BAT Needs to Cough Up a Bit More for Reynolds

(Bloomberg Gadfly) -- It's just what the world could do without: a bigger, more powerful cigarette company. But investors are cheering British American Tobacco's proposal to take over its U.S. partner Reynolds American. No wonder. The one group that stands to benefit from the creation of this smoke-filled behemoth would be its shareholders.

BAT has owned a minority stake in Reynolds for years and made several failed attempts to take control. Full ownership would create a geographically diverse group, since Reynolds is focused on the U.S. and BAT is weighted towards everywhere else. The combo would enjoy scale economies in R&D for vaping and other next-generation smokeless technologies. There could be scope to use each sides' brands to plug gaps in respective markets.

BAT Needs to Cough Up a Bit More for Reynolds

That story should appeal to Reynolds too. While BAT wants more U.S. exposure, Reynolds might feel over-reliant on its home market. As the smaller of the pair, Reynolds has more reason to want bigger research resources.

BAT's timing is opportunistic. Shares in Reynolds have drifted from June's all-time high because their yield could be less attractive if the Federal Reserve raises interest rates. The BAT proposal doesn't look too shabby at first glance: $24.14 in cash plus a bunch of BAT shares worth $33.43 in London morning trading on Friday. The combined $57.57 is a 22 percent premium to Reynolds' last closing price, and 7 percent above its high. Not bad, given BAT already has an influential 42 percent stake.

The proposal looks even better if you believe BAT's estimate that pretax savings from any deal would be $400 million annually. These may be worth as much as $5 billion when capitalized on generous assumptions. But all of this would be paid away to Reynolds' independent shareholders. The terms equate to an $8.6 billion premium on their 58 percent holding.

Finally, the proposal ascribes Reynolds an enterprise value of 16.3 times 12-month trailing Ebitda, high compared to recent tobacco deals. BAT is on 13.4 times.

All that said, there is almost certainly more value creation to be had here than BAT is willing to put a firm number on right now. The identified cost savings are equivalent to just 1 percent of combined sales. 

BAT won't want to use too many of its relatively cheap shares as currency for any deal, but its rising share price is already helping to fund a bump. It shouldn't be hard to Reynolds to demand something more generous -- and for BAT to offer it.

Andrea Felsted contributed to this article.

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