Fitch: Reynolds/BAT Deal Would Force Consolidation Review

NEW YORK--(BUSINESS WIRE)-- Participants in the tobacco industry may likely be forced to reconsider consolidation or reunification should British American Tobacco (BAT) take complete control of Reynolds American Inc. (RAI), according to Fitch Ratings.

Philip Morris International Inc. (PMI) and Japan Tobacco (JT) could potentially intensify their consolidation efforts in the US. The reunification of PMI with Altria may occur given that litigation risk in the US is now more manageable than previously and, like BAT, PMI's sales and profit growth have been slow yet consistent, compared with the US. Although PMI is heavily involved in its heat-not-burn next generation product called iQOS and has an existing strategic agreement with Altria on e-vapour and other next generation products, the unexpected timing of the BAT/Reynolds transaction could accelerate consideration of a reunification.

BAT's involvement in this transaction has JT left without a potential tie-up or partner for an asset swap or disposal if the much talked-about potential acquisition of Imperial Brands (Imperial) occurs. This is due to a few significant, although not insurmountable, antitrust issues, which will probably require the divestment of individual markets and/or brand licences should Imperial be acquired by JT. Additionally, Imperial's currently high share price (the market capitalization is GBP37.7bn as of Oct. 25) makes it an expensive acquisition for JT or any potential buyer.

Notwithstanding valuation estimates for the potential transaction, the table below illustrates the potential appetite to increase market share or strengthen market position by JT in the various key markets of Imperial in a hypothetical combination. This also attempts to illustrate the potential antitrust issues faced and the likely success of such a combination. For example, the total market share for both Imperial and JT in the UK would be 87%. The grouping of Imperial and JT may be possible if the UK business is sold off and some brands are sold in Spain. Nevertheless, there has recently been a trend of Japanese companies snapping up assets outside of Asia and into the US and Europe.

BAT's USD47 billion offer would allot the company full control of Reynolds as BAT currently has a 42.2% ownership. The offer announced last week came unexpectedly as the industry has already undergone a recent round of consolidation in 2015 when assets of Lorillard Inc. were acquired by both Imperial Tobacco Group (ITG) and RAI. Imperial's USD7.1bn acquisition enhanced its US business, giving it a distant number-three position, with a cigarette market share of around 10%, up from 3% previously. At the same time, in maintaining its 42% ownership share in RAI, BAT contributed USD4.7bn capital to funding the acquisition by its associate, RAI, through a cash and equity offer.

Altria (51%) and Reynolds (34%) together control 85% of the US cigarette market. As a result of BAT's intended transaction, we calculate that BAT would derive almost 50% of its profits from the US market.

While the US cigarette industry remains in secular decline, typically in a range of 3% to 4% per year in terms of cigarette volumes, the industry benefits from growth in both sales and profits owing to consistently good pricing power. The US market has essentially three players commanding over 90% of volumes. Both Altria and RAI have historically been able to offset volume declines with price increases, benefiting recently from increased disposable income in the hands of US smokers. Notwithstanding the risks inherent in the US tobacco market, it still remains a lucrative prospect, especially for EMEA tobacco players or potential Japanese players with low or stagnant growth in their home markets.

Additional information is available on www.fitchratings.com.

The above article originally appeared as a post on the Fitch Wire credit market commentary page. The original article can be accessed at www.fitchratings.com. All opinions expressed are those of Fitch Ratings.

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