$25 billion tobacco merger promises to shake up industry

Reynolds American is to buy rival Lorillard for $25 billion, merging two of the world's biggest cigarette makers in a deal that includes the sale of the top-selling US e-cigarette to Britain's Imperial Tobacco .

The deal, which gives Reynolds control of Newport menthol cigarettes, strengthens the combined company's hand in competing for a shrinking pool of smokers and sets up a three-way battle with Marlboro-maker Altria Group for the e-cigarette market.

Imperial's purchase of the blu e-cigarette brand, as well as Reynolds' Salem, Winston and KOOL and Lorillard's Maverick brands, is meant to ease potential antitrust concerns from the marriage of the number two and number three US tobacco companies.

While cigarette sales volumes have been falling about 4 per cent a year, e-cigarette sales have been booming. E-cigarettes generate roughly $2 billion a year in sales in the United States, and some industry analysts expect sales to overtake the $85 billion conventional-cigarette industry within a decade.

The divestiture of blu surprised many analysts as the brand, which has 40 per cent of the US e-cigarette market, could have boosted Reynolds’ lead in the fast-growing market.

Reynolds sells its own e-cigarettes under the Vuse brand, but controls less than 5 per cent of the market, according to Euromonitor. "It looks like everybody gets what they wanted," said Morningstar analyst Philip Gorham, adding that the deal will likely win approval from antitrust regulators.

Reynolds’ purchase of Lorillard’s Newport brand gives the company a stronger presence in the market for menthol cigarettes, which experts say have disproportionate popularity among young people, lower-income smokers and African-Americans.

Newport had 12.6 per cent of the overall U.S. market in 2013. Menthol cigarettes have roughly a 28 per cent market share in the United States, according to Euromonitor.

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 per cent since reports of the deal first surfaced in February, were down 7.5 per cent at $62.19 on Tuesday. Reynolds' shares were down 4 percent at $60.61. 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 more shares to maintain its 42 percent stake in Reynolds through a $4.7 billion investment. Reynolds' financial advisers are Lazard and JP 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.