(Reuters) - Reynolds American Inc (RAI.N) will buy Lorillard Inc (LO.N) for $25 billion (14.58 billion pound), merging two of the world's biggest cigarette makers in a deal that includes the sale of the top-selling U.S. e-cigarette to Britain's Imperial Tobacco Group (IMT.L).
The deal, which gives Reynolds control of Newport menthol cigarettes, strengthens the combined company's hand in competing for a shrinking pool of smokers and sets up a three-way battle with Marlboro-maker Altria Group Inc (MO.N) for the e-cigarette market.
Imperial's purchase of the blu e-cigarette brand, as well as Reynolds' Salem, Winston and KOOL and Lorillard's Maverick brands, is meant to ease potential antitrust concerns from the marriage of the No. 2 and No. 3 U.S. tobacco companies.
While cigarette sales volumes have been falling about 4 percent a year, e-cigarette sales have been booming.
E-cigarettes generate roughly $2 billion a year in sales in the United States, and some industry analysts expect sales to overtake the $85 billion conventional-cigarette industry within a decade.
The divestiture of blu surprised many analysts as the brand, which has 40 percent of the U.S. e-cigarette market, could have boosted Reynolds' lead in the fast-growing market.
Reynolds sells its own e-cigarettes under the Vuse brand, but controls less than 5 percent of the market, according to Euromonitor.
"It looks like everybody gets what they wanted," said Morningstar analyst Philip Gorham, adding that the deal will likely win approval from antitrust regulators.
Reynolds' purchase of Lorillard's Newport brand gives the company a stronger presence in the market for menthol cigarettes, which experts say have disproportionate popularity among young people, lower-income smokers and African-Americans.
Newport had 12.6 percent of the overall U.S. market in 2013.
Menthol cigarettes have roughly a 28 percent market share in the United States, according to Euromonitor.
Reynolds, whose brands include Camel and Pall Mall, offered $68.88 per Lorillard share, representing a premium of 2.5 percent to Lorillard's Monday close.
Lorillard's shares, which have risen about 37 percent since reports of the deal first surfaced in February, were down 7.5 percent at $62.19 on Tuesday.
Reynolds' shares were down 4 percent at $60.61. Imperial's shares fell 3.4 percent to 2,647 pence in London.
Including debt, the deal is valued at $27.4 billion.
Reynolds said it expects to have over $11 billion in revenue and about $5 billion in operating income annually after the deal closes. Reynolds had sales of $8.24 billion in 2013.
British American Tobacco (BATS.L), Reynolds' largest shareholder, will buy shares to maintain its 42 percent stake in Reynolds through a $4.7 billion investment.
BAT's shares were down 1.8 percent at 3,532 pence on the London Stock Exchange.
Reynolds' financial advisers are Lazard and J.P. Morgan Securities, while Lorillard is being advised by Centerview Partners and Barclays Plc.
Legal advisers to Reynolds are Jones Day, while Simpson Thacher & Bartlett is advising Lorillard.
BAT is being advised by Deutsche Bank and UBS. The legal advisers to BAT are Cravath, Swaine & Moore and Herbert Smith Freehills. Credit Suisse and Goldman Sachs advised Imperial.