BAT Offer for Reynolds American Looks Slightly Rich

There are several reasons why this is a good deal for BAT strategically. Reynolds possesses solid competitive advantages, including very high brand loyalty to Newport, arguably the strongest brand in U.S. tobacco, and a cost advantage over smaller domestic manufacturers. There will be some synergies, and BAT expects to extract $400 million in annual costs from Reynolds. This is likely to come primarily from centralised functions, as BAT currently has no direct operations in the U.S. market. Bringing Pall Mall under one roof, as well as consolidating vapour product development, is also likely to yield efficiencies.

At first glance, the deal looks slightly rich. Most of our tobacco coverage is trading slightly above our fair value estimates, and Reynolds' stock has rallied by more than 50% since its transformative acquisition of Lorillard, announced in 2014. However, as this is a cash and stock deal (at current prices, 57% of the consideration will be paid in BAT stock), the acquirer's overvalued currency mitigates this impact. The weakening in the value of sterling, which has boosted BAT's market valuation in recent weeks, has helped to make this deal more financially attractive. BAT could have acquired Reynolds at any time over the past two years at a lower valuation, although, admittedly, the integration of Lorillard would have made it more complex. Nevertheless, the valuation of Reynolds, at 20 times this year's earnings, does not appear optimal.

Morningstar Premium Members gain exclusive access to our full analyst reports, including fair value estimates, bull and bear breakdowns, and risk analyses. Not a Premium Member? Get this and other reports immediately when you try Morningstar Premium free for 14 days.