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Reynolds, Altria Lead Smokers Toward Tobacco's New Era

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 (RAI), announced on July 15 it plans to buy Lorillard (LO) in a deal that would create a tobacco company in the U.S. second only to Altria Group (MO), 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 the market.

Big Money

Reynolds' largest shareholder, British American Tobacco (BTI), 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 electronic cigarettes.

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 deal.

"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 Lorillard shareholders.

"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 Azer.

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," she said.

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 note.

In a report, Lavery gave it a 50% chance to be approved as is.

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 even higher.

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 front.

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 Thomson Reuters.

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 Agnese.

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 and Prevention.

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 cash.

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 vapor.

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 report.

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 release.

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 release.

Independent startups such as NJOY, Logic and Vapor have also launched e-cigarettes.

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 years.

"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 share.

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," Herzog said.

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 ban.

He also notes that regulators are still "assessing the impact of e-cigarette smoking on consumers' health and whether to impose restrictions."