Apologies near, Big Tobacco looks ready for M&A

John Jannarone
British American Tobacco builds global brand

At last, Big Tobacco may apologize publicly for misleading consumers about the dangers of smoking. With that embarrassing step out of the way, it may be time for a round of consolidation that creates a new generation of cigarette behemoths.

In early January, a federal court ordered the major U.S. tobacco companies to publish a series of corrective statements through advertisements on television, newspapers and the Internet. Those companies, which include units of Altria, Reynolds American, and Lorillard, will be required to apologize for "deliberately deceiving" the public, though they still have a right to make an appeal over the wording of the statements.

New York's Times Square, circa 1940s.
Hulton Archive | Getty Images

But while Big Tobacco might appear to have lost a major battle, any apologies are unlikely to cause meaningful financial harm to the corporations. On the contrary, industry experts say the risk of litigation has decreased significantly over the last several years. "The tobacco companies have proven that they can defend themselves," said Thilo Wrede, an analyst of Jefferies.

That begs the question of whether companies that have split into pieces to protect investors from litigation should reunite. The original thinking was that tobacco companies operating outside of the U.S. were better off as separate stocks because there has never been significant litigation risk beyond American borders.

One pair that will soon have an opportunity to make a deal is London-listed British American Tobacco (London Stock Exchange: BATS-GB) and Reynolds American, maker of the iconic Camel-brand cigarettes. The latter was created back in 2004 when BAT merged its Brown & Williamson division with R.J. Reynolds. That merger, which left BAT with a 42 percent stake in Reynolds American, included a standstill agreement preventing the British company from increasing its stake until July 30, 2014.

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By Reynolds American's own count, the potential for litigation has diminished sharply since the original deal came together. The number of pending "smoking and health" cases against the company had fallen from 352 in 2001 to just 69 in the third quarter of 2013, Reynolds American said in a recent investor presentation. The number of health-care reimbursement cases fell from 62 to two over the same period.

BAT declined to comment on any deal, but a person familiar with the company said it has reviewed the possibility in recent years. One reason it could make sense to purchase the remaining 58 percent stake is that BAT can borrow cash to fund a deal at a reasonable rate. Even assuming a 30 percent premium to Reynolds American's recent share price, BAT would still see an immediate improvement in its own earnings per share through a deal, Barclays said in a recent investor note.

And BAT might get an even better deal for Reynolds American, given there aren't any other likely bidders. The likes of Lorillard and Altria would likely face serious antitrust scrutiny if either tried to take over Reynolds. Even if one of them made a bid, BAT already has such a large position in Reynolds American that it could probably stand in the way.

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One reason BAT might be cautious is the risk that the U.S. Food and Drug Administration will crack down on the sale of menthol cigarettes. Menthol remains a growth area for certain Reynolds American brands, and it would be painful if the FDA took steps to limit their sale.

Even so, BAT could use the boost that a deal would provide. Analysts expect the company's earnings per share to rise just 3.5 percent in 2014. And BAT shares have gained just 6 percent since the start of 2012, less than most rivals. A deal with Reynolds American might give BAT shares just the spark they need.

-By CNBC's John Jannarone. Follow him on Twitter @jannarone.