors breathed a collective sigh of relief following an FTC approval of the $27.4 billion megamerger between Reynolds American (RAI) and Lorillard (LO.DL), a deal that will reshape the tobacco industry by concentrating market power in the hands of a duopoly.

Although there was some concern that antitrust considerations might squash the union, a side deal that makes U.K.-based Imperial Tobacco a new major player in the industry -- albeit in a distant third place -- helped sway the divided regulators to vote 3-2 for approval. The deal is expected to close at the end of June pending approval from a federal judge. Shareholders at all three tobacco companies approved the plan in January.

Smoke 'em if you got 'em
Under the agreement, every Lorillard shareholder will receive $50.50 in cash and 0.2909 shares of Reynolds stock in exchange for their holdings. Reynolds expects some $11 billion in annual revenue after the merger closes, putting it in second place behind industry leader Altria(MO 0.02%), which generated almost $25 billion in sales last year.

To help the deal pass muster with the antitrust regulators, Reynolds and Lorillard agreed to divest certain brands to Imperial for $7.1 billion. From Reynolds, Imperial will receive:

  • Winston
  • Cool
  • Salem

From Lorillard, the U.K. company gets:

  • Discount brand Maverick
  • Electronic cigarette brand blu eCig
  • Manufacturing facilities in Greensboro, NC
  • The opportunity to hire on most of the company's existing management, staff, and sales team
  • Guaranteed shelf space at retail stores for a period of time 

Reynolds keeps its two top-selling brands, Pall Mall and Camel, which have a combined 19.4% share of the retail market. Lorillard holds onto Newport, the best-selling menthol cigarette, which owns almost 38% of the menthol cigarette market but also has over 13% of total retail market share. Of course, that is still a far cry from Altria and its Marlboro brand, which controls 44% of the market.

Stubbing out growth
The problem for some opponents of the deal is that Reynolds and Lorillard are shedding their weakest brands to a company with barely any presence in the U.S. Even after the merger, Imperial will still have just a 10% share of the U.S. tobacco market, and because the divested brands are among the weakest its rivals own, there is doubt whether Imperial can make them successful over the long haul.

Moreover, one commissioner believes the deal will lead to higher prices as well.

For the past decade, Reynolds American, Lorillard, and Altria have owned over 90% of the combustible cigarette market. Commissioner Julie Brill argued the Big Three have used their market power to raise prices in a coordinated fashion, regardless of "costs or market fundamentals."

She also said the FTC's own regulations have served to impede competitive forces, allowing the tobacco giants to further consolidate their power.

Discount brands were once a formidable threat to the tobacco companies, which was partially the reason behind the regulatory agency allowing British American Tobacco's Brown & Williams division to merge with R.J. Reynolds to form Reynolds American.

Since then, however, the tobacco industry has been operating under a master settlement agreement with most states that requires many discount brands to pay into an escrow fund to cover any claims that might arise against them. Those payments, though, raise their expenses and diminish the price advantage they once held over the cigarette giants.

Furthermore, because FTC rules strictly regulate advertising, smaller competitors are virtually prohibited from increasing consumer awareness through aggressive marketing. In essence, the regulatory agency has ensured the oligarchical stratification of the industry.

A second dissenting commissioner took a completely different approach, saying the merger would have no impact on industry competition, so the need for the FTC to operate as overlord and watchdog of the merger was unnecessary.

Marlboro Man still has free rein
The merger promises to reshape the tobacco industry. While Altria will still control nearly half the market, the new entity will have an estimated 34% share, at least giving it the possibility of offering some real competition to the industry leader.

Yet it remains an industry in decline. The tobacco companies are still attractive to investors for their dividends, which have yields averaging 3.8%. However, that might not be enough to help the new, larger Reynolds, which will carry a roughly $23 billion debt load as a result of the deal.

That means investors looking for the best play in this space should ignore the noise surrounding the merger and pass on both Reynolds American and Imperial Tobacco, instead focusing their attention on the biggest and strongest tobacco company: Altria. 

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Stocks Mentioned

Reynolds American Inc. Stock Quote
Reynolds American Inc.
RAI
Lorillard, LLC Stock Quote
Lorillard, LLC
LO.DL
Altria Group, Inc. Stock Quote
Altria Group, Inc.
MO
$41.77 (0.02%) $0.01
Apple Inc. Stock Quote
Apple Inc.
AAPL
$136.72 (-1.80%) $-2.51
British American Tobacco p.l.c. Stock Quote
British American Tobacco p.l.c.
BTI
$42.91 (-2.10%) $0.92
Imperial Brands PLC Stock Quote
Imperial Brands PLC
IMBB.Y
$22.46 (-1.65%) $0.38

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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