British American Tobacco Should Come Back for Reynolds American

It makes a lot of sense for the 2 companies to merge

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Dec 21, 2016
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At the end of October, British American Tobacco (BTI, Financial) announced an offer to buy U.S.-based Reynolds American (RAI, Financial) for $47 billion. British American has owned 42.2% of Reynolds since 2004 when it merged its U.S. subsidiary, Brown & Williamson, with R.J. Reynolds Tobacco to create Reynolds American.

Speculation has been going around for years about whether or not British American will make a move on its smaller peer, but legal issues have prevented any merger. Reynolds American has been dealing with lawsuits related to smoking for decades and British American has done everything possible to keep the suits at arm's length.

However, in recent years, the number of tobacco lawsuits has dwindled, making Reynolds a more attractive acquisition target.

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British American’s initial $47 billion takeover offer was rejected and now the market is waiting to see whether or not the British tobacco giant will make a second offer for the second-largest tobacco company in the United States.

Another offer is on the cards

I believe British American will come back with a higher offer than its previous $56.50 a share offering in cash and shares. The offer, which was made at a 20% premium to Reynolds’ closing price on the day before the deal, would have created a company with a combined market value of around 146 billion pounds ($180.8 billion), overtaking Philip Morris (PM, Financial) as the world’s largest publicly traded tobacco company. By buying Reynolds, British American would also gain a leading position in electronic cigarettes.

As the number of cigarette smokers around the world dwindles, tobacco companies are left with little choice but to diversify into new technologies and acquire each other to drive growth. This is why I believe British American will come back for Reynolds. Not only will the deal increase British American’s sales, give the company a leading position in the U.S. tobacco market and help improve margins through cost synergies, but the deal will also help British American diversify into the highly competitive electronic cigarette market, which is expected to become the next big thing for smokers in the near future.

An attractive market

Technology is not the only thing driving British American’s interest in Reynolds. The U.S. tobacco market is one of the world’s most robust; sales are relatively steady and gradual price increases are helping cigarette manufacturers improve margins, profits and cash flow. For the three months ended Sept. 30, Reynolds reported a 1.4% increase in net sales, a 10.6% increase in adjusted non-GAAP earnings, a 12% increase in adjusted non-GAAP net income and a 30.4% increase in reported earnings per share.

Further, the overall volume of cigarettes shifted by Reynolds during the three months to Sept. 30 decreased 1.5% year over year with the company’s overall share of the U.S. tobacco market inching up 0.3% to 34.6%. British American sales are growing faster, but bear in mind the country has more exposure to developing markets. For example, the company saw the volume of its Lucky Strike brand grow by 14% during the third quarter after launching in Indonesia. For the nine months to the end of September, the group’s overall volume of cigarettes sold increased 2% to 515 billion units. For the same period, revenue grew 6.2% on an organic basis and the company’s market share across all markets increased by 0.4%.

British American does not have a presence in the U.S. So by acquiring Reynolds, the company will be able to gain access to this market, plus Reynolds’ lucrative cash stream and electronic devices. Put simply, it makes a lot of sense for the two companies to combine.

Conclusion

British American has the firepower needed to do the deal. And even though Reynolds just acquired Lorillard, the company’s long-term growth will be constrained by saturation of the U.S. tobacco market. The only sticking point for any deal appears to be the price. If British American comes back with a more attractive price for its smaller peer, it is likely the board and company shareholders will be won over.

Disclosure: The author does not own any stock mentioned.

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