The Tobacco Market Is Heating Up

Reynolds American (NYSE: RAI  ) is the second-largest tobacco company in the U.S. by revenue, but it has also been a hot topic in the merger and acquisition speculation conversation over the last month. The most notable rumor is that the company is planning to acquire Lorillard (NYSE: LO  ) , the largest US tobacco company and the manufacturer of Newport cigarettes.

Reynolds CEO Susan Cameron initially downplayed this, but she did not completely extinguish speculation, and it looks like we might be closer than ever to a deal. But one company could capitalize more than either Reynolds American or Lorillard with a deal.

What about British American Tobacco?
Another bit of speculation has British American Tobacco (NYSEMKT: BTI  ) increasing its 42% investment in Reynolds at the expiration of a 10-year standstill agreement in July. This should rule out a hostile takeover. British American Tobacco would have to acquire all the outstanding shares in Reynolds before it could increase its minority representation on the board of directors. But Reynolds sees British American Tobacco as a partner and not a predator, with the key being they could work together to complete a Lorillard deal.

British American Tobacco has hired Deutsche Bank to give advice on acquisition prospects and financing for deals in the U.S. American companies are ahead when it comes to some growth aspects of the tobacco industry, notably with e-cigarettes.

British American Tobacco could use the Lorillard deal
British American Tobacco, the second-largest tobacco company in the world, reported an improvement in sales volume for the first quarter on a year-over-year basis. For the quarter, sales volume fell by 1%. This is an improvement on the 2.7% decline reported for 2013. Declines in European markets like Russia and Poland wiped out the gains in Asian countries such as Indonesia and Pakistan.

As people in the developed world cut down on smoking, companies like British American and its U.S. competitors depend on price increases for growth in revenue. British-American said that excluding the impact of foreign currency rates, revenue grew by 2% in the quarter because of price and market share increases; but, at the current currency translation rates, revenue was down by 12%.

How the future of tobacco looks
British American Tobacco has a strong brand portfolio including Rothmans, Lucky Strike, and Pall Mall. It has one of the best international presences of the major tobacco companies, and the rising middle class in developing markets will go a long way to helping British American Tobacco grow sales. When it comes to the developed markets, growth is somewhat hindered given the increasing health awareness of consumers. However, British American tobacco could use a presence in the large U.S. market. It is an established market with a large customer base.

Where e-cigarettes fit in
Despite the growth of e-cigarettes, the tobacco industry is still facing the major problem of declining sales volumes in traditional cigarettes, and mergers and acquisitions may well be the solution to this problem. With speculation crediting British American with a war chest running into the billions of dollars, any kind of combination is possible.

In March, speculation had it that Reynolds American was interested in acquiring Lorillard for more than $20 billion. Once the standstill agreement expires, British American could pursue Reynolds and then pursue Lorillard. It is also within the realms of possibility that British American could allow Reynolds to acquire Lorillard and then acquire the merged companies at a later stage.

A major factor in all of this is going to be the e-cigarettes market in which Lorillard's blu eCig is the biggest name, with a market share of 45%; but, later this year, both Reynolds and Altria are planning to launch their own national brands. British American Tobacco has its own e-cigarette, Vype.

How shares stack up
The dividend yields in the tobacco industry are robust. British American Tobacco pays one of the highest yields in the industry at 5.6%. It also trades at a P/E ratio of 15.3 based on next year's earnings estimates. Meanwhile, Lorillard and Reynolds American have dividend yields below that, at 4.6% and 4.1%, respectively. Each also trades at a higher forward P/E ratio, with Lorillard trading at 19.9 and Reynolds American at 16.2.

Bottom line
Despite all these problems, smoking continues to be a highly addictive habit, and smokers still buy tobacco products despite the rising prices. The strong cash flows of the industry mean that companies offer very high dividend yields. British American Tobacco offers a strong international presence, and it could end up capitalizing on the Reynolds-Lorillard merger. For investors looking to play the tobacco industry, British American is worth a closer look.

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