By Tripp Mickle
The giant, three-way deal to transform the U.S. tobacco industry
goes to a shareholder vote this week, but that's not likely to
determine the outcome of the transaction.
Its real test will come when the Federal Trade Commission weighs
in, which is expected later this quarter. And the market still has
doubts.
Shareholders of Reynolds-American Inc. and Lorillard Inc. will
vote on Wednesday. Reynolds Chief Executive Susan Cameron said she
is confident shareholders will approve the deal, which combines No.
2 Reynolds and No. 3 Lorillard to create a more formidable rival
for Marlboro maker and market leader Altria Group Inc.
"I feel confident investors believe this is a good transaction,"
Ms. Cameron said. "It's good for the shareholders, and it's good
for future returns."
Investors don't share that level of confidence, however.
Lorillard on Friday closed at $66.02, nearly 7% below Reynolds'
offer price ($70.57). Two analysts say the price differential means
the market gives the deal about 60% chance of getting FTC
approval.
If the deal is approved, Reynolds would own three of the top
four cigarette brands: Camel, Newport and Pall Mall. Its market
share would go from 24% to 34%, much closer to Altria, which has
the top brand Marlboro and a 47% share.
British American Tobacco PLC, which owns 42% of Reynolds,
already agreed to vote in favor of the deal, and Ms. Cameron said
she has talked to more than 100 Reynolds investors, who she expects
to support it. She also spoke with a host of Lorillard
shareholders.
Shareholder of Imperial Tobacco Group TLC, the third party in
the transaction, are also expected to approve it because it turns
Imperial into the No. 3 player in the U.S., the world's most
profitable tobacco market, with a 10% share. Imperial agreed to pay
$7 billion for Reynolds' Winston, Salem and Kool brands and
Lorillard's Maverick cigarette and Blu e-cigarette brands.
The Imperial part of the deal was designed to satisfy antitrust
authorities, but the FTC hasn't said publicly whether it is
enough.
The deal is getting more scrutiny than most deals the FTC
evaluates. The federal agency asks for additional information from
companies in about 4% of mergers annually, according to a 2013
report it produced.
Reynolds and Lorillard executives have argued that Imperial will
be a stronger No. 3 player than the one created during industry
consolidation in 2004. Brown & Williamson Tobacco Corp. and
R.J. Reynolds Tobacco Co. merged to become the No. 2 tobacco
company and Lorillard moved up a notice to become the No. 3 player,
with about 8% market share. Lorillard's share increased to 14% over
the following decade.
Imperial's acquisition of Winston, Salem, Kool and Maverick will
give it a 10% market share. But unlike Lorillard's Newport, which
is growing, the four brands that Imperial will hold in the U.S.
each have been losing market share.
In a letter to shareholders, Imperial said market research shows
that Winston, the No. 7 brand in the U.S., with a 2.1% market
share, "retains strong brand awareness" and "can be reinvigorated."
It plans to invest significantly in the brand.
The deal also would reshape market share among smokers under 30.
Currently, Marlboro maker Altria enjoys an estimated 48% share of
smokers under 30. If Reynolds adds Newport to its portfolio of
Camel brands, its market share under 30 will rise from about 26% to
nearly 45%.
The majority of the more than 250 billion cigarettes sold in the
U.S. are bought by people between 30- and 60-years old. But most
consumers become brand loyal by the age of 30, so most consumers of
the future would be divided between two companies. Imperial's share
of the under 30 market would be about 5%, according to analysts'
estimates.
The FTC is expected to look at the menthol category. Newport is
the nation's leading menthol cigarette with an estimated 37% share
of the market, Marlboro is No. 2 with 29% and Camel is No. 3 with
12%. Imperial would have Salem and Kool with about 10% combined of
the menthol category.
Menthol smokers almost exclusively smoke mentholated cigarettes,
so regulators will have to determine if Reynolds position as the
No. 1 and No. 3 player in that category would give it pricing
advantages.
"That's precisely the stuff they watch out for," said Michael
Lavery, an analyst with CLSA Americas LLC, who put the likelihood
the FTC approves the deal at about 50%. Wells Fargo, however, puts
the likelihood the FTC approves the deal at 80%.
Ms. Cameron, said she is "fascinated" by the spread between
Lorillard's current stock price and the deal's closing price. She
often gets asked what Reynolds would do if the FTC challenges the
deal as it is written.
"People ask me things like, 'Would you sell Camel if they told
you to?'" Ms. Cameron said. "I say, 'Never. My company is Camel.
I'm keeping Camel.'"
Ms. Cameron said if the deal isn't approved, Reynolds would
continue to operate as it currently is. But she remains optimistic
the FTC will approve the acquisition in the first half of the year.
She added, "When that regulatory approval, which we hope will be
granted, comes, I expect people all the sudden to recognize the
real value."
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