Transaction Overview

Reynolds American (ticker: RAI) announced an agreement to acquire Lorillard (LO) for $27.4 billion in a cash-and-stock transaction valued at $68.88 per LO’s share (based on RAI’s closing price on 7/14/14).  As noted by Reynolds, this price represents a premium of about 40% to Lorillard’s stock price on February 28, 2014, which was the last trading day prior to initial media speculation around a possible transaction.

The deal is complex as it is actually a four-way transaction involving British American Tobacco (BATS.LN) as well as Imperial Tobacco Group (IMT.LN).  As part of the deal, IMT will buy some brands from RAI and LO in an effort to mitigate antitrust concerns. Included in IMT’s $7.1 billion purchase are the Salem, Winston, Kool and Maverick cigarette brands, as well as the Blu eCigs brand.  Moreover, BATS is injecting $4.7 billion into the combined RAI/LO company to maintain its existing 42% ownership of RAI.

E-Cig Details

As we noted in Cornerstone’s conference call earlier this year, e-cigarettes currently account for less than 0.5% of global volumes, though they have come a long way in a relatively brief period of time.  In 2007, e-cig sales in the US, their largest market, were under $10 million and have now grown to $1.7 billion.  Prior to this deal, the Big 3 (Altria (MO), RAI and LO) constituted about a 95% market share for conventional cigarettes, yet they held less than half of the e-cig market, and LO’s Blu brand accounted for the large majority of this share.  Clearly, the deal has significant ramifications for Imperial, as it vaults them ahead of competitors and into a leadership position in the e-cig market.

Given Blu’s dominant market position, it is somewhat surprising that it is among RAI’s divested brands.   That said, RAI expresses confidence in its own e-cig brand, VUSE, stating that it “offers superior technology and has received very positive early results in its national rollout.” It’s also worth noting that RAI and BATS have the opportunity to collaborate on next-generation products, including e-cigs and so-called “heat-not-burn” tobacco products.

Investor Perspective

Investors are currently questioning the sustainability of e-cig growth given that U.S. sales fell 6.1% YoY in the 4 weeks ended June 15 (volume -5.2%, price -1%).  Not only did this mark the second consecutive YoY decline, but it’s also in stark contrast to the 60% YoY increase over the trailing 52-week period.  There are varying opinions on what’s driving stalling e-cig sales, but we believe the cause is twofold:

1) Technology: E-cig technology is still insufficient to drive adoption, as evidenced in data that shows only about 25% of smokers who try e-cigs become regular users (others return to traditional methods).

2) Competition from open system vapors/tanks: Refillable vaporizers allow users to control nicotine content and flavor, and often are larger and have more battery power. These systems are fairly common in the burgeoning “vape shop” market that has sprung up nationwide.

Still, we believe in the long-term potential for e-cigs if the technology is met with sensible regulation and a responsible and transparent approach from the industry itself.  The large industry players are dedicating significant resources towards improving e-cig technology, suggesting that the aforementioned low e-cig conversion rate should improve over time.  On the regulatory front, the FDA’s recent announcements focus on banning sales to teens and requiring content disclosure, but not in addressing advertising nor ingredients, such as flavor enhancements.  At the same time, we think that sensible regulation favors the larger players that are able to manage the costs associated with regulatory standards, such as quality assurance.  On the margin, this could be destabilizing to the current “wild west” vape shop model.

When assessing the value of e-cig brands, investors should consider how industry players are pursuing the business. We note that NJOY developed a code of conduct that starts with their goal to make tobacco obsolete and includes voluntary actions to restrict sales to youth, restrict certain flavors and marketing approaches, introduce safety standards, and invest in research aimed at refining the product in terms of nicotine uptake as well as safety.

We will continue to monitor the emerging details of how IMT and RAI plan to market their respective e-cig brands in order to assess long-term value and potential investment performance.

 

Michael Shavel, CFA, is the Research & Business Analyst at Cornerstone Capital Inc. and a former Research Analyst on AllianceBernstein’s Global Growth & Thematic team.