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— Analysis —
"Fast forwarding a few years, we find it hard to believe that UST, Lorillard, Swedish Match and even Reynolds American will all exist in their current forms," UBS analyst Nik Modi wrote in a June 24 report on the tobacco industry, then rightly predicting the sale of smokeless giant UST, maker of Copenhagen and Skoal. Next on the block may likely be Lorillard Tobacco Co., the Greensboro, N.C., cigarette maker; speculation has Reynolds as the probable buyer. Lorillard's coveted Newport menthol cigarettes are the best-selling and fastest-growing menthols on the market.
With Lorillard, Reynolds would gain that leading brand and a well-run company and generate substantial cost savings that it could use to reinvest into growth products and expansion into other areas. "We believe Reynolds American is a willing buyer and Lorillard's management team and board ... would be willing sellers at the right price," Modi wrote. Neighboring Reynolds, the Winston-Salem, N.C., maker of Kool menthol, Pall Mall and Camel cigarettes and the parent company of R.J. Reynolds Tobacco Co., last week set the stage for a possible deal when it announced it was downgrading Kool from a growth brand to a "support brand," while Camel and Pall Mall will remain as growth products. Analysts have long predicted a Reynolds-Lorillard merger could startle regulators with the combination of Newport and Kool and that Reynolds may choose to divest its Kool brand, should it embark on the deal. "We view the Kool menthol repositioning as a potential preemptive portfolio adjustment to mitigate antitrust questions on any future acquisition of Lorillard's no. 1 U.S. menthol brand Newport," wrote Erik Bloomquist, an analyst at J.P. Morgan Securities Inc., in a Sept. 9 research note. A combined Newport-Kool business would give Reynolds 54% of the menthol market. Tobacco brands have been trying to kill each other for decades. Reynolds American was formed by the $2.5 billion merger of R.J. Reynolds and the U.S. operations of Brown & Williamson Tobacco Corp. in 2004. London's British American Tobacco plc, the former owner of Brown & Williamson, owns 42% of Reynolds American through the merger. On July 31, New York-based Philip Morris International Inc., which Altria spun off in March, moved to take full control of Rothmans Inc., offering C$2 billion ($1.95 billion) for Canada's second-largest cigarette maker. In November 2007, Richmond, Va.-based Altria paid $2.9 billion to buy cigar maker John Middleton Inc. from privately held Bradford Holdings Inc. to expand beyond cigarettes in the U.S. For many years, the industry relied on cash flow from cigarettes. But now it must diversify its product lines as cigarette sales continue to decline at roughly 3% anually. Moist smokeless tobacco, or MST, products, meanwhile, are expected to expand at a 5% to 6% rate over the next several years. Cigarette sales have steadily dropped because of statewide smoking bans, rising federal and state taxes on the products, the inability to advertise in most mediums and because fewer people are lighting up due to health concerns. And while litigation against tobacco companies has slowed, it's still a problem. As of year-end 2007, more than 4,000 claims had been filed against the U.S. tobacco industry, according to a May report by Standard & Poor's, though lawsuits tend to be less threatening to industry cash flow than in previous years. Steve Ralston, a senior research analyst at Zacks.com, says tobacco companies, once focused primarily on cigarettes, are like old-time buggies in that they are part of an industry in a steady decline. "The buggy bus used to be a very growing and prosperous industry back in the late 1800s, but things changed," he says. Smokeless tobacco, however, has become a fad of sorts among young people and has received less health-related scrutiny than cigarettes. Some tobacco players, such as Sweden's Swedish Match, are touting their "snus," or smokeless, pasteurized tobacco pouches, which by some accounts pose less of a health risk to users. Altria's Philip Morris USA launched Taboka, a smoke-free, spit-free tobacco pouch in 2006. The growth of smokeless tobacco has prompted some deals, including Altria's purchase of UST, since cigarettes compose about 70% of Altria's business. "The acquisition will give Altria immediate national scale in the highly profitable MST category," Altria chairman and CEO Michael Szymanczyk said in a press conference on Sept. 8. UST commands a 58% share of the MST sector, and Copenhagen and Skoal have a combined share of almost 50%. Altria also owns Philip Morris Capital Corp., John Middleton and the maker of such cigarette brands as Marlboro, Parliament and Virginia Slims. The company also holds a 28.5% economic and voting interest in beermaker SABMiller plc. "They had to make a move at some point ... to bring in something to the portfolio that was tangential to cigarettes," says Gregg Warren, an equity analyst at Morningstar Inc., about Altria. Two years ago, Reynolds American bought smokeless company Conwood Co. LP, the second-largest smokeless tobacco maker, for $3.5 billion to bolster its smokeless business. The U.K.'s Imperial Tobacco Group plc or other suitors could also pursue Lorillard. "Given the growing nature of its business, we believe other players would have to at least consider taking a look," Modi wrote. He predicts Imperial, which has already shown interest in the U.S. market with a handful of acquisitions, may "jump into the mix" if Reynolds steps forward with an offer. Imperial, though, is still digesting its €16.2 billion ($25.1 billion) purchase of Franco-Spanish Altadis SA, which it acquired last year. Imperial or Lorillard may look to buy Swedish Match. Lorillard and Swedish Match already operate a joint venture together, Triumph Snus, and the deal would give Lorillard access to premium hand-rolled cigars, moist smokeless tobacco and snus. Most analysts believe M&A activity following the Altria deal will be minimal, with a Reynolds-Lorillard deal the most sensible in the near term. Reynolds holds a second-place market spot in both the cigarette and smokeless tobacco sectors. "Their margins are likely to continue to shrink" says Chris Collins, associate director at Fitch Ratings. "They've been under pressure for several years now." Still, he says, a deal would be expensive to finance. Companies may be itching to do deals before the end of the Bush administration, since some may fear Democrats could toughen antitrust regulations if they win the White House. "The pressure is on for companies with adequate funding to consider buying strategic assets before the M&A window shuts further from another combination," Modi says. |
Marlboro maker 
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