Tobacco Cos. See Value in Merger

WINSTON-SLEM, N.C. -- Reynolds American Inc.'s (RAI) $27.4-billion acquisition of rival tobacco company Lorillard Inc. is getting mixed reactions.

As part of the price tag, Lorillard shareholders will receive, for each Lorillard share, $50.50 in cash and 0.2909 of a share in RAI stock, representing $68.88 per share based on RAI's closing share price on July 14. The terms of the transaction have been approved by the boards of directors of both companies.

In conjunction with the deal, a subsidiary of Imperial Tobacco Group plc will acquire several brands, including Lorillard's blu eCigs, for $7.1 billion. In addition, British American Tobacco (BAT), which will retain its 42-percent ownership in RAI, has reached an agreement in principle with RAI to a joint technology sharing strategy for next-generation products.

While executives from all the tobacco companies involved gave high marks to the deal, the pricing details are raising some eyebrows.

"While the deal is largely structured as we expected, we were surprised that the price paid for Lorillard was only $68.88 as we believe it is worth at least $72 per share," said Bonnie Herzog, managing director of beverage, tobacco and convenience store research at Wells Fargo Securities LLC.

RAI's expected cost savings are larger than anticipated and Herzog was surprised to see the blu divesture, she added.

"We anticipate that Lorillard will trade down this morning by around $3 to $4 per share with RAI trading down initially but encourage investors to take advantage of pullbacks to build positions in the name," Herzog said. "We believe this is a value-creating transaction for RAI and Lorillard shareholders and sets the stage for an even stronger No. 2 player in the United States."

And indeed, stocks are taking a hit -- and not just for those tobacco companies in on the transaction. RAI, Lorillard, Imperial Tobacco, BAT, Philip Morris, The Altria Group Inc. and Vector Group all experienced mid-morning slumps after the merger was announced.

Stronger as One Than Two

According to a joint RAI-Lorillard release on the transaction, the acquisition of Lorillard will significantly strengthen and diversify R.J. Reynolds' cigarette portfolio, resulting in a balanced offering with brands including Newport, Camel and Pall Mall. The addition of Newport will be a key component of R.J. Reynolds' future growth-brand strategy as Newport leads the U.S. menthol category. Lorillard reported that Newport ended 2013 with a 12.6-percent share of market.

R.J. Reynolds will also see increased geographic capabilities resulting from its brands' strength in the western United States and Lorillard's complementary strong presence in the eastern United States.

RAI President and CEO Susan Cameron said RAI believes R.J. Reynolds Vapor Co.'s VUSE brand is a game-changing vapor product.

"We made the determination several years ago to internally design and develop VUSE as the first digital vapor cigarette, and intend to remain focused on its growth and expansion nationwide. Imperial is getting a great brand in blu eCigs, and will remain a key competitor in that growing category of the industry," Cameron said.

"Additionally, our agreement with BAT to jointly pursue development of new tobacco products, such as heat-not-burn cigarettes and vapor products, holds great promise for global growth in those categories," she said. "This will certainly enhance value for all shareholders."

Cameron added RAI is confident that the review of the menthol category of the U.S. cigarette market underway at the Food and Drug Administration (FDA) will result in reasonable, science-based regulatory decisions.

The synergies and higher sales volumes resulting from this transaction will position RAI's operating companies to fuel continued investment in product development, research and development, and innovation for the long-term future of the company. RAI anticipates that after completion of the acquisition, R.J. Reynolds will begin hiring for manufacturing and selected other positions and that process is expected to extend over an 18-month period.

Cameron will continue in that role after completion of the acquisition, and the company will remain headquartered in Winston-Salem. Murray Kessler, Lorillard's chairman, president and CEO, will join RAI's board after the closing.

RAI and Lorillard expect the deal to close in the first quarter of 2015. For details on the deal, including interviews with Cameron and Kessler, click here for the transaction website.

Imperial's Building Strategy

For its part of the deal, Imperial Group will acquire certain assets of RAI and Lorillard, including U.S. cigarette brands Winston, Maverick, Kool, Salem, and e-cigarette brand blu eCigs. In addition, the United Kingdom-based tobacco company will acquire the national sales force, offices and production facilities currently owned by Lorillard in Greensboro, N.C.

Imperial plans a brand portfolio strategy with a primary focus on Winston and blu, supported by a secondary focus on either Maverick, Kool or its own U.S. Gold on a state-by-state basis.

"These brands will combine with Imperial's existing U.S. portfolio at Commonwealth-Altadis. Imperial's existing U.S. brand portfolio currently accounts for a 3-percent share of the U.S. market, principally with USA Gold (share 1.2 percent) which is growing its presence in its target 19 states in the United States with a focused marketing and distribution strategy," the company stated.

Imperial also hopes to realize its growth ambitions as it expands nationwide from its 19-state presence.

The $7.1-billion deal builds on Imperial's strategy of investing in growth brands and growth markets, and boosts its U.S. portfolio. The addition of the national distribution and sales force "transforms Imperial into a major U.S. competitor," the company noted in a release.

Imperial has appointed Martin Orlowsky, former chairman, president and CEO of Lorillard, executive vice chairman designate of its enlarged U.S. business.

"A cigarette portfolio across different price points, including mass market cigars and a national brand leader in e-cigarettes, will make our business much more important to retailers," the company explained. "More sales visits, stronger retailer relationships, better coverage of key accounts and the resulting ability to achieve greater shelf space, merchandising and point-of-sale presence will be a key difference post the transaction and one that will support the increased brand investment."