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Shares of both Reynolds American Inc (RAI - Analyst Report) and Lorillard Inc (LO - Analyst Report) jumped after Financial Times reported that Reynolds American is considering taking over its rival Lorillard.

Per the report, Reynolds - the maker of Camel brand cigarettes has hired Lazard, an investment bank, to look for a possible deal with the third largest U.S. cigarette company, Lorillard. The report also stated that the purchase price could be more than $20 billion. However, it is unclear whether Reynolds plans to bid for the whole company or only a portion of it. Any deal would also involve U.K.-based British American Tobacco (BATS), which owns roughly 40% stake in Reynolds and whose brands include Pall Mall and Kent. Shares of Reynolds and Lorillard surged 4.84 and 9.25%, respectively on the speculation.

Both Reynolds and Lorillard are the biggest tobacco sellers in the U.S. after peer Altria Group Inc. (MO - Analyst Report), which makes Marlboro cigarettes. So, a combination of these two companies and their leading brands might pose a threat to Altria. Lorillard’s Newport brand holds the number one position in the menthol cigarettes market in the U.S. and also has a solid footprint in the profitable electronic cigarettes market with its blu e-Cigs brand (acquired in Apr 2012) and UK-based SKYCIG (acquired in Oct 2013).

The combination of two leading U.S. cigarette makers would also change the industry dynamics – possibly creating one of the strongest global tobacco companies. Companies like Altria Group, Reynolds American, Lorillard and Philip Morris International Inc (PM - Analyst Report) have been facing declining cigarette volumes and regulatory restrictions for years. The slowdown in the tobacco industry, increasing health consciousness among consumers and significantly higher prices of cigarettes has impacted volumes. Increases in federal, state and local excise taxes and manufacturer price have increased cigarette prices, which have significantly impacted the consumption of cigarettes. In addition, a rise in the number of people who quit smoking has also impacted sales.

The global cigarette-making industry continues to be in a flux as it deals with increased regulation on packaging (graphic warning labels) in some international markets, heightened FDA concerns about public health issues of menthol cigarettes, and the advent of the electronic cigarette. The adoption of graphic warning labels on cigarette packaging in the U.S. will always be a risk, while the adverse effect of exposure to menthol variants and selling of e-cigarettes have also come under FDA review. The tobacco industry in Europe also received a blow after the Presidency of the Council of the European Union (EU) and the Members of European parliament reached a settlement recently on draft legislation, which could curb the growth of e-cigarettes industry.

Currently, Lorillard has a Zacks Rank #3 (Hold), while Reynolds holds a Zacks Rank #4 (Sell).

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