What You Need to Know About the Reynolds American/British American Tobacco Merger

By Nicholas Rossolillo Markets Fool.com

Reynolds American's (NYSE: RAI) board of directors decided to accept a takeover bid from British American Tobacco (NYSEMKT: BTI) on Jan. 17. While the announcement may be an exciting one for existing shareholders, big tobacco is exhibiting signs of an industry that is in decline.

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Reynolds American's Vuse brand. Image source: Reynolds American.

First off, the details. British American already owns about 42% of Reynolds' business and the proposal that was initially made last October was for the remaining 58%. The cash-and-stock offer that was accepted values each share of Reynolds at $59.64. The original deal outlined on Oct. 20 valued shares at $56.50, so the accepted offer will give shareholders a bit more.

The $59.64 in value is also a more than 26.4% premium over Reynolds' share price before the bid was originally announced and a 9.5% premium over the stock's all-time highs reached over the summer of 2016.

Should the deal go through, each holder of Reynolds stock will receive $29.44 in cash and a number of BAT
American depositary shares representing 0.5260 of a BAT ordinary share for each share of Reynolds American. As of this writing, Reynolds America shares had jumped to about $58 while British American Tobacco had been hanging out well below its summer 2016 highs of about $130.

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RAI data by YCharts.

Both boards of directors have given their nod of approval. It's now up to shareholders of both companies to vote on the matter, as well as needing clearance from regulators. Should this all pan out, the companies expect to close the deal in the third quarter.

A recap of big tobacco's recent history

As I outlined a few months ago, this takeover follows a long string of mergers and acquisitions over the years in the tobacco industry. A strong argument could be made for tobacco products being the poster child of competitive advantages. Tobacco use is addictive, providing a reliable and rising source of revenue for the companies that sell it. However, increased regulation and rising public awareness of health risks have taken a bite out of usage. Especially in the last decade, cigarette shipment volumes have been in decline as smokers in developed markets have increasingly quit and a growing percentage of individuals in younger generations have been reluctant to start in the first place.

The solution? Big tobacco has turned to price increases, with cigarettes doubling in pricesince the year 2000. These price hikes have been bolstered by merger and acquisition activity, to the point that there is very little competition to keep prices in check. This agreement between Reynolds and British American looks to continue that trend.

Image source: U.S. Food and Drug Administration.

What the deal means for shareholders

Owners of Reynolds American have a choice to make: cash out now after the offer has lifted prices, or keep their British American Tobacco shares, which, if the deal goes through, will give them part-ownership of the new company. The two companies combined would be the world's second-largest publictobacco company, surpassing Philip Morris International but still behind Imperial Brands.

The company would also have a global presence, combining Reynolds' sales of brands like Newport and Camel in the U.S. with British American's Kent, Dunhill, and Lucky Strike sales overseas. The merged companies would also hope to capitalize on e-cigs with the Vuse brand in the U.S. and a number of products in other countries that British American has in its portfolio.

However, the merger is unlikely to fuel explosive growth. This deal is more about cost-cutting and pricing support, as mentioned in the presentation outlining the detail. Big tobacco is still a profitable venture, but with a shrinking user base, reliance on cigarette price hikes to support growth, and risk inherent in the business model, it's hard to get excited about the opportunity here.

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Nicholas Rossolillo has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.