In a deal that could dramatically alter the way tobacco products are sold at retail, the parent company of Philip Morris USA, Altria Group Inc., reached a deal today to acquire of John Middleton Inc., a leading manufacturer of machine-made large cigars, from privately held Bradford Holdings for $2.9 billion in cash.

“This acquisition, which takes place on the eve of Altria Group Inc.’s intended restructuring, is being undertaken to enhance our long-term growth momentum in the U.S. market and create shareholder value,” said Michael Szymanczyk, chairman and CEO of Philip Morris USA. “The acquisition is both strategically compelling and financially attractive. It fits squarely with our announced strategy to grow our U.S. tobacco business beyond cigarettes and complements our recent initiatives in the smokeless category.”

The net cost of the acquisition, after deducting approximately $700 million in present value tax benefits arising from the terms of the transaction, is $2.2 billion. It’s the biggest acquistion to date in Altria’s 105-year history.

Operating revenues for John Middleton Inc., based in King of Prussia, Pa., are projected to reach $360 million in 2007, generating operating income of $182 million. Over the 2003 to 2007 period, operating revenues and operating income are estimated to have grown at compound annual rates of approximately 10% and 13%, respectively, driven by the strength of the Black & Mild cigar brand franchise. In 2007, total company cigar volume is expected to reach a level of 1.2 billion units.

Subject to necessary regulatory approvals, Altria anticipates that the transaction will be completed by year-end 2007. The acquisition, which will be financed with existing cash, is expected to be modestly accretive to Altria’s 2008 earnings and generate an attractive double-digit economic return.

“While there may be some cost savings, captured predominantly through procurement synergies and the elimination of duplicative expenses, the real appeal of this acquisition is to capitalize on PM USA’s sales, distribution and marketing infrastructure and expertise,” Szymanczyk said. “Further, PM USA will contribute its strong capabilities, resources and focus on corporate responsibility, including youth smoking prevention.”

“We look forward to welcoming John Middleton, Inc.’s talented employees to the Altria family and to building upon the company’s strong growth track record,” Szymanczyk added. “The plan is to accelerate the Black & Mild brand’s market share growth momentum in the years ahead by leveraging the expertise and capabilities of both John Middleton and PM USA.”

Retail Outlook
This deal is expected to have strong ramifications at retail, especially as Philip Morris begins to use its muscle to negotiate premium positioning of Middleton products. But it could also intensify the tobacco wars as analysts speculate whether RJ Reynolds, which already owns OTP brands including Conwood and distribution rights to Lane Ltd’s pipe and bulk tobacco business, might attempt to counter this move by acquiring a similar cigar manufacturer, such as Swisher International.

One analyst, who asked not to be identified, said a company like Swisher, “would be a great fit for Reynolds and would certainly be an answer to the Philip Morris deal with Middleton.”

Furthermore, the deal could affect USST, by far the leading manufacturer of smokeless tobacco, the analyst said. “I think this deal will only make USST more attractive Philip Morris and RJ Reynolds because they are the dominant leader in their category. Any company that could pull off a deal to acquire them would be getting an enormous share of a growing retail segment.”

Last month, Philip Morris USA began marketing snuff under the Marlboro brand in Atlanta. It trails UST and Reynolds in smokeless tobacco, a $3.7 billion market that grew more than 8% last year. Americans smoke 1-2% fewer cigarettes each year.

“Altria sees snuff and cigars as the two fastest-growth adjacent tobacco categories to cigarettes,” Erik Bloomquist, a J.P. Morgan Ltd. analyst in London, wrote today in a note to clients.