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The Five Key Reasons Why the Reynolds/Lorillard Deal Is Taking Shape

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On Friday 11th July, the US’s second-largest tobacco company, Reynolds American (RAI) confirmed that it was in advanced negotiations with Lorillard (LO), the third-largest, for its acquisition. Any deal, facilitated by the increased stability in litigation facing US tobacco companies, is expected to be worth in the region of US$60 billion and is also likely to involve Imperial Tobacco Plc purchasing a congeries of tail brands from RAI (or perhaps even both companies) to help satisfy any anti-competition concerns on the part of the Federal Trade Commission who will have to approve the merger.

While there are inevitable question marks surrounding the deal (amongst which, the precise extent of economies realisable from the merger, the value for Imperial in its part of the bargain and the weighting being put on Lorillard's e-cigarette brand, blu) it is, in general terms, one which is likely to be beneficial to all parties, as a result of the following:

1. Strength in numbers for Reynolds/Lorillard

At its heart the proposed merger is an old-fashioned scale deal which would provide the new entity with increased muscle to compete against the US market leader Altria, parent company of Philip Morris USA and manufacturer of Marlboro. Altria currently boasts 47% of the US market with Reynolds trailing in second on 27%. Looked at in terms of leading brands Altria’s dominance is even starker, with Marlboro accounting for 40% of sales, followed by Lorillard’s Newport with 12%. The US’s disparate distribution structure is expensive for manufacturers to negotiate and whatever efficiencies Reynolds/Lorillard can achieve from the merger (in all likelihood relatively modest) would give them scope to challenge the pricing stranglehold currently enjoyed by Altria.

2. Newport is an estimable brand

In 2013, sales of Newport accounted for 90% of Lorillard's total sales volume at retail meaning that, notwithstanding the emergence of the blu brand within the e-cigarette category, Lorillard is a one-brand company. And what a substantive brand it is. Newport has grown from an 8% share of the US market a decade ago to just over 12% in 2014 and it dominates the menthol segment with 43% of sales. It is easy perhaps to forget that Newport is a larger brand at US retail than Coca-Cola Classic and Lorillard have only just begun to scrape the surface of the large potential of non-menthol variants. In fact, Lorillard has probably taken the brand more or less as far as it can with the resources available to it and providing it with access to Reynolds's scale is the right course of action.

3. The new entity will benefit from a premium focus

The strong bias of US tobacco taxation towards specific excise means that (as Altria continues to demonstrate) the ability to control pricing with a robust brand reaps considerable dividends. After the merger, (and the divestment of Kool which Newport’s dominant menthol share will mandate), the combined Reynolds/Lorillard entity will boast four out of the top six premium brands in the US. Aside from Kool most of the brands which the combined entity are likely to shed will be in the mid-price or economy segment, resulting in a significant premium tilt to its portfolio. Further, it would bring greater geographic balance and opportunity as Newport’s strong eastern presence is joined with Camel’s western skew to allow each brand to penetrate more deeply in the other’s region of strength.

4. Imperial boosts its presence 

As mentioned above, any deal between RAI and LO will need to be facilitated by the divestment of Kool and a number of other non-focus brands (thought to include Winston, Salem, Misty and Capri) to IMP. Assuming just the five brands above as part of the deal, this would more than double Imperial’s volume share of the lucrative US market overnight (from 4.5% to 9.7%) and make an immediate contribution to company revenues. The additional brands would also increase its cachet as an international player and potentially provide it with enhanced distribution for any future e-cigarette launch. Having said that, this cluster of 5 brands declined in 2013 by 6% from 16 billion to 15 billion sticks, a level which itself is less than 40% of total sales for the group just a decade ago. At a time when Imperial is streamlining its portfolio in other markets and has limited A&P resources it is unclear what sustainable future it can create for these brands.

5. Positioning for an alternative future

Along with Newport, Lorillard owns blu e-cigarettes, the largest international e-cigarette brand and it may be on this which British American Tobacco (BAT), partly financing the deal by agreeing to extend its 42% holding of Reynolds into the new combined entity, has its eye set. The new entity would boast both blu and Reynolds' Vuse brand (along with the distribution strength this implies) in the US along with Reynolds' emerging heat-not-burn technology. BAT would then look to distribute the most promising of this spread of technology internationally (and incidentally perhaps also the Newport cigarette brand). However, in an environment in which e-cigarette consumers in both the US and the UK are increasingly moving towards the less commercially valuable, less brandable open form of vapour consumption, it would be misguided to overstate the importance of blu as a brand. In fact, in the UK blu has recognised this by launching its own tank system at the beginning of June. Therefore, potential returns from this element of the deal are highly uncertain.

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