What BAT's Bid for Reynolds Could Mean for Big Tobacco

WINSTON-SALEM, N.C. — On Oct. 21, British American Tobacco (BAT) made an offer to acquire Reynolds American Inc. (RAI) for $47 billion, but that's just the opening bid. And it could trigger additional deals.

According to tobacco industry analysts, the No. 2 U.S. tobacco company could counter U.K.-based BTA's offer. BAT already owns 42.2 percent of RAI.

The $47-billion offer values RAI at $56.50 per share, of which $24.13 would be in cash and $32.37 would be in BAT shares. It represents a premium of 20 percent over the closing price of RAI common stock on Oct. 20.

"While we have long discussed the possibility of BAT acquiring the remaining 57.8 percent of RAI it does not currently own, we believe BAT's current offer — $24.13 in cash and 57 percent in BAT stock, valuing RAI at $56.60 a share as of Oct. 20 will need to be sweetened," said Bonnie Herzog, managing director of tobacco, beverage and convenience store research at Wells Fargo Securities LLC.

Wells Fargo Securities believes RAI, as a standalone company, is worth at least $55 a share, according to Herzog. In addition, BAT's estimated $400 million in synergies is conservative since it likely underestimates the global opportunity the combined entity would have in reduced risk products (RRP) and only modestly represents procurement, research and development, and other cost considerations.

As she explained, "a higher takeout price for RAI is justified based on a rough calculation that an additional $100 million in synergies would equate to another $1-$3 a share."

Vivien Azer, director and senior research analyst at Cowen and Co., agrees the $47-billion initial offer could just be a starting point.

"While BAT approached RAI with an attractive merger offer, we see room for BAT to sweeten the deal, given only modest leverage implications and low financing costs, coupled with RAI's attractive margin and cash flow profile," Azer said, adding the final offer could hit roughly $62 a share.

The proposed deal also faces "virtually no antitrust risk" because the two tobacco companies have no overlap in geographies, Herzog noted, adding the deal could be approved in the next several months given the companies' existing close relationship.

The deal, according to Herzog, would provide BAT with full ownership of lucrative U.S. market, complementing its existing presence in high-growth emerging markets; significant synergies and cost savings; and geographic diversification. It would also create "the world's largest listed RRP company with better-aligned incentives and greater investments in RRPs," she added.

With a 100-percent BAT-RAI tie up, Wells Fargo Securities does not expect Philip Morris International Inc. to "sit idly by and allow BAT to gain the upper hand in expansion into the U.S., and to become the largest listed global tobacco and RRP company in the world," Herzog said.

"Therefore, we believe this increases the probability that Philip Morris International will acquire Altria Group Inc. has been discussed in the media but unconfirmed by the companies," she added.

According to Bloomberg, the merger could signal a final wave of consolidation in the tobacco industry as rival companies link up to compete.

As the news outlet noted, only a few possible combinations remain: Japan Tobacco Inc. buying Britain's Imperial Brands plc, and Philip Morris International re-merging with Altria Group eight years after splitting up are the most plausible scenarios, experts say. 

Any future deals would be more complicated than previous combinations, though.

"This may pave the way for further consolidation," Owen Bennett, an analyst at Jefferies, told Bloomberg. "Given the attractiveness of the U.S. market, we believe Japan Tobacco would want greater exposure and Philip Morris International also."

BAT's offer may, however, indicate that companies are putting aside their reluctance to owning U.S. tobacco businesses due to legal liability has disappeared, according to Chris Wickham, an analyst at Whitman Howard. 

Plus, the report noted, "the quest for reduced-risk tobacco products, is changing the dynamics of tobacco (mergers and acquisitions), as cigarette makers look for growth in the U.S., the world's most profitable tobacco market and the region where electronic cigarettes have made the biggest impact."