A BAT deal with Reynolds adds to Big Tobacco's e-cig advantage

NEW YORK/LONDON (Reuters) - British American Tobacco Plc's proposed takeover of Reynolds American Inc could speed up Big Tobacco's dominance of the quickly changing e-cigarette market, putting more pressure on early innovators already getting squeezed out.

BAT offered last week to buy its U.S. peer for $47 billion (38.54 billion pounds) in a deal that would combine Lucky Strike and Newport cigarettes, and Vuse and Vype e-cigarettes. Reynolds has yet to respond to the unsolicited approach.

A combination would create a company with significant share of two of the biggest e-cigarette markets - the United States and United Kingdom - and pit it more directly against the efforts of rival Philip Morris International Inc, and U.S. partner Altria Group Inc, to devise a successful alternative to traditional cigarettes.

The deal is expected to spark further consolidation, such as a reunification of Philip Morris with Altria, analysts said. It would also put further pressure on smaller players Imperial Brands Plc and Japan Tobacco International to do deals of their own.

Electronic cigarettes and other alternatives to smoking are seen as the future of a tobacco industry whose sales are shrinking in Western markets as more people give up the deadly habit.

BAT and Reynolds already have a technology-sharing and licensing deal for their e-cigarettes, which produce vapor from liquid nicotine instead of tobacco smoke, but a full takeover is expected to speed and simplify innovation.

This is critical as Philip Morris and Altria work to launch a promising, new technology called iQOS - using tobacco instead of liquid - in the United States, the biggest market for "vaping" products.

"Leveraging that R&D more seamlessly across the enterprise is one of the big benefits" of the potential BAT deal for Reynolds, said Morningstar analyst Adam Fleck.IQOS and similar devices heat tobacco enough to create a vapor that its makers say is less harmful than the smoke derived from burning it. They could be more successful than e-cigarettes for smokers who find e-cigarettes unsatisfying.

Reynolds' Vuse e-cigarette is the top selling vapor product in U.S. chain stores tracked by Nielsen. Its "heat-not-burn" product Eclipse is only available in limited distribution and not separately reported by the company.

BAT, which sells e-cigarettes under the Vype brand, also has a medicinal nicotine inhaler called Voke and a tobacco-heating product called glo iFuse that it launched in Romania.

It has about 35 percent of the UK mainstream market for e-cigarettes, according to Nielsen. The data does not include vape shops, which often sell smaller brands.

CHANGING LANDSCAPE

Use of e-cigarettes has grown quickly in the last decade, with U.S. sales expected to reach $4.1 billion in 2016, according to Wells Fargo Securities.

While it is unclear how the market will evolve over time, the success of the tobacco-based vapor category would favor global businesses already based on tobacco.

Philip Morris, maker of Marlboro, has spent more than $3 billion in recent years on research, development and production of cigarette alternatives. BAT has spent about 500 million pounds ($606.8 million).

Philip Morris sells its iQOS product in 10 test markets. It plans to be in 20 by year end.

Philip Morris said in September that iQOS was luring smokers away from traditional cigarettes, citing conversion rates of 60 to 70 percent over a period of up to two months.

By contrast, users often try e-cigarettes but drop them over time.

Altria, which has an exclusive U.S. licence for iQOS, is eager get the U.S. Food and Drug Administration to approve it as a "modified risk tobacco product," which if approved would carry a different warning than traditional cigarettes.

Philip Morris hopes to begin that process by the end of the year.Regulation is also favoring big tobacco companies.

After years of delay, the FDA in August implemented new rules that require companies to submit e-cigarettes for government approval before marketing them.

The lengthy, expensive process is difficult for small startups without experience navigating government bureaucracy. NJOY - one of the first big U.S. e-cigarette makers - filed for Chapter 11 bankruptcy protection in September, citing poor sales and high costs associated with the new rules.

"We're going to have a huge contraction of the vaping market with most of the market share going to the tobacco companies," said Dr. Michael Siegel, a professor at the Boston University School of Public Health, who has advocated vaping as a way to wean smokers off conventional cigarettes.

(Additional reporting by Pamela Barbaglia in London; Editing by Joseph White, Michele Gershberg and Lisa Shumaker)