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A deal is brewing in North Carolina that would give two big tobacco companies a quick fix in the U.S. market. It could also spark a round of dealmaking well beyond American borders.
Camel-cigarette manufacturer Reynolds American is in ongoing discussions to purchase rival Lorillard, maker of Newports, according to a person familiar with the matter. The merger would take the number of major U.S. tobacco firms from three to two, with Marlboro-maker Altria remaining the largest cigarette company by sales.
Assuming antitrust regulators don't get in the way, which is far from certain, a merger would have clear benefits. Given expectations for cigarette unit volumes to remain in decline, tobacco companies are keen to save on costs.
The two companies share neighboring production facilities in places near Winston-Salem, N.C., that could probably be combined. They both also have large sales forces that perform similar roles selling products to retailers across the country.
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Altogether, a deal would create annual cost synergies of $341 million, estimates Thilo Wrede, an analyst at Jefferies. Taxed and put on a mulitple of 10 times, those cost savings are worth well over $2 billion to Reynolds. That's enough to justify a decent premium to Lorillard's roughly $18 billion market capitalization before news of deal talks broke Monday.
The deal has implications far further afield. The reason is that Reynolds is 42 percent owned by London-listed British American Tobacco, a structure that came about in 2004 when BAT merged its Brown & Williamson division with R.J. Reynolds. The deal included a standstill agreement that prevented BAT from increasing its stake before July 30, 2014, unless it can reach a friendly deal with Reynolds.
The timing of the Lorillard talks raises the question of whether BAT is on board with a deal or not. Some investors may wonder if Reynolds wants to make itself larger so that BAT would have a harder time buying it. A BAT spokesman declined to comment and the other two companies didn't respond to calls for comment.
More likely, BAT and Reynolds can work out a deal of their own together. Another person familiar with the matter said BAT has contemplated buying the rest of Reynolds in recent years, in part because the British company enjoys a low cost of debt.
One possibility is that Reynolds would issue stock to BAT, either to keep its stake at 42 percent or bring it higher, and equip the U.S. company with more cash to do a deal. Cash would probably be more attractive to Lorillard shareholders than stock, possibly helping Reynolds negotiate a better price.
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U.S. consolidation could also throw Imperial Tobacco into play. The U.K. company, which makes brands such as Davidoff, has a U.S. division called Commonwealth Brands. If BAT had a substantial presence in America, it would make more sense to pick up Commonwealth.
A buyer for Commonwealth is important because there are likely international buyers who would be happy to own other parts of Imperial but don't want to buy a U.S. business. Japan Tobacco and Philip Morris International, for instance, have explored picking up other parts of Imperial, according to a person familiar with the matter. The companies didn't respond immediately to requests for comment.
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Imperial trades at just 11.5 times consensus forward earnings, well below the average for major tobacco companies. That valuation surely looks enticing for potential acquirers that could save in regions across Europe where they have overlapping production and distribution. If U.S. consolidation becomes a reality, global tobacco companies could also get hooked.
—By CNBC's John Jannarone. Follow him on Twitter