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Consequence of BAT's Full Acquisition of Reynolds Can Scarcely Be Overstated

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Despite recent whispers of an impasse in negotiations (revolving around the valuation of Reynolds’ next generation product portfolio), in a joint statement this morning Reynolds American and British American Tobacco confirmed that they had agreed the terms of a merger in which the UK-based company will acquire the remaining 57.8% of RAI it did not already own for some USD49.4bn. Reynolds shareholders will retain almost a fifth of the new entity, the world’s largest public tobacco company (by valuation, if not by volume). This deal heralds the final act in industry consolidation in combustible cigarettes, creates the first truly global next generation product operation and brings to a definitive close the US market’s litigation-induced isolation from the global landscape.

A substantial deal for BAT

By any measure, this is a substantial deal for BAT, as big as the USD50bn price tag implies (not forgetting the USD4.7bn that BAT paid in 2015 to retain its share of an expanded, post-Newport RAI). At a stroke, the US becomes the company’s largest market, eclipsing its current biggest volume markets of Russia (63 billion sticks, 2015) and Brazil (51 billion sticks, 2015). Indeed, BAT will now sell two and a half times as many cigarettes in the US (94 billion) as in its third largest market, Pakistan (38 billion, 2015).
Of course - to misappropriate the slogan of leading UK retailer Marks & Spencer – the importance of this transaction for BAT lies in the fact that these are not just volumes, but US volumes. The US cigarette market is currently almost unnaturally robust with a contained secular decline trend, very strong pricing and a regulatory regime which looks more favourable relative to the global environment with every passing year.

Newport a prize

Full access to this market is a prize in itself for BAT, while the stable of brands with which they are acquiring this access makes the deal even more compelling. Reynolds’ acquisition of Newport in 2015 appears to have been a key trigger, or one of the final pieces to prompt this move on the part of BAT. Newport is a very strong brand, the US’s second largest by volume and somewhat remarkably appears to still have headroom to grow in both share and volume terms.
All of this is not to say that the deal is without possible imperfections. The asking price is large, and will have implications for BAT’s credit position. Any unexpected changes to the regulatory or excise regime in the US (perhaps unlikely under a Trump administration) could disrupt the stream of revenue flowing from there. Further, in an ideal world, one would like a more clear-cut brand windfall in BAT’s international markets. Reynolds sold the ex-US rights to Natural American Spirit, its most profitable, super-premium brand to Japan Tobacco International in 2016 and the same company owns Reynolds’ second largest brand – Camel – internationally. Of available brands, Reynolds’ third-largest brand, Pall Mall is already BAT’s biggest seller and its path to globalising Newport is not straightforward.

A development of profound consequences

Finally, in the lead up to today’s confirmation much has been made of the benefit of marrying Reynolds next generation engine to BAT’s existing structures. Without having seen the second generation of the Revo product or indeed, the premium attached to Reynolds’ emerging product portfolio one might be cautious about the value of this proposition. While in-house product development of next generation products will retain relevance, we are arguably also moving into a new phase of industry innovation in which the acquisition of small-scale but internally coherent product start-ups will be as important as organic R&D; the latter alone – no matter its quality - will be no guarantee of future success.
Without equivocation, this deal is one of the most profoundly consequential developments in global tobacco of recent times. It establishes BAT as a predominant global player while rebalancing its focus back on the developed cigarette world. It makes the reunification of Altria with Philip Morris International all but inevitable. It renders a BAT approach for Imperial (either alone or in concert) less viable (at least in the short-to-medium term). And it creates the first engine for development of next generation products spanning all three of the category’s key markets – the US, UK and Japan.

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