Tobacco buyout creates two giants

Reynolds American Inc. (NYSE:RAI) agreed to buy rival Lorillard Inc. (NYSE:LO) for about $25 billion excluding debt, a deal that would leave the 400-year-old U.S. tobacco industry with two competitors controlling 90 percent of the market.

Reynolds, the producer of Camel and Pall Mall cigarettes, will pay a mixture of cash and stock valuing each Lorillard share at $68.88, according to a statement. British American Tobacco Plc will fund $4.7 billion of the transaction, letting it maintain a 42 percent stake in Reynolds. BAT’s U.K. rival Imperial Tobacco Group Plc, meanwhile, will acquire brands such as Kool and Blu e-cigarettes for $7.1 billion, potentially assuaging antitrust concerns.

After decades of anti-tobacco health campaigns, slumping demand has put pressure on the industry to consolidate. Acquiring Lorillard, the U.S. industry’s third-largest competitor, would help Reynolds cope with the slowdown and give it the Newport menthol line, which is popular in urban areas. Still, the deal faces challenges and investors signaled that they’re uncertain the transaction will close in its current form. Lorillard shares slid as much as 7.2 percent to $62.35 in New York trading, falling well below the purchase price.

“There’s a lot of risk,” said Owen Bennett, an analyst at Nomura Holdings Inc. in London. “There are a lot of factors involved.”

Market share

Including debt, the purchase is valued at $27.4 billion, according to the statement. The new company will have annual revenue of more than $11 billion and operating income of about $5 billion, making it a bigger competitor to U.S. market leader Altria Group Inc.

Reynolds shares also fell after the acquisition was announced, dropping as much as 4.1 percent to $60.61. Imperial Tobacco declined 1.6 percent to 2,696 pence in London, while BAT fell less than 1 percent to 3,568 pence.

After the transaction is closed, the combined company will account for almost 33 percent of the U.S. industry, according to Reynolds. Imperial will see its market share more than triple from 2.5 percent to 9.5 percent, the company said. Still, that leaves the U.S. with two competitors -- Reynolds and Altria -- selling nine out of every 10 cigarettes.

They’ll wrestle for customers in an industry where health concerns and smoking restrictions have eroded sales. Total U.S. cigarette shipments fell by a median of 2.9 percent in the first quarter among the nation’s top tobacco companies, according to data compiled by Bloomberg Industries.

Lorillard drops

The deal -- which followed months of on-again, off-again talks -- will have to pass antitrust hurdles. As part of the effort to overcome those challenges, Imperial will acquire well- known brands such as Salem, Winston and Maverick. Getting the Blu lineup also gives Imperial a foothold in the emerging market for e-cigarettes -- battery-powered devices that can deliver nicotine and other substances through vapor.

The U.K. company said separately that it will fund its portion of the transaction entirely through debt.

“The most surprising element is that Imperial is taking the e-cigarette business from Lorillard,” said Philip Gorham, an analyst at Morningstar Inc. in Amsterdam. “It was probably the sweetener that convinced them to buy what is essentially a selection of third-tier brands.”

Reynolds said it expects cost savings of about $800 million and for the deal to add to earnings in the first year. Susan Cameron will continue as chief executive officer of Reynolds after the acquisition, and the company will remain headquartered in Winston-Salem, North Carolina. Murray Kessler, chairman, president and CEO of Greensboro, North Carolina-based Lorillard, will join Reynolds’s board.

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