What Does The Reynolds-Lorillard Deal Mean For Altria?

+2.73%
Upside
44.51
Market
45.73
Trefis
MO: Altria Group logo
MO
Altria Group

The U.S. tobacco industry is highly consolidated, with three main players dominating the industry, viz. Altria (NYSE:MO), Reynolds American (NYSE:RAI), and Lorillard (NYSE:LO).  Of these, Altria takes the leading position, with close to 47% of the market in smokable tobacco and 55% of the market in smokeless tobacco. In July of last year, the news of a merger between Reynolds American and Lorillard surfaced. The proposed $27 billion deal is presently under consideration by the Federal Trade Commission (FTC), with Reynolds expecting closure by mid-2015. According to CLSA, there is a 50% chance for the deal to go through, whereas Wells Fargo expects approval with an 80% chance. [1] In case the deal is pushed through, the question arises as to what a stronger post-merger Reynolds could mean for Altria’s business.

Let’s start by looking at what Reynolds has to gain from this move. First and foremost, it will make Reynolds a stronger competitive force against Altria. Presently, Altria has around 47% of the U.S. tobacco market, Reynolds American has around 28%, and Lorillard has 12.6%. Post the deal, the competitive landscape of the tobacco industry could change, with analysts anticipating Reynolds’ market share to go up to 34%, after some divestitures.  [2]

Relevant Articles
  1. What’s Next For Altria Stock After A 15% Fall In A Year?
  2. What’s Next For Altria Stock After A 6% Fall In A Month Amid Downbeat Q3?
  3. Is Boston Scientific A Better Pick Over Altria Stock?
  4. Will Altria Stock Rebound To Its 2022 Highs?
  5. Here’s What To Expect From Altria’s Q1
  6. Should You Buy Altria Stock At $44?

Secondly, Reynolds is expected to have a major competitive edge in the menthol market. The deal will give Reynolds access to Lorillard’s menthol offering, Newport, which has managed to trump Altria’s Marlboro menthol for decades. This is commendable given that Marlboro holds the dominant position when it comes to traditional cigarettes.

However, things are not so simple for Reynolds and Lorillard, since mergers of this magnitude are mostly confronted with various antitrust issues, the biggest worry being that the deal would essentially turn the U.S. tobacco market into a duopoly. In order to counter this, the players proposed to sell off $7.1 billion worth of assets and brands to Imperial Tobacco, which according to the tobacco giants will give the British company a fairly strong U.S. presence, with close to 10% of the market. Imperial will see the addition of Winston, Salem, Kool, Maverick, and Blu e-cigarettes to its portfolio, all of which have been losing market share in the U.S. [3] Now, whether the Reynolds-Lorillard deal goes through or not, is to an extent, conditional on whether or not the FTC believes Imperial can establish itself as an important player in the American tobacco industry. In particular, the FTC questions whether Imperial will be able to stand up to the likes of Altria and Reynolds. [4] So what would all this mean for Altria?

It is clear that Reynolds, with a 34% market share as opposed to 28% pre-merger, will be a stronger force to deal with. Since the purchase of cigarettes tend to be an impulsive buy, Reynolds stands to gain plenty from combining its distribution channels, marketing muscle, and promotional activities with Lorillard. In particular, the two powerhouses could plug into each other’s shortcomings to prove to be stronger against Altria. For instance, presently, Reynolds’ Camel has a prominent presence among Caucasian smokers while Lorillard’s Newport is the brand of choice among African-American smokers. Furthermore, Camel is more prevalent on the West Coast while Newport has a stronger presence on the East Coast. [5] Clearly, if the two companies join forces, they are bound to have better demographic and geographic reach, which could really weigh on Altria.

Apart from an inorganic increase in market share following the combination, there are other reasons why a stronger Reynolds could eat into Altria’s market share. For one, post-merger Reynolds’ presence could really harm Altria in the menthol category, which is fairly important for cigarette makers. This is because, although both regular cigarettes and menthol cigarettes are seeing volume declines, the rate at which menthol cigarette consumption is declining is around half that of regular cigarettes. [6] Lorillard’s brand, Newport, which accounts for close to 37% of the menthol market, has actually been witnessing rising shares over the past few years. [7] Apart from Newport, Reynolds has its own brand Camel at the number 3 position in the menthol market, with a 12% share. [2] Hence, with these two brands, Reynolds could potentially threaten Altria’s Marlboro Menthol offering, which currently has an 18% market share.

This is particularly true among “adult smokers under 30 (ASU30).” While older smokers tend to have settled on a brand and display loyalty, ASU30 tend to demonstrate higher rates of switching and are more responsive to promotions and pricing strategies. It is for this reason that this group is often the target group for cigarette manufacturers, who increasingly try to consolidate their brands among these customers to ensure brand loyalty going forward. Presently, market shares in this category stand at 42.9% for Altria, 27.6% for Reynolds, and 19.5% for Lorillard. Post the merger, Reynolds is expected to win in this category with a market share of 47.1%. Furthermore, the divestiture of brands to Imperial tobacco is only expected to have a minor impact on shares in this group. This performance among ASU30 is expected to come from Newport and Camel brands, which have a 22% and 12% market share, respectively, among smokers under the age of 25. According to research by Citi group, while market shares for Camel and Newport increased by 65% and 30%, respectively, among 18 to 25 year-olds between 1999 and 2010, that for Marlboro declined by almost 20%. So what does this indicate? If this trend continues, and if Reynolds manages to build its brands among this group, it could ultimately lead to lower sales even in the over 30 category for Altria in the future. Furthermore, these figures point to the increasing rate at which Camel has been establishing itself, which could lead to Marlboro being entirely knocked off it’s number 2 position in the Menthol segment. [8]

Within the menthol segment, Reynolds also stands to gain a certain degree of pricing power. With America’s number 1 and number 3 brand in its portfolio, Reynolds could increase prices in a way that it continues to reap profits without really losing its customer base. For instance, suppose Reynolds chooses to increase the price of Camel cigarettes. In this case, there will be some consumers who may choose to switch to a cheaper alternative and some would choose to remain loyal to Camel and pay the higher price. Now, with the number 1 brand, Newport, in its portfolio, chances are that those who switch actually end up consuming Newport. In this situation, Reynolds will gain from those paying more for Camel without really losing out on sales from those who choose to switch. This is one of the FTC’s main arguments against the merger, since a unilateral price increase could ultimately hurt consumer interests. While Reynolds makes a case citing that any increase in prices could, in fact, hurt them by moving customer traffic to Altria’s Marlboro, it could be something the company may use to drive profits, especially when they have the market leader with them. ((Reynolds American/Lorillard: A Closer Look at Reynolds’ Arguments on Unilateral Effects, Head to Head Competition, The Capital Forum))

There is no doubt that there is hardly any silver lining for Altria in a situation where the FTC approves the deal. However, the FTC could put up further restrictions or asset sales in order to preclude any anti-competitive moves in the industry, which can disrupt the efficiencies Reynolds and Lorillard hope to gain. Further, and possibly the biggest impediment for realization of the gains from the deal, could be a ban on the sale of menthol cigarettes, which is increasingly being adopted across many countries. Given that Reynolds’ biggest benefit and Altria’s biggest weakness lies in the menthol segment, regulation against the sale of the product could potentially turn the dynamics around, in the post-merger American tobacco industry.

We have a price estimate of roughly $47 for the Altria Group, which is slightly below the current market price.

See Our Complete Analysis For Altria

View Interactive Institutional Research (Powered by Trefis):

Global Large CapU.S. Mid & Small CapEuropean Large & Mid Cap

More Trefis Research

Notes:
  1. For Reynolds and Lorillard, Shareholder Vote Is the East Step []
  2. Reynolds American, Lorillard Shareholders OK Merger [] []
  3. Here’s What you Need to Know About the Reynolds American Lorillard Deal []
  4. Report: FTC approval for Reynolds and Lorillard merger is going to happen []
  5. Reynolds American Bets on Menthol Cigarette Brands []
  6. Menthol Cigarette Acquisition Could Help Camel Maker Reach Minority And Younger Smokers []
  7. Lorillard Inc., Form-10K, SEC []
  8. Reynolds American/Lorillard: A Closer Look at Reynolds’ Arguments on Unilateral Effects, Head to Head Competition, The Capital Forum []