BAT, Japan Tobacco Face Threat From Philip Morris-Altria Combo

(Bloomberg) -- British American Tobacco Plc and Japan Tobacco Inc. risk falling further behind in fast-growing cigarette alternatives should Philip Morris International Inc. and Altria Group Inc. complete the biggest tobacco deal ever.

Analysts said BAT may be the biggest loser if New York-based Philip Morris succeeds in combining with Richmond, Virginia-based Altria. Shares of BAT fell Wednesday, extending the two-day slump to as much as 6.5%. Japan Tobacco dropped less than 1% in Tokyo.

The proposed combination would reunite two companies that split more than 11 years ago and result in a behemoth that would outrank BAT as the world’s largest publicly traded cigarette maker. Plus, it would put two of the most successful smoking alternatives, Juul and IQOS, together under the same roof.

BAT’s new chief executive officer, Jack Bowles, faces unprecedented pressure to jump-start its underperforming portfolio of potentially reduced-risk products such as electronic cigarettes. The company has lost almost half of its market value in the past two years. The maker of Lucky Strike cigarettes lowered the outlook for growth in cigarette alternatives for both this year and last.

The transaction would give Philip Morris about 58% ownership of the new company, according to a person familiar with the terms who asked not to be identified because the deal hasn’t been made public. The firms are considering a transaction based on Altria’s market value as of the close on Aug. 23, which was about $87 billion.

The Marlboro-maker split up in 2008, making two companies with different strategies in the U.S. and the rest of the world. Now, they’re embracing again as Big Tobacco faces severe disruption amid declines in cigarette use and the rise of smoking alternatives.

Philip Morris has invested billions of dollars in its heat-not-burn product IQOS, and Altria has the right to start selling the device in the U.S. this year, starting with a store in Atlanta next month. Altria has also invested about $13 billion in Juul, which could speed up its expansion worldwide with Philip Morris’s help.

The deal would heighten prospects for further M&A, according to Jefferies analyst Ryan Tomkins. Speculation has been smoldering that BAT and Japan Tobacco could consider a joint bid for Imperial Brands Plc, which had been one of the most successful e-cigarette vendors in the U.S. until Juul came along. However, both of the potential bidders are struggling with the industry decline and have significant debt from past acquisitions.

Shares of Japan Tobacco, the world’s third largest publicly traded cigarette maker, have dropped for three consecutive years to touch the lowest level since 2012 last week. Japan Tobacco has a market value of $42 billion, compared with $84 billion for Altria and $131 billion for Philip Morris. BAT is worth about $80 billion.

Although Japan Tobacco does minimal business in the U.S., it sells cigarette brands such as Winston and Mevius across the globe. If those markets gain a significant Juul presence, it would cut into sales of traditional smokes and threaten earnings.

Japan Tobacco has had difficulty gaining traction with its own heated tobacco business, Ploom Tech, and it’s starting to drag on results. The company earlier this month cut its full-year earnings forecast partly due to weaker-than-anticipated sales tied to its high-tech smoking devices.

Chief Financial Officer Naohiro Minami said Ploom Tech has struggled with keeping repeat customers, and the company was having trouble managing production costs related to the devices.

The increased competition may force Japan Tobacco to double down on its parallel strategy of seeking growth in traditional cigarettes in emerging markets. While its rivals have been staking their future more heavily on new smokeless tobacco products, Japan Tobacco has viewed the sector as just one alternative and has been expanding more than rivals by snapping up local players in emerging markets from Indonesia to Russia over the past several years.

While the company has aimed to boost growth with traditional cigarettes in places where smoking rates are still high, currency volatility has weighed on international results in recent quarters. Also, the long-term term prospects for cigarettes remains a question as global demand falls and smoking regulations tighten.

--With assistance from Lisa Pham and Jeff Sutherland.

To contact the reporters on this story: Thomas Mulier in Geneva at tmulier@bloomberg.net;Lisa Du in Tokyo at ldu31@bloomberg.net

To contact the editors responsible for this story: Eric Pfanner at epfanner1@bloomberg.net, ;Rachel Chang at wchang98@bloomberg.net, John Lauerman, Frank Connelly

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