Deals

Chris Hughes is a Bloomberg Gadfly columnist covering deals. He previously worked for Reuters Breakingviews, as well as the Financial Times and the Independent newspaper.

Reynolds American Inc. has pushed British American Tobacco Plc to the limit in securing a $49 billion takeover offer from its U.K.-based cigarette peer. The punchy price shows how badly BAT management wanted to create a global tobacco company. Others in the sector may end up doing similar.

BAT made an initial-cash-and shares proposal to buy the 58 percent of Reynolds it didn’t already own back in October. That was worth $56.50 a share, 20 percent above over Reynolds's prior closing price. The target's independent directors rightly judged the premium too mean for handing BAT full control.

The new offer is a more reasonable 26 percent premium. BAT can just about justify the increase. Recent talks with Reynolds have allowed BAT to revise the estimated cost savings in a deal from “around” to “at least” $400 million annually. The acquisition will cover its cost of capital in five years, BAT says. Not great, but acceptable.

The deal will pay for itself sooner if those savings come in much higher. The financial benefits are just 3 percent of Reynolds's yearly revenue. Historic tobacco deals have achieved on average 11 percent, Barclays notes -- although the overlaps between BAT and Reynolds are unusually slender.

The higher cash component will push BAT’s leverage to nearly 4 times Ebitda, which is just about manageable. It will drop to a more tolerable 3 times by the end of 2019.

The pricing of the transaction reflects an evenly balanced negotiating position. BAT’s existing 42 percent stake means Reynolds couldn’t have found an alternative buyer. Equally it would have been hard for BAT to walk away given the evident strategic logic of moving to full ownership. Just after BAT made its first proposal, tobacco and other defensive stocks dipped amid expectations of higher interest rates. That negotiating advantage was short-lived for BAT: the Bloomberg World Tobacco Index has since recovered pretty much all its losses.

Round And Round
Defensive stocks like tobacco have bounced back since BAT approached Reynolds in October
Source: Bloomberg

Why was BAT willing to go right up to its pain barrier? The deal will reunite the British company with the assets of its former U.S. business, Brown & Williamson, which it agreed to sell to Reynolds in 2003. Back then, the logic was to rid BAT of exposure to U.S. tobacco litigation. Today, fears of lawsuits have been eclipsed by a bigger worry: not having a sizeable U.S. and global presence.

Scale and U.S. market access are emerging as advantages as the tobacco industry tries to reinvent itself around so-called "heat-not-burn" and smokeless technologies such as vaping. On that basis, the long-mooted reunification of Philip Morris International Inc. and Altria Group Inc., separated back in 2008, has stronger logic than ever. Watch this space.

Together Again?
Shares in Philip Morris International and Altria have diverged since the U.S. election
Source: Bloomberg

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

To contact the author of this story:
Chris Hughes in London at chughes89@bloomberg.net

To contact the editor responsible for this story:
James Boxell at jboxell@bloomberg.net