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Plans by R.J. Reynolds Tobacco Holdings Inc. and British American Tobacco plc to combine their U.S. operations are running into antitrust trouble. Sources said Federal Trade Commission staff lawyers have reservations about the $2.5 billion deal, which would result in Reynolds and rival Philip Morris USA Inc. controlling 80 percent of the market. The government’s investigation into the merger is ongoing, these sources indicated. But they also said that only an offer by the cigarette giants to sell assets involving overlapping brands is likely to sway FTC staff. Further clouding the deal’s fate are two recent reports highlighting antitrust concerns around the transaction. The American Antitrust Institute on Wednesday urged the FTC to block the deal, while Prudential Equity Group LLC on Tuesday predicted the deal would be blocked unless the company agrees to divest brands. “This is the second biggest antitrust problem in Washington after Oracle-PeopleSoft,” one tobacco investor said. An FTC spokesman declined to comment. Reynolds spokeswoman Jan Smith said the company expects the FTC to approve the deal, which she said would result in significant efficiencies and boost tobacco industry competition. Smith also said Reynolds does not anticipate selling any brands to secure federal clearance. “We expect the merger can proceed without divestitures given the highly competitive nature of the market,” she said. Reynolds attorney Joe Sims of Jones Day in Washington said the FTC should complete its review of the deal within the next few months. “We are pushing it as fast as we can,” he said. “It won’t be an enormous amount of time.” In its 16-page analysis, AAI concludes that the merger is likely to foster collusion between Reynolds and Philip Morris, further enable the top two manufacturers to use their control over retail shelf space to exclude smaller competitors from the market, and raise the barriers to entry for small cigarette makers by limiting access to wholesalers and retailers. “The proposed merger will greatly reduce whatever vestiges of price competition there are in the upper product tiers of the U.S. cigarette market, further increasing concentration,” the group concludes in the report, which was sent to the five FTC commissioners and agency competition bureau director Susan Creighton. AAI recommendation came a day after Prudential Equity distributed a research note predicting the FTC would block the deal unless the companies agreed to sell brands. “We are of the opinion that the merger will be allowed to take place but that RJR and [BAT unit Brown & Williamson] will have to agree to divest some brands to a third party in order to maintain sufficient competitiveness in the industry,” it said. Brands that could be sold include GPC and Salem, Prudential said. If Reynolds and BAT decline such a move, then the transaction could fail regulatory review, Prudential and AAI conclude. AAI said eliminating the Brown & Williamson unit is especially problematic because it has a reputation of pushing retailers to control their own shelf space rather than cede it to Reynolds or Philip Morris, neither of which is likely to offer much space or visibility to smaller brands. The group also dismissed arguments that the tobacco settlement, by forcing the big manufacturers to increase prices, would make it easier for new companies to enter the market. This is because many states have adopted provisions that reduce payments by the big cigarette makers if new entrants capture more than 1 percent of the market, it said. Finally, the merger could give Reynolds so-called monopsony power over its purchase of tobacco leaves from farmers because, as one of only two major buyers for the product, it could force below-market sale prices, AAI said. Sims dismissed AAI’s analysis, saying the group is radical and lacks credibility. “It’s the same old stuff,” he said. Sims noted that FTC chairman Timothy Muris has criticized the antitrust institute several times for advocating an enforcement agenda not supported by the latest in economic research. R.J. Reynolds unveiled the deal Oct. 27. It calls for the creation of a new, public company that would issue 150 million shares. BAT would get 42 percent of the shares; the rest would go to RJR shareholders, who would exchange each of their shares for an equivalent stake in the new company. RJR also agreed to spend $400 million to buy BAT’s Lane Ltd., a unit that makes cigars and distributes Dunhill tobacco products. Copyright �2004 TDD, LLC. All rights reserved.

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