Morningstar analysts have upgraded their fair value estimate of Reynolds American (RAI) to $66 per share from $60. This is to account for the increase in the acquisition value of the company as a result of the continued rise in the market price of British American Tobacco (BATS).
Reynolds is expected to be acquired by BATS in the third quarter of this year, and with 55% of the total consideration being paid in stock, the value of the deal is sensitive to the market value of BAT. Our valuation of Reynolds accounts for the current market value of the acquisition in full, reflecting our high conviction that the deal will close. It is not based on our discounted cash flow valuation model, which does not reflect the synergies of the combined business and implies a lower valuation. Regulatory approval for the deal has already been granted in the U.S. and Japan, and we expect the remainder of the process to be relatively smooth sailing.
Our £48 fair value estimate of BAT is unchanged because the underlying terms of the deal have not changed. At almost 11 times enterprise value/EBITDA, the deal is slightly above historical developed-market tobacco deals since 1998. It is very slightly value-destructive, in our view, although not by a material amount, and any value destruction will have been mitigated by the recent weakness in the British pound against the U.S. dollar, following the U.K.'s recent general election.
We acknowledge that of the few acquisition opportunities available to British American, the consolidation of Reynolds probably makes the most sense. Another transformative deal would be to acquire Imperial Brands, but the deal would be complex and could require a joint bid with Japan Tobacco to avoid antitrust issues in South Africa, Australia, and several European markets. In addition, the U.S. is an attractive market, where the affordability of cigarettes leaves plenty of scope for multiyear price increases.
Using Euromonitor retail price data from 2014, we estimate that the number of minutes of labour required to buy a pack of 20 cigarettes is up to 50% lower than in most developed markets, and even lower than most developing markets. Litigation, once a significant fat-tail risk in U.S. tobacco, has also been more manageable since the Master Settlement Agreement broke up class action lawsuits.
Pricing Provides Power
Cost advantage is a significant moat source for cigarette manufacturers, and an inverse relationship exists between scale and average cost of production. The consolidation of Reynolds should therefore enhance BAT’s procurement advantages, particularly as the company uses U.S.-sourced Burley and Virginia tobacco in some of its international brands, while non-U.S. tobacco is used in some of Reynolds’ blends. The combined company will leapfrog Philip Morris International to be the largest global cigarette maker by volume outside of China. We also believe the addition of Reynolds’ portfolio, and in particular the recently acquired Newport, will enhance BAT’s brand equity.
