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Cigarette makers Reynolds American, Lorillard discussing merger; would create formidable No. 2

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RICHMOND, Va. - Big Tobacco may soon get smaller.

The makers of Camel and Newport cigarettes said Friday they are in talks to combine two of the nation's oldest and biggest tobacco companies. A deal between Reynolds American Inc. and Lorillard Inc. would create a formidable No. 2 to rival Altria Group Inc., owner of Philip Morris USA. It also could spur a wave of consolidation in the tobacco business, shrink factories and workforces, and push prices for cigarettes higher even as smokers buy fewer of them.

The news follows months of speculation about the possible combination. In separate statements, the companies said no agreement has been reached and there's no guarantee one will be.

The merger would be "very positive for the global tobacco industry and could be just the beginning of future transactions," Wells Fargo Securities analyst Bonnie Herzog wrote in an investor note.

That's partly because demand for traditional cigarettes is falling in the face of tax increases, smoking bans, health concerns and social stigma. U.S. cigarette sales fell about 2.6 per cent last year to 285 billion cigarettes, according to market researcher Euromonitor International.

But raising prices and cutting business costs has kept the industry handsomely and reliably profitable. The companies also have cut costs to keep profits up, and the larger scale of a combined company could make future cost-cutting easier.

"If you take a look back historically, the way to drive margins in the U.S. tobacco industry has been through consolidation," Cowen analyst Vivien Azer said in an interview with The Associated Press, adding that the improvement in profitability would come from cost-cutting in the near-term and manufacturing consolidations down the road.

The next step for tobacco companies is an increased focus on cigarette alternatives — such as electronic cigarettes, cigars and smokeless tobacco — for sales growth.

Reynolds markets Camel, Pall Mall and Natural American Spirit cigarettes, as well as the Grizzly and Kodiak smokeless tobacco brands. It has about 27 per cent of the U.S. retail cigarette market. Reynolds, which is based in Winston-Salem, North Carolina, also expanded its Vuse brand electronic cigarette nationally last month.

Reynolds' profit rose 35 per cent to $1.72 billion last year on revenue of $8.24 billion, excluding excise taxes.

Lorillard, which was founded before the Revolutionary War and is the oldest continuously operating U.S. tobacco company, was spun off from Loews Corp. in 2008. The Greensboro, North Carolina-based company has about 15 per cent of the retail market, bolstered by its flagship Newport cigarette brand, which commands 37.5 per cent of the menthol cigarette market.

Lorillard because the first major tobacco company to jump into the e-cigarette market when it acquired the Blu e-cigarette brand in 2012. Blu now accounts for almost half of all e-cigarettes sold. Lorillard's profit rose 8.5 per cent to $1.19 billion last year on revenue of $4.97 billion, excluding excise taxes.

A deal would likely mean a consolidation of the companies' operations and staff. Reynolds has about 5,200 full-time employees and produces its cigarettes at its 2 million-square-foot Tobaccoville, North Carolina, plant. Lorillard has about 2,900 full-time employees and produces cigarettes in Greensboro, about 40 miles southwest of Reynolds' plant.

A merger also could push cigarette prices higher because it could ease competition, although the companies may have to shed some smaller brands to ease regulatory concerns about competition.

And even selling smaller brands, such as Kool or Winston, might not be enough. The combined company would be very dominant among younger smokers and fans of menthol cigarettes, which could mean a bigger brand might have to be sold.

"The likelihood of a deal closing in the structure that we think these companies are envisioning is highly unlikely," Azer said. "If you look at the implications of selling all the tail brands even, it doesn't really change the math. You have to sell Camel."

The combined company would challenge Richmond, Virginia-based Altria, which holds about half of the retail cigarette market, led by its top-selling Marlboro brand. It also sells Black & Mild cigars, Copenhagen and Skoal smokeless tobacco and is expanding MarkTen e-cigarette brand nationally.

Any deal would include involvement from British American Tobacco PLC, which makes Kent and Dunhill cigarettes overseas. British American Tobacco owns a 42 per cent stake in Reynolds, and a 10-year moratorium on the company increasing that stake expires at the end of July. Reynolds said Friday that British American Tobacco is involved in the merger discussions and expects to support the deal and maintain its existing stake in the company.

Also on Friday, Imperial Tobacco Group PLC said it was in talks to buy some Reynolds and Lorillard brands should a merger occur.

The U.S. "remains one of the world's largest and most profitable cigarette markets," noted Imperial, which owns Bowling Green, Kentucky-based Commonwealth Brands Inc., maker of USA Gold cigarettes. Altria, Reynolds American and Lorillard all sell cigarettes only in the U.S. Other companies sell their brands overseas.

Herzog also noted that Imperial's involvement in the potential deal could help to stem any potential Federal Trade Commission anti-trust concerns by buying up several of the companies' smaller brands.

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Michael Felberbaum can be reached at http://www.twitter.com/MLFelberbaum .

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