Reynolds American and Lorillard Are Stronger Together

The dealReynolds American is buying Lorillard in a transaction valued

at $68.88 per share, or a total of $27.4 billion, including the assumption of net debt.

Lorillard shareholders will receive $50.50 in cash and 0.2909 of a share in Reynolds American for every Lorillard share, representing $68.88 per share based on Reynolds’ closing price on Monday.

British American Tobacco will retain its 42% ownership in Reynolds American through an investment of approximately $4.7 billion.

Asset divestmentsImperial Tobacco will be buying certain brands and other

assets from the combined company for a total cash consideration of $7.1 billion. Reynolds expects to receive net cash proceeds of approximately $4.4 billion after taxes from this sale.

Brands included in the transaction are Kool, Salem, Winston, Maverick, and blue eCig in the e-cigarette business.

Imperial is also acquiring Lorillard’s manufacturing and R&D facilities in Greensboro, North Carolina.

The rationale

Reynolds American will be in a much stronger position to compete against industry leader Altria after the acquisition.

Industry consolidation increases pricing power by reducing competition.

Cost savings, operational efficiencies, and scale advantages could be considerable.

A big challenge for AltriaAltria is the undisputed industry leader in the U.S. tobacco

market thanks to its Marlboro brand, which has a market share of 43.8%. Altria owns an estimated 51% of the market when considering all its brands.

Reynolds American and Lorillard are the second and third industry players, with a market share of 27% and 15%, respectively. The merger will substantially reduce the competitive gap, even if Altria will remain the industry leader.

Brand powerThe combined company will own many popular brands such

as Newport, Camel, and Pall Mall in combustible cigarettes, Grizzly in smokeless tobacco, and VUSE in e-cigarettes.

This will generate opportunities to optimize the product portfolio for better pricing power and more efficient competition against Altria and others.

With cigarette sales volumes falling across the industry over the last several years, pricing is a key factor when it comes to sustaining sales levels.

Size advantagesCost savings and synergies in areas such as administration,

operations, and distribution, among others.

Increased financial resources to invest in research and development, and opportunities to collaborate in new technologies.

A bigger and more diversified company could mean better access to low-cost financing because of increased financial strength.

Financial projectionsThe combined company is projected to have over $11 billion

in revenues and approximately $5 billion in operating income.

Cost savings are expected to be approximately $800 million on a run-rate basis.

Reynolds American expects the transaction to be accretive to earnings in the first full year, with strong double-digit accretion on a percentage basis in the second year and beyond.

RisksThe deal is still subject to approval from regulators as well

as shareholders from both companies. Considering that Reynolds American and Lorillard are the second and third industry players in terms of size, regulatory approval could be particularly uncertain.

Cigarette sales volumes are on a long-term decline, and that is a huge risk factor for investors in the business.

In addition, legal and regulatory uncertainties are particularly relevant in the tobacco industry.

Foolish takeawayThe merger between Reynolds American and Lorillard is a

smart strategic move in terms of competitive position, and it represents a big challenge for Altria.

Cost savings and scale advantages are another plus for shareholders in these companies.

On the other hand, falling sales volumes, as well as legal and regulatory risks, are major risk factors that deserve thoughtful consideration when analyzing investments in the tobacco business.

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