Tobacco’s $27 billion (£16 billion) proposed mega-merger between US giants Reynolds American (RAI:NYSE) and Lorillard (LO:NYSE) impacts the two UK-listed tobacco firms and is set to take centre stage in the coming months.

Competition regulator the Federal Trade Commission is reported to be eyeing the deal carefully and a decision is expected by the end of June.

British American Tobacco (BATS) is impacted via its 42% stake in Reynolds while Imperial Tobacco (IMT) will buy $7.1 billion of assets from the merged entity.

Combining the United States’ second and third-largest tobacco businesses would see the merged entity take a 35.3% share of the US market, according to data produced by Euromonitor.

US Market leader Altria (MO:NYSE) has 46.7%. The deal is broadly positive for British American and Imperial and we rate both stocks a ‘buy’ based on long records of profitability and high barriers to entry in the industry.

Key risks are regulatory challenges, declining smoker numbers in developed countries and the sustainability of industry-wide margin expansion strategies.

DEAL DETAILS

British American will need to stump up an estimated $4.7 billion to maintain its stake in an enlarged Reynolds-Lorillard. The sum is less than one year’s annual profit for BAT and will be funded from operations and drawn down debt facilities.

Central to the proposed merger’s logic is Lorillard’s Newport brand, which is the second-largest cigarette marque in the US (market share: 11.7%) behind Marlboro (40.3%). Also part of the Newport portfolio is the best-selling menthol tobacco product in the US. Newport in total represents around 85% of Lorrilard’s $5 billion annual net sales.

Brands already owned by Reynolds include Pall Mall, aimed at the value market segment, Camel, a premium product, and VUSE, Reynolds’ e-cigarette product available in four US states.

BAT sells and markets Pall Mall outside the US and owns the Dunhill, Kent and Lucky Strike brands - it calls these its ‘Global Drive Brands’.

The deal is ‘broadly positive’ for British American, according to Alicia Forry, an analyst at Canaccord Genuity.

‘Clearly it will be accretive for BAT, which participates in the deal passively through its stake in Reynolds,’ says Forry.

‘There are expected to be synergies generated from the Reynolds-Lorillard tie-up and it is a sensible deal in our opinion, strengthening the number two and three players in the US market.’

Imperial is considered the white knight of the deal as it stepped in to buy $7.1 billion of assets from the Reynolds-Lorillard combination in a bid to head off competition concerns.

Menthol cigarettes are likely to be a key area of regulatory focus given Newport’s market leadership in the segment and Reynolds’ existing menthol brands KOOL and Salem.

Imperial will take both KOOL and Salem from Reynolds, as well as Winston (also a Reynolds brand) and Maverick (Lorillard) in order to reduce competition concerns.

E-cigarettes are another area where the parties have sought a compromise. Lorillard’s Blu eCigs is the number one seller in the US, while Reynolds’ VUSE is showing early promise in Colorado, its first market. As a result, Blu is being included as part of the Imperial deal.

The M&A merry-go-round ultimately increases Imperial’s US market share from 2.5% to 9.5%.

Financing the deal at Imperial, which is smaller in profitability and market capitalisation than British American, has concerned some analysts.

‘The proposed acquisition of US assets would restrict Imperial Tobacco’s room for manoeuvre,’ writes RBC Capital Markets analyst James Edwardes Jones.

‘A modest deterioration in Imperial’s operating performance would position both leverage and dividend payout on an unsustainable trajectory, in our opinion, with the additional risk of a credit downgrade.’

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BILLION DOLLAR FINES

Concerns over leverage may be small beer for the two UK tobacco companies considering the other risks they run.

Legal and regulatory risks, market shrinkage and stretched margins are all high up the agenda.

Regulatory action hit hard in the US in 1998 when the Tobacco Master Settlement Agreement (MSA) required four manufacturers to pay a minimum of $206 billion over 25 years on public health grounds.

In the year to April 2014, Altria paid $3.3 billion in annual payments taking its total contribution to $66 billion since the legislation was enacted.

UK-listed British American and Imperial have so far avoided material financial penalties though governments elsewhere are eyeing up the industry for potential windfalls.

Contingent liabilities disclosed in the accounts of British American and roughly tallied up by Shares, for example, total in excess of £145 billion. Disclosures in the accounts require estimates and judgement by management and represent a best guess of liabilities which may or may not crystallise.

Potential claims by Canadian state governments alone are recorded at C$140 billion (£75 billion) in BAT’s 2013 annual report.

Europe-focused Imperial includes some disclosure on the same topic, though tobacco-focused legal actions appear to have been less active in its markets.

Another bonus for Imperial is that Reynolds has indemnified from historical liabilities the $7.1 billion of US assets it intends to buy as part of the US merger.

‘European tobacco companies have not had anything like the same issues as in the US through the MSA liabilities,’ says Forry at Canaccord.

‘The MSA was a massive, unprecedented legal action and it’s a possibility elsewhere. There do not seem to be the same class action law suits in Europe as there are in the US, however.

‘We don’t assume it will happen in Europe but there is the potential for governments to come down hard - and they have the science on their side.’

Regulation is not all bad for tobacco companies, particularly the larger ones. Early academic studies argued historical US advertising bans simply led to higher aggregate profits for tobacco companies because of lower industry-wide marketing costs.

Larger companies with stronger brands also benefited from a reduction in competition.

A recent, more nuanced study by Shi Qi at Florida University in 2011 The Cigarette Advertising Ban of 1971 comes to a slightly different conclusion.

One of the first examples of tobacco advertising restrictions, the 1971 ban prevented tobacco companies in the US advertising on the TV and radio.

Qi finds advertising spend at tobacco companies continues through other channels but becomes less efficient. Marketing expenditure at larger firms increases, leading to gains in market share at the expense of smaller companies. Previous studies reached similar conclusions on consolidation, Qi writes.

‘They show theoretically that it is possible for an industry with primarily goodwill advertising to attain an asymmetric outcome when advertising is restricted,’ writes Qi.

Plain packaging is another regulatory initiative which is generally regarded as negative for the industry. Unsuccessful attempts by tobacco companies to sue the Australian government for implementing plain packaging legislation indicates there is industry concern around the impact on brands and also the potential for the policy to increase illicit or counterfeit trade.

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END MARKETS

High stock market valuations at tobacco companies have been underpinned over the decades by an increasing number of smokers globally, price increases above the rate of inflation and mergers and acquisitions.

Smoker numbers are declining as a percentage of the adult global population. But the falling proportion of smokers is offset by rising populations as a whole, meaning that global cigarette volumes increased from an estimated 5 trillion in 1980 to 6.3 trillion in 2012.

Global tobacco volumes are expected to hit between 6.7 trillion and 6.8 trillion cigarettes by 2020, according to United Nations estimates.

In developed markets, where the percentage of smokers is falling and populations are growing less quickly, tobacco markets have been in reverse for many years.

In the UK, for example, cigarette consumption halved from 102.5 billion cigarettes in 1990 to 51.5 billion in 2012, according to the Tobacco Manufacturers’ Association.

Retail prices per pack increased from £1.65 to £8.47 in the same period.

For Forry at Canaccord, tobacco companies will not be able to pull this profit margin lever for ever.

Year-on-year price increases are stretching affordability in developed markets, Forry says. Rolling out the same margin-led strategy in emerging markets, where prices are lower, is not guaranteed to succeed.

A key performance indicator at British American, for example, is to increase operating profit margin 50 to 100 basis points (half a per cent to one per cent) a year. That margin hit 38.7% in 2014 and arguably cannot rise indefinitely.

Imperial boasts an even more impressive operating margin of 43.3%. This may reflect products with greater brand strength, including Rizla cigarette papers, Davidoff, Gauloise, West, John Player, Golden Virginia loose tobacco and Montecristo cigars.

Adding to the pressure on profit margins and smoker numbers is the evolution of e-cigarettes.

Research on the market by Canaccord Genuity analyst Eddy Hargreaves forecasts e-cigarettes will represent 22% of the tobacco market in the US and UK by 2018.

CATCH TWENTY-TWO

Risks to the tobacco industry - many though there are - should not completely outweigh the long term investment appeal stocks in the sector can offer investors, according to Erik Bloomquist, an analyst at Berenberg.

‘The appeal of tobacco stocks is their ability to grow revenue and profit on a steady and consistent basis, despite regulatory initiatives,’ Bloomquist tells Shares.

‘There is a wider issue that is rarely addressed by Tobacco Control groups. Often the groups push for regulation that in many instances has little or no impact on actual tobacco consumption - Australia’s plain packaging rules are a good example.’

Bloomquist argues there is an element of interdependence between tobacco firms and governments because of the significant tax take gleaned from duty on smoking products.

‘Trends in smoking are hard to influence by regulators other than through taxation and price,’ he adds.

‘Regulatory levers like tax have to be balanced against the risks posed by illicit trade, which undermines tax revenue by arbitraging the high tax level [85% of the cigarette retail price in UK is tax. Source: European Commission, Jan 2015].

‘Tax increases often provide catalysts for retail product price rises that pass on the tax with additional modest increases in the manufacturer take that in turn can offset volume declines and drive revenue growth.’

FTC approval of the Reynolds-Lorillard deal could be worth another £2-3 on Imperial’s share price, according to the Berenberg analyst’s estimates.

DISCLOSURE: The author owns shares in British American Tobacco.

Imperial Tobacco (IMT) £31.28

Market value: £30.7 billion

Net debt: £8.5 billion

Prospective PE Sep 2015: 15

Prospective yield Sep 2015:

4.6%

Interest cover (reported) 3.7

British American Tobacco (BATS) £35.72

Market value: £66.7 billion

Prospective PE Dec 2015: 17

Prospective yield Dec 2015: 4.4%

Interest cover (reported): 10.2

Data: Morningstar

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