By Mike Esterl and Peter Evans
Reynolds American Inc. agreed to acquire Lorillard Inc. in an
ambitious and risky $25 billion deal that would reshape the
landscape of U.S. tobacco and make Newport menthols an even more
formidable rival to Altria Group Inc.'s top-selling Marlboro.
The transaction would add Lorillard's Newport, the No. 2 U.S.
cigarette brand, to Reynolds's portfolio, which includes Camel and
Pall Mall cigarettes, giving Reynolds a commanding position in
popular menthol smokes, which have been stealing share from
unflavored cigarettes.
Reynolds expects to have more than $11 billion in revenue and
about $5 billion in operating income after the deal.
The deal--ultimately involving four different cigarette
makers--is so complex that it isn't expected to close before the
first half of next year. It must win approval from antitrust
authorities and shareholders not just of Reynolds and Lorillard,
both based in North Carolina, but also of Imperial Tobacco Group
PLC of the U.K.
To clear antitrust hurdles, the transaction was structured to be
"pro-competitive," executives said in a conference call with
investors Tuesday. Under the plan, certain operations will be
divested to Imperial with the idea of turning Imperial into a
strong No. 3 in the U.S., behind the newly enlarged Reynolds.
Among those divestitures will be Lorillard's Blu electronic
cigarette, the No. 1 e-cigarette in the U.S., with a market share
of more than 40% in convenience stores.
The deal requires Reynolds to make a couple of huge bets. First,
it is taking a chance on menthol, even as the Food and Drug
Administration weighs possible restrictions on the minty smokes
after banning all other cigarette flavors in 2009.
Currently, Reynolds is the No. 2 tobacco company in the U.S. and
Lorillard is the No. 3, as measured by dollar sales.
In a preliminary assessment last year, the FDA said menthol
cigarettes appeared to make it easier to start smoking and harder
to quit.
Newport's share of the U.S. cigarette market rose to 12.2% last
year from 9.7% in 2008, trailing only Marlboro, according to
Euromonitor.The leading menthol brand also skews younger than most
brands, giving Lorillard a 22.5% share of consumers aged 18 to 25,
RBC Capital Markets recently estimated.
Reynolds is also betting it can rise to the top of the small but
fast-growing e-cigarette market without Blu. Reynolds began rolling
out its own brand, Vuse, nationally last month.
In a telephone interview, Reynolds CEO Susan Cameron said the
Blu divestment was fueled in part by the need to shed assets for
antitrust reasons. But she said Reynolds also believes its Vuse
e-cigarette technology is superior to that of Blu, noting Vuse
captured a retail share of more than 70% last year when it was
launched in the test market of Colorado.
"We believe Vuse has game-changing technology," because it
delivers a more consistent puff than other products on the market,
she added. Reynolds is rolling Vuse out across 15,000 stores in the
first leg of its national launch.
Blu's sales have stalled in recent months as more powerful
e-cigarettes known as "vaporizers" with larger, refillable
cartridges and bigger batteries become more popular.
The way the deal is structured, Reynolds would acquire Lorillard
in a cash-and-stock transaction valued at $68.88 per Lorillard
share, or $25 billion. Including the assumption of debt, the value
rises to $27.4 billion. Reynolds, based in Winston-Salem, N.C.,
estimated the merger would create about $800 million in cost
savings.
Lorillard's share price plunged 10.5% to $60.17, after many
investors had placed bets in recent days that Reynolds would offer
a bigger premium for the company. Shares in Reynolds also tumbled,
closing 6.9% lower at $58.84.
"Mostly I think it's just that there is not enough certainty on
whether or not it gets regulatory approval," said Michael Lavery, a
tobacco analyst at CLSA.
Under the agreement, Imperial, the fourth-largest international
tobacco company, would invest $7.1 billion to acquire the Winston,
Kool, Salem and Maverick cigarette brands along with Lorillard's
Blu--a gem of the combined companies' portfolio.
Imperial also would get Lorillard's manufacturing facilities and
about 2,900 employees, including most of its sales force. Lorillard
is based in Greensboro, N.C. If the Reynolds deal is completed,
Imperial would have a 10% share of the $100 billion U.S. tobacco
market, up from about 3%. The U.S. will account for 24% of
Imperial's global sales, up from 7%.
Making it a four-party transaction, British American Tobacco
PLC, the No. 2 international cigarette company, has agreed to pay
$4.7 billion to maintain its existing 42% stake in Reynolds.
The deal is likely to draw intense antitrust scrutiny by
creating a potential duopoly. Even with the divestments, the new
company would control roughly one-third of the U.S. cigarette
market. Marlboro-maker Altria, based in Richmond, Va., already
controls about half the market.
The two sides have been working on the deal for approximately 18
months and the talks have had a number of stops and starts since
then, according to a person familiar with the matter. They were
active around the end of last year before fizzling, for example.
The negotiations rekindled about three months ago, leading to
Tuesday's announcement.
A number of factors came together to enable the companies to
finally strike the complicated four-way deal. They include: an
ample supply of cheap debt financing, even for tobacco companies,
which have typically been constrained in their ability to borrow by
the decline of the industry as well as regulatory and litigation
risk; and fewer concerns on the part of the companies that the
macroeconomic picture will darken dramatically--a factor that
generally crimped deal making for years in the wake of the
financial crisis. Imperial Tobacco's willingness to participate was
also crucial, as antitrust concerns had been one of the factors
that slowed the deal's progress in the past, this person said.
The merger between the two companies, which have a combined
stock-market capitalization of more than $50 billion, coincides
with growing efforts by tobacco competitors to consolidate
manufacturing and pare costs amid shrinking cigarette consumption
in the U.S.
Despite facing long-term declines in cigarette consumption--down
about 4% last year, according to industry estimates--the U.S.
tobacco market is proving increasingly attractive for international
tobacco companies. Sales of cigarettes are declining even more
sharply in Europe, and sales in several emerging market countries
are slowing or contracting.
The U.S. offers a relatively benign regulatory environment
compared with that in some European countries, as well as the
opportunity for cigarette makers to raise prices. Trade in illicit
tobacco is also less of a problem in the U.S. than in many
developed markets.
"The U.S. is a key growth market for us," Imperial Chief
Executive Alison Cooper said on a call with reporters. "We're
hugely excited about the opportunities that lie ahead." Ms. Cooper
said Imperial would focus on expanding the Winston brand, currently
the No. 7 brand in the U.S.
Imperial said it would finance its purchase entirely through
debt.
Imperial was founded in 1901 when a number of British tobacco
companies combined to avoid being bought out by American Tobacco
Co., maker of Lucky Strike, which is now owned by BAT.
The Bristol, England, company also wants to dominate the
fast-growing e-cigarette market, both in the U.S. and in
international markets where e-cigarettes have yet to make their
mark. E-cigarettes are heating devices that use batteries to turn
nicotine-laced liquid into vapor.
Imperial already owns one e-cigarette brand, Puritane, but sells
it only in the U.K. Ms. Cooper said Blu could be built into an
international brand, something that doesn't currently exist in the
fragmented e-cigarette market.
"Clearly we've got a great international opportunity," Ms.
Cooper said.
Lazard is lead financial adviser to Reynolds and J.P. Morgan
Chase & Co. is also advising the company. Lorillard's financial
advisers are Centerview Partners and Barclays PLC.
Dana Cimilluca and Karishma Mehrotra contributed to this
article.
Write to Mike Esterl at mike.esterl@wsj.com and Peter Evans at
peter.evans@wsj.com
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