Feeling blu? E-cig company spun off in major tobacco deal

Two electronic cigarette brands might have been company, but three was definitely a crowd for this Big Tobacco merger.

The $27 billion mega-merger that will unite Reynolds American with smaller competitor Lorillard raised eyebrows Tuesday because the deal includes the selloff of Lorillard's blu e-cig brand to rival Imperial Tobacco Group.

Some analysts had expected Reynolds was attracted to buying Lorillard because it would also be getting blu, the leading e-cig brand in the fast-growing $2 billion nicotine vapor space.

Jim Watson | AFP | Getty Images

A woman smoking a 'Blu' e-cigarette

Lorillard, itself, had acquired blu in 2012, making it the first of the Big Three tobacco companies to enter the category. Over the past two years, Lorillard took the brand from relatively small sales to the No. 1 spot, beating both Reynolds and Altria to market at a time when traditional tobacco sales continue to dwindle in the U.S. and e-cig sales are booming.

But Reynolds' own e-cig brand Vuse, as well as a British brand owned by yet another tobacco company linked to the deal, may have left no room for blu in the merged behemoth.

Blu will be sold to Imperial, along with the Kool, Salem and Winston traditional cigarette brands, for $7.1 billion. Imperial is the fourth-largest tobacco company in the world.

Read MoreReynolds to acquire rival Lorillard, ditch Kool

"Bottom line, it was a business decision" to retain Vuse as the sole e-cig brand sold by the company when it merges, said Reynolds American spokesman David Howard. "Our approach is to remain focused on Vuse."

"We have a whole lot invested in" Vuse, Howard said of the brand, which after its launch last year is now available for sale at select retail outlets in 50 states, with plans to have it widely distributed nationally by next spring.

"We believe we truly have a game-changing product on our hands...we believe Vuse offers a superior technology."

Michael Lavery, a tobacco industry analyst at CLSA Americas, said the fact that British American Tobacco is playing a role in the merger could have also affected the decision to sell off blu.

BAT owned about 42 percent of Reynolds, and has agreed to buy around $4.7 billion of extra shares to help finance the purchase of Lorillard, and to retain an equivalent level of ownership in the resulting company. But BAT recently rolled out Vype, a e-cig brand in the United Kingdom.

Read MoreThe real winner in the Lorillard takeover: BAT

"With blu's business in the U.K., it was competing with BAT, and it feels like BAT wouldn't want to be contributing $4.7 billion to compete with itself," Lavery said.

When asked by CNBC whether BAT had asked for blu to be sold as a condition for helping financing the merger, Reynolds' Howard said, "I have no insight to that, at all."

However, Howard did say that Reynolds and BAT now "have an agreement in principle to pursue an ongoing technology-sharing initiative for the development and commercialization of next-generation tobacco products, including electronic cigarettes."

Read MoreAcquisition talks show Reynolds' taste for menthol

Selling blu to Imperial also may have been aimed at easing antitrust concerns for the larger deal. Blu is being sold along with Reynolds' two menthol tobacco brands, Kool and Salem, which currently compete with the menthol category leader Newport, a Lorillard brand.

"Regulatory issues most certainly were part of the conversation" about selling blu, Howard said.

Lavery, however, said that because of its relatively small market size, having competing e-cig brands such as Vuse and blu owned by a single company would not have been nearly as large a concern to antitrust regulators as the menthol brands would have been.

And in the end, Lavery said, that fact that blu's sales are very small compared with Reynolds' overall business "makes it quite possible that Imperial was more interested in owning blu than Reynolds was."

The news agency Reuters, citing a source familiar with the situation, reported Tuesday that Imperial Tobacco insisted that blu be among the assets it was buying in the deal.

Read MoreAn e-cigarette boom could be around the corner

Miguel Martin, president of Logic, the No. 2 e-cig brand after blu, told CNBC.com, "My quick read on it is that I don't know that Reynolds felt that they had to have blu. My sense is they felt they didn't have to have it."

"It wasn't important to them, and it was to Commonwealth," he said, using the name of Imperial's U.S. sales division. "I think Reynolds feels comfortable going it alone with Vuse."

Martin said he doesn't believe that blu's change of ownership will affect Logic's sales.

"From my point of view, I don't know it changes anything," Martin said. "I don't know that it's better off fighting blu under the Commonwealth flag than under the Lorillard flag."

Blu has lost market share to Logic in recent months, according to both Martin and Lavery.

Regardless of who owns blu, the brand will continue facing future declines in market share due to competition from Logic and ongoing "disruption" in the still-young industry, Martin said.

He said companies such as Logic, which do not sell traditional combustible tobacco products, may have an edge with getting shelf space while competing with blu because convenience stores keep a larger percentage of the sale price with their products than they do with the e-cig brands sold by traditional tobacco companies.

Also, Blu, like other e-cig companies that sell replaceable nicotine liquid cartridges, are now facing competition from the accelerated growth of so-called open system vaping devices, said Cynthia Cabrera, executive director of the Smoke-Free Alternatives Trade Association.

Unlike "ciga-likes" such as blu, whose shape resembles a traditional cigarette and whose manufacturers sell disposable or refillable cartridges of nicotine liquid of their own brand, open-tank systems allow users to refill the devices with a nicotine liquid of their choosing. "Vaping" shops often sell a wide range of such liquids, with different levels of nicotine and a variety of flavors.

Bonnie Herzog, a tobacco analyst at Wells Fargo, noted earlier this year that the open system sector is growing twice as fast as the overall e-vapor category, which includes traditional e-cigs like blu. Herzog said users of open-system vaping devices spend less money on their habit than people who buy traditional branded e-cigs.

In terms of innovation, "the ciga-like category is really not where it's at right now, where it is is open vapor," Cabrera said.

Still, she doesn't expect Imperial to let blu lose market share to open system products without a tough fight.

Big traditional tobacco companies "will use every competitive and regulatory means possible to squeeze out the little guys, the innovative guys, because those aren't their products," Cabrera said. "I do have concerns about that."

—By CNBC's Dan Mangan