Despite a rising onslaught of health warnings, Big Tobacco is
muscling up with the marriage of two industry giants, the rise of
e-cigarettes and increasing pricing power, even in the face of a
long-term decline in cigarette sales.
On the merger front, the nation's No. 2 cigarette
maker,Reynolds American (
), announced on July 15 it plans to buyLorillard (
) in a deal that would create a tobacco company in the U.S.
second only toAltria Group (
), the parent of Marlboro-maker Philip Morris USA.
Under the deal, Reynolds, the maker of Camel and Pall Mall
brands and parent of R.J. Reynolds Tobacco, will acquire
Lorillard, maker of Newport, for cash and stock valued at a total
of $27.4 billion, including Lorillard debt.
One of the largest unions in the industry's deal-rich history,
it will likely face regulatory scrutiny.
In a move to minimize concerns regarding competition, Reynolds
plans to sell its Winston, Kool and Salem brands.
Lorillard will offload its e-cigarette blu eCigs brand, the
No. 1 player in the growing e-cigarette market, to Britain's
Imperial Tobacco for $7.1 billion. The deal would vault Imperial
to the No. 3 player in the U.S. and more than triple its share of
Reynolds' largest shareholder,British American Tobacco (
), will maintain its 42% stake in the new entity by investing
$4.7 billion. The arrangement includes an agreement between
Reynolds and BAT to jointly pursue new tobacco products such as
heat-not-burn cigarettes and vapor products, which include
The combined entity is projected to have over $11 billion in
revenue and roughly $5 billion in operating income.
Reynolds now has a 26.5% share of the U.S. market. Lorillard
has 15%. Combined, they'll constitute a more pressing threat to
Altria, which holds around a 51% share in terms of unit volume,
says CLSA analyst Michael Lavery.
The combination aims to "strengthen and diversify R.J
Reynolds' cigarette portfolio, resulting in the most balanced
offering in the industry with brands including Newport, Camel and
Pall Mall," said Reynolds CEO Susan Cameron in announcing the
"The rationale for the deal is to create a stronger No. 2 and
have access to one of the best brands, which is Newport," said
Wells Fargo Securities analyst Bonnie Herzog.
Menthol category sales are not declining as rapidly as the
nonmenthol cigarette category. Newport has one of the "highest
brand equities and commands higher margins, given its higher
price points," she added.
In a note issued after the merger announcement, Herzog called
the deal "a value-creating transaction" for Reynolds and
"The deal makes sense in terms of consolidating the No. 2 and
No. 3 manufacturers and generating cost savings by consolidating
their manufacturing," said Cowen & Co. analyst Vivien
In terms of the deal's impact on the industry, the
establishment of Imperial as the No. 3 cigarette maker helps in
"maintaining a balanced competitive landscape for the industry,"
Still, Imperial faces the challenge of re-accelerating the
market share in the brands it's acquiring. Those products have
been significant share losers the last few years.
The deal isn't a lock.
There's the "potential for antitrust review and for the
Federal Trade Commission not to OK the deal," Azer said.
A central concern is that the combination would consolidate
market share among young smokers in America. Camel and Newport
have been the two biggest share gainers with young-adult smokers
in the U.S. the past decade, Azer says.
Herzog fully expects the FTC to approve the transaction.
"The deal will be completed in the next year," she said in a
In a report, Lavery gave it a 50% chance to be approved as
It would mean the two top players, Altria and pro-forma
Reynolds, would hold 85% of all U.S. cigarette sales, more than
any category he has examined, he added.
"The two top players would also own the brands that have
market share momentum and that have the highest shares among
adult smokers under 30, an indicator of likely future market
share," he said. "So there is a real prospect of the 85% moving
The way the deal "might get approved would be if they can
convince the regulators that Imperial would be a credible
competitor and likely a feisty price competitor, which, if true,
poses risks to the category dynamics," Lavery told IBD.
Meanwhile, the tobacco group is smoking hot on the stock
Reynolds, Altria and Lorillard rose to all-time highs in July.
That helped boost the Tobacco industry group to a No. 47 ranking
on Friday out of IBD's 197 industries.
Reynolds reported a 6% rise in second-quarter earnings to 89
cents a share, 2 cents ahead of views by analysts surveyed by
Reynolds' prices also rose about 6%, Herzog reported.
The next day, Lorillard posted earnings of 84 cents a share,
according to Thomson Reuters -- roughly flat with a year ago and
short of analysts' forecasts.
Herzog notes that the miss was driven primarily by lower
cigarette volume and by drag from e-cigarettes, partially offset
by a cigarette price gain of 6%.
Still, Lorillard's blu eCigs brand kept its lead in the U.S.
e-cigarette category with a 40.9% dollar market share.
Demand for cigarettes tends to remain steady, and makers wield
strong pricing power because of the addictive nature of the
product. But health concerns, higher taxes, stricter regulations
and smoking bans in an increasing number of venues have led to
long-term declines in demand. Sales have been falling about 3% a
year, according to a report by S&P Capital IQ analyst Joseph
The share of U.S. adults who smoke slipped to 18.1% in 2012
from 20.9% in 2005, according to the Centers for Disease Control
Still, 42.1 million people smoke.
Cigarette makers have pricing power because the consumers are
addicted to their products, says Lavery.
"The volume declines in the category are nothing new," he
said. "Pricing is the strongest lever to offset that."
Historically, cigarette makers have been able to increase
revenue by pricing ahead of volume declines.
"That's what makes the stocks an interesting investment,"
Lavery said. "If you can grow your revenue on shrinking volumes,
especially with periodic cost rationalization, you can grow your
margins as well. So profits grow and they throw off a lot of
Big Tobacco is hustling to shore up its arsenal of products
that can serve as alternatives to traditional cigarettes.
E-cigarettes and vaporizer cigarettes are gaining momentum.
These are devices that emit doses of vaporized nicotine that are
inhaled. The device runs on batteries and can emit nonnicotine
vapor, says MedicalNewsToday.com.
"I'm of the opinion the industry is entering a new era of
growth," Herzog said. "The catalyst is e-cigarettes and
Consumption of vapor products, which include e-cigarettes and
vapor tanks-mods, or VTMs, will surpass consumption of
combustible cigarettes in the next decade, Herzog said in a
Altria's subsidiary Nu Mark began its national expansion of
its MarkTen e-cigarette in June and is "achieving strong
distribution," said Altria CEO Marty Barrington in a press
R.J. Reynolds launched its VUSE digital vapor cigarette
nationally in June.
The VUSE roll-out is progressing smoothly, and the brand is in
about 21,000 selected retail outlets, Cameron said in a press
Independent startups such as NJOY, Logic and Vapor have also
Could Heat Up
Herzog forecasts the big three players will win a roughly 80%
share of the combined combustible cigarette and vapor revenue
pool and around 75% of the combined operating profit pool in 10
"I think e-cigarettes will become a much bigger share of the
overall market," Agnese told IBD. "It's still early in the game.
The big players need to be there. If not, they will lose
Growth in the next five to 10 years will come from the
disruptive innovation, Herzog says, as the industry shifts toward
educed risk products such as e-cigs and personal vaporizers.
"I continue to believe consumption of vapor products will
surpass consumption of combustible cigs in the next 10 years,"
The industry faces ongoing regulatory risks, including the
potential for a menthol ban, which Agnese said "has been an
overhang on the tobacco group, given its importance to the
cigarette market. Though we believe that an outright ban on
menthol cigarettes is unlikely, we do not rule out an eventual
He also notes that regulators are still "assessing the impact
of e-cigarette smoking on consumers' health and whether to impose