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BAT-Reynolds deal:

lucky strike for tobacco industry?

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David Lerche

Senior Investment Analyst

In a deal set to create the world’s largest tobacco company by sales, British American Tobacco (BAT) earlier this month reached an agreement to buy full control of US tobacco giant Reynolds American for US$49.4 billion. Given the well-established health risks associated with smoking, the most exciting part of the transaction is the potential combination of the two groups’ next-generation products (NGPs), including e-cigarettes.

The transaction – in terms of which BAT will acquire the remaining 58% of Reynolds American that it doesn’t already own – will see Reynolds’ key brands Newport and Camel added to BAT’s Dunhill, Lucky Strike and Kent. The US is the world’s second largest tobacco market by profits, after China, and the largest market for NGPs, with 45% of global sales.

BAT’s rationale for the deal centres on improved scale for the combined entity. By taking full ownership of Reynolds – the second largest US tobacco company – BAT will be able to consolidate production into fewer factories, while also taking advantage of distribution and marketing synergies. In an environment of slow but sustained volume decline in developed markets, consolidation is key to the continual unit-cost reduction that is integral to BAT’s strategy.

BAT management sees at least US$400 million of potential annual synergies, which if capitalised at a price-to-earnings (P/E) ratio of 17 times, equates to value creation of US$6.8 billion, around R50 per share.

COLLABORATION ON VAPING PRODUCTS

The most exciting aspect of the BAT and Reynolds deal is the collaboration of development efforts with regard to NGPs such as electronic cigarettes. Many tobacco companies have been experimenting with alternative nicotine-delivery systems like vaping, which generally result in a 90% reduction in harmful chemicals relative to traditional cigarettes.

Currently, Philip Morris is the global leader in the NGP space. Although Reynolds has a superior NGP portfolio to BAT, by sharing intellectual property, management believes that the combined entity will gain market share more quickly to take the global lead in NGPs.

Irrespective of the tie-up with Reynolds, BAT plans to continue to buy interesting NGP start-ups as part of its strategy to lead this growth area. A quarter of vapour users are new to nicotine, which facilitates growth in an industry experiencing a secular decline in customer numbers.

Given the inelastic nature of tobacco demand, BAT is able to achieve revenue growth through a combination of price hikes and mix improvements. In much the same way that alcohol companies have successfully pushed customers towards premium products, tobacco companies use flavours and improved packaging to upsell premium brands.

WINNING MARKET SHARE

As the tobacco market is consolidated among a few global giants, the focus continues to shift towards more oligopolistic behaviour: companies look to compete more on product quality and innovation than price, which is positive for profitability. Effectively, BAT plans to continue to grow its own volumes not through the recruitment of new smokers, but rather through winning market share.

BAT has closed four factories worldwide over the past 18 months, which is testament to the ongoing rationalisation of the production side of the business. In particular, the group is steadily moving factories to emerging markets, where labour is cheaper and where markets are growing faster.

Over the past five years, BAT has delivered a total return of 22% per year and outperformed the South African market by 8% per year, validating its position as a long-term core holding in our house view portfolio. The company fits our philosophy of investing in quality businesses, given its high and rising return on equity of 75% in 2015, and likely 90% for 2016. The stable nature of the business, coupled with world-class management and high barriers to entry, means the business should continue to perform through future cycles. BAT is highly cash-generative and accordingly pays out at least 65% of earnings as dividends.

While BAT’s valuation is no longer as obviously attractive from an absolute perspective as in the past, it remains attractive relative to both sector peers and the wider market. At a forward P/E ratio of 16.8 times, it trades at a 6% discount to global tobacco peers, with a P/E of 17.9 times. BAT’s 14% and 2% premiums to the FTSE 100 Index and the MSCI World Index respectively are six percentage points below historic levels, suggesting the stock still offers relative value.

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