British American Tobacco’s (BTI, Financial) $47 billion offer to acquire the Reynolds American (RAI, Financial) shares it does not already own has sparked a wave of takeover speculation in the tobacco industry.
British American’s offer is symbolic as it is the second such deal in two years. Last year, Reynolds American acquired its smaller U.S. peer Lorillard in a deal half the size. Before 2015, big tobacco deals had become rare as regulators clamped down and lawsuits piled up. Indeed, the three main U.S. tobacco companies, Lorillard, Reynolds and Altria (MO, Financial), all emerged as independent companies due to diversification away from litigation risks. These companies were either spun off from their parent companies or spun off their international operations.
Philip Morris (PM, Financial) was the biggest and most anticipated spinoff of them all. Completed in 2008, Altria spun Philip Morris off to help achieve better returns for shareholders as litigation risk fell.
As Barron’s described in 2008:
"Management has long maintained that Altria's shares traded at a discount to the sum of the company's parts, and that an unfettered Philip Morris International (PM, Financial), now the world's largest publicly traded tobacco company, would thrive independently and deliver for shareholders. For years, however, the company and investors feared litigants would succeed in blocking a breakup, a concern that has ebbed with the cigarette industry's victories in court and a sharp drop in individual and class-action claims against the industry.”
A decade on and it is clear that much is changed for the tobacco industry. At the time of the Philip Morris spinoff, international growth was all the rage, but today global growth has taken a backseat to the slow and steady tobacco market within the United States. This is why British American, which has a dominating market share in many markets overseas, made a bid for Reynolds. This is also why Imperial Brands, (another U.K.-based international tobacco giant) paid around $7 billion for a selection of Lorillard brands last year as part of the Reynolds deal.
International attraction
To get some idea of how attractive the U.S. market is compared to the international market, all you need to do is compare the growth of Philip Morris, the largest publicly traded tobacco company with zero exposure to the U.S., to growth at Reynolds or Altria.
Specifically, between 2010 and 2015 Philip Morris’ operating profit declined from $11.2 billion to $10.6 billion while net profit fell from $7.3 billion to $6.9 billion. Free cash flow per share slid from $4.74 to $4.46 over the same period.
In comparison, between 2010 and 2015 Altria’s operating profit rose from $6.2 billion to $8.1 billion. Net profit increased to $5.2 billion from $3.9 billion, and free cash flow per share more than doubled from $1.25 to $2.85. Reynolds’ operating profit rose from $2.4 billion to $6.9 billion. Net profit increased from $1.1 billion to $3.2 billion, and between 2010 and 2014 free cash flow per share leaped from 68 cents to $1.33.
There are many reasons why Philip Morris’ growth has lagged during the past five years. Raising tobacco taxes, increasing competition, health concerns and falling sales volumes are all reasons to blame. All in all, the international tobacco market is no longer as attractive as it once was.
So now that the tobacco merger market is thawing, will Altria and Philip Morris come back together again?
Merger on the cards
There’s certainly scope for a merger of equals. Combining the two groups would create a global tobacco behemoth with over $50 billion in annual tobacco revenues.
Together Altria and Philip Morris would have the power to change the world. Philip Morris’ iQOS smokeless cigarette is redefining the smoking experience and, according to analysts at Wells Fargo, could displace up to 30% of the combustible cigarette industry in developed markets by 2025. It could also increase smoking prevalence and accelerate the premiumization of the overall market. All in all, Wells estimates iQOS could add an incremental value of $27 per share for Philip Morris and could add $10 per share for Altria using a discounted cash flow model. Further, Altria owns a small, but not insignificant, stake in the recently enlarged SAB Miller- Anheuser-Busch Inbev, giving the company diversification outside tobacco.
That being said, the two groups have only been separate for a few years, and any re-merger is bound to attract unwanted criticism. Still, cost savings could run into the hundreds of millions if any deal is completed. As Philip Morris is headquartered in Switzerland, the enlarged group would benefit from a lower tax rate at the corporate level although, tobacco excise taxes would be unchanged, and this is arguably a more significant issue for Philip Morris.
Two other important issues to consider are competition rules and debt. Philip Morris’ debt is currently around three times EBITDA, while Altria’s is projected to come in at 1.5 times EBITDA for 2016. These ratios aren’t that concerning, especially considering the environment we’re in today. Nonetheless, both Altria and Philip Morris are $100 billion-plus companies and the debt required to buy them out would be significant. An all-share merger might be a better option and would leave the enlarged company in a very comfortable financial position. The second issue is competition – regulators might not be happy to have around 50% of the world’s tobacco market controlled by one company. That said, health officials might not think a monopoly in tobacco is such a bad thing. Higher prices will only push more consumers away from the toxic products.
Disclosure: The author owns shares in Imperial Brands but does not own shares in any other company mentioned.
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