By Anjali Athavaley and Siddharth Cavale
(Reuters) - Reynolds American Inc's proposed $25 billion acquisition of smaller rival Lorillard Inc shows how the tobacco company is placing its bets on the market for menthols even as a growing number of smokers opt for e-cigarettes.
With the deal, Reynolds American picks up Newport menthol cigarettes, one of the few U.S. brands that is gaining share in a shrinking market. At the same time, Reynolds is giving up blu - the top-seller in the e-cigarette market seen by many as the tobacco industry's future - to Britain's Imperial Tobacco Group.
As part of the deal, Imperial will buy Reynolds' Salem, Winston and KOOL and Lorillard's Maverick brands in a move meant to ease potential antitrust concerns. Experts say that still may not satisfy regulators.
Sources familiar with the transaction said gaining the blu brand made the deal more attractive to Imperial. While cigarette sales volume has been falling about 4 percent a year, e-cigarette sales have been booming. Reynolds sells its own e-cigarettes under the Vuse brand but controls less than 5 percent of the market, according to market research firm Euromonitor International.
But Reynolds' chief executive officer, Susan Cameron, says Vuse has a "superior technology" that will make it a strong contender in the e-cigarette market. The company, which started selling Vuse roughly a year ago in Colorado and Utah, is rolling out the product nationwide this quarter.
Meanwhile, Reynolds' purchase of Lorillard's Newport brand gives the company a stronger presence in the market for menthol cigarettes. Menthols now make up 31.4 percent of the total market compared with 26 percent in 2002, according to Morningstar.
"The e-cigarette category is very small today," said Cameron. "It's growing and consumers are interested in it, but this transaction is really about adding Newport to our portfolio."
Menthol is a mint-flavored additive that may reduce the irritation and harshness of smoking when used in cigarettes, according to the U.S. Food and Drug Administration.
Experts say menthols have disproportionate popularity among young people, lower-income smokers and African-Americans. The FDA last year released a preliminary review that said that a majority of African-American smokers use menthol cigarettes. Menthols were also associated with lower socioeconomic status, according to the FDA review of available studies.
But the deal shows that Reynolds isn't banking on significant regulation of menthols by the FDA, which regulates the substance in medical products but not in cigarettes. The agency is conducting its own studies on the topic and has said it would consider restricting the use of menthols.
In an interview, Lorillard’s CEO, Murray Kessler, said both companies are confident there is no justification for regulating menthol cigarettes differently than nonmenthols.
Analysts have also said that smoking-related lawsuits are leveling off in the United States, making it a ripe time for consolidation in the industry.
"I think the industry believes the litigation environment is manageable and has certainly improved over the last decade," said Kessler.
Still, health advocates have raised concerns that the proposed acquisition would bring together two companies they say have a history of marketing to children and minorities.
"A bigger tobacco company is not better for public health," said Lisa Henrikson, a senior research scientist at Stanford Prevention Research Center, part of the Stanford University School of Medicine.
Lorillard and Reynolds declined to comment.
The companies also downplayed concerns that the deal wouldn't pass antitrust scrutiny. The planned divestitures could be just a starting point, with more offered if regulators balk at allowing the deal, said Andre Barlow, an antitrust expert with Doyle, Barlow & Mazard Pllc.
"We are very confident we will close this in the first half of 2015," Cameron said.
Cameron will continue to be president and CEO of Reynolds, the company said. Kessler will join RAI’s board after the closing of the transaction.
Reynolds, whose brands include Camel and Pall Mall, offered $68.88 per Lorillard share, representing a premium of 2.5 percent to Lorillard's Monday close.
Lorillard's shares, which have risen about 37 percent since reports of the deal first surfaced in February, were down 7.5 percent at $62.19 on Tuesday.
Reynolds' shares were down 4 percent at $60.61. Imperial's shares were down 3.4 percent at 2,647 pence in London.
Including debt, the deal is valued at $27.4 billion.
Reynolds said it expects to have over $11 billion in revenue and about $5 billion in operating income annually after the deal closes. Reynolds had sales of $8.24 billion in 2013.
British American Tobacco, Reynolds' largest shareholder, will buy shares to maintain its 42 percent stake in Reynolds through a $4.7 billion investment.
BAT's shares were down 1.8 percent at 3,532 pence on the London Stock Exchange.
Reynolds' financial advisers are Lazard and J.P. Morgan Securities, while Lorillard is being advised by Centerview Partners and Barclays Plc.
Legal advisers to Reynolds are Jones Day, while Simpson Thacher & Bartlett is advising Lorillard.
BAT is being advised by Deutsche Bank and UBS. The legal advisers to BAT are Cravath, Swaine & Moore and Herbert Smith Freehills. Credit Suisse and Goldman Sachs advised Imperial.
Allen & Overy represents Imperial Tobacco. The team is led by London partner Jeremy Parr and U.S. partner Eric Shube and was supported by Elaine Johnston, David Ernst, Brian Jebb, Shira Selengut, Mark Davis, Sarah Shaw, Mike Maier, Jochem Beurskens, Loren Thomas and Natalie Montano. In-house counsel was Anthony Pickard-Rose.
(Additional reporting by Sweta Singh, Sagarika Jaisinghani and Shailaja Sharma in Bangalore, Martinne Geller in London, and Jilian Mincer in New York; Editing by Saumyadeb Chakrabarty and Prudence Crowther)