The Federal Trade Commission has approved the proposed transactions involving Imperial Tobacco (IMT), Lorillard (LO), and Reynolds American (RAI). The deal will now proceed as planned, and we expect it to close within a month. The ruling proposes no major changes and requires Reynolds to divest cigarette brands Winston, Kool, Salem, and Maverick as well as Lorillard's manufacturing facilities in North Carolina.
We believe Imperial's competitive advantages are intact
We are reiterating our moat ratings for the companies involved and believe the transactions are priced into the stocks. Of the tobacco stocks Philip Morris International (PM) is the company trading at less than Fair Value.
The dissolution of Lorillard will transform the landscape of the U.S. tobacco industry. Imperial's market share will rise from 3% to 10%, while Reynolds' will rise from 27% to around 36% with a strong brand portfolio including Camel, Newport, and Pall Mall.
Imperial's portfolio will comprise a collection of brands declining at a faster rate than the industry. Leading manufacturer Altria (MO) will face a stronger number-two player and potentially a more aggressive number three in Imperial.
However, we think the strategic options available to Imperial in the United States are fraught with risk. The firm could either attempt to expand its acquired brands by cutting prices and margins, or it could maximize cash generation with volume continuing to underperform in a declining industry. Both of these options have the potential to erode the firm's wide economic moat over a multiyear time frame.
For now, though, we believe Imperial's competitive advantages are intact and the increase in scale generated from the move into the U.S. supports our wide moat rating. In addition, at less than 9 times enterprise value/EBITDA, Imperial has executed these transactions at a value-accretive price, in our opinion, even if the brands continue their downward trajectory; we increased our fair value estimate 2% when the deals were announced.
Of the cigarette brands Imperial is buying from Reynolds and Lorillard, Winston has the best chance of share growth, in our opinion. Four decades ago, it was the leading brand in the U.S. until its market share under Reynolds' stewardship was overtaken in 1975 by Marlboro. Since then, it has dropped to number seven in the U.S. with a retail share of just 2.1% and falling, and with Reynolds having provided little funding for the brand in recent years, its core consumer is the legacy smoker from the 1970s.
Price sensitivity is greatest at the value end of the cigarette market, and historically, competitive pricing strategies have not led to sustained market share gains. As recently as 2012, some improved resource allocation from Reynolds helped Winston to temporarily stabilise its share at close to 3%, but it was only through price cuts that the brand was able to fight back against its stronger competitors.
If Imperial repositions Winston as a value brand, it is more likely to take share from Reynolds' Pall Mall than Altria's Marlboro, which is a premium brand.
We think price promotions through such strategies would be detrimental to the industry profit pool because competitors are likely to reciprocate in order to defend share, and we believe restraint from creating widespread price skirmishes would maximize profitability.
We prefer the plans Imperial management revealed for its non-growth brands Salem, Kool, and Maverick, which it has said will be managed for cash, as the firm does quite successfully in large parts of its existing portfolio, including its U.S. brands. As a rational price-taker in the industry, Imperial would be able to follow Altria and Reynolds in raising prices.
However, the lack of brand loyalty among these third-tier brands and their unfavourable demographic profiles could mean that under a strategy to maximize cash, volume could materially underperform the industry, and this in turn could erode the firm's scale, the source of its wide economic moat.
