It has been almost a year since Reynolds American Inc., Winston-Salem, N.C., confirmed what industry analysts had long predicted: The No. 2 tobacco company intended to purchase No. 3 player Lorillard Inc., Greensboro, N.C. Though many believed it was only a matter of when, not if, the deal would go through, no one knew for certain if the U.S. Federal Trade Commission (FTC) would require further divestitures—or block the deal outright.
Exactly as Proposed
That answer came in late May, when the FTC voted 3 to 2 in favor of the proposed consent agreement, authorizing Reynolds to close its acquisition of Lorillard with no changes to the proposed divestitures to Imperial Tobacco’s ITG Brands LLC subsidiary, based in Bristol, U.K.
“The merging parties chose to present this acquisition to the commission with a proposed divestiture aimed solely at securing our approval of the acquisition,” the FTC wrote. “As proposed, Reynolds will purchase Lorillard for $27.4 billion and then immediately divest certain assets from both Reynolds and Lorillard to Imperial Tobacco Group plc in a second $7.1 billion transaction. At the end of both transactions, Reynolds will own Lorillard’s Newport brand and Imperial will own three former Reynolds’ brands, Winston, Kool and Salem, as well as Lorillard’s Maverick and e-cigarette blu brands, and Lorillard’s corporate infrastructure and manufacturing facility.”
One week later, Reynolds announced that the final significant condition facing the acquisition—the approval of the federal district court overseeing a remedial order in relation to a lawsuit brought by the U.S. Department of Justice against subsidiaries of Reynolds and Lorillard—had been cleared, and the deal officially went through June 12 (subject to remaining closing conditions).
In other words, one year later, the merger is going exactly as proposed.
Uncertainties Remain
And yet there are still many uncertainties surrounding what this major shakeup of the tobacco industry ultimately means for retailers. Exactly which Lorillard reps will go to Imperial? (The deal acknowledged some may move to Reynolds.) Can Imperial fill Lorillard’s shoes as a true third player without a powerhouse like Newport in its portfolio? What happens to Reynolds’ contracts now?
“The industry is resilient and the players will work this all out,” says Lou Maiellano, a former tobacco buyer for Sunoco and president of Sevierville, Tenn.-based TAZ Marketing & Consulting Group. “Is it good or bad for retailers? Only time will tell.”
Here’s a look at some of the most pressing questions hanging over this big tobacco deal.
A Significant No. 3?
Whether Imperial can capture the 10% share the deal estimated is one of the larger unknowns. Vivien Azer, a tobacco analyst for The Cowen Group, New York, is dubious about ITG’s potential as a No. 3 competitor given the more discount brands it’s acquiring.
“It’s less of a possibility, in my opinion, given in particular the outsized preference for premium offerings of adult smokers under 30,” she says.
Both Maiellano and New York-based Wells Fargo analyst Bonnie Herzog pointed to Winston as a huge opportunity for Imperial not only to maintain share but also grow it.
“When I was a retailer, when the correct emphasis was put behind Winston, it actually grew,” Maiellano says, also citing Winston’s success globally. “Winston could be a brand of revival.”
Herzog referenced in a research note tests Reynolds conducted in 2012, in which greater marketing and promotions for Winston resulted in a “small surge.”
“I believe Reynolds performed this test on Winston in an effort to ‘prove’ that it has brand equity and can therefore show some signs of life and take share if given a little love,” Herzog wrote.
Perhaps more important than Winston’s (or any one brand’s) potential is what Maiellano describes as the “very talented and quality team” Imperial is inheriting from Lorillard.
“If you asked Imperial what their weakness is, in the past not only did they not have the brands, they did not have the infrastructure,” Lorillard CEO Murray Kessler told CSP last September.
“It’s a big component of how Imperial views this investment: It’s not just in the brands, but the people. They’ve tripled their selling organization in size, sales and capacity.”
Still, Herzog said 62% of retailers participating in Wells Fargo’s annual “Tobacco Talk” survey predicted Imperial will lose cigarette share in the aftermath of the deal, because of less-than-optimal shelf space and servicing of the new brands.
That isn’t necessarily a bad thing. Even if Imperial doesn’t fill Lorillard’s shoes as the No. 3 player, another company could swoop in.
“One thing that could happen is the Liggett-Vectors or the JTIs of the industry could create some value in the midst of this confusion,” Maiellano says. “They might be capable of gaining some presence.”
Head To Head With Altria
Out of all the potential positives from the Reynolds-Lorillard-Imperial deal, the Wells Fargo “Tobacco Talk” respondents listed “a stronger No. 2 to go head to head with Altria” as a top benefit, echoing Kessler’s position on the deal.
“After this deal is completed, Reynolds becomes a stronger No. 2 U.S. competitor who goes to a 32% market share,” he said. “They’ve spent $27 billion and will want to do everything to grow those brands, making this a success. There’s no doubt in my mind that this means more competition for Altria.”
Even with a 32% share once Newport is added, Reynolds will still be a distant second to the roughly 50% of retail cigarette sales owned by Altria Group Inc., Richmond, Va. However, as Azer points out, it’s not just about the numbers, but also with which brands and in which subcategories the various players are succeeding.
“Reynolds is in a stronger position today with the deal, given their bigger exposure in the menthol subcategory, which has historically been an advantage subcategory relative to non-mentholated cigarettes,” she says. “I do view this as good for the tobacco industry. Consolidating the industry really reinforces their pricing power, which in turn drives profitability.”
Maiellano prefers to look at the situation not in terms of how Reynolds stands up to Altria but how this restructuring changes the tobacco industry as a whole.
“Is Reynolds a threat, or is it a neutralizer to Altria?” he says. “It could create a more even playing field between the top two. That could potentially be very, very good for retailers.”
CONTINUED: Good or Bad for Retail?
Whither EDLP?
The shifting of brands and a different “Big Three” aren’t the only changes retailers may face in the wake of this landmark merger. Herzog anticipates the deal may prompt changes to Reynolds’ Every Day Low Price (EDLP) program.
Many retailers have been opting out of the voluntary retail program, which grants participants promotional allowances for Camel and other brands in exchange for aggressive pricing. Participation is down to 60%, perhaps because of the requirement that retailers use EDLP pricing in all locations (vs. Altria’s Marlboro Leadership Price program, which now allows retailers to pick and choose which stores participate).
“I don’t have that insight on what Reynolds might do with EDLP,” Maiellano says. “We’ll see. Retailers dislike the EDLP program and many of them work around it. What does Reynolds do at this point?”
With the FTC not preventing Reynolds from adding Newport to EDLP, the company has multiple options: add Newport to its existing program, not add Newport, or add Newport while updating the terms of EDLP.
Herzog suspects Reynolds will add Newport to its EDLP program, in one way or another, to manage price gaps and accelerate share gains and also entice retailers to participate in the program.
“Newport could be the ‘carrot’ that Reynolds dangles,” she wrote. “If Reynolds includes Newport in its EDLP program, retailers should have a greater incentive to join, although some feel they may have ‘no choice’ given the importance of Newport.”
For the time being, no one knows for sure what Reynolds will or won’t do with the EDLP program.
“It’s hard for retailers to speculate because they don’t yet know what the contracts are,” Maeillano says. “You don’t know what these programs are going to look like, or how Altria’s going to respond.
“That part of it’s not really fun.”
Good or Bad?
Here’s the ultimate question on retailers’ minds: Will this deal be good or bad for business?
Though Wells Fargo’s “Tobacco Talk” showed retailers listed stronger competition for Altria as one of the biggest potential benefits, they also said key negatives would be only two “powerful” cigarette companies with stricter contracts and even lower cigarette margins for retailers.
Andrea Myers, president of Kocolene Marketing LLC, Seymour, Ind., believes such concerns are valid.
“Any time there’s consolidation of big companies such as these two, it’s not good for retailers,” she says. “There aren’t too many big players out there anymore, and now this one will hold a really big stick. Big sticks aren’t good for little retailers.”
However, retailers are seemingly moving toward a more positive outlook. In an April 2015 RBC Capital Market/CSP survey of tobacco retailers, 37.5% said the merger will have a positive effect on business, vs. 20.8% predicting a negative effect. That’s a big difference from a July 2014 survey, in which 27% of respondents were for the merger and 32% were against it.
The majority of retailers in both surveys expressed a “wait-and-see” attitude. Nearly 42% of respondents in the April survey said they were unsure or neutral about how the deal would affect their business, almost exactly the same percentage of retailers who described themselves as uncertain last July.
“Once we see the changes to Reynolds, Lorillard and Imperial, we can make a more fact-based comment,” says Anne Flint, manager of tobacco and other tobacco products (OTP) for Framingham, Mass.-based Cumberland Farms. “We really have not seen any changes from either side and probably won’t see a lot over the next six months.”
Maiellano, however, remains cautiously optimistic. “There’s always going to be ups and downs, things you like and things you don’t like,” he says. “Most of the consolidation that’s happened has been good. It makes the business much more profitable.”
Retailer Conjecture and Concerns
- “Newport will be stronger due to Reynolds’ EDLP program.”
- “Is it good or bad for retailers? Only time will tell.”
- “What brands survive: Vuse or blu? That is the biggest question.”
- “Less competition is usually not a good thing. I see more of a duopoly.”
- “This makes life easier with one less vendor (for retailers) to deal with.”
- “Imperial is going to win on this deal.”
- “How will Imperial gain visible space on the cigarette backbar?”
- “The more powerful the largest companies become, the lower retailer margins are pushed.”
- “My only concern is if blu is impacted, because that is a strong brand in my stores.”
Sources: Wells Fargo Securities 1Q15 “Tobacco Talk” Survey, RBC Capital Markets/CSP April 2015 Tobacco Outlook Survey, CSP interviews
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