Tobacco Deal Needs Smoke and Mirrors

The U.S. election fallout makes it harder to justify paying much more.
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British American Tobacco Plc is feeling the downdraft from the U.S. election.

Its $47 billion effort to buy the 58 percent of Reynolds American Inc. it doesn't already own has been complicated by the result. Both tobacco companies seem to want a deal -- but reaching an agreement on price has become complicated.

Reynolds is poised to reject BAT's overture and wants a higher price, according to Bloomberg News.

The snag is it's getting harder for BAT to afford that.

BAT's stock has fallen 6 percent since Donald Trump's victory, or more than 10 percent since the company announced its intentions on Oct. 21.

Diminishing Currency

BAT's stock has declined more than 10 percent since its move on Reynolds

Source: Bloomberg

BAT is offering stock as part payment, so it would have to add more to the mix to keep the overall value at the $56.50 a share it claimed its original offer was worth when it was announced.

The weaker share price isn't simply a reflection of concern that BAT might over-pay for Reynolds. Shares in British peer Imperial Brands Plc have fallen just as much. In the U.S., Philip Morris International Inc. and Altria Group Inc. are down too.

Not Alone

Imperial Brands, Philip Morris and Altria have also fallen since the election

Source: Bloomberg

That's because tobacco shares are falling in sympathy with the post-election sell-off in long-dated bonds. Soaring yields on government securities make even the tobacco's industry's stable dividends look less attractive.

If BAT didn't want to add more shares to its bid, it could increase the cash component. But that's also complicated by the recent turn in the bond market, which makes financing more expensive.

In any case, BAT can't take on too much more leverage: its existing proposal would take proforma net debt to 3.2 times Ebitda, analysts at RBC estimate. That's at the limit of what investors tolerate in major publicly traded companies.

Meanwhile, Reynolds' price demands may have increased. Trump's election has generated expectations of a more benign tax regime for U.S. companies in general, and tobacco firms in particular, as analysts at Citigroup point out.

In reality, Reynolds would find it hard to make such a case. The plunge in tobacco share prices suggest investors are more worried about the end of an eight-year period of out-performance for tobacco stocks than they are excited about possible corporate tax cuts.

The world has changed since the proposal was made. Reynolds shares have only briefly traded above the value of BAT's proposal since it was made public, putting little pressure on the U.K. company to go higher.

Reynolds' best argument remains that BAT's predictions of $400 million in annual cost savings understate the true benefits of the combination. Those synergies may equate to about 3 percent of Reynolds' annual revenue. That seems low, given the combined buying power of the group, plus the scope for savings by combining R&D in next-generation smokeless technologies. Reynolds still needs to prove it.

A small sweetener from BAT would enable the Reynolds board to show it has done its duty to shareholders and provide a pretext for recommending the deal. It's just got harder for BAT to justify doing that.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

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    Chris Hughes in London at

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    Edward Evans at

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