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North Carolina - Reynolds American proposed $25bn acquisition of smaller rival Lorillard shows how the tobacco company is placing its bets on the market for menthols even as a growing number of smokers opt for e-cigarettes.
With the deal, Reynolds American picks up Newport menthol cigarettes, one of the few US brands that is gaining share in a shrinking market. At the same time, Reynolds is giving up blu - the top-seller in the e-cigarette market seen by many as the tobacco industry's future - to Britain's Imperial Tobacco Group.
As part of the deal, Imperial will buy Reynolds' Salem, Winston and KOOL and Lorillard's Maverick brands in a move meant to ease potential antitrust concerns. Experts say that still may not satisfy regulators.
Sources familiar with the transaction said gaining the blu brand made the deal more attractive to Imperial. While cigarette sales volume has been falling about 4% a year, e-cigarette sales have been booming.
Reynolds sells its own e-cigarettes under the Vuse brand but controls less than 5% of the market, according to market research firm Euromonitor International.
Reynolds' purchase of Lorillard's Newport brand gives the company a stronger presence in the market for menthol cigarettes. Menthols now make up 31.4% of the total market compared with 26% in 2002, according to Morningstar.
"The e-cigarette category is very small today," said Susan Cameron, chief executive of Reynolds. "It's growing and consumers are interested in it, but this transaction is really about adding Newport to our portfolio."
Menthol is a mint-flavored additive that may reduce the irritation and harshness of smoking when used in cigarettes, according to the US Food and Drug Administration.
Experts say menthols have disproportionate popularity among young people, lower-income smokers and African-Americans.
The FDA last year released a preliminary review that said that a majority of African-American smokers use menthol cigarettes. Menthols were also associated with lower socioeconomic status, according to the FDA review of available studies.
But the deal shows that Reynolds isn't banking on significant regulation of menthols by the FDA, which regulates the substance in medical products but not in cigarettes. The agency is conducting its own studies on the topic and has said it would consider restricting the use of menthols.
In an interview, Lorillard's chief executive officer, Murray Kessler, said both companies are confident there is no justification for regulating menthol cigarettes differently than nonmenthols.
Analysts have also said that smoking-related lawsuits are leveling off in the United States, making it a ripe time for consolidation in the industry.
"I think the industry believes the litigation environment is manageable and has certainly improved over the last decade," said Kessler.
Still, health advocates have raised concerns that the proposed acquisition would bring together two companies they say have a history of marketing to children and minorities.
"A bigger tobacco company is not better for public health," said Lisa Henrikson, a senior research scientist at Stanford Prevention Research Center, part of the Stanford University School of Medicine.
Lorillard and Reynolds declined to comment.
The companies also downplayed concerns that the deal wouldn't pass antitrust scrutiny. The planned divestitures could be just a starting point, with more offered if regulators balk at allowing the deal, said Andre Barlow, an antitrust expert with Doyle, Barlow & Mazard Pllc.
"We are very confident we will close this in the first half of 2015," Cameron said.
Deal details
Reynolds, whose brands include Camel and Pall Mall, offered $68.88 per Lorillard share, representing a premium of 2.5% to Lorillard's Monday close.
Lorillard's shares, which have risen about 37% since reports of the deal first surfaced in February, were down 7.5% at $62.19 on Tuesday.
Reynolds' shares were down 4% at $60.61. Imperial's shares were down 3.4% at 2 647 pence in London.
Including debt, the deal is valued at $27.4bn.
Reynolds said it expects to have over $11bn in revenue and about $5bn in operating income annually after the deal closes. Reynolds had sales of $8.24bn in 2013.
British American Tobacco, Reynolds' largest shareholder, will buy shares to maintain its 42% stake in Reynolds through a $4.7bn investment.
BAT's shares were down 1.8% at 3 532 pence on the London Stock Exchange.
Reynolds' financial advisers are Lazard and JPMorgan Securities, while Lorillard is being advised by Centerview Partners and Barclays Plc.
Legal advisers to Reynolds are Jones Day, while Simpson Thacher & Bartlett is advising Lorillard.
BAT is being advised by Deutsche Bank and UBS. The legal advisers to BAT are Cravath, Swaine & Moore and Herbert Smith Freehills. Credit Suisse and Goldman Sachs advised Imperial.
