BAT better off with UK neighbour than US merger

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

BAT 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 March, a $7.8 billion (R83bn) of value has been created for BAT shareholders, even as the firm reported weak sales growth.

While there has been talk that BAT could eventually acquire the merged Reynolds-Lorillard entity, analysts say that would make the UK company too reliant on the slowing US cigarette market and drag down its valuation. US tobacco firms trade at a discount to the rest of the industry. Keeping itself a minority investor in Reynolds left the door open for BAT to buy the UK’s Imperial Tobacco instead, said Jefferies Group.

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

“BAT is really the linchpin of this deal,” Philip Gorham, a tobacco analyst at Morningstar, said. “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 deal that kept BAT from boosting its stake in Reynolds. While that had fuelled talk that BAT could seek a full takeover, BAT’s returns were more attractive if it helped Reynolds buy Lorillard instead, analyst James Bushnell at Exane BNP Paribas said.

BAT “probably wants to retain the financial flexibility to do other deals if available”, Erik Bloomquist, an analyst at Berenberg Bank, said.

The UK firm had £2.2bn (R40bn) of cash and equivalents in December. Debt was equal to 1.9 times earnings before interest, taxes, depreciation and amortisation. Its market capitalisation is about $113bn.

BAT “looks likely to do no more than support” the Reynolds-Lorillard deal, Martin Deboo, an analyst at Jefferies, said. That “keeps alive the possibility that BAT might one day consolidate” Imperial.

Imperial is worth about $45bn. It will sell 30 percent of its stock in its Madrid unit this month to raise $800 million.

Imperial is in talks with Reynolds and Lorillard to buy assets that regulators may force them to divest. Sale proceeds could help fund a purchase of those divestitures.

Compared with Reynolds and Lorillard, whose revenue comes from the US, Imperial’s global sales make it a more appealing target as Americans cut their tobacco spending. Buying Reynolds “would tip the geographical balance too much and give them too much exposure to a developed market”, Gorham said. “BAT investors like that it is focusing on emerging growth markets.” – Bloomberg


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