On October 21st, British Tobacco approached Reynolds with a cash and stock offer worth $56.50 per share on announcement day to buy the 58% of Reynolds that it did not own ($24.13 in cash and 0.5502 BAT per each RAI). On November 14, news reported that the independent transaction committee at Reynolds has refused the offer and asked for a higher valuation, although the company has not issued an official statement yet. We think it is now a good move to buy Reynolds and short around 0.4 shares of British Tobacco per each share of Reynolds to set the pre-event M&A spread for the following reasons. We use 0.4 instead of 0.5502 as BAT could increase the cash component of the new offer.
This transaction is highly strategic and well motivated. BAT actually owns 42% of Reynolds, as in early 2000 it contributed its own assets to a US joint venture. So this second step is just a continuation of that initial move and BAT knows the asset very well. There is no other way for BAT to grow in the US market but to buy minorities at Reynolds. No other asset is so interesting and strategically linked to BAT. In its offer letter, disclosed on BAT's investor relations website, the company states that it regularly evaluates the feasibility and attractiveness of acquiring the shares of RAI. This is a recurring strategic idea for BAT.
The US market is the biggest and most interesting in terms of e-cigarettes, which are one of the few segments in this industry that show growth.
There are no material regulatory hurdles for an eventual transaction. BAT does not own other assets outside of its stake in RAI, so no antitrust issues, no political complications, no security issues and similar.
This is the first approach from BAT to RAI because rules require that the buyer cannot negotiate privately with the seller in case of a minority purchase. Strategic M&As typically don't end up with the first offer proposed.
Part of the 2004 JV between BAT and RAI included a standstill on BAT buying additional RAI stock, which ended in 2014, hence BAT quite quickly made its next step as soon as allowed.
The new offer will have to be approved by the independent committee at RAI and by the majority of its shareholders excluding BAT, which will not be able to vote, therefore the offer has to be fair and convincing.
Still in its offer letter, BAT indicated that there is substantial overlap in the shareholder register of the companies. This is a factor that usually facilitates M&A.
BAT states that the transaction would be accretive to earnings immediately in the first year and the offer will not be conditional on any financing. Using the cash and shares exchange ratio proposed by BAT, Reynolds is currently trading at a premium of 1.5% to the current value of the terms proposed, so the premium to pay to get involved in this situation is modest.
The offer was worth $56.50 on announcement day, and it is now worth around $54.9, slightly lower, which justifies further an increase.
The Sunday Times has recently reported that BAT is considering an $8 increase to its offer to agree with the RAI board. That would represent an offer value of approximately $63 and a spread available of around 13% for a deal that should close within 5-6 months from announcement without any major issues, and that will therefore trade tight as soon as it will be agreed.
Downside is modest, as in the very unlikely scenario of no-deal, Reynolds would go down 10-12%.
Disclosure: I am/we are long RAI.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.