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Reynolds is now focusing solely on 'brand growth' in the U.S. market.

Reynolds-Lorillard: A nicotine juggernaut in the making?

May 22, 2014

FORTUNE -- Reynolds American's reported move to acquire rival cigarette maker Lorillard could be too much for regulators to inhale.

The combined company would not only dominate certain segments of the cigarette business, it would also have a leading position in the nascent, but growing, e-cigarette market as well. While the traditional cigarette market is shrinking, Washington may still not take too kindly to Big Tobacco getting any bigger.

At the end of trading on Wednesday, reports emerged that tobacco kingpin Reynolds American (rai), maker of such brands as Camels, Pall Mall, and Kool, was in "late stage talks" to acquire Lorillard (lo), which makes brands like Newport, Kent, True, Maverick, Old Gold, and blu eCigs, in a deal that could be worth $60 billion.

Talk of a merger between the second (Reynolds) and third (Lorillard) largest tobacco companies in the U.S. has been swirling around for the last few months, helping to elevate shares in both companies relative to their peers. Despite all the talk, Lorillard's stock still jumped nearly 10% yesterday as investors scrambled to get a piece of the company before it was too late.

The specifics of the deal are a bit sketchy, as neither company has confirmed the deal chatter, but apparently the two sides have been working together for months to hash out an agreement that would make everyone happy and, most importantly, pass regulatory scrutiny.

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But there is no mistaking the fact that Reynolds-Lorillard would still be a smoking behemoth. Reynolds currently has 27% of the U.S. cigarette market while Lorillard has 15%. A merger would give the company control of 42% of the U.S. cigarette market. While that may sound absurdly large, Altria (mo), the maker of Marlboro, would still have a larger market share, at 47%.

Since the newly combined company's share of the overall U.S. tobacco market would still be smaller than that of Altria, some investors have speculated that the government might approve the deal. But the devil is in the details. While Reynolds-Lorillard will control less of the overall market, it will dominate certain segments of the industry, much to the chagrin of antitrust regulators.

For example, Reynolds-Lorillard would end up controlling both the No. 1 and No. 2 menthol cigarette brands in the U.S. -- Newport Menthol (Lorillard) and Kool (Reynolds). As such, the new entity would control 80% of menthol sales in the U.S. Menthol's make up nearly a third of overall cigarette sales in the U.S., giving a combined company huge pricing power, especially in urban markets, where menthols are largely sold.

The new company would also have a dominant position in the e-cigarette business. Lorillard's blu e-cig brand on its own maintains a 40% market share in the industry. Combined with Reynolds's VUSE e-cigarette, which has recently rolled out to positive reviews, the new company could easily control well over 50% of the e-cig space by year's end.

Only Altria has the distribution network to counter the newly combined Reynolds-Lorillard e-cigarette juggernaut, but it has been slow to market. Indeed, the company is just now starting to roll out its MarkTen brand e-cigarette this quarter. It is unclear how it will fare against the more established brands from Big Tobacco as well as from smaller independents like Vapor Corp and others.

E-cigarettes are a big business, generating $2 billion in sales in 2013. By 2020, sales of e-cigarettes are projected to overtake sales of traditional cigarettes. Clearly, whichever company dominates this space will hold the key to the U.S. nicotine delivery market for the foreseeable future.

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Regulators may have a problem with Reynolds-Lorillard dominating the e-cigarette space so completely. The smaller, independent e-cig companies simply can't compete against Big Tobacco's distribution and marketing power and will probably end up as rounding errors when all is said and done.

It has been some time since we've seen any deal activity in the cigarette market. With so few players and such high potential liabilities, a lull was understandable. But with e-cigarettes now moving into the mainstream, consolidation makes sense again and Reynolds wants to pounce before it's too late. Given how big the newly combined entity will be in both traditional segments of the industry, like menthols, as well as in the new e-cig segment, chances are regulators will be giving this deal a very thorough once-over.

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