Now that the merger of Reynolds American andLorillard has been successfully completed, and the U.S. tobacco industry condensed into a duopoly, is there room for any further consolidation?
For at least one analyst, the answer is yes, and global cigarette giant Philip Morris (NYSE:PM) is the most likely candidate, with its former parent, Altria (NYSE:MO), being the one to acquire it. Yet there doesn't seem to be any way that could happen.
Stubbing out an industry
Cigarettes are a dying industry. Shipment volumes remain in a state of steady, continuous decline. Reynolds reported that total industry volume dropped to 264.6 billion cigarettes shipped in 2014, down 3.2% from the year before, and 33% below where they were a decade ago. And there's no one expecting the trend to reverse -- ever -- which means that, if the tobacco companies are to advance, they're going to need to go in a different direction.
It was thought that electronic cigarettes had the potential to become a new growth industry. While it's still expanding -- and the major cigarette manufacturers quickly co-opted the industry -- it's already running into headwinds.
Lorillard acquired blu electronic cigarettes in 2012 for $135 million, and quickly coaxed it into the leading brand with a 50% share of the e-cig market. Then it sold it to the U.K.'s Imperial Tobacco asone of the conditions for getting the merger approved with Reynolds, which has its own Vuse brand. Altria owns both MarkTen and Green Smoke, which it acquired last year for $110 million.
Yet government regulation and user fatigue from the profusion of options available -- blu eCig's market share has since fallen to below 30% -- has led Wells Fargo analyst Bonnie Herzog to essentially suggest the industry needs to innovate or die.
Another option for the U.S. combustible tobacco market is expansion, but with Altria owning 47% of the market, Reynolds now having 34% after all the acquisitions and divestitures, and Imperial owning 10%, there's really not much room to maneuver here at home. Acquiring one of the smaller, also-rans wouldn't move the needle at all.
What's left is the international market, and it's why an Altria-Philip Morris hookup is considered a possibility.
Philip Morris was spun off from Altria in 2008 as a means for each company to look after their respective markets. Altria was saddled with the tobacco industry lawsuits, and no one knew just how much U.S. tobacco companies would end up paying out. Overseas markets didn't face such potentially crushing expenses, and a spin out was seen as a way of increasing shareholder value at a critical time for the company.
Turnabout is fair play
But the tobacco industry is a very different world today. Altria's lawsuits are behind it, profits remain plentiful, and its stock has jumped 150% since the split.
In contrast, where Philip Morris was seen as the growth portfolio at the time, it's now stagnated despite two earnings beats so far this year. Currency effects and declining shipment volumes continue to prove challenging, though its profit margins remain relatively strong.
Philip Morris' stock is up almost 8% year to date and some 70% since it began trading on its own in 2008. But during the past three years, shares have fallen more than 6%, while Altria and the S&P 500 have gained more than 50% each.
It may be true that acquiring Philip Morris would give Altria the geographical diversity it currently lacks, and the two have already been collaborating on e-cig ventures, but fully merging the two companies is not going to happen. Here are three good reasons why it won't.
1. The global market share of a combined Altria-Philip Morris would be huge
Both Altria and Philip Morris own the Marlboro brand, one of the most valuable brands ever. It has a 44.1% share of the entire U.S. cigarette market and a 20% share in the European Union. Yet, as Philip Morris notes, its volumes are more than the next two biggest brands combined. In fact, Marlboro's volume exceeds that of the top four global brands of British American Tobacco combined. In total, Philip Morris has a 40% share of the EU cigarette market.
Adding the domestic dominance of Altria to the mix would undoubtedly bring antitrust scrutiny from U.S. regulators, as well as those abroad.
2. It would upset the delicate competitive balance created by the Reynolds-Lorillard merger
One consideration in allowing Reynolds American to merge with Lorillard was that it would become a competitor of sufficient size to more effectively challenge Altria. Market concentration that would allow further pricing power, which in theory would cause fewer people to smoke, would not necessarily be inconsistent with public policy. But allowing Altria to consume yet another cigarette company, albeit an overseas rival, would make Reynolds that much less competitive, undermining one of the justifications for the deal.
3. It would eliminate the rationale for building up Imperial Tobacco
The inclusion of Imperial Tobacco in getting some brands from the Reynolds-Lorillard deal was its nominal ability to be a third competitor in the market. True, it was given tobacco brands (Kool, Winston) that had been in decline, but it had experience turning around other brands, and might be able to do so here, as well. Making Altria that much stronger by adding Philip Morris would gut that incentive.
In short, while there's logic to a pairing of the former parent and offspring, the practical application of a merger strongly casts doubt on that ever being able to happen.