Article / 10 July 2014 at 6:51 GMT

Plenty of money still swashing around in tobacco coffers

Managing Partner / Spotlight Group
United Kingdom
  • Global corporations sitting on USD 7 Trillion in cash
  • Tie-up between Reynold and Lorillard on the cards
  • BAT would have something to say about any deal
By Stephen Pope

Since the financial crisis of 2007/8 the humbling of the banks, the ensuing credit squeeze mixed with economic uncertainty has all combined to create a corporate mindset that investing for the future was too risky.

Until the past few months’ global corporations, large, medium and small have focused on cost control and headcount restrictions. So much so that many corporate treasuries have had a problem knowing what to do with all the cash that was sitting in bank accounts earning next to nothing in the zero interest rate environment.

According to Thomson Reuters, Global corporations are sitting on USD7Tn in cash - double the amount recorded in 2003. In the developed world business appears to have moved past the most aggressive stages of Schumpeter’s “Creative Destruction” that has prevented investment in plant and equipment, staff, or acquisitions. That last point is underlined as it crucial.


BAT may buy up more of  Reynolds thereby sinking the Reynolds-Lorillard deal which has e-cigarette control at its heart. Photo: Thinkstock

Of course, the market is a mix of positive and negative views and the naysayers are always quick to reach for their standard riposte; cash piles have been created as a direct result of demographics and regulatory reform that have fuelled corporate concern over private pension and healthcare liabilities plus money grabbing tax policies that governments will resort to as a means of rebuilding diminished national treasuries. 

This view is wrong. It is precisely because the UK and US in particular have been keen to emphasise the supply side and to promote free market entrepreneurial activity that the economies are recovering. The conditions for business optimism is more advanced than in the Eurozone.

Cash flexes its muscles

Pfizer may yet return with a new proposal for the shareholders of AstraZeneca and on June 23 General Electric Company was declared the winner in a battle for the energy businesses of Alstom. Indeed GE had to fend off a challenger in the guise of Siemens which had enlisted the help of another of GE’s main competitors, Mitsubishi Heavy Industries of Japan.

So the cash pile is starting to be put to work and my attention is drawn to another ongoing situation that exemplifies shifting tastes, needs and the need to be compliant with regulatory requirements.

A opportunity that is smoking

One industry undergoing a dramatic shift in the profile of consumer demand, especially in the developed world, is tobacco.

I want to take a look at the idea that Reynolds American, 42 percent owned by British American Tobacco (BAT) is reported to be close to a deal to merge with rival Lorillard. The talk in the financial media is that this tobacco tie-up between Reynolds American (RAI) and Lorillard (LO) is a mere matter of weeks away. 

BAT has tended to use its shareholder muscle whenever it has felt that any potential merger between Reynolds and another party did not offer a large enough level of synergy that would either compensate it for seeing its shareholding in the newly merged company decline or persuade it to consider digging deep into its reserves or use borrowing as a means of up scaling its stake in the new entity.

BAT is a rich player as cash generated from operations in the last full financial year was equal to USD 5.1 Billion, a gain of 8.8 per cent over the previous period. There was strong free cash flow of USD5.77 Billion equivalent which as a percentage of adjusted earnings was 82 percent. The listed amount of cash on the books at BAT is equal to USD 3.61 billion and the total current assets amount to USD16.24 billion.

The reason for labouring the detail about the cash pile at BAT is that the merger under consideration between Reynolds and Lorillard is different from previous situations that have not appealed to this large shareholder.  Lorillard is significantly smaller than Reynolds as it has just 15 percent of the US market. That said, it is a key player in the top or premium end of the traditional cigarette market via the Newport brand. The industry knows that Lorillard is a higher quality company than Reynolds. It also is the force behind the leading e-cigarette in the US. BAT may be sensing a unique opportunity to position these core Lorillard strengths in the global domain.

If Reynolds were to merge with Lorillard it is suggested that BAT would have to dig into its cash pile or seek borrowed funds if it were to at least re-establish a 40 percent plus shareholding in the new company. If it sees greater potential in such a deal as against developing the unvalued potential in Santa Fe, is it not reasonable to spin off what is an undervalued entity and seek the funding into an area where there are more globally lucrative gains to be enjoyed.

BAT is known for being a visionary in the industry and if Reynolds were to show a well-reasoned strategic plan that could exploit the hidden potential in Santa Fe’s Natural American Spirit (NAS) brand then one could foresee a fairly quick market realisation that NAS’s growing market share (~1.5 percent), highly impressive volume growth (+13.3 percent, three year average), premium pricing, and above industry average profitability (49 percent operating margin) could be realised.
I think BAT and Reynolds would best advised to hold onto the potential diamond in the rough that is Santa Fe and let BAT pump in the capital to consummate the deal with Lorillard as soon as possible. 

It's worth considering whether BAT, which owns 42 percent of Reynolds, would wish to buy up the rest of Reynolds. I sense it is important to see what the merger would mean in terms of an impact on the P&L structure.

Basic market form

If one blends the two separate sets of reports and accounts one can see that this merger would allow the new entity to claim a market share of approximately 43 percent. That substantially closes the advantage Altria Group (MO) currently enjoys; it lays claim to a market share of 51 percent.

From that would arise a heightened ability to streamline the supply chain and implement a sharper pricing policy as full knowledge about the elasticities of their flagship brands – Newport, Camel, and Pall Mall will be known. On that dimension the new group will become a more competitive threat to Altria.


Lorillard has an undoubted level of expertise in the e-cigarette market. After all, its market share is above 50 percent. It is nothing new to state that the market for traditional tobacco products is falling, especially in the heavily litigated and regulated developed world. In contrast the consensus of market projections is that the global market for e-cigarettes is set to expand by just shy of 25 percent per annum until 2018. It would be no surprise to find that is an underestimate. 

In this tobacco territory, Reynolds is something of a latecomer and only has a presence in the guise of “Vuse”. This product is currently just sold in two US states. That shows why Reynolds is keen to see this merger through as soon as possible.

Regulatory concern

For all the appeal and natural logic that can be applied to the deal, the words “tobacco” and “regulation” are never far apart. Reynolds and Lorillard are more than likely going to face an inquiry from the authorities who may be concerned with the issue of post-merger predatory pricing power. In industrial economics, we look at the concept of the “Concentration Ratio (X)” of a set number of firms to see how tight the holding of market share is. Here the CR(2) (market share of the top two firms) is equal to 94 percent. 

The concentration ratios provide a sign of the oligopolistic nature of an industry and indicate the degree of competition. Clearly, in this case the concentration is indicative of a duopoly. It may be said that the new entity from Reynolds and Lorillard would enjoy too great an ability to inflate prices and margins. However, why has the regulator not gone on the offensive against Altria?

Of course, Reynolds could find a way to cast of some percentage points of market share in an attempt to fly the merger under the regulatory radar. So it could look to shed weight in the combustible product area e.g. Kool, Salem and Winston, given it is keen to occupy a strong position in the e-cigarette market. 

My sense is that BAT will operate in the background and use its influential 42 percent holding to push Reynolds into conducting a vigorous and ruthless in-house brand analysis so that anything that is a fetter or not delivering a high hurdle rate of return on capital will be dispensed with. Then it will make an offer …perhaps it is going to inject capital anyway to allow the acquisition to be financed in the most cost effective way. After all cash in the bank earns next to nothing.
Source: NYSE

Reynolds closed at USD62.67 - USD1.36 up or 2.22 percent. As a rule of thumb the usual marginal increase for an acquisition is between 22 percent and 25 percent. So at first glance BAT would have to pay between USD 76.45 and USD 78.33 a share. 

However, such is the potential of the riches for those that dominate the e-cigarette market I could see BAT actually paying a 27 percent to 30 percent premium. I would have no surprise if I saw the price paid soar to USD79.50 and USD 81.47. 

That could cost up to USD25.4 billion.

- Edited by Adam Courtenay


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