Reynolds American Inc Gains $5 Billion in a Lopsided Deal With Japan Tobacco

Reynolds American (RAI) recently sold the non-U.S. rights to its Natural American Spirit cigarette brand to Japan Tobacco for about $5 billion. The deal will help Japan Tobacco expand beyond the declining Japanese market, and help Reynolds reduce its debt after its $25 billion purchase of Lorillard in June.

Some analysts, however, questioned the premium that Japan Tobacco paid for the brand, which equaled around 250 times the pre-tax profit of the Natural American Spirit brand in non-U.S. markets last year. Credit Suisse analyst Masashi Mori pointed out that Reynolds' brands were popular among smokers in their 20s and 30s -- where Japan Tobacco lacks a strong market presence -- but he didn't think that the price was justified.

Natural American Spirit. Source: Reynolds American.

What this deal means for Reynolds American
RBC Capital Markets estimates that Reynolds will receive about $3.5 billion after taxes from the deal. RBC analyst Nik Modi told the Wall Street Journal that the deal would likely help Reynolds pay down the $3.5 billion in debt it assumed from Lorillard "more quickly than investors expected."

The payment is also expected to reduce Reynolds' annual interest expenses by $150 million, and boost earnings by $0.07 a share in 2017. Those savings also complement the recent expiration of the Tobacco Transition Payment Program (subsidies to tobacco farmers), which Reynolds spent $583 million on during the past three years.

Reynolds will continue selling Natural American Spirit cigarettes in the U.S. Natural American Spirit is nowhere as popular as Reynolds' flagship Camel brand, but it remains one of the top-10-selling cigarettes by volume in the U.S., with a market share of 1.8%. Sales of the brand rose from $289 million in 2009 to $658 million in 2014, when it accounted for nearly 8% of Reynolds' top line.

Like its main rival Altria (MO 1.14%), Reynolds is primarily focused on the U.S. market. Reynolds only employs around 280 people in Europe and Japan, and stated that it had "immaterial exposure" to foreign currency fluctuations last quarter. Therefore, selling a tiny overseas business to pay off Lorillard's debt was a fairly simple choice.

What this deal means for Japan Tobacco
This isn't the first time Japan Tobacco purchased Reynolds brands. Back in 1999, it acquired the non-U.S. rights to Camel, Winston, and several other brands from Reynolds' predecessor, RJR Nabisco, for about $7.8 billion. It also purchased additional brands from British tobacco company Gallaher for $18.8 billion in 2007.

Those brands greatly expanded Japan Tobacco's international business, which accounted for 55% of its top line last year, compared to 28% for its Japanese business. During the past 25 years, the percentage of Japanese male smokers has declined from 60% to 30%. The percentage of female smokers dropped from 14% to 10% during that same period.

Natural American Spirit often appeals to younger smokers because most of its styles are made from additive-free blends, which only consist of organic tobacco and water. However, that distinction also makes it pricier than most mainstream brands. Japan Tobacco will also gain Reynolds' established sales infrastructure, saving it the trouble of hiring new employees.

Compare and contrast
Reynolds American's and Japan Tobacco's moves highlight interesting contrasts within the tobacco industry. First and foremost, the U.S. tobacco market has been in favor lately, thanks to lower gas prices and higher consumer-spending power. As a result, U.S. leaders Reynolds and Altria didn't have to drastically hike prices to offset slower shipments. Reynolds and Altria are also well protected from overseas currency fluctuations.

Meanwhile, Japan Tobacco evolved from a single-country player into a worldwide one, which is exactly the opposite of Altria's strategy. Altria spun off its international operations as Philip Morris International (PM 0.31%) in 2008, intending for the former to handle domestic litigation and slower demand, and for the latter to expand into stronger overseas markets. PMI initially posted stronger growth than Altria, but the tables turned after emerging markets weakened, and the U.S. dollar spiked.

Single-country U.S. players have recently fared much better than the multinational ones. Shares of Reynolds and Altria have respectively risen 53% and 20% during the past 12 months compared to Japan Tobacco's 15% gain, and PMI's 3% decline. Japan Tobacco has outperformed PMI because the yen remains fairly weak to the dollar.

The key takeaway
In a previous article, I stated that Reynolds American was a great "all-American" stock with a hefty forward annual dividend yield of 3.2%. I still stand by that statement, and believe that the company's market-leading position in e-cigarettes, its recent acquisition of Lorillard, and an uncanny ability to sell overseas rights to its brands for billions make it a solid long-term investment.