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BAT Better With U.K. Neighbor Than U.S. Merger: Real M&A

Camel Cigarettes Manufactured by Reynolds
An agreement between Reynolds American Inc., the producer of Camel cigarettes, and Newport-maker Lorillard Inc. could be announced as early as tomorrow, people familiar with the situation told Bloomberg News. Photographer: Simon Dawson/Bloomberg

As North Carolina’s Reynolds American Inc. and Lorillard Inc. work out the details of their merger, British American Tobacco Plc may be wise to keep its focus on the other side of the ocean.

Reynolds, the producer of Camel cigarettes, is in talks to acquire Newport-maker Lorillard, the U.S. companies confirmed last week. BAT, as the U.K. company is known, owns 42 percent of Reynolds and expects to maintain that stake after the deal closes. Since reports of the possible tie-up first emerged in early March, about $7.8 billion of value has been created for BAT shareholders, even as the company reported disappointing sales growth, according to data compiled by Bloomberg.

While there’s been speculation that BAT could eventually acquire the merged Reynolds-Lorillard entity, analysts from Oriel Securities Ltd. and Morningstar Inc. say that would make the British company too reliant on the slowing U.S. cigarette market and drag down its valuation. American tobacco companies tend to trade at a discount to the rest of the industry. Keeping itself a minority investor in Reynolds leaves the door open for BAT to potentially buy the U.K.’s Imperial Tobacco Group Plc instead, said Jefferies Group LLC.

“You don’t need to buy a cow when you just want a glass of milk,” Chris Wickham, a London-based analyst at Oriel, said in a phone interview. Keeping Reynolds as a separate company “makes it very clear what the value component of BAT is that comes out of the United States.”

Annie Brown, a spokeswoman for London-based BAT, declined to comment today.

Lengthy Talks

Reynolds and Lorillard confirmed the merger discussions July 11. The announcement was sparked by reports last week that the deal may be close after months of negotiation. In its own statement that day, BAT said that if the deal proceeds, it will subscribe for additional shares in order to maintain the 42 percent ownership.

“BAT is really the linchpin of this deal,” Philip Gorham, a tobacco analyst at Morningstar in Amsterdam, said in a phone interview. “It would be much more difficult for Reynolds to get shareholder approval without BAT at least partly funding it.”

July marks the end of a standstill agreement that kept BAT from increasing its stake in Reynolds. While that’s created speculation that BAT could seek a full takeover, BAT’s returns are more attractive if it helps Reynolds purchase Lorillard instead, according to James Bushnell, a London-based analyst at Exane BNP Paribas.

Better Combination

Reynolds and Lorillard would have synergies, and BAT and Reynolds wouldn’t, Bushnell said. Not pursuing Reynolds also means BAT has the ability to make other acquisitions, he said.

BAT “probably wants to retain the financial flexibility to do other deals if available,” Erik Bloomquist, a tobacco analyst at Berenberg Bank in London, said in a phone interview.

If Reynolds funds the Lorillard takeover with half debt and half equity, it may cost BAT about $6 billion to maintain its 42 percent stake, Bloomquist estimates. BAT can “easily finance” that with cash and debt, he said.

The British company had about 2.2 billion pounds ($3.6 billion) of cash and equivalents at the end of December, data compiled by Bloomberg show. Debt was equal to 1.9 times earnings before interest, taxes, depreciation and amortization, the data show. Its market capitalization was the equivalent of $113 billion, based on last week’s closing price.

Help Only

BAT “looks likely to do no more than support” the Reynolds-Lorillard deal, Martin Deboo, a London-based analyst at Jefferies, wrote in a July 11 report. That “keeps alive the possibility that BAT might one day consolidate” Imperial.

Imperial was valued at $45 billion last week. The cigarette maker raised 470.7 million euros ($641 million) through the sale of a 27.3 percent stake in its Spanish logistics unit, which began trading today in Madrid. Imperial confirmed last week that it’s in discussions with Reynolds and Lorillard to potentially purchase certain assets that regulators may force them to divest. Proceeds from the Madrid sale could help fund a purchase of those divestitures.

Compared with Reynolds and Lorillard -- whose revenue primarily comes from the U.S. -- Imperial is diverse, making it a more appealing target as Americans cut tobacco spending. Imperial has a presence in parts of Asia, Europe, the Middle East and Africa.

Dwindling Smoking

U.S. tobacco expenditures were about $86 billion in 2013, down from $111 billion a decade earlier, according to data compiled by Bloomberg from the Bureau of Economic Analysis. The prevalence rate of smoking in the U.S. slid to about 18 percent last year. It rose in countries such as South Africa, Malaysia, Nigeria, France and Colombia, the data show.

BAT already trades at a discount to its peers because of its U.S. interests, and it shouldn’t double down on Reynolds, said Wickham of Oriel.

Before the Reynolds-Lorillard speculation emerged, BAT traded at about 16 times earnings, 16 percent lower than the average valuation for global tobacco stocks larger than $5 billion, data compiled by Bloomberg show. A year ago, the discount was even more pronounced at 22 percent.

Imperial, which trades at 38 times earnings, is more than twice as expensive as BAT. Such disparities among countries are what led U.S. tobacco market leader Altria Group Inc., formerly Philip Morris Cos., to spin off its international division to investors six years ago, Wickham said.

Buying Reynolds “would tip the geographical balance too much and give them too much exposure to a developed market,” Gorham of Morningstar said. “BAT investors like that it is focusing on emerging growth markets.”

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