Will Cigarette Maker Reynolds Try Kicking the Habit?

It would be either one of the most cynical diversifications ever—or a brilliant stroke of synergy. If a report in The Wall Street Journal is correct, America's second-largest seller of cigarettes may soon be peddling products that help people quit smoking. The Journal reported on Nov. 9 that Reynolds American (RAI), the distributor of Pall Mall, Camel, and Natural American Spirit cigarette brands as well as smokeless tobacco, is in "advanced talks" with Niconovum, a Swedish manufacturer of nicotine replacement products such as gum and mouth spray. University of Ottawa law professor David Sweanor told the Journal he was briefed by people close to the deal. The move would mark the first time that a big tobacco company also sold smoking-cessation products, according to industry analysts. But it would be in line with the industry's efforts to diversify as cigarette purchases shrink in the U.S. One analyst referred to a purchase of Niconovum as a "cheap hedge" against the smoking decline. Smoking has been falling off in the U.S. for years—from more than 490 billion cigarettes sold in 1995 to 345 billion in 2008, according to Philip Gorham, a stock analyst at Morningstar (MORN). Adult smoking in the U.S. has declined by half since 1965; in 2006, 26 million men and 21 million women in the U.S. smoked, according to the National Center for Health Statistics. Overseas, the picture is different: Some 1.1 billion people smoked worldwide in 1999, a number the World Bank expects to swell to 1.6 billion by 2025. "If a smoker wants to quit, they'll quit," says Gorham. "If they're spending money trying to quit anyway, I think Reynolds is thinking, 'Why not let us sell them that product, too?' " Expanding Product LineupsTobacco companies are broadening their product lineups to adapt to the spread of regulations that prohibit where people can smoke, while providing more socially acceptable alternatives. And smokeless products, which make up about 7.5% of the tobacco market, are growing by about 8% a year. R.J. Reynolds, a subsidiary of Reynolds American, unveiled its latest creation of smokeless and spitless tobacco in three test markets across the country starting in January. Camel Sticks, Camel Orbs, and Camel Strips are marketed as a dissolvable alternative to smoking, made from a combination of finely milled tobacco and food-grade binding agents and flavoring. The industry leaders—Reynolds has 28% of the U.S. market; Altria (MO), the parent company of Philip Morris and seller of Marlboros in the U.S., has a 50% share—depend on deals for their growth. "There's been a lot of merger and consolidation activity in tobacco—it's really a no-growth or negative-growth industry, so companies have to acquire if they want to grow," says Jack Russo, an analyst at Edward Jones. In the third quarter, Reynolds posted slight gains in market share with its Pall Mall brand and offerings like Grizzly by its Conwood division, said Thilo Wrede, an analyst at Credit Suisse (CS), in an Oct. 22 research note. But Camel, the company's flagship brand, lost market share, while the total number of cigarettes that R.J. Reynolds shipped fell by 11% year-over-year. That was a much steeper decline than what analysts had expected. Niconovum was formed in 2000 by Karl Olov Fagerström, whom the company's Web site describes as "one of the world's leading experts on smoking cessation and nicotine dependence." Located in Helsingborg, 35 miles north of Copenhagen, the company develops nicotine replacement therapies, or NRTs, that help calm withdrawal symptoms and cravings for those kicking the habit by normalizing the level of nicotine receptors in the brain. The company could not be reached for comment. FDA Regulation LoomsThe rumored deal comes as Reynolds fights recently imposed regulations by the Food & Drug Administration. If the deal goes through and Niconovum products were introduced to the U.S., Reynolds would become the first company that is regulated by the FDA on both drugs and tobacco. In June, President Barack Obama signed a law allowing the FDA to regulate tobacco products. Along with other tobacco companies, two of Reynolds' subsidiaries, R.J. Reynolds and Conwood, have filed suit challenging some of the provisions of that new regulatory framework. David Howard, a spokesperson for Reynolds, declined to comment on the speculation surrounding the possible acquisition. He emphasized the company's desire to "offer a total tobacco portfolio" and to continue to expand beyond cigarettes, as evidenced by its May 2006 takeover of Conwood smokeless and the introduction of such new products as Camel snus, which is smokeless, finely ground tobacco sold in small pouches. "As [Reynolds CEO] Susan Ivey has said in calls before, we're always looking at opportunities that would be strategic moves, as any company should be doing," he said. An investor presentation scheduled for Nov. 16 may shed more light on the company's plans. In any event, the quit-smoking business is likely to be a small sideshow for Reynolds or any other big tobacco company for the immediate future. According to the Journal, the deal's value is estimated to be around $45 million. Given that Reynolds' 2008 net income was $1.34 billion, says Wrede, "the size of the nicotine replacement market is too small to be currently relevant, but it might be a cheap hedge in case smokers are increasingly looking for non-tobacco nicotine alternatives." Publicity Stunt?But as Morningstar's Gorham points out, Reynolds can make far more money convincing people to smoke than helping them quit. The cost per unit to produce cigarettes is extremely low—operating margins average 25%-30% industrywide, he says, which is high for consumer goods. (Pepsi (PEP), by comparison, which enjoys enormous scale and volume operating margins, reaches into the high teens, according to Gorham.) It's unlikely that returns from smoking-cessation products can compete with that anytime soon. "I think we're talking 20 years-plus at this point before tobacco sales are offset by other sources," says Gorham. Indeed, some view any talks between Reynolds and Niconovum as more of a publicity stunt, designed to place Reynolds in a better light. "This is just a distraction from what their core business is, to still make the most profit from cigarettes—which, by the way, is the most lethal product they sell," says Richard Hurt, director of the Nicotine Dependence Center at the Mayo Clinic in Rochester, Minn. "Nothing surprises me about tobacco companies anymore, they really just continue to morph every time they get the chance to do so."

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