My reaction to the news that British American Tobacco (BTI) has offered about $56 per share to purchase the 58% of Reynolds American (RAI) stock that it does not currently own.
I. What is the publicly traded fair value of Reynolds stock?
Consider this: Between 1992 and 2007, Reynolds American only saw its P/E ratio dip above 13x earnings once. It was a fourteen-month period between 2006 and 2007 in which Reynolds stock traded at a valuation of 15x earnings. Other than that, Reynolds was a stock that spent the 1990s and first half of the 2000s trading between 8x earnings and 12x earnings.
The average valuation for the stock from 1992 through 2007 was 10.3x earnings. This does not mean that this represented Reynolds’ intrinsic value. It just gives us a glimpse of how the investor community historically appraised the stock, which we can use as a reference point. It is also worth remembering that Reynolds and its tobacco peers managed to generate such exceptional returns because these companies were perpetually undervalued and generated substantially higher returns than the earnings growth of the business would otherwise merit because high dividend payouts could get reinvested at low rates.
From 2014 through 2016, a period in which gas prices declined, interest rates stayed low, and there were no major new developments affecting tobacco product taxation or regulation, the valuation of Reynolds reached a level we have not seen before. The stock crossed the 20x earnings threshold, traded at a high of 26x earnings net of Lorillard merger costs, and traded at 21x earnings as of pre-merger with British American Tobacco trading.
The fair value for Reynolds stock is somewhere between 14x and 18x earnings. In other words, it spent most of the 2000s undervalued, and then has spent the past three years overcompensating and trading at a range above what is fair.
If you figure that Reynolds’ earnings power is somewhere around $2.50 per share once the integration with Lorillard is fully realized, the highest justifiable fair price for the stock is $45 per share.
II. What is the control premium value of Reynolds stock?
It is generally well accepted that having control over a profitable business is worthy of a premium—after all, you get to set the dividends, set the prices, and enter into debt covenants when you’re the owner/operator whereas you are only along for the ride when you log onto etrade.com and press an order for 1,000 shares of RAI.
Between 2003 and 2013—a period that excludes the froth of the dotcom era—the average takeover premium for a company was 37% of its pre-existing trading value. Figuring out what is a fair price for a takeover is an incredibly fact specific analysis because the answer depends on the degree of mismanagement of the prior owners compared to the value-added of the new owners (i.e. the delta of change in earnings between the old and new operator is the touchstone of the inquiry.)
If we make the assumption that Reynolds is worth 1.37x its fair value when adjusting for the control premium, the Reynolds is worth $61.65 per share to British American Tobacco.
The market price was pretty close to this. The typical takeover at 1.37x the pre-existing market price would give you a takeover value of $64.34. This deal is theoretically a win-win because Reynolds shareholders get a price that is higher than it is worth to them in the private marketplace while British American Tobacco gets in at a price lower than the control premium.
III. The Funding For The British American Tobacco / Reynolds Merger
If the deal is approved, each share of Reynolds stock will convert into 0.2751 shares of British American Tobacco and $24.13 in cash (if you see the 0.5502 per share figure, be sure to remember the 2:1 conversion ratio for the ADR listing). At a price of $113.35, the stock component is worth $31.18 so the total deal currently values each share at $55.31.
The cash component is self-explanatory, but what about the British American Tobacco stock—is this something that Reynolds shareholder should welcome as part of the consideration for relinquishing their ownership position?
I think the answer to that question is yes. This has been a generationally strong year for cigarette volumes, as cigarettes volumes are up 4% compared to the first three quarters of 2015 and is a stark departure from the regular 3% annual declines. At British American specifically, the volumes are up 11% this year. This has been a year that has far exceeded the best case scenario for cigarette volumes, from the perspective of tobacco shareholders.
Vype, British American’s e-cigarette brand, is growing at about 20% per year. It has about a 10% market share in the British e-cigarette market, up from 5% in 2012.
In 2003, earnings at British American were at $1.23. Now, it is at $6.20 for a 13.3% annual earnings growth rate. It wouldn’t surprise me if British American plans to reduce costs big time after buying out Reynolds. When British American sells a cigarette, it keeps about $0.32 on each dollar as pure net of tax profit. At Reynolds, the figure is $0.24.
I would imagine that British American tobacco executives have been eyeing the 33% profitability difference as a way to immediately create value from the deal. As a 42% holder of Reynolds stock, British American already has deep knowledge of Reynolds’ operations.
IV. No Winner Is The Sign Of A Fair Business Deal
You know how when you’re undecided between two options people say you should toss a coin in the air to determine the fate, and whatever you’re hoping for while the coin is in the air focuses your mind on what you really wanted all along? Similarly, the best way to figure out the winner of this deal is to ask whether you’d rather be a Reynolds or British American shareholder right now.
At a valuation of about 18x earnings, the stock itself that Reynolds shareholders are receiving seems like a fair price. The Reynolds shareholders get to trade in their own overvalued stock for fairly valued stock in British American, and the British American shareholders get their hands on a company growing at 7-8% in the United States which ought to be a welcome prospect for them as well.
I don’t think there is a clear winner here. The Reynolds shareholders get a nice premium, which is basically a gift because the company is trading at an incredibly high P/E ratio without offering higher than usual growth.
British American, meanwhile, can become a company making $10 billion in annual profits when the deal is fully integrated, and it will be able to exploit its lower cost structure to compete with Altria and Philip Morris International.
By 2018-2019, British American will have about $300 million coming in per month that won’t be allocated towards the dividend that can be used to figure out what the post-cigarette frontier for the company will be. Weed, e-cigarettes, vapors, whatever they want to do next, they are going to have very deep pockets to repurpose itself over the next generation. Reynolds gives them this opportunity to become equals with Philip Morris, and if British American can get Reynolds to match its profitability, there may be a quick and sustainable boost to net profits.
British American Tobacco is basically valuing Reynolds at its 2019-2020 publicly traded fair value with its initial offer. If a deal falls through, Reynolds shareholders wouldn’t FAIRLY see this price for at least three more years.
That said, I understand why some Reynolds shareholders may be reluctant to sell. The dividend goes up every year, the returns are in the high double digits, and the stock price hit a high of $54.50 this year. Why fix what’s not broke, and why jump at the chance to sell the business for a price that had already been seen this year? The answer to my question is that British American has actually produced superior thirteen-year earnings growth while trading at a lower P/E ratio right now, and that $54.50 price earlier was a moment of undeserved overvaluation that you can’t count on returning until the earnings justify.
If you are British American, you know that the cigarette industry is generally stagnant, and the 33% superior profitability is a chance to move up net profits in a hurry. The deal is in the 22-23x earnings, which is about the best you can expect from M&A activity in slow growth so-called grocer industries.
If the deal goes through, an investor that buys shares in Altria, Philip Morris International, and British American Tobacco will have an ownership claim on 77 out of every 100 cigarettes smoked in a given day. The consolidation has been unbelievable, with Lorillard and now Reynolds exiting the public standalone stage in the past two years.
The more I think about it, I sense that British American is getting the slight edge here, but I don’t know of a numerical analysis you could point towards that would confirm this.