It’s been a year of colossal mergers or proposed mergers among some consumer goods and services companies. Comcast wants to take over Time Warner Cable (not affiliated with TIME) to form the nation’s largest cable company. AT&T and DirectTV want to combine to compete against them. The market also expects T-Mobile and Sprint to hook up, further reducing competition in mobile phone service.
Now add to that the tobacco industry. Reynolds American announced a deal to acquire Lorillard Inc. which it values at $27.4 billion. It’s a combination of the second and third largest cigarette makers after Altria Group, which owns Philip Morris USA. As part of the deal, British American Tobacco Plc retains its 42% stake in Reynolds by providing $4.7 billion in funding.
That’s a lot of dealmaking for the Federal Trade Commission and the antitrust division of the Justice Department to bless or deny. The goal of antitrust statutes is to preserve competition in any industry segment. Trustbusters don’t care who provides that competition, just as long as enough of it exists. That’s the ongoing debate in the proposed cable combination. It’s axiomatic that when two dominant players mergers prices rise and consumers suffer.
The proposed tobacco merger has a similar competitive profile. Combining the second and third largest companies will certainly reduce competition, giving Reynolds a 34.1% market share after divestitures. Unlike the media mergers, though, this one takes place in a shrinking market, as smoking continues to decline. Consolidation in a declining market certainly makes sense from an economic point of view. And there’s a clever wrinkle in this deal, in that Reynolds will sell off the KOOL, Salem, Winston, Maverick and blu brands to Imperial Tobacco for $7.1 billion—the idea is to create a stronger No. 3 competitor to keep the antitrust forces at bay.
There’s one other big difference, though: the merger will allow these two companies to be more efficient in killing people with their products. In its merger document, Reynolds says the deal would produce $800 million in cost savings and produce double digit profit gains by the second year. Not that Reynolds is a laggard. The company had already doubled its operating profit margin to 36.7% since 2004. And its 10–year return to shareholders of 542.2% has dwarfed the S&P’s return. This is a profit machine, even if a lethal one. According to the American Cancer Society, about 224,210 new cases of lung cancer will be diagnosed this year and 159,260 people will die from lung cancer—that’s more than colon, breast, and prostate cancers combined, says the ACS.
The new company will feature brands including Camel, one of the top premium smokes, and Vuse, a fast growing e-cigarette, but the prize in deal for Reynolds is Lorillard’s Newport, now the No. 1 menthol brand. Newport now owns a 12.6% share of the entire cigarette market in the U.S. and it’s growing —33.7 billion menthol “sticks” were sold last year. According to the Reynolds’ presentation, Newport has an “attractive demographic profile.” That profile, says smokefree.gov, includes blacks, women, Hispanics and younger people, all of whom are higher-than-average consumers of menthol cigarettes. These very characteristics have put menthol under the regulatory spotlight, leading to speculation that the Food and Drug Administration might ban menthol. But Reynolds clearly doesn’t believe that the feds will make any such move. “While cigarettes are dangerous there is not a significant difference between a menthol cigarette and a non menthol cigarette,” noted Murray Kessler, Lorillard’s CEO. “And ultimately the science will prevail.”
The same science holds the view, which none of these companies disputes, that tobacco use is deadly. And smoking costs our health care system billions of dollars annually to treat smokers. Should the FTC or Justice factor public health considerations into the deal? For instance, if the FTC believes that cigarette prices will increase, would it still bless the deal because rising prices might help ration demand—force more smokers to quit. Conversely, would blocking the deal, and keeping the competitors in place, have the opposite effect and lower prices, thus attracting more smokers?
That’s not necessarily an analysis that antitrust regulators are willing to make. Typically the antitrust agencies look only at the competition effects. As a former FTC official told me: “The traditional view has been that if the health and safety regulators wish to impose conditions, that’s their call entirely.” Expect the FTC to stick to the economics, which will be great for the tobacco companies, and their investors. The customers are on their own.