British American Tobacco (BATS) announced that it has made an offer to acquire the remaining 57.8% of Reynolds American (RAI) it does not already own for a total consideration of $47 billion, or $56.50 per share.
Our initial impression is that the deal is slightly rich, and we may adjust our fair value estimate for British American when we have combined the discounted cash flow models. However, the deal would create a truly global tobacco giant, merging two wide-moat companies, and would slightly enhance British American’s competitive positioning.
There are several reasons why this is a good deal for British American strategically. Reynolds possesses solid competitive advantages, including very high brand loyalty to Newport, arguably the strongest brand in U.S. tobacco, and a cost advantage over smaller domestic manufacturers.
There will be some synergies, and British American expects to extract $400 million in annual costs from Reynolds. This is likely to come primarily from centralised functions, as British American currently has no direct operations in the U.S. market. Bringing Pall Mall under one roof, as well as consolidating vapour product development, is also likely to yield efficiencies.
At first glance, the deal looks slightly rich. Most of our tobacco coverage is trading slightly above our fair value estimates, and Reynolds' stock has rallied by more than 50% since its transformative acquisition of Lorillard, announced in 2014.
However, as this is a cash and stock deal, at current prices, 57% of the consideration will be paid in British American stock, the acquirer's overvalued currency mitigates this impact. The weakening in the value of sterling, which has boosted British American's market valuation in recent weeks, has helped to make this deal more financially attractive.
British American could have acquired Reynolds at any time over the past two years at a lower valuation, although, admittedly, the integration of Lorillard would have made it more complex. Nevertheless, the valuation of Reynolds, at 20 times this year's earnings, does not appear optimal.
We are slightly puzzled at the positive reaction of Imperial Tobacco's (IMB) stock to the news. The transaction will create an even stronger competitor and number-two player in the US, with greater financial flexibility to compete on price. It also makes it less likely, in our opinion, that Imperial itself will be acquired in the foreseeable future.
For financial and antitrust reasons, any approach for Imperial would probably have required a joint bid from two or more players, with British American and Japan Tobacco the two most likely suitors. We now expect British American’s operational focus to shift to integrating Reynolds and its capital-allocation priorities to be debt reduction and dividend growth.
