Deal Creates Tobacco Giant -- WSJ

BAT looks to U.S. for growth, agreeing to pay $49.4 billion for full control of Reynolds

By Saabira Chaudhuri in London and Jennifer Maloney in New York 

British American Tobacco PLC agreed to take full control of Reynolds American Inc. in a $49.4 billion deal that marks renewed interest among international players in the U.S. tobacco market.

BAT, which already owned 42.2% of Reynolds before Tuesday's announcement, said it saw the U.S. as the largest tobacco profit pool outside of China -- with affordable pack prices, high disposable income and a burgeoning market for e-cigarettes and other alternative products combining to create opportunities for growth.

Reynolds holds a 34% share of the U.S. cigarette market, trailing only Marlboro maker Altria Group Inc. The deal will give BAT brand Kent an opportunity to expand in the U.S., and Reynolds's Newport a chance to grow overseas, Reynolds Chief Executive Debra Crew said in an interview.

The BAT-Reynolds deal is subject to antitrust review but hasn't been expected to face big hurdles. The two companies compete in different markets, with little of Reynolds's business outside the U.S. BAT, apart from its existing stake in Reynolds, doesn't have much business in the U.S.

The U.S. market has come a long way since 1998, when a landmark tobacco settlement hit cigarette makers with huge legal liabilities that led to $200 billion in costs over the years. More recently, tobacco companies have pushed through price increases, and the industry's steady dividends have lured investors amid low interest rates. Follow-on litigation after the 1998 settlement hasn't been as damaging as expected.

As legal risks faded in the U.S., tobacco regulations expanded around the globe, prompting international tobacco companies to return. In the U.S., the First Amendment protects companies from rules being adopted in Europe and elsewhere that force cigarette makers to use plain packaging or apply graphic warning labels.

The U.S. cigarette market has grown to $94 billion in retail sales in 2015 from $71 billion in 2001, according to Euromonitor International, a market-research firm, as steadily rising prices more than offset a decline in cigarette volumes -- which fell to 269 billion sticks from 413 billion sticks over the same period. U.S. sales of vapor products, including e-cigarettes, totaled $3 billion in 2015.

Both BAT and Reynolds in recent years have poured money into alternatives like e-cigarettes and so-called heat-not-burn devices. Unlike e-cigarettes, which contain nicotine-laced liquid, heat-not-burn devices heat tobacco to a high temperature, vaporizing it.

Ms. Crew said the merger would allow Reynolds to expand its Vuse e-cigarette overseas and combine their R&D efforts with BAT's.

BAT in December launched a heat-not-burn device in Japan called Glo, which resembles an iPod. Reynolds briefly distributed a cigarette-shaped device called Revo and continues to explore heat-not-burn technology, executives said.

After the deal is completed, emerging markets will make up 60% of the new company's footprint by sales volume, BAT said Tuesday. Sales volumes have continued to climb across parts of the developing world, bucking the trend seen in developed markets and making these particularly lucrative for cigarette companies. BAT said revenue per pack from emerging markets has grown at more than twice the rate in developed ones over the past five years.

The deal will give Reynolds, based in Winston Salem, N.C., access to faster-growing emerging markets in South America, the Middle East, Africa and Asia where BAT has a strong presence.

The acquisition, with brings together other brands like Camel, Dunhill and Pall Mall, increases the likelihood of Philip Morris International Inc. acquiring Altria -- from which it was spun off in 2008 -- said Wells Fargo tobacco analyst Bonnie Herzog. "Scale becomes increasingly critical as the industry consolidates," she wrote in a note Tuesday. "We don't expect [Philip Morris] to sit idly by as BAT becomes the world's largest global tobacco" company.

The two businesses hold the same portfolio of cigarette brands, which are sold by Altria in the U.S. and Philip Morris elsewhere.

Altria declined to comment. Philip Morris said it has no plans to cooperate with Altria beyond an existing agreement to jointly sell e-cigarettes and other smokeless products.

Separately Tuesday, Altria said it bought Sherman Group Holdings LLC, the closely held maker of Nat Sherman cigars, for an undisclosed sum.

BAT said Tuesday it is paying $29.44 in cash and 0.5260 of an ordinary share -- totaling $59.64 for each Reynolds share -- valuing its U.S. peer at more than $85 billion. The deal comes after BAT said in October that it had made an offer for Reynolds valued at $56.50 a share, or about $47 billion for the stake it didn't own. The agreed price represents a premium of 26% over Reynolds's closing price the day before BAT made its October announcement.

BAT shares closed 3.8% lower in London Tuesday, while Reynolds rose by 3.1% in New York.

Reynolds's board considered the prospect of the incoming Trump administration pushing corporate tax cuts, Executive Chairman Susan Cameron said during a call with analysts. In a separate call, BAT Chief Executive Nicandro Durante said it had been "impossible to consider the potential impact" of any change to the U.S. tax code.

The two companies haven't yet discussed who will helm the combined business, Ms. Cameron said in an interview.

BAT and Reynolds have a longstanding relationship. BAT has been a Reynolds shareholder since 2004, which had given it access to the U.S. market without having a direct presence.

The deal is subject to a breakup fee of $1 billion payable by either company should its board fail to recommend the transaction to shareholders or withdraw its recommendation. BAT could be forced to pay a $500 million breakup fee if antitrust authorities ask it to sell assets it doesn't agree to.

Three new Reynolds shareholders will join the company's board once the deal closes, expected in the third quarter of 2017.

Centerview Partners, Deutsche Bank AG and UBS Group AG are advising BAT.

Weil, Gotshal & Manges LLP and Moore & Van Allen PLLC are lawyers for Reynolds's transaction committee and Goldman Sachs Group Inc. is its financial adviser. Jones Day is legal counsel for Reynolds and J.P. Morgan Chase & Co. and Lazard are financial advisers to the company.

Write to Saabira Chaudhuri at [e-mail] and Jennifer Maloney at [e-mail]

(END) Dow Jones Newswires

January 18, 2017 02:48 ET (07:48 GMT)

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