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British American Tobacco - Reynolds merger and Q3s

Equity research team | 21 October 2016 | A A A
British American Tobacco - Reynolds merger and Q3s

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British American Tobacco plc Ordinary 25p

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Alongside positive third quarter results British American Tobacco (BATS) has announced a proposed merger with Reynolds American. The shares climbed 2.9% following the announcements.

Our View

British American's move to acquire the outstanding stake in Reynolds shouldn't come as a great surprise.

Reynolds American was partly founded out of BATS' US operations, when international tobacco companies pulled out of direct involvement in the US in the face of huge litigation costs. As a result it's held a large stake in the business since inception, one it paid up to maintain when Reynolds bought Lorillard last year.

M&A has been central to the tobacco industry's success in recent years; as companies look to grow scale in the face of ever increasing competition. With litigation largely a thing of the past, it's not surprising to see BATS drawn back to what is one of the world's most lucrative tobacco markets. Especially after rival Imperial took a direct stake in the industry after buying up bits of Lorillard.

The deal is expected to be accretive to earnings and, perhaps more importantly, dividends from year one, making it attractive for shareholders. With many institutional investors already holding both companies, it's difficult to imagine the deal not getting the green light.

Elsewhere the business is performing well, with good volume growth in key markets and brands. Emerging markets, which account for around 70% of BATS' sales, have seen their currencies depreciate sharply against the dollar over the last couple of years. That continues to cause a headache for BATS as higher raw material costs lead to margin pressure.

BATS has a great track record and generates prodigious amounts of cash, most of which can be returned to shareholders through dividends (which have grown every year since 1999) and share buybacks. It benefits from dominant market positions and sells an addictive product, which translates into tremendous pricing power.

The industry is subject to numerous regulatory risks, with plain packaging in the process of being introduced in France, the UK and Ireland a good example. But BATS' geographic diversity and exposure to faster growing emerging nations should stand it in good stead in the long run.

The shares are trading on a price to earnings ratio (P/E) of 17.8x, a 23% premium to their long run average rating; with analysts forecasting more 10% earnings growth for 2017. The prospective yield is 3.8%.

Reynolds Merger

British American Tobacco (BATS) announced the agreed terms for the acquisition of the 57.8% of Reynolds American that it does not already own on 17th January 2017. The deal values the outstanding stake at $49.4bn. This equates to $59.64 per share, of which $29.44 will be in cash with the remainder in BATS shares. The offer represents a 26% premium to the Reynolds share price the day before the deal was announced.

The merger will create the world's largest listed tobacco company, bringing together brands such as Newport, Kent and Pall Mall. The deal is expected to be earnings accretive in the first year, with synergies of around $400m over three years.

The merger has been approved by Reynolds independent directors, but remains subject to the approval of BATS and Reynolds shareholders.

BATS Chief Executive, Nicandro Durante, commented;

"Our combination with Reynolds will benefit from utilising the best talent from both organisations. It will create a stronger, global tobacco and NGP business with direct access for our products across the most attractive markets in the world. We believe this will drive continued, sustainable profit growth and returns for shareholders long into the future."

Q3 Results:

Year to date (YTD) revenues increased 8.1% at constant exchange rates, up 6.2% on an organic basis. The group improved market share in 'Key Markets' by 40 basis points, with 'Global Drive Brands' increasing volumes by 9.8%.

The group saw a 2.2% increase in cigarette volume YTD, 0.9% on an organic basis, with the remaining revenue increase accounted for by a 5% improvement in price/mix. Tobacco volumes for the quarter were down slightly as a good performance from Western Europe and EEMEMA was offset by weakness in the Americas and Asia-Pacific.

Next Generation products, including Vype, continue to perform well, achieving a 35% market share in the UK. The group's products are available in the UK, France, Germany Poland, Italy, Colombia, Monaco and Kuwait with further product launches planned.

Transactional currency headwinds remain a challenge, as a stronger dollar increased the cost of raw materials in BATS emerging market trading currencies. This more than offsets the translational benefits from lower sterling. At current levels the group would see a transactional headwind of 7% and translational tailwind of 6%.

Unless otherwise stated, all estimated figures, including prospective dividend yields, are taken from a consensus of analyst forecasts compiled by Thomson Reuters. These estimates should not be taken as a reliable indicator of future performance.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research for more information.