Death or Evolution? Big Tobacco Consolidates

Source: Justin Sullivan/Getty Images

Source: Justin Sullivan/Getty Images

Once considered one of the more ironclad industries, tobacco is not as strong as it once was. Because of that, the industry itself is starting to see big-time seismic shifts, most notably the announced merger between Reynolds American (NYSE:RAI) and Lorillard (NYSE:LO). Reynolds American will buy its smaller rival for a reported price of $27. 4 billion, completing a deal that has been in the works for more than a year. The merger puts Reynolds American in a better position to battle another big rival, Marlboro maker Altria Group (NYSE:MO), parent company of Philip Morris (NYSE:PM).

The merger isn’t quite as cut and dry as it would seem on the surface, as some third parties are also involved in the shift. A Lorillard manufacturing plant will be shifted to The Imperial Tobacco Group, which is also throwing down $7.1 billion in exchange for several brand names, including Winston, Salem and Kool. The Imperial Tobacco Group will also be taking on Blu e-cigarettes, a growing brand in the new electronic smoking sector.

Last but not least, British American Tobacco is spending $4.7 billion to buy more shares in the new company formed from the merger. British American Tobacco already holds a 42 percent ownership stake in Reynolds American, and is looking to maintain its current ownership level.

It’s all terribly messy, but in the end it’s another example of the consolidation of power in one of the world’s biggest industries. Tobacco is a bit different from the world of tech and telecom, however. Both of those industries are rife with mergers and acquisitions, as has been seen with news of internet service providers joining hands, and mobile phone carries teaming up to become monopolistic behemoths. The tobacco world is strange in that there have been coordinated efforts from consumer and government groups to get people to stay away from it altogether.

It’s also important to note that the big tobacco companies have also engaged in widespread deception tactics to retain customers and gain more, and that their products lead to 6 million annual deaths and costs the economy $500 billion each year, according to U.S. News and World Report.

Big tobacco has been under fire for many years, and their customer base is dying off. Is the news of the Reynolds American-Lorillard merger in response to a shifting business climate, or is it simply the first shot fired in a round of restructuring, set to take place industry-wide?

Source: Joe Raedle/Getty Images

Source: Joe Raedle/Getty Images

There’s no doubt that the business climate, specifically when it comes to tobacco, is in a state of flux. For decades, the tobacco industry has been able to hold on and watch the profits roll in from sales of their products, which are by and large impervious to economic conditions. Tobacco companies have been able to survive some of the biggest lawsuits on record, and still rake in profits despite the known dangers their products present.

The fact is, it’s a hard industry to get into, and especially to prosper in. Think about it. What was the last time you saw a cigarette company start up from scratch?

Despite the near-impossible barrier to entry, entrepreneurs are finding a way. And they’re posing a real threat to the incumbents.

Recognizing that the tobacco industry has seen decline rates for sometime has opened the doors for others to get in and give the industry a shot in the arm. According to numbers from the Centers for Disease Control and Prevention, overall smoking prevalence saw a decline of 2.8 percent from 2005 to 2012, dropping from 20.8 percent to 18.1 percent during that time. There is still an estimated 42 million smokers in the U.S., but those numbers have been on a downhill descent for years.

Electronic cigarettes have recently entered the fray, and are presenting a real challenge to the established tobacco companies. This may be one of the major factors Big Tobacco is taking into account, and by joining forces, they believe they will be able to survive better in an increasingly-obscured business environment. CNBC reports that the electronic cigarette industry doubled during 2013, hitting a market level of $1.7 billion.

Still small change compared to cigarette sales, but it should be turning some heads.

Big tobacco also needs to be keeping a close eye on the legalization of marijuana, which might also have a significant effect on the industry.

Of course, the major tobacco firms could see both of these new industries as a chance to capture even more market share, and do some innovating while they’re at it. But their past behavior has indicated that most are unwilling to change, or even shift their course. So maybe teaming up to ‘hold out’ against the storm of threats has been dubbed the best strategy?

Source; Peter Parks/Getty Images

Source; Peter Parks/Getty Images

Marijuana and electronic vaporizers might be the future of smoking in the United States, and that has tobacco companies looking elsewhere to bolster profit margins. Despite threats from all directions — including lawsuits and outraged consumer groups — tobacco companies have been able to weather the storm. What has been the secret to their success, especially of late?

Overseas markets.

In western countries such as the United States and the U.K., smoking rates are dropping. But that is not the case in countries like China, where smoking rates are holding strong right alongside the population. Between 1980 and 2012, 100 million new smokers were added in the Chinese market, according to The New York Times. Think of that in terms of adding one-third of the American population to the list of smokers in the past quarter-century.

And analysts don’t expect it to slow down, not yet anyway.

“The tobacco epidemic is going to be a whole lot worse before it gets better, particularly in lower income countries,” says Judith Mackay, a senior adviser to the World Lung Foundation.

What effect does a growing market overseas have on American tobacco companies? Well, by joining forces through mergers and acquisitions, it expands the overall reach that tobacco companies can have. By using each other’s assets, and bringing them together under one united company umbrella, it allows easier access to markets that would have otherwise been difficult to break in to.

The question is, will the Reynolds American merger with Lorillard kick off a wave of mergers and acquisitions, like we’ve seen in the tech and telecom industries? There really isn’t a clear answer yet, as this merger still has a ways to go before it becomes official. It’s still the biggest move yet by any of the big tobacco companies in the face of a changing landscape, though.

The tobacco industry is changing, and these kinds of moves shouldn’t be completely unexpected as smoking rates decline and new technologies and products emerge. Consider the Reynolds American merger with Lorillard perhaps the warning shot in a coming era of restructuring in tobacco industry.

More From Wall St. Cheat Sheet: